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r150918a_BOA

australia

stevens

Members of the Committee Thank you for the opportunity to meet with you today. The Australian economy continues to progress through a major adjustment, in the midst of testing international circumstances. The terms of trade have been falling for four years and have declined by a third since their peak - though that was a very, very high peak. They are now back to about the same level as in 2006 - still about above their 20th century average level. Resources sector capital spending has been following the terms of trade with a lag. From an extraordinarily high peak - at about of GDP, nearly three times the peaks seen in most previous upswings - this investment has been falling for about two and a half years. By the time it is finished, this decline will probably total something like of GDP. We are probably now about halfway through the decline. It is having a predictable impact on those industries and regions that had earlier experienced the effects of the boom. Resources sector exports have risen strongly as the greater capacity resulting from all the investment has been put to use. Australia now exports around three times the volume of iron ore that it did a decade ago, and around twice as much coal. A very large rise in exports of natural gas is in prospect over the next few years. Outside the mining sector and parts of the economy most directly exposed to it, there are signs that conditions have been very gradually improving. Survey-based measures of business conditions have been a bit above their longer-run average levels for some time now, and the most recent readings are about where they were in 2010. A few of the non-mining sectors have shown quite marked improvements over the past twelve months. To this we can add that the overall number of job vacancies in the economy has been increasing, even as employment opportunities in mining and some other areas diminish. The increase has not been rapid, but nonetheless the trend has clearly been upward for about two years. Since this time last year, moreover, we have seen a rise of about 200,000, or about , in employment. The labour force participation rate and the ratio of employment to population have both started to increase. The rate of unemployment, though variable from month to month, seems to have stopped rising, and it is at a level a bit lower than we had thought, six months ago, it might reach. Of course, this performance is not uniform geographically or by industry. The two large south-eastern states show the largest increases in demand and employment, and dwelling prices, while conditions elsewhere are more subdued. By industry, the rise in employment has been strongest in services, especially those types of services delivered to households, though business services activities have also added to employment over the past year. Monetary policy is seeking to support this transition, something it can do because inflation remains low. Very low interest rates, coupled with financial institutions wanting to lend, have played a part in the improvement in conditions in some sectors. Residential construction is running at very high levels, households are adding a little less of their incomes to savings and savers have been searching for higher returns. These are all indications of easy money at work. Cognisant of the risk that very low interest rates may foster a worrying debt build-up, regulatory initiatives are in place to maintain sound lending standards and capital adequacy. I hasten to add that the objective of such tools is not to control dwelling prices, but to contain leverage. The evidence is emerging that they are doing their job. More recently, the significant decline in the exchange rate is starting to have more discernible effects on the pattern of spending and production. The decline over the past two years amounts to about against a rising US dollar and against the trade-weighted basket. We are hearing about the effects of this in our liaison and also seeing it in the data on such things as tourism flows as well as exports of business services. This is to be expected as the exchange rate adjusts to the change in the terms of trade. Over the year to June, real GDP grew by . This was in line with our forecast of three months ago and at the lower end of our forecast range from a year ago. The effect of unusual weather conditions on exports meant that GDP as measured exaggerates both the strength in the March quarter and the weakness in the June quarter. There are still some puzzles in reconciling what has happened to real GDP with what has happened to employment and indications from business surveys. Hopefully, those puzzles will be resolved over time. Nonetheless, what is pretty clear is that the economy is growing, albeit not as fast as we would like, the adjustment to the decline in the terms of trade is well advanced, and non-mining activity is improving rather than deteriorating. If the latter trend continues, it is credible to think that we can achieve better output growth, particularly as we reach the later phases of the decline in mining investment. This is what is needed to bring down the unemployment rate. As always, global factors will be important and the international setting continues to be a rather complex one. Since the last hearing, growth in the Chinese economy has continued to moderate. Growth in other parts of Asia was also weaker around the middle of the year. Reflecting these outcomes, forecasts for global growth over the period ahead are a little lower than they were six months ago. That was the backdrop for a period of volatility in some financial markets. The unwinding of an equity market bubble in China appears to have served as the proximate trigger for a revision of equity valuations around the world. Risk appetite diminished somewhat and the currencies of many emerging market economies came under downward pressure. Whether that financial volatility itself will serve further to dampen global growth prospects remains to be seen. Sometimes such events portend a wider set of economic events, but just as often, they don't. In the present instance, it is important to stress that long-term debt markets and core funding markets for financial institutions have not been impaired. These markets remain open and it is still the case that highly rated private borrowers and most sovereigns can borrow at remarkably low cost. Things could change, but at present we do not see anything approaching the dislocation of funding channels seen in serious crises. To be sure, emerging market countries are under some pressure and some of them have specific problems that are being recognised by markets. At the same time, though, many emerging market countries have done quite a bit to improve their resilience over the years. It's also worth noting that performance in the Unites States continues to improve. Everyone knows that, eventually, this will have to be reflected in less accommodative US monetary policy. Some fretting about the first increase in US interest rates for nine years is to be expected, no matter how well telegraphed it has been. The more important factor, though, will be the pace of subsequent increases. The Federal Reserve has indicated this is expected to be very gradual, but of course that will depend on what happens with the US economy. There is a degree of irreducible uncertainty here and hence the possibility of further financial market volatility at some point. Overall though, it seems very likely that global interest rates will still be quite low for quite some time yet. For Australia, we cannot, of course, determine our terms of trade or other forces in the global economy. We can only adjust to them. The record of adjustment in recent years is good. We negotiated the financial crisis without a major financial crisis of our own or a big downturn in economic activity. We negotiated the first two phases of the resources boom without major inflationary problems, and are part way through our adjustment to the third phase - so far without a major slump in overall economic activity. There is still a pretty good chance that we will come out of this episode fairly well, and much better than we came out of previous episodes of this type. I now turn briefly to another area of the Bank's responsibilities, namely the payments system. The New Payments Platform (NPP) will enable real-time, data-rich payments on a 24/7 basis for households, businesses and government agencies. The Payments System Board, having worked to facilitate the process of the private sector coming together to drive this project, supports the industry's efforts. The Reserve Bank itself is making good progress in its own part in this project. In the card payments area, the Bank has announced a review and we released an Issues Paper in early March. Among other things, the review contemplates the potential for changes to the regulation of card surcharges and interchange fees. It provides an opportunity to consider some of the issues raised in the Financial System Inquiry. As usual, the Bank has been consulting widely, including via a roundtable in June that included representatives from over 30 interested organisations. The Payments System Board has asked the staff to liaise with industry participants on the possible 'designation' of certain card systems. A decision to designate a system is the first of a number of steps the Bank must take to exercise any of its regulatory powers in respect of a payment system, but does not commit it to a regulatory course of action. The Payments System Board will have further discussions on the case for changes to the regulatory framework at future meetings. In the event that the Board were to propose changes to the regulatory framework, the Bank would, as usual, undertake a thorough consultation process on any draft standards. In our financial stability role, a focus has been on central counterparties, which facilitate efficient and safe clearing of some types of financial transactions. These entities are increasingly important given the way global regulatory standards have been moving. The Bank has focused on ensuring their risk management meets the highest standards and that they have the capacity to recover from financial shocks. We have also done a lot of work to ensure that our regulatory framework is appropriately recognised by regulators in other jurisdictions, which is important if we are to keep the Australian financial system connected with the global system. With those remarks, Chair, my colleagues and I await your questions.

r151105a_BOA

australia

stevens

Thank you for the opportunity to take part in this conference. The previous occasion on which I spoke at this event was six years ago (to the day, as it happens) in 2009. That conference carried the title 'The Road to Recovery'. The background was that we had experienced a downturn in the economy at the end of 2008, at a time when the global economy went into a serious recession. For some months thereafter public discussion about the economy contained a good deal of fretting and debate over whether the word 'recession' should be used to describe conditions in Australia. I certainly used the term myself. But by November 2009, it was pretty clear that the recession had been short and shallow, and that we were in fact already on the road to recovery. The issue then was managing the next phase - ensuring that the road to recovery joined the path to prosperity. At that stage, of course, what has been referred to as 'mining boom mark II' still lay ahead. The terms of trade had fallen by close to 20 per cent from their 2008 peak, but had stabilised. They would rise by 40 per cent over the ensuing two years. Resources sector capital spending declined over 2009 but would more than double over the next several years, reaching the highest share of GDP for at least 150 years. These were much bigger increases than we expected at the time. An unusually long and strong search for yield in global capital markets, driven by ultra-easy monetary policy in the major jurisdictions, was just beginning. By and large this continues today, perhaps more so than we would all have hoped in 2009. The European crisis, which would challenge the very foundations of the European project, was, in late 2009, still to come. So there were some surprises in store over the ensuing six years. Nonetheless, some of the features of that next phase and the issues in managing it were reasonably apparent. It was clear that the remarkable growth of China was a powerful force and that Australia was becoming much more exposed to that growth - which was a good thing, but not without some risks. It was clear that there would need to be a focus on structural reform. It was clear that improving housing supply for a growing population and infrastructure for a growing economy generally would be a key theme. It was clear that there would need to be a significant effort at restoring the state of the budget, so that fiscal expansion would again be possible in the face of a future shock, as it was in 2008 and 2009. All these things were said at the time. Where are we, then, six years on? The world economy, despite various threats, has not had a relapse into recession. Even with something of a slowing this year, global growth is still proceeding at a moderate pace. That said, this growth has taken extraordinary policy settings to achieve and many policymakers and observers find the outcomes disappointing. Most countries around the world would like some more growth. But they can't all get it by just exporting to others and focusing their own demand inwards. And, for a variety of reasons, policymakers are finding the effectiveness of policies aimed at boosting domestic demand more limited than they might have hoped. In some cases the efforts that have been made to foster growth have not been without a degree of risk. For our part in Australia, we have managed the biggest terms of trade event for more than a century with, so far, some success. History has many examples of such booms that, ultimately, were not successfully managed and which ended badly. It's easy to see how that happens. A gift of higher national income comes our way as a result of the discovery of natural resources or a rise in demand for them. The higher income permeates through the economy and before long even industries and regions not directly exposed to that shock are feeling good. Human nature being what it is, we tend to assume that the good times will continue and we borrow and spend accordingly. Credit growth speeds up, leverage increases, usually inflation increases. And then the terms of trade turn down, at which point the whole process goes into reverse - and a serious downturn ensues. The current episode is not yet over. But from what we can observe thus far, we can say two things. First, we did not see the same excesses on the upswing as we did in other similar episodes. This has to put us in a better position to manage the inevitable down phase. Second, in the down phase we are still managing to grow. We are probably roughly halfway through the decline in resources sector capital spending now; the headwinds from that source are about as intense now as they are likely to get. We are still growing. It would be good if the growth was a bit stronger, but nonetheless over the past year the non-mining side of the economy has generated respectable growth in employment. The 'rebalancing' is occurring. It isn't as seamless as it would be in an ideal world, but we don't live in such a world. Monetary policy is contributing to that rebalancing, consistent with its mandate, with a very accommodative stance. It seems likely that an accommodative stance will be appropriate for some time yet. Were a change to monetary policy to be required in the near term, it would almost certainly be an easing, not a tightening. The rate of CPI inflation is clearly no impediment to easing. The housing market may be calming, lessening risks from that source, though by how much and how persistently we cannot yet know. This is perhaps an opportune moment to offer some observations about the recent change in mortgage interest rates on the part of the major, and some smaller, banks and in particular the question of whether the Reserve Bank should respond to it with a decline in the cash rate. On some other occasions, the Reserve Bank has moved the cash rate by more than otherwise to take account of changes in the relationship between the cash rate and other interest rates. One such occasion was in May 2012, when the Reserve Bank Board wished to ensure that the economy received a worthwhile stimulus from a policy easing after a period in which lending rates had tended to increase even while the cash rate had been steady. The Board wanted to make sure that financial conditions would move to a clearly easier position than they had been when the cash rate had previously been lowered, five months earlier. So on that occasion the Board decided on a larger than normal reduction in the cash rate. The question that is relevant for the Reserve Bank Board at present is, first and foremost, whether the recent changes in mortgage rates result in an effective set of financial conditions that is 'too tight' for the economy. In addressing that question, it's worth noting that over the course of 2014 and 2015, effective rates on most loans tended to decline by more than the cash rate, reflecting both declining funding costs and increased competition to lend. For fixed rate mortgages and many business loan rates the fall was quite marked. The average rate on outstanding business loans, for example, fell by over 90 basis points during a period in which the cash rate fell by 50 basis points. Even for floating rate mortgages, rates had fallen a bit more than the cash rate. The actions of those banks that have lifted mortgage rates over recent weeks reverse a little under half of this year's decline for floating rate mortgages for owner-occupiers and have no effect, at this stage, on the 15 per cent of loans with fixed rates. For investors in housing, these actions and those a month or two earlier reverse the effects of this year's monetary policy easing but, of course, this was the lending that had been growing most quickly. Business loan rates have not risen. Measuring across the total loan book, the recent actions are the equivalent of roughly half of one 25 basis point monetary policy change. They take back perhaps a quarter of the extent of interest rate easing seen since the start of this year, and a smaller proportion of the total easing in lending costs seen over the past two years. For mortgages, this increase is from the lowest rates that any current borrower will have ever seen. As it is, there are still a number of mortgage products with rates not much above 4 per cent, even a few advertising a '3' before the decimal point. We also note that a significant proportion of owner occupier households is ahead of schedule on mortgage repayments - in large part because these households did not lower their payments as interest rates fell. Most of these households are unlikely to need to part with extra cash each month as a result of the recent interest rate changes. (Equally, many of these households were probably not boosting spending as interest rates fell, instead allowing their loan principal to fall faster.) As for the general environment, according to business surveys conditions outside mining have been slowly improving, not deteriorating. So it is not as though the increases in mortgage rates are compounding the effects of a serious deterioration in economic conditions overall. Could the 'shock' value of the rises in mortgage rates itself lead to a significant change in that trend, gentle as it is, of improvement? While such an outcome is perhaps conceivable, given the starting point and all the above considerations, it seems to me a bit of a leap to draw that conclusion. At this point, then, my preliminary assessment is that the macroeconomic effect of these actions in themselves may not be large. It is one part of a much bigger and evolving landscape. Nonetheless, the Reserve Bank Board will keep this matter, and that broader landscape, under careful review. Let me be clear that in making these comments I am not offering an endorsement of the banks' actions. Nor should an assumption that shareholder returns must not decline as a result of the effects of supervisory measures, or any other factor, simply be accepted without question. The 'right' rate of return for bank shareholders is, as others have observed, an open question. It is not a constant of the universe. Returning then to the general theme of 'where are we, six years on?', my next observation is that many of the points that were being made at that time remain as relevant today as they were then. The Australian economy's exposure to China has increased, as was understood then. So China's prospects matter more. The current rate of growth of the Chinese economy is uncertain, as is its future growth rate. Chinese policymakers are attempting a profound transition in the growth model while dealing with some legacy issues (such as a substantial debt build-up) arising from the previous model. It is likely that the marginal steel intensity of China's growth will be lower in future than in the past. Some suggest that Chinese steel consumption, which has fallen this year, may continue to do so. At the same time, the marginal propensity of the Chinese people to consume services is rising noticeably. So the challenge for Australian resource producers to be the most efficient suppliers in a world of slower growth in demand for resources will co-exist with greater opportunities for other firms to offer value added in services. The challenges of adjusting the responsiveness of our economy and developing its infrastructure, noted six years ago, are still relevant. To say this is not at all a suggestion that nothing has been done in the interim, but the importance of productivity performance for growth in living standards has become progressively clearer as the terms of trade have fallen. The effects of population ageing, moreover, while slow moving, are now occurring. There is perhaps more of an edge in the productivity discussion just lately, as there should be. On infrastructure, there are some encouraging developments and a degree of expectation is building. Without wanting to dampen the enthusiasm in any way, I simply repeat that the key issue is not funding. The key issues are: governance, appropriate risk sharing and pricing. The need for medium-term budget repair also remains. Here also progress has been made, and the budget deficit at present still compares favourably with what we see in many other countries. But my sense is that a fair bit of the necessary national conversation about how we pay for all the things we have voted for lies ahead. This doesn't imply a need for radical immediate action, but I suspect it does mean an unusually long period of tight budget discipline on recurrent spending is likely to be required. Perhaps the main message is that the nature of the path to prosperity doesn't seem much different today from what it was six years ago. Macroeconomic policies can provide a measure of counter-cyclical stabilisation, but they can't serve as a magic bullet to achieve sustained growth in living standards. And with the terms of trade-driven improvements now behind us - and at least partly reversing - productivity is the main game. Gains in productivity come in part from improvements to the way we do the things we currently do, in part from stopping doing things we are not very good at and doing more of things we are good at. It's understandable that this is often seen as a threatening notion and it is certainly disruptive when adjustment has to happen in a short period. It is unrealistic, though, to think the pressure to adjust will simply go away. But equally importantly, gains will come from doing completely new things - the provision of new products to meet people's changing desires and needs. These will also, in time, be sources of major employment opportunities. The answer to the question 'where will the jobs come from?' is usually: from lots of places we haven't thought of yet. Many of the jobs in the economy today are in activities that few predicted 25 years ago. Few would have foreseen the vast growth in employment in a range of industries that provide services to both households and businesses. For example, employment associated with computer system design and related services has quadrupled as a share of total employment over the past 25 years. Few would have anticipated the rapid rise in employment related to social media, cloud computing and the creation of apps or other services related to environmental sustainability, to take just a few examples. It will also surely be the case in the future that jobs will come from unexpected places and new occupations will continue to emerge. The questions then are whether Australian businesses and their workforces have, or can acquire, the necessary capabilities to offer those services and perform those jobs; whether the incentives they face to do so are adequate; whether the public policy framework appropriately encourages risk-taking and entrepreneurship; and so on. No doubt various aspects of 'reform' are needed to ensure the answers to such questions are in the affirmative. As on other occasions when 'reform' has been discussed of late, my suggestion would be that such reforms are most likely to succeed - that is, to be implemented in a durable fashion - when the conversation is framed within a narrative about growth. Hopefully your deliberations today will contribute to that narrative.

r151124a_BOA

australia

stevens

Thank you for the opportunity to address you this evening. You've spent all afternoon talking about the near-term outlook. No doubt there was a lively discussion and some points of debate. I would hazard a guess that most forecasts have the Australian economy continuing to expand at a moderate pace, with inflation low and the rate of unemployment around 6 per cent. The points of debate might be around whether, and when, growth might speed up a bit or slow down; whether inflation would be broadly consistent with the 2-3 per cent target or a bit on the low side; and whether unemployment could start to drift down, or instead, might resume its drift up. The Reserve Bank released its own views about the outlook a few weeks ago. These left the forecast for growth about where it was before. Over the next couple of years, as the drag from the decline in mining investment starts to lessen (mainly in 2016/17), and the effects of assumed low levels of interest rates and the exchange rate continue to accrue, growth is thought likely to pick up a bit. A number of data points over recent months suggest that prospects for firmer conditions in the non-mining economy are improving. Business surveys indicate that firms report conditions to be, if anything, above their long-term average in some key sectors. Firms seem to have stepped up their hiring. Job vacancies have been increasing, hours worked have been increasing and employment growth, even before the most recent month's data, had strengthened noticeably over the past year. Labour force participation has risen, and the unemployment rate has been stable. This is supporting income growth as the terms of trade decline works its way through the economy. The Bank did lower its forecast for inflation a little. This was based on an assessment that the latest reading contained some signal, not just noise. As in the case of many other countries, the effects of a decline in the exchange rate are proving a bit slow to come through. And slow wage growth makes for a low underlying rate of increase in domestic costs. On this basis, the Board concluded that inflation would not be a barrier to further easing of monetary policy, should that be useful to support demand. But there is little numerical precision that can be attached to these rather qualitative views. For a few years now the Bank has sought to emphasise the idea of the outlook being probabilistic. The 'central forecast' is simply the modal point of a distribution of possible outcomes. It is more likely, in our judgement, than any other single outcome, but the likelihood of that particular outcome is in fact not that high at all. We have tried to convey this sense of imprecision by publishing 'fan charts' and by putting ranges in tables for forecast variables over horizons longer than a couple of quarters. The point of this is to try to get people to focus less on the central number and more on the set of issues that accompany the forecasts. It seems that we have not been very successful on that score. There still seems to be inordinate attention paid to changes in the central forecast that are often no more than a couple of tenths of a percentage point. I've debated at times with our staff whether we should leave the central line off the fan charts altogether. The response is that people would simply back it out of the charts. Likewise, the desire I often feel to put wider ranges in the forecasts would probably still result in people just computing the mid-point of the range, ascertaining whether that had moved slightly and offering interpretation of that change. It's a natural human tendency to focus overly on small changes, perhaps because it allows us to maintain the comfortable illusion that things are predictable and controllable. But this fervent desire for precision is not supported by any demonstrated accuracy of economic forecasts. Its cousin, a hankering for policy fine-tuning, is barely, if at all, better supported by the historical outcomes of economic policymaking. While small forecast changes get a lot of attention, the far more important question is whether we have recognised and understood the big forces at work. Even if we cannot predict the outcomes with great accuracy, an understanding of these forces ought to help us get policy responses roughly right. And that, in the real world, is probably about as much as we dare hope. Right now the big forces include: To this list of 'conventional' forces we might add: Many of these sorts of forces are low-frequency in their nature. Most of the ups and downs in the time series from month to month, or even year to year, on which we all expend so much energy are just temporary fluctuations around these longer-run trends. If numerical forecasts can't be very dependable, are we - the economics community - much good at predicting these long-run forces? If we look back a decade, to the sorts of things that occupied much attention, the evidence is mixed. By the middle of last decade, we had certainly noticed the change in household borrowing and spending behaviour, understood that it was important and wondered how long it could continue, and what might cause it to alter course again. In that respect, we were at least looking in one of the right places. People had also sensed that the emergence of China was starting to have important implications for Australia and the global economy. That said, the strength and duration of the 'China boom' tended to be under-estimated. In forecasts made over a succession of years, people routinely tended to expect that the strong growth then being observed in China would slow. Likewise, through most of the period in which Australia's terms of trade were rising, forecasters routinely tended to call a near-term peak followed by a decline - and were wrong in most years. Even those resource companies that would eventually make massive investments on the back of the rise in commodity prices were initially sceptical. Now, as this period of exceptional, and not well forecast, Chinese growth has ended and we face less spectacular outcomes, a few have been surprised on the downside. A decade ago, everyone was celebrating the 'great moderation' - that period of reduced macroeconomic volatility, good average growth and low inflation. This was regarded as a success of macroeconomic policy. It was also thought that the development of modern financial tools, with fairly light regulation, had helped us to understand, unbundle and disperse risk around the system. To be fair, there were some voices questioning compressed risk spreads, leverage and so on. Some worried about the complex interactions between the various players and how the system would cope in a stressed environment. Some wondered whether apparent stability would lead people to take on leverage to the point where it would threaten that very stability. A few presciently placed financial bets against the prevailing trend. But, overall, very few foresaw either the severity of the crisis that would unfold or the longevity of its adverse economic effects. If we look at what featured in most discussions about risks to global growth at the time, we find that the so-called 'global imbalances' were prominent. It was not uncommon to hear people worry that markets would at some point decline to 'fund' the US current account deficit, leading to a crash in the US dollar. Yet it wasn't the global imbalances that caused a crisis. It was the implosion of complex financial products, against the backdrop of excessive leverage, that ushered in the crisis. It was the drying up of dollar funding liquidity in the financial systems of several major countries that propagated it. The onset of the crisis saw a shortage of dollars in the market, not a glut. And the 'global imbalances' continue today, though they have diminished in size. A decade ago, Japan was experiencing deflation, 'ZIRP' - zero interest rate policy - and 'QE' - quantitative easing. People offered various analyses of this; many opined that it should not be that hard for the central bank to return to inflation, by sufficiently aggressive action. Thoughtful people pondered the difficulties Japanese policymakers confronted and hoped never to find themselves in that situation. Ten years on, policy interest rates have been effectively zero in the United States, the United Kingdom and Europe for quite a long time. They are still zero in Japan. 'Quantitative Easing' by one name or another has become more widespread. Central bank balance sheets in these cases are a multiple of their sizes in the mid 2000s. I recall few, if any, who a decade ago saw that outcome as having a significant probability. While outright deflation is still comparatively rare, inflation being a bit too low relative to announced objectives seems to be not uncommon. It is difficult to avoid the conclusion that, in practice, it is more difficult than the textbook says it should be for a central bank (by itself) to create inflation, when other powerful forces are at work. For economists and policymakers trained from the 1960s to the 1990s, when the task was always to stop inflation rising and/or to get it down, this is a remarkable outcome. One area in which good long-term thinking was being done a decade ago was population ageing. Australian work in this field foreshadowed adverse long-run trends in the fiscal balance. And we can find GDP growth projections from Intergenerational Reports from a decade ago that put average growth between 2010/11 and 2015/16 at 2 3/4 per cent, noticeably below the growth rates being observed at the time this projection was made. That was not a bad 'forecast', actually: the outcome is likely to be about 2 1/2 per cent. This is despite the fact that the people who made this estimate obviously could not have had any knowledge of many of the non-demographic forces that would be at work over the relevant years. One can't help but observe that, in common discussion about the economic outlook, we too often ignore the influence of demography. But it may be that demographic forces are a common factor behind some of the most important 'big force' developments. It seems likely that the characteristics of the 'baby boom' cohort - its relative size and different propensities from those of other generations - have affected saving and investment choices, housing markets, asset values, leverage and so on through time. Further effects no doubt will occur (not necessarily in the same direction). What then might be some of the 'big forces' at work over the next decade? Perhaps unwisely, I shall chance my arm at some ideas. In so doing, I am comforted by the very low likelihood that I shall have to return to a future ABE forecasting conference to explain why these prognostications were wrong! It is not very controversial to suggest that China will grow more slowly on average than in the past decade, but it will still be a big deal given its overall size the extent of transition required in its growth strategy. China's financial weight will be increasingly apparent in markets. Those days, like in late August this year, when US and global markets are roiled by some event in China, will probably become more common. The growth transition towards services will have implications not just for the value of resource shipments from Australia, but for the Asian regional manufacturing chain. But China's demographics are not favourable. To be sure, the continuing process of urbanisation means that the labour available for manufacturing or services production may grow for a while. But, overall, China's total working-age population will be shrinking over the years ahead. Contrast this with India, another large country, but with vastly different demographics. India's population of working age will exceed China's within a decade and continue to grow. So India should become much more prominent in our conversation about the global economy and our own. Are we intellectually prepared for that? The United States will still be a very large economy and, perhaps more important, still a leading source of innovation and dynamism. It will probably retain its current position of global leadership in international economic governance, though much depends on how two political establishments - the US's and China's - behave, including towards each other. There are no prizes for guessing that the share of services in most economies will continue to increase. Health and aged care are obvious areas for expansion - another effect of demographics. It may be that jobs will be 'robotised'. But on the other hand, in the long run we may need that to some extent. Demographic factors suggest strongly that, all other things equal, the problem isn't going to be a shortage of jobs, but instead a shortage of workers. 'Digital disruption' will continue. Some of this will be faddish and no great aid to productivity. But other elements will mean fundamental changes to business models. It's already obvious that models that rely on having an information advantage over a customer are struggling as information becomes ubiquitous. Models that can profit by using more information the customer will be advantaged - up to the point at which customers decline to reveal any more about themselves. The issue of trust will be key. On that note, I suspect the already-considerable resources devoted to IT security will grow further as awareness increases of cyber risk and its consequences. Maybe IT security will need to get as inconvenient as airport security and more costly - a whole new meaning of the term 'digital disruption'. It remains to be seen whether, at some point, the potential risks of further connectedness might be judged to outweigh the benefits. There are, for example, some organisations sufficiently concerned about cyber risk that they construct a duplicated IT architecture - one connected to the world, the other sealed off. The issue of trust in cyber space may turn out to be every bit as problematic as that of trust in the financial system. My guess is that global interest rates are still going to be very low for a good part of the decade ahead. Clearly there is a likelihood that the Federal Reserve will raise the fed funds rate next month or, if not then, pretty soon. Once it does, intense speculation will begin about a question much more important than the timing of the first increase, namely the timing of the second (and, by extension, the future path of the funds rate). But it seems likely that the pace of increase will be very gradual. The ECB and the Bank of Japan are a long way from even thinking about higher interest rates; the ECB is openly contemplating further easing. So the average policy rate in major money centres may be very low for quite a while. In a low interest rate world, the problems of providing retirement incomes will become ever more prominent. The very low level of yields on fixed income assets means that it is very expensive today to purchase a secure stream of future income, which is what someone who is retiring is usually seeking. And there are more of such people, living longer. The retiree can of course respond to this by holding more of her portfolio in dividend-paying stocks - accepting more risk. She may hope for a dividend stream that is fairly stable from year to year but that tends to grow over time. It certainly seems that many Australian listed corporates feel the pressure from shareholders to deliver that, even some whose earnings are inherently volatile. Can the corporate sector realistically promise growing dividends over a long period? Not without being prepared to take the risk on investment in new products, processes and markets. How much of that risk an older shareholder base will allow boards and managements of listed entities to take is an important question. Overall, in a world where a higher proportion of the population wants to be retired and living (even if only in part) off the return on their savings, those returns are likely, all other things equal, to be lower. Part and parcel of the same adjustment may be higher real wages for the smaller proportion of the population that is working. These changes, driven by demographics, may require some adjustment to our collective thinking about what is 'normal', not just for rates of return on assets but also for returns to labour. My final, fairly uncontroversial predictions: So there will continue to be interest in forecasts, and the ABE forecasting conference will, I'm sure, go from strength to strength. Thank you.

r151202a_BOA

australia

stevens

It is very good to be back in Perth. As you know, the Reserve Bank Board held its meeting here yesterday. We decided to leave the cash rate at 2 per cent. The reasoning was given with the decision, and so I don't propose to discuss that. Instead I want to reflect on the nature of the adjustments going on in the economy, and in which Western Australia is very important. It is four years since the Board last met here. The previous occasion was in September 2011. I don't need to tell you that quite a lot has changed in the intervening period. At that time, the price of a tonne of iron ore was about US$170. A tonne of hard coking coal was bringing in about US$300. These were among the prices that saw Australia's terms of trade soar to a level some 75 per cent above their average for the preceding century. Few countries have seen such a windfall. These extraordinary prices had already, by that time, triggered a massive investment program, which was lifting capacity. Four years ago, Australia was shipping about a million tonnes of iron ore each day, which was already double the rate of 2004. A bit under a million tonnes of coal left our shores daily. By 2011, capital spending by the resources sector had already roughly trebled since 2005. It would peak the following year after rising by a further 50 per cent. The results of that investment have come on stream, or soon will. Today, Australia ships around 2 million tonnes of iron ore and 1 million tonnes of coal per day. The investment was not just in iron ore and coal. On forecasts of strong demand from Asia - not just China but Korea and Japan as well - massive investments are under way in gas. LNG exports have begun from some of the Queensland projects and are expected to increase strongly over the coming years. As the WA projects come on line in the next few years, Australia's total LNG production capacity will reach over 80 million tonnes per year. This compares with a production capacity of around 10 million tonnes a decade ago. I should note in passing here that I have felt that we have been given a pretty good steer on the magnitude of the investment build-up and the early stages of the reversal, on the back of the very good work done by our regional liaison people, especially here in Perth. As a result, we've been much better at forecasting investment in the resources sector than in the other industries. That's because of the help we were given by the large players in the resources industry. I know that many of you have participated in these discussions, which have been extremely helpful in understanding the nature of the episode. So I want to thank you for helping in that way. As it happens, about the time the Board was meeting here in 2011, resource prices and Australia's terms of trade were about at their peak. And what a peak it was. On a ten-year average basis, the terms of trade exceeded anything seen for at least a century. This was not just a very brief spike like some commodity price events have been (such as the early 1950s rise in the price of wool). It was quite persistent. Not permanent, but quite persistent. Nonetheless, the peak was four years ago. Since then, as you know, prices have fallen considerably. Today the price of iron ore is about US$40 per tonne, and coking coal around US$75. At a national level, Australia's terms of trade, having been through an extraordinary surge, have fallen by a third and are still declining. But even at those reduced prices, iron ore is still bringing a price 60 per cent higher than it did in 2000. Natural gas prices are 50 per cent or more above their 2000 level. The terms of trade, though down a long way from the peak, are still nearly 30 per cent higher than their 20th century average. Of course they may yet fall further. Time will tell. In the meantime, many resource companies are making significant strides in reducing their production costs so as to remain viable, and in some cases still very profitable, at these reduced prices. That's consistent with most experience in the long history of the resources business. Australia's presence in these markets is greater now. It would be true to say that, though weaker demand is part of the story, a significant part of the fall in prices is a result of increased supply from this continent. The 'super-cycle' in commodity prices, and the associated surge in capital spending, have been of national and international significance. At times, the price of iron ore has even, on occasion, displaced from page one of newspapers the price on which Australians typically focus most intensely - that of a house. The spill-overs of these activities have been felt around the country. For the fifty years up to 2005, resources sector investment had averaged just over 1 1/2 per cent of national GDP. Periodically, in a boom it tended to reach a peak of perhaps of GDP. This peak was about 8 per cent - nearly three times the size of the 'normal' peak, and easily the biggest such surge for over a century. The resources sector was doing 40 per cent of the nation's total business capital spending. And, as you know, a big share of that was occurring here in WA. On other occasions, these types of events have ended up being very disruptive for the national economy. Terms of trade surges in the 1950s and the 1970s produced significant inflation on the way up and were followed by very major slowdowns or recessions in economic activity as the terms of trade fell back. That hasn't happened at a national level on this occasion. Inflationary pressure was relatively contained on the way up, and while aggregate growth has been a little disappointing for the past couple of years, in the circumstances we face - including very difficult global conditions in the aftermath of the financial crisis - the outcomes are, I think, quite respectable. In fact, in a number of respects the economy has adjusted to the shocks in the way you would hope. Productive resources were re-deployed to sectors where returns looked like they would be higher. This was true for capital but also for labour - relative wages shifted upwards in WA, for example. Population shifted in response, we had fly-in-fly-out and an immigration response, facilitated by visa arrangements and so on. These were helpful parts of the adjustment process. Likewise, the exchange rate adjusted, as would be expected in a flexible system. When we were here in early September 2011, the Australian dollar was trading around US$1.07 and had been as high as about US$1.10. Today it is about 35 per cent lower than that against the US dollar, and about 20 per cent lower against a relevant basket of currencies. This movement - both up and down - was part of what helped the economy through the commodity super-cycle without seriously inflating or crashing. Through all that, tested macroeconomic policy frameworks have aimed at overall stability, and the financial sector has been kept in good shape by sensible regulation and generally competent management. While the episode is not yet over, at this point the economy overall has been recording growth. We will very shortly get a reading on GDP and the various expenditure and income accounts for the September quarter. Looking ahead, nationally, the outlook appears to be for a continuation of moderate growth. The Reserve Bank issued its latest forecasts a few weeks ago. I won't go into detail here, but, in brief, year-ended GDP growth is forecast to be in the range of 2 to 3 per cent in June 2016 and to pick up a bit during the following year. Domestic inflationary pressures are expected to remain subdued. Inflation is forecast to be in the range of 1 1/2 to 2 1/2 per cent over the year to June 2016, and 2 to 3 per cent over the year to June 2017. The unemployment rate is projected to remain around 6 per cent or a little above over the next year, before gradually declining. We do not make detailed forecasts at state level, but obviously the picture for WA relative to the rest of the country looks different from the way it did a couple of years ago. Previously, economic activity was very strong in the west and the north-east, driven by the investment boom, while in the south-east of the country it was somewhat subdued. Now, as the mining investment boom in the west is in the reversal phase, economic activity here in WA is more subdued, while in the south-east it is picking up. These differences are plain in most of the economic data. Whereas business investment in NSW and Victoria is growing (albeit modestly), in WA it is, of course, contracting very sharply (as it is in Queensland). I think most people have understood for some time that this was on the cards. Consumer spending and employment growth in WA, which had outpaced the national average by a wide margin, have come back to be a bit below the national average. The rate of WA's population growth has slowed. Housing prices have declined a little, while those in Sydney and Melbourne have, at least until recently, risen at quite a clip. Measures of business conditions in WA are at about their long-run average, having been a long way above that for some years. So WA has 'come back to the pack', though the pack has actually picked up some speed in the meantime. Yet even with all that, employment in WA is still increasing. The unemployment rate has increased, though only to the national average so far. Going back a few years, WA had, at times, the lowest unemployment rate recorded of any state at any time over the past 40 years; on occasions there was a '2' before the decimal place. That was obviously not going to be sustained indefinitely. And while labour market performance is not as strong as it was, it is still a good deal stronger than it was in episodes like 1983 or 1991-92. Interestingly, those periods of serious weakness in the labour market in WA were part of a national event. In the early 1990s, that event had little to do with mining and a lot to do with an asset price boom and bust, coupled with high corporate leverage. Of course, further adjustment in the resources sector is still ahead. Although most of the construction employment losses in the iron ore sector have probably occurred, the large LNG projects in WA are still in the investment phase. Over the next few years some labour presumably will be released from these projects. So it will be a while yet before we will be able to say that the difficult phase is completed. That aside, the point I want to offer is that it's worth remembering the positive legacy of the events of the past decade. The sheer scale of the investment that has been undertaken makes WA production, already a powerful force in some key commodities, more powerful. To be sure, prices are lower, but the quality of the resources, the attention to cost reduction and of course a lower Australian dollar are likely to leave many producers well placed. Of perhaps more direct relevance to the ordinary person has been the trend in income per head. In 2000, WA's per capita income was about the same as in Queensland or South Australia but lower than in either NSW or Victoria. But WA has seen easily the largest increase over the intervening period. Today WA enjoys the highest per capita income of any state, at around $50 000 per person per year. It is true that the ACT and NT boast higher figures, but they are very unusual cases, being heavily influenced by the effects of government employment and/or subsidies, not to mention being quite small. It would take quite a few years at the current pace of growth for the other states to catch up to WA. Household net worth in WA in 2013/14 (the latest available data), at about $950 000 per household, was a good deal higher than in any other state. Since then, housing prices in WA have declined while those in some other places have risen, so this gap may have diminished. Nonetheless, my guess is that, among the Australian states, the citizens of Western Australia are on average, probably still among the richest. Even if the others gradually close the gap over time, as they well might, you are better off for having had the boom. WA has unique endowments of resources. Mining has always been a cyclical business, which has long been understood. On this occasion, given the size of the boom, you've done a pretty good job of managing it. As a result, there will be permanently more income and wealth than there was before. I expect that, in a few years' time, the Reserve Bank Board will once again meet in Perth. I imagine that, by then, the current contraction in capital spending will probably have reached an end. New opportunities for growth will have emerged, resulting from things like the growth in the middle class of Asia, with all what that means for demand for services as well as for energy and agricultural production. The growth of India is surely also a potential opportunity for WA - facing as you do the Indian Ocean, and with the advantage of relative lesser distance. A mere eight hour flight time! No doubt Western Australians will be looking to seize those opportunities. At the same time, this vast part of the Australian continent, endowed by nature with so many resources, will still be a major player in key commodities. Even if the extraordinary boom in investment was hard to digest, and even if some of the investments don't pay off quite as handsomely as hoped, it still seems that Western Australians will be richer for the experience.

r160212a_BOA

australia

stevens

Members of the Committee Since the Committee's previous meeting in September, we have continued to see evidence that economic activity outside the resources sector has been gradually improving. The pattern observed six months ago whereby business surveys were suggesting improving conditions by and large continued through to the end of the year. Inevitably, this expansion is not uniform across the country or across industries. Areas that led the growth dynamic a few years ago are on the trailing edge now. Conversely, some that were subdued for a few years are among those leading growth today. But few, if any, expansions are completely even, either geographically or by industry. Given the nature of the economic events through which we have been living, moreover, it is not surprising that there are differences. The good thing is that there are strong areas to counteract the weak ones. The available information suggests that real GDP is expanding at pace a bit lower than what we used to think of as normal. Our estimate is that growth over the four quarters of 2015 was about 2 1/2 per cent. This continued expansion has occurred in the face of a very large contraction in capital spending in the mining sector, restrained public final spending and the reduction in national income coming from the declining terms of trade. It has been helped by easy monetary policy and the lower exchange rate. Notwithstanding below-average GDP growth, the demand for labour increased at an above average pace in 2015. The number of people employed, as measured, increased by well over 2 per cent, participation in the labour force picked up and the rate of unemployment declined, to be below 6 per cent. That is a noticeably better outcome than we expected a year ago. This poses the obvious question of how, with apparently still somewhat below-trend GDP growth, the rate of unemployment has fallen. And whether the pattern will continue. Of course, it may be that the labour force data overstate the strength. Alternatively they may be telling us something not yet apparent in the GDP estimates. More data may shed light on this question over time. Part of the reconciliation appears to be that growth has been concentrated somewhat in labour-intensive areas, like certain household and business services. Another part of the reconciliation probably lies in the very modest pace of growth of labour costs. At any given rate of unemployment, wages growth appears to have been lower than would have been expected based on historical relationships. In fact, at an economy-wide level, unit labour costs - that is, wages per unit of aggregate output - have not risen for four years. This has surely helped employment. This same phenomenon is also important in understanding the behaviour of inflation, which has been quite low. As measured by the Consumer Price Index, inflation was 1.7 per cent over 2015. This was affected by falling prices for petrol and utilities, the latter in part due to government policy decisions. But even the underlying measures, which remove or down-weight such effects, at around 2 per cent, are low. Price rises for non-tradeable items are at their lowest for many years, and this reflects, among other things, the modest growth of labour costs. In summary then, the economy is continuing to grow at a modest pace, in the face of considerable adjustment challenges. It has apparently been generating more employment growth and lower unemployment than we expected, while inflation has remained quite low. Turning then to the rest of the world, there have been some key developments since we last met with the Committee. In December, the United States Federal Reserve raised its policy interest rate for the first time in 9 1/2 years. The last time the Fed actually started an upward phase in rates was as far back as 2004. The Fed's rationale for this change was that the US economy had sufficient strength that a zero interest rate was no longer needed - and, as such, it is a welcome development. The change had been very well telegraphed and was absorbed by financial markets without any immediate disruption. That said, US dollar funding costs are important to many financial strategies around the world and when they start to increase, however gradually, investors adjust their positions. This had already been happening in anticipation of the Fed's decision, with funds seeking to lessen their exposures to emerging markets, high-yield debt instruments and so on. These adjustments continued subsequent to the Fed announcement. For some emerging market economies, facing lower commodity export prices, things have become more challenging. At the same time, some other major jurisdictions have sought to ease their monetary policies further. Both the European Central Bank and the Bank of Japan have pushed rates on some deposits at the central bank below zero. In other words, policy trajectories among the major jurisdictions are diverging, which creates the potential for market movements, not least in exchange rates. Meanwhile, the Chinese economy has become more of a concern for many observers. It is not that the actual data on the Chinese economy are all that different from what we had been seeing. They paint a picture of softness in growth - but they were already saying that some time ago. The more recent anxiety is probably best described as greater uncertainty over the intentions of Chinese policymakers and over whether they will be able to carry off the economic transition China needs. This anxiety has been reflected in capital flows. Commodity prices have generally fallen further over recent months. Most prominent was the further fall in crude oil prices to about US$30 per barrel. While this level of oil prices is not especially low in a longer-run historical context, it is a large decline from prices prevailing in recent years and is bringing considerable adjustment. Oil-producing companies and nations are seeing a decline in their incomes, and yields on debt issued by corporates in the energy sector have increased sharply. Exploration expenditure and investment in new capacity is being rapidly curtailed. Sovereign asset managers for some key oil producers are liquidating some assets to help manage the effects on fiscal positions. As with most price changes, there are gainers as well as losers. The fall in energy costs is a windfall to energy users and represents a terms of trade gain for countries that are net importers. Importantly, it does not appear to be the case that the fall has predominantly been caused by weak demand for oil. Indications are that oil demand has still been rising, albeit not as quickly as it had been. Supply increases appear to have been more important than demand factors in explaining the large price fall, at least thus far. Hence, we should not interpret the decline in oil prices as uniformly negative. On the contrary, a fall in oil prices resulting from additional supply has usually been seen clearly as a bonus for consumers and many businesses in advanced economies, including Australia. In financial markets, as investors and traders have sought to make sense of all these conflicting currents, we have seen a period of volatility recently. This has been apparent in equity and bond markets, as well as foreign exchange markets. Equity markets are lower, yields for core sovereign obligations are lower, spreads for lower-rated corporates and emerging market sovereigns are wider. Exchange rates have seen more variability, with currencies for many emerging market countries weaker. The Australian dollar is around the same level now as when we last met with the Committee, though commodity prices are lower. Looking ahead, forecasters expect a bit less growth in the global economy this year than they did a few months ago. Expectations for Australia's trading partner group itself are for growth to be a bit below average, little changed from six months ago. Inflationary pressures globally look quite subdued. Global interest rates will still be very low, even if short-term rates move up a bit further in the United States. For Australia, the adjustment we have been experiencing for a couple of years now will most likely continue. The terms of trade are still falling. The fall in mining investment spending will continue for at least one more year, though it is probably having its most significant effect on the rate of growth now. Other areas of demand are expected to add to growth. The net effect of all this is likely to be continuing expansion at a moderate pace. One key question will be whether the recent financial turbulence itself will have a material negative effect on aggregate demand - in Australia or abroad. I don't expect that we will be able to answer that question for a little while yet. Another question is what the recent unexpected strength in the labour market means for the outlook. If it turns out that the strength is just temporary, then the outlook is still for moderate growth, but no near-term acceleration. If, on the other hand, recent trends were to continue, the income gains coming from higher employment may start to feed into stronger demand growth, which would probably lead in due course to higher levels of investment. Alternatively, if demand growth were to be in areas that require relatively little capital to support the labour employed, then the apparent weakness in capital spending outside mining could be of less concern anyway. As usual, there are many questions regarding both our current circumstances and the outlook. At its recent meetings, the Reserve Bank Board has kept the stance of policy unchanged, with the cash rate at 2.0 per cent. We will be examining new information over the months ahead as we try to discern the answers to these and other questions. With inflation unlikely to cause a problem by being too high over the next year or two, the statement after the recent meeting indicated that the Board retains the flexibility to ease further, should that be helpful.

r160322a_BOA

australia

stevens

The listed topic for this session was 'can we withstand a major global shock?' I'm going to take a few liberties with that title and re-frame it as ' do we withstand shocks?' For it is inevitable that 'shocks' will come along. One way or another the human condition is characterised by things happening that were not well predicted and for which we are sometimes less prepared than we might, in hindsight, have wished to be. So the question is not if such events will occur, but when. There is a business cycle, and there always will be. There is a cycle of fear and greed in financial markets; it was ever thus. Things rarely move in straight lines and even when they do, as we start to assume that will continue, we set up the very dynamics that ensure it won't. Unfortunately, we will not be very good at forecasting these events. In fact forecasts, almost by definition, assume 'shocks' will not occur. About the best that forecasts can do is to sketch out the likely effects of shocks that are known already to have occurred. What that means is that we need resilient systems - systems that are robust to some things going wrong. We need flexible, adaptable economies. We need financial markets that price risk sensibly as opposed to habitually 'pricing for perfection'. We need providers of finance, be they banks, so-called 'shadow banks' or capital markets, that have ample capacity to bear losses when things go wrong - because sooner or later some things will. With that framing, two questions to ask are: There have been a few developments that have attracted attention for their potential implications for the global and local economies. First, commodity prices have fallen considerably. In Australia, of course, this is part of the everyday narrative. Our terms of trade peaked about four and a half years ago and have fallen by about 35 per cent since then. This has a number of important effects and has caused considerable adjustment in the economy. The effect of the terms of trade fall on which our public discussion typically focuses is the impact on the Federal government's fiscal position. Since the outlook for nominal GDP is critical to projections of tax revenues, the linkage of commodity prices to revenue forecasts has become a key part of the economic story. That is reasonable so far as it goes, though the sequence of downward revisions to terms of trade assumptions, while important, has really served to expose the deeper, and more profound, fact that the budget is structurally in deficit, for reasons largely unrelated to the commodity price decline. That is still something that, over time, we need to address. But the effect of the terms of trade fall is more than just the effect on the budget. It is a large change in relative prices and real incomes. It results in different paces of economic performance by industry and region. Other things adjust, including the exchange rate and allocation of labour and capital resources. It's complex but overall, in my judgement, the Australian economy is adjusting quite well in the circumstances - certainly far better than in other episodes of commodity price fluctuations we have seen in history. That said, the adjustment is still a work in progress. Out in the broader world, the price that has captured attention is that for crude oil, which has fallen by about two-thirds over the past two years. This was a genuine shock: it was not well predicted. But what sort of a shock is it? It matters a great deal whether the price is falling because demand for oil has slumped - say due to a major slowdown in global economic growth - or whether it reflects a large increase in the supply of oil. The evidence thus far is that demand has slowed a little, but supply has increased rapidly in recent years and is expected to remain at a high level this year. This matters because, usually, more supply of something and a cheaper price is good news, not bad. To be sure, lower oil prices require adjustment on the part of producers - corporate and sovereign. But this has always been so and an increase in the availability of energy and cheaper prices has generally, in the past, been seen as a plus for overall global growth - a positive 'shock'. This was because the response of consumers of oil to a decline in its price was to consume more - not just more oil but other goods and services as well, using the higher real income afforded by lower oil prices. It was thought that this outweighed the negative effects of spending cutbacks in oil-producing countries. It seems people are less confident this time of a fall in oil prices being expansionary. Why so? The fact that the United States has become a larger oil producer (and a significant producer of the short-run 'marginal barrel') is clearly relevant. So is the possibility that consumers both there and in Europe may, for particular reasons, be more inclined to save any windfall from lower oil prices than they used to be. These factors may, for a time, work against the traditional positive effect. In addition, the price for oil was high enough, for long enough, that many investment and spending decisions were taken around the world that look, perhaps, not quite so sound in hindsight. Hence, producer countries have budget strains; some sovereign wealth funds are liquidating financial assets; spreads on debt instruments issued by energy companies have widened sharply; exploration and new investment is being curtailed rapidly. It seems as though the sheer strength and longevity of the preceding period of very high oil prices prompted behaviour that made some players more vulnerable to a price decline. That, of course, is not unknown in the history of commodity markets. Having said all that, people might be being a little too pessimistic about the effects of the fall in oil prices. It is still equivalent to a reduction in taxes for a very large number of consumers around the world who now have more disposable income to spend or to repay debt. The shareholders and state owners of the producing assets, who gained from the higher prices, are wearing most of the costs of the lower price, along with those who provided capital market debt funding. At this stage, though, it does not appear that the effects of lower oil prices are being greatly magnified through significant adverse effects on the banking system - though of course this has to remain under careful watch. The second development is that the outlook for global growth is assessed as having weakened, with forecasters expecting less growth in the global economy this year and next year than they did six months ago. The point here is not so much that growth is weak: it is forecast to be higher than it was in the relatively mild global slowdown in the early 2000s, for example, and nothing like as weak as 2009. It is more that there have been a number of years now of below-average performance and the effects of that are cumulating. Many countries are finding the 'strong, sustainable and balanced growth' talked about in the G20 process to be rather elusive. The emerging world, which led growth after the crisis of 2008-09, accounts for much of the slower performance of late, and there has been a focus on China in particular. There is no doubt that China's growth trajectory today, and in the foreseeable future, is a slower one than that which we saw up to about 2011. The Chinese authorities have been telling us for some years that this had to occur. The real question is how successful they will be in landing a transition to a sustainable but still strong growth model, one that is less reliant on investment, more driven by domestic consumption and associated with less build up in leverage. They also have to manage the debt legacy of the previous period of expansion. The truth is that we can't know how all this will turn out. No one has done such a transition on this scale before. A third feature is that observers and investors have to grapple with a more complex policy environment. The Federal Reserve's interest rate decision in December was very well telegraphed and understood. So it, , doesn't really count as a 'shock'. It resulted in the expected sorts of effects - like a turnaround in earlier international capital flows to emerging markets. Some of these actually began ahead of the event itself. At the same time, though, the very low rates of inflation and still very gradual pace of economic growth have led other central banks to seek further easing of monetary policy. Balance sheet measures have been stepped up and several European jurisdictions have applied negative interest rates to parts of banks' reserve holdings at the central bank. The same is happening in Japan. At this point, people are still trying to assess the implications of these changes. Meanwhile, for various reasons there has been renewed focus on asset quality in parts of the European banking system and Europe's resolution arrangements. Changes to China's exchange rate mechanism have attracted much attention. So, in summary, there has in recent months been somewhat more policy uncertainty. This, in turn, reflects the difficulties that policymakers are having in securing growth. Perhaps it's not altogether surprising, then, that we have seen some periods of elevated volatility in financial markets over recent months. Financing conditions for some emerging markets were becoming more difficult a year or more ago; that has generally continued. Major advanced economy sovereign bond yields, on the other hand, have remained very low or even fallen. The Bank for International Settlements has calculated that about US$6 1/2 trillion in sovereign bonds, or about one-quarter of the JPMorgan government bond index according to one report, are now trading at negative yields in global capital markets. The Japanese government - by far the most indebted government in the developed world - can borrow for 10 years at a negative interest rate. But spreads for lesser rated sovereign and private debt have widened, in some cases quite significantly. Equity prices have been choppy and generally weaker. Exchange rates have become more volatile and have been particularly sensitive to shifts in perceptions about central bank actions. Uncertainty about the future direction of the renminbi has been a factor in exchange markets, but the same must be said about the yen and the euro. How should we evaluate this period of volatility and reduction in risk appetite? Is it just reflecting the same information that is embodied in the softer global growth forecasts? Or is it telling us there has been a significant shock we don't see in other data? If it persists, could it a shock that leads to a worse global outcome - by leading to a tightening of credit conditions, loss of wealth and confidence and therefore crimping demand? Alternatively, might the trend of the past couple of weeks, when markets seem to have been regaining a degree of composure, continue? If it does, might we look back on this recent period of turbulence as just a bout of market nervousness that carries little lasting importance? These are the questions policymakers have to grapple with and as yet we do not know the answers. there a material change to the global outlook happening - and, let me be clear, I am not saying there is, but there were - how resilient are we? And how can we be more resilient? There are a couple of things to say at a global level. The first is that the global banking system is better capitalised and more liquid, and hence more resilient, today than it was eight years ago. This part of the financial sector is a good deal less likely to be an amplifier of other shocks than it was then. Of course this strengthening needs to continue; there is a way to go yet for full implementation of the various reforms. But progress is being made. It is noteworthy that much of the increase in financing in recent years has flowed through capital markets. It has to be acknowledged that bond markets are less liquid than they used to be. This is partly because the major international banks now do not commit the same size of balance sheet to market-making activities - and that stems, in part, from regulation. This, no doubt, is part of the story as to why markets have been more volatile recently, though it is probably not the whole story. Large investors are coping with this by accepting that it takes longer to move a parcel of securities. But some worry that liquidity may be much more significantly reduced in moments of stress, meaning that it may require much bigger price changes for markets to clear. As it is, some of the world's deepest and most important markets have, on a few occasions over the past year, seen very large price movements - thankfully for only fairly short periods. More generally, the search for yield has seen investors, including sovereign funds, insurers, and mutual funds held by retail investors, move into assets that are inherently less liquid. This leaves us, unavoidably, with a degree of uncertainty about how markets might cope with larger shocks, and how larger price changes for assets priced in those markets may feed back to the economy. Not surprisingly, liquidity management for asset managers and the question of liquidity conditions in markets in general are key themes for the Financial Stability Board at present. But for all that, it seems to me generally a good thing that (1) more of the credit risk is borne by entities or forms of financing generally less characterised by leverage; and (2) those entities that do have leverage (i.e. banks in the main) have less leverage than they used to. Such developments lessen the system's tendency towards crisis; resilience is greater. That said, all of this is still a work in progress and more progress is required. On the domestic front, the information we have received recently suggests that the Australian economy was growing at a respectable pace in the second half of last year. The national accounts data released this month showed that the economy expanded by 3 per cent over 2015, a bit better than we estimated at the time of our most recent in February. This outcome seems to fit together with other pieces of information such as business surveys and labour market data, which improved noticeably over the course of 2015. So at the turn of the year the Australian economy seemed to have been picking up. That's a good starting point. In the case of business surveys, better conditions seem generally to have continued in the early part of 2016, though labour market data have been more ambiguous. The fact that Australia has a sound and credible macroeconomic policy framework, which could, if needed, respond as appropriate to significant negative events is also a good starting point. Even with interest rates at already low levels, and public debt higher than it was, there would, in the event of a serious economic downturn, be more room to ease both monetary and fiscal policy than in many, indeed most, other countries. Leaving aside the potential for macroeconomic policy responses, the economy's inherent ability to adjust has been on display through both phases of the mining boom. Of course we should always be looking for ways to improve that flexibility, but I think it should be said that businesses and their workforces have been much more flexible than once used to be the case. Turning to financial resilience, Australian banks' asset quality has generally been improving over the past couple of years. Like their counterparts abroad, in the post-crisis period the banks have lifted capital resources, strengthened liquidity and reduced use of short-term wholesale funding. So their ability to handle either a funding market shock or an economic downturn has improved compared with the situation in 2008. At this stage we do not see a material problem in Australian financial or non-financial entities accessing capital markets. If anything, net bond issuance by Australian banks has been strong over recent months, and to the extent that banks are able to take advantage of this availability to extend the term of their wholesale liabilities, that will further improve their resilience to any funding disturbances that may eventuate. Wholesale funding is a little more expensive than it was, though marginal funding costs are still no higher than the average cost of the funding being replaced. On the topic of loan quality, the strengthening of lending standards for housing that has resulted from the actions of both APRA and ASIC was timely. So often over the years, tighter standards tended to come too late and reinforced a downturn after it had begun. These measures have occurred ahead, so far as one can tell, of the point in the cycle when measures of asset quality start to deteriorate. Some moderation in house prices in some of the locations where they had been rising most rapidly, while not the direct objective of the supervisory measures, is also, in my judgement, helpful. In the business space, the banking system has fairly modest direct exposure to the falls in oil and other commodity prices, with lending to businesses involved in mining and energy accounting for only around 2 per cent of banks' total lending. More generally, competition to lend to business has increased over the past couple of years and business credit growth has picked up appreciably. Overall, this is to be expected and is a welcome development at a time when a missing element of the economic growth story is capital spending outside the mining sector, which appears to remain very weak. One notable trend is the aggressive expansion of some of the foreign banks active in the Australian market. Here there is a note of caution. If these are taking opportunities left on the table where local players (or earlier foreign players) were simply too conservative, all well and good. But one is duty-bound to observe that there is a history of foreign players expanding aggressively in the upswing only to have to retreat quickly when more difficult times come. It is worth remembering that cycle. It seems to be part of the economic that people are continually looking for the 'downside' risks. It hasn't always been so - I recall lengthy periods when the mindset was always to see inflation pressures around every corner. That people seem to find it easier to imagine the downside today is a mark of the length of the shadow cast by the financial crisis, seven years on. For financial regulators and policymakers, it is, of course, our duty to look out for possible problems. At present, we can think of several, not all of which, by the way, are on the downside. Some of those may come to pass; some probably won't. But it is virtually impossible to say which ones are which. So, to repeat, the key thing is to try to build resilience in economies and financial structures so that, when shocks do occur, the damage can be contained rather than amplified. In that respect it is good that banks in most places in the world are stronger, though that process needs to be completed. The bigger role in financing being played by capital markets is also, on balance, probably a good thing, even though we are yet to be able to assess how such markets will perform under more stressed conditions. The local economy has been improving and the financial system overall gaining in resilience, albeit with a few pockets to watch. Given that and a reasonable track record of adapting to shocks, we have some grounds for confidence in our capacity to negotiate whatever lies ahead.

r160419a_BOA

australia

stevens

It is good to be in New York once again. Thank you to Credit Suisse for the invitation. By way of a preface to these remarks, I note that we have all just been in Washington, D.C. for the IMF and G20 meetings. With that context, my comments today are international in focus, rather than carrying any particular message about my own country. It has certainly been another interesting few months in global financial markets. Faced with falling commodity prices, diverging policy stances among major jurisdictions, the odd policy surprise and the sense that the economic growth outlook was a bit softer than had been assumed before, market participants had a lot to digest. To this picture was added a new dimension of uncertainty about the way regulations pertaining to some capital instruments might affect returns, and about the way resolution actions may work in some places. In the opening weeks of this year we saw sovereign yields in major advanced economies move towards historic lows, while spreads for some other sovereigns and corporates - especially high-yield obligations - moved out, with particularly sharp increases for bonds issued by resources companies. Share market volatility increased, with prices generally lower, especially for banks. Currencies of a range of emerging market countries, already marked down considerably over the preceding year, came under more pressure and sovereign spreads for some, though not all, of these countries increased. Since about the middle of February, markets seem to have regained some composure. A range of commodity prices have risen. Share prices have recovered some ground, though they remain mostly lower than they were a year or six months ago, and bank share prices in Japan and Europe are back around their recent lows. Investment-grade spreads have declined to where they were about six months ago. That is higher, to be sure, than a year or two years ago, but those spreads were unusually compressed. Even energy-related spreads have narrowed quite noticeably, to be back around their levels at the start of the year. The same is true for emerging market sovereign spreads, while yields on advanced-economy bonds remain close to their record lows. Emerging market currencies have generally appreciated, as have the currencies of commodity-exporting nations. So things have calmed down somewhat. That said, I think most observers and policymakers tend to the view that while some recovery is welcome, the relative 'calm' seems a little eerie - perhaps fragile. Certainly, these events have posed a few questions for policymakers, at least for the present speaker. Among the questions being considered over recent weeks were the following: As always, it is impossible to be sure, but it would not be unreasonable, I think, to draw the tentative conclusion that while these movements did reflect some underlying softening in the global outlook that was already emerging, the reaction was overdone. Commodity prices are well down, but actually some prices had been declining for quite a while. Iron ore, for example, peaked as long ago as February 2011. Moreover, in many cases declining commodity prices reflect additional supply, which usually carries a different - positive - implication for global growth, as opposed to weaker demand. While global growth forecasts are being lowered, at this stage they see higher growth rates than in 2001, which was a relatively mild slowdown episode. Of course that is just a forecast - but so far there are not any actual data that invalidate that view. Given some recovery in markets of late, it seems too extreme to conclude that this event itself is developing into a significant financial shock with important additional macroeconomic significance beyond the softer global growth already understood to be in prospect. Having said all that, I don't think we should write the episode off as just another bout of nervousness. Even if the volatility was not necessarily a reflection of fundamentals, it's worth ensuring that we have extracted all the information we can from it. In addition, some quite big policy questions are lurking. It may be that these are playing a role in bouts of market nervousness - and could do so again. With that in mind, let me talk about a few issues - some familiar, but one or two rather newer. One issue that both the regulatory community and many market participants have focused on for a while now is an apparent decline in market liquidity at a time when capital markets have become a more important source of funding for the economy. We can debate how much of that decline in liquidity is a result of regulation - and certainly some of it is - and how much simply owes to large players deciding to alter the way they run their businesses independently of regulatory changes. There is at least some evidence that market liquidity is more costly than it used to be. Whether that is a big a problem is not clear. It could matter, for example, through the cost of capital to the productive side of the economy, as investors price the illiquidity of the assets they buy. This would mean that borrowers pay a little more than otherwise as a result. But are creditworthy borrowers actually having material difficulties accessing finance on reasonable terms, beyond what is explainable by their own macroeconomic fundamentals? It also seems that liquidity is somewhat less reliable even under conditions that could be thought to be 'normal', even in some of the largest sovereign markets in the world. Recent events have not obviously demonstrated any deterioration, nor any improvement, in that situation. We don't know how liquidity will stand up under genuine stressed conditions. This is of increasing importance, particularly given the large growth of assets under management. Regulators are rightly emphasising the need for sound liquidity management by the asset managers, while market participants rightly point to the practices and tools they have to address these questions. But the key question is: what liquidity promise do the investors - many of them retail - they have been given? Not what the fine-print says, but what are they actually assuming? If their assumptions are at variance with the genuine underlying liquidity in the relevant markets, there could still be trouble even with careful planning by asset managers. The Financial Stability Board continues to work on these issues and over time presumably we will be able to refine our assessments. Turning to other policies, when the financial crisis ushered in a very serious economic downturn in late 2008, central banks around the world reduced their policy rates dramatically - in a number of cases reaching the so called 'zero bound'. Central bank balance sheet expansions were also enacted. These were initially associated with system-wide liquidity provision, but their more persistent use was an effort to provide more monetary policy support to weak economies. Together with more explicit guidance about the future path of short rates, these actions were aimed at reducing rates further along the yield curve. Some details differed, such as whether measures were configured to work through general capital market pricing or through the banking system, or indeed, through exchange rates. These details were determined by the institutional details of the various countries. But overall, 'non-conventional' policies had the effect of lowering borrowing costs by pushing savers further out on the yield and risk curves. That is, they prompted a search for yield. They were supposed to do so. Portfolio substitution is part of how monetary policy works. When the central bank removes low-risk (and perhaps some not so low-risk) financial assets from the system as a monetary policy action, its intent is that, much further out along a long chain of substitution effects, consumers and businesses will respond by purchasing real goods and services. The extent to which demand for real goods and services was increased as a result of these actions is hotly debated. In the United States, business investment as a share of GDP had largely recovered by 2015. Of course, that might have happened anyway. Meanwhile, investment is still below pre-crisis levels in Europe. In Japan, it has never recovered to levels prior to the collapse of the bubble in the early 1990s. Of course, those levels may well have been unsustainably high, and we can't know the counterfactual. So the debate continues. My personal view is that central bank policy at the global level was very effective at heading off a potential catastrophe after the Lehman event, but was always going to have limited capacity to accelerate the recovery. That is not to say central bank policy should not have done all it could, only that we should be realistic about what it can achieve. I think the evidence is consistent with that view. But of course it is also consistent with the argument that the measures were very effective, and that the recovery would have been much weaker in the absence of these actions. And that is why the debate will continue. In the meantime, there are some new areas of discussion emerging and, in a way, they are related. The first is the increasing concern that this world of ultra-low interest rates over a lengthy period is a big problem for savers. Here we are not talking about short-term trends. When everyone wants to save, the return to doing so will fall - that's economics. In a cyclical sense that has to be expected, just as costs of borrowing rise when demand is strong. The issue is when long rates are very low for a long time. In such a world, the whole set of assumptions embodied in retirement income plans will be called into question. Increasingly, we hear commentary about the difficulty - or impossibility - of defined-benefit pension plans making good on their promises with long-term rates of return so low. The fact that accounting rules and regulation now strongly incentivise trustees to hold bonds - at the lowest rates of return in human history - so as to minimise mark-to-market valuation changes over the short term only exacerbates the problem. The problem is surely not confined to defined-benefit plans. Accumulation arrangements are still predicated on some set of assumptions about future income needs and returns. It may take longer but surely many of the owners of these funds are going to feel disappointment. The implicit promises - even if made only to themselves - about their retirement incomes are in danger of not being fulfilled. It is not a very daring prediction to say that these issues will loom ever larger over the years ahead. Some critics lay these problems at the door of the central banks, whose policy actions have worked to lower long-term yields on financial assets. If it were really true that central bank policies were the only factor at work in very low long-term interest rates, while at the same time they were not helping growth, the critics might have a point. But are central banks alone responsible for the decline in long-term interest rates? Real interest rates have fallen noticeably since 2007 - nearly a decade ago now. For there to be effects on interest rates as a result of central bank actions is perhaps not impossible, but seems contrary to everything we were taught when we studied economics. Monetary policy is not supposed to be able to affect variables - like real interest rates - on a sustained basis. Presumably, changes in risk appetite, subdued growth and expectations that growth will continue to be subdued have also played a role in lowering real rates. This brings into focus the really critical question: what are the prospects for sustained growth in the future? Relatedly, what expectations about rates of return in the future are reasonable? The real economy needs to generate decent returns on the real capital stock that are then matched (risk-adjusted) by the yield on financial assets. The financial assets are, in the end, just paper claims on that flow of real returns - directly in the case of private sector obligations and indirectly for government obligations, which rely on being able to tax growing private incomes. If the real economy can't perform to provide real returns to capital, there is nothing to back higher yields on financial assets. In that world, nominal and real yields on bonds would remain extremely low, the income being generated by those working with the capital stock would struggle to fund the benefits required by retirees through dividends and returns on bonds and bank deposits. Governments may not receive all the revenue they need to service their obligations. On the other hand, the stronger the prospects for long-term growth and good returns on the real capital stock, the smaller those problems will be and the more we can expect that, sooner or later, the yield on financial assets will be higher, in line with those real outcomes. Which outcome will it be? The more pessimistic are moving closer to the position of 'secular stagnation': that situation where the desire to save is so overwhelming and the apparent opportunities for profitable investment so weak, that real interest rates cannot equilibrate saving and investment for the system at positive rates of interest and full employment. The result is that the excess saving leads to a sustained below-full-employment equilibrium. The concept arose originally in the 1930s, but has recently been articulated by Lawrence Summers as a description of the current environment. I still find this a bit too pessimistic, because I struggle to accept that today, to an extent virtually unprecedented in modern history, ingenuity, technological development, entrepreneurial drive and opportunity for improvement are so weak - so unprecedentedly weak - and people's desire to defer gratification so strong, that the equilibrium real rate of interest is actually going to be negative over an extended period. What is undeniable, though, is that monetary policy alone hasn't been, and isn't, able to generate sustained growth to the extent people desire. Maybe this is simply the inevitable outcome after a period of excessive optimism and over-leverage - an essentially cyclical explanation, where the cycle is a low-frequency, financial one. Or maybe it is something more deep-seated and structural. That can all be debated. Either way, though, policies that encourage growth through means other than just ultra-cheap borrowing costs are surely needed. It is often said, rightly, that policymakers should try to avoid unnecessary policy uncertainty. For central banks, this has meant trying to be clear about our objectives and our reaction functions - and what we will, or might, do in various states of the world. Maybe we need to be clearer about what we can't do. Monetary solutions are for monetary problems. If there are other problems in the underlying working of the economy, central banks won't be able to solve those. It is this recognition that purely monetary actions can go only so far, coupled with the need for some more growth and more inflation, that lies behind the recent discussion of 'helicopter money'. In essence, this approach, were it to be attempted, would really be fiscal policy or a combined fiscal-monetary operation. It could involve unrequited transfers (gifts) to individuals' bank accounts by the central bank - which diminishes the central bank's net worth and so would require the acquiescence of its owner. Alternatively, it could involve direct funding of government spending by central bank finance - monetary-fiscal coordination. There would be a host of practical issues to sort out in the 'helicopter money' approach. Other commentators have talked about these recently. The main complication is surely that it would be a lot easier to start doing helicopter money than to stop, if history is any guide. Governments have found that a difficult decision to get right. That is, after all, how we got to the point where direct central bank financing of governments is frowned upon, or actually contrary to statute, in so many countries. It would be a very large step to overturn those taboos, which exist for good reason. The governance requirements in doing so would be, if not intractable, at least very complex. Desperate times call for desperate measures, perhaps. Are we that desperate? Before we even got close to that point, one would have thought that for many governments today there must still be projects of an infrastructure kind that would, through conventional fiscal operations at current bond rates, offer returns comfortably above their cost of funding. Helicopter money is surely not needed in these cases. Questions may arise, in some jurisdictions at least, in the minds of citizens about the 'soundness' of such conventional policies. But if such questions arise about conventional fiscal actions, it seems unlikely that adding central bank financing to the mix would allay them. But the very fact - extraordinary as it is - that such possibilities are being openly discussed by serious commentators reinforces the point that, while people find global growth outcomes still a bit disappointing, we are reaching the limits of monetary policy in boosting it. Central banks must of course do what they can, consistent with their mandates, and they continue to explore options. It is certainly clever to find ways of pushing the effective lower bound for interest rates down a bit further. It is inventive to find ways of lending more, at more generous terms, to the private sector. But surely diminishing returns are setting in. My suspicion is that more and more people realise this. Maybe this has something to do with market confidence being easily rattled. There was a hint in the recent episode of the feeling that central banks didn't have much left they could do, if things got worse. So in the end we will collectively have to face up to the question of whether trend growth is lower and, if so, what is to be done about that. A few candidates might be advanced as contributing to such an outcome. Demographics is one. What we might label productivity pessimism - or is it realism? - along the lines of Robert Gordon's views might be another. Others would point to excess debt in many jurisdictions as another. If trend growth lower and we can't or don't want to do anything about that, then expectations about future incomes, tax bases and so on will have to be reconfigured. People will need some explanation of why we have to accept that outcome. It may be that this reconfiguration is, in fact, what is happening. That would help to explain why ultra-low interest rates are not, apparently, as successful in boosting growth in demand as might have been expected. The future income against which people would borrow looks lower than it did, not to mention that the current income against which some already had borrowed has turned out to be lower than assumed. Alternatively, even if we accept that demographic headwinds and the legacy of earlier problems make growth harder to achieve, perhaps we can re-double our efforts to address the things that may be unnecessarily restraining growth today and in the future. They might be things like: If we could engender a reasonable sense that future income prospects are brighter, that there is a good return to innovation and 'real economy' risk taking, and so on, then people might use low-cost funding for more productive purposes than just bidding up the prices of existing assets. Over time, the return on financial instruments could rise in line with returns in the real economy. Pension funds and insurers would be better able to meet their obligations. Governments would more easily service their debts. Citizens, having had some explanations as to why changes were necessary, would, in time, see some gains in their way of life, or at least some threats to their living standards abate. They would see less resort to very unorthodox policies, because there would be less need for them. And I can't help thinking they would feel better about that. We have lived through various bouts of financial market volatility before and doubtless these will recur from time to time. To some extent, this is inevitable. But we can limit the damage from these mood swings by keeping a strong focus on improving growth fundamentals. It is surely time that policies beyond central bank actions did more in this regard. Our inability, so far, durably to lift growth prospects is arguably the biggest vulnerability the global financial system faces today. This needs to be our focus.

r160810a_BOA

australia

ac

Thank you for coming out once more to support the Anika Foundation. The Australian Business Economists and Macquarie Securities Australia have been outstanding in their help over the past 10 years. Through their generosity and yours, as well as some remarkably generous individual donations, the Foundation is in a good financial position. The only problem is that while the Foundation is required to donate at least 4 per cent of the fund each year to activities consistent with its charter, it is hard to find assets that earn 4 per cent with acceptably low risk. That, of course, is a sign of the times in which we live. Very, very low interest rates for 'safe' assets, and even many 'not quite so safe' ones, have persisted for quite a long time now, and may well continue for some time yet. When I gave the first of these addresses 10 years ago, about the conduct of monetary policy, I certainly did not imagine that the world would look like this in 2016. Since this is the last of these addresses I shall deliver, and since in fact it is the last public address I expect to give as Governor, I intend to use it to look back at those 10 years. This will be my account of the Bank's stewardship over that time. Rather than a chronology of events, I will take the approach of looking at average outcomes over decade-long periods, which I think is more useful. I shall conclude with some observations about the future, though these should not be seen in any way as constraining the actions of the Bank under the guidance of my successor. The times have certainly been anything but boring, mainly because of events beyond our shores. Ten years ago, the 'Great Stability', as Lord Mervyn King labels it, was about to come to an end in the advanced economies. That period of reduced economic volatility dating from the mid 1980s was associated with macroeconomic outcomes that were remarkably good. But it wasn't a permanent state of the world. In fact, in some ways, that period of stability and confidence could be said to have sown the seeds of its own demise. Low volatility in economic outcomes encouraged under-pricing of risk and a sense that higher leverage was safer for the individual household or firm (or government). But as leverage increased, this left the world financial system and economy more vulnerable when an adverse shock eventually came along. As we know, the international financial crisis was very serious and had major deleterious effects on economic activity in the advanced countries. At the same time, the 'China boom' really started to find its legs in the mid 2000s. The associated rise in Australia's terms of trade was something my predecessor had already remarked upon. It ultimately went much further than even the optimists a decade ago would have expected. Some of this was due to the financial crisis. As the crisis unfolded in the period from 2007 to 2009, the Chinese economy, which was approaching the time it would experience a structural slowing anyway, decelerated abruptly, as did many other economies. The Chinese authorities responded with a very large stimulus that brought the boom back bigger than ever. This helped global growth recover in 2010 after its 2009 performance, which was the weakest since World War II. This in turn saw Australia's terms of trade rise to the highest sustained level for more than a century. At the peak they were more than 80 per cent above the average level for the preceding hundred years. Of course, nothing is forever and the terms of trade have been falling for about five years now, and are down from the peak by about a third (though they are still about 20 per cent above that very long-run average). Overall, then, the past decade has been a much more volatile time, from the external point of view, than either of the two preceding decades. This is easily demonstrated with some simple metrics for the growth and variability of the world economy, and Australia's terms of trade. The tables show data for four decade-long periods. Global growth has been lower than it was in the 'great stability' period, led by much weaker outcomes for the major advanced countries. Those outcomes were in substantial part a legacy of the financial crisis, of course, though other longer-run factors may also have been at work. Global growth would have been weaker still were it not for two factors: emerging market economies as a group did not slow on average; and in addition, their weight in the global economy increased significantly. This change in weights alone added about one-third of a percentage point to the IMF's measure of global growth in GDP in the latest period. The world economy has also been much more variable - even more variable than in the late 1970s/early 1980s, a period not fondly remembered by economic policymakers. Inflation among the advanced economies was lower on average, but noticeably more variable. As noted above, Australia's terms of trade rose quite a bit in the period of the great stability, then rose even further, and became much more variable, over the past decade. If the global environment became more complicated and more variable, and if the shocks hitting the economy became larger, it would not be entirely surprising if this resulted in more variability of the Australian economy. But that is not, in fact, what we find. Table 2 presents the relevant data. The first feature I want to point out is that the variability of growth, measured here as the standard deviation of the quarterly growth rate of GDP, was, if anything, slightly lower over the past decade than that in the period 1996-2006 and much lower than in preceding decades. Another way of putting this is that Australia has continued to avoid major downturns. Second, we have achieved the inflation target. As of late 2007 and for the first half of 2008, it looked like inflation was going to be a material problem. It reached 5 per cent. The Bank's analysis at the time was that the economy was overheating and inflation was rising mainly for that reason. That judgement stands the test of time. The marked change in the path of the global economy in 2008 had a big effect on sentiment in Australia and the course of the economy and prices. Absent that, I suspect we may have had a fair bit more trouble containing inflation. But events being as they were, inflation came down pretty quickly and we have achieved something pretty close to 2 1/2 per cent on average. In fact, we have been achieving the inflation target for over two decades. From 1993 to 2016, a period of 23 years, the average rate of inflation has been 2.5 per cent - as measured by the CPI (and adjusting for the introduction of the GST in 2000). When we began to articulate the target in the early 1990s and talked about achieving '2-3 per cent, on average, over the cycle', this is the sort of thing we meant. I recall very well how much scepticism we encountered at the time. But the objective has been delivered. The variability of inflation has been a bit higher over the past 10 years than in the preceding decade. This reflects partly the brief period of high inflation in 2007-08, and some big swings in oil and utilities prices over the decade. Still, in the recent period inflation variability has been much reduced from the days prior to the inflation target. Third, the rate of unemployment, on the standard definition, has been lower and less variable over the past 10 years than in the preceding three decades. This is to be expected given that two of the preceding periods included a major recession and the other included a recovery from one. But that is the point. Managing to avoid deep downturns has been a major advantage. It has given us an average unemployment rate 'in the fives' and a low variation around that mean. In summary then, we faced a more volatile world than the one of the 'great stability' of the previous period. It was a world characterised by massive swings in our terms of trade, and a very serious international financial crisis followed by a deep global recession, not to mention the effects of the adoption of 'non-conventional' policies in the major jurisdictions. And yet the Australian economy avoided a major downturn and turned in a performance on economic activity characterised by no more, and on some metrics slightly less, volatility. We have achieved the inflation target and with an average unemployment rate of between 5 and 6 per cent. Had anyone, a decade ago, accurately forecast all the international events and simultaneously predicted that things would turn out in Australia as they have, they would not have been believed. But here we are. No doubt many factors were at work in achieving this. The economy's inherent ability to adapt has been considerably better than in past episodes of large shocks. I think that is a tribute to various reforms over earlier years and the better management of many individual enterprises. Policy frameworks functioned effectively. The exchange rate responded to the external shocks in the way it is supposed to. Prudential supervision was effective. The managements of the most important financial institutions managed to avoid being caught up in a major way in the things that brought so much grief to their counterparts elsewhere in the world. Fiscal policy played a major countercyclical role in the most acute phase of the international downturn (though how much latitude it would have to do that again, if needed, is less clear). And as you would expect, I think that the monetary policy framework has functioned very well. The operation of that framework has involved: I think it can be said that, operating this framework and under the guidance of the Board, the Bank has delivered on its mandate through difficult times. Before leaving indicators of overall performance, though, a fourth observation needs to be made, which will frame the forward-looking part of my remarks. The observation is obvious from the numbers in the first column of Table 2: the average rate of economic growth over the past decade has been lower than it was previously. This requires some explanation. To the extent that the economy was growing above its potential rate in the preceding decade, as the spare capacity created by the serious recession in the early 1990s was wound back, some slowing in actual growth was always likely. This could probably account for growth slowing from 3.6 per cent to about the 3 to 3 1/4 per cent growth that most people assumed, up until recently at least, to be trend or 'potential' growth. If one further thinks that, by about 2006-07, the level of output was probably above the trend level, then one could expect a further slight reduction in average growth over the ensuing period as the level of output came back towards the trend level. But it's unlikely this would account for much more than another tenth of a percentage point of slowing, measured over a 10-year average. That still leaves something - maybe up to a quarter percentage point or so - of slower GDP growth on average to be explained. If we measure it on a per capita basis, the extent of slowing is considerably larger. So what is the explanation? There are likely to be both demand-side and supply-side factors at work. On the demand side, it seems more difficult to generate growth in spending in an economy where households are already carrying significant debt. The real cash rate has been about 140 basis points lower, on average, than in the preceding decade. So on that metric monetary policy has been easier. Even achieving the present trajectory of domestic demand that we have, which has left the economy with a bit of spare capacity, has involved some net rise in the ratio of household debt to GDP. On the supply side, overall population growth increased and was its highest in many decades. But growth in the population of people aged 15 to 64 years was slower than overall population growth (see Table 3). This was in contrast to previous decades, when the '15-64' population typically grew as fast as or faster than total population - a 'demographic dividend'. The rise in labour force participation that had been seen in the 1980s to the mid 2000s has not, in net terms, continued in recent years. Even if we accept that some of this may have reflected demand-side factors, it is likely that the increasing proportion of 'baby boomers' moving into the 65-plus age group has started to dampen the trend in overall participation. On top of that, growth in productivity per hour appears to have slowed a little in the 2006-16 period. All this suggests some moderation in potential output growth probably occurred. These factors individually are not especially large, but together they can explain why overall GDP growth has been lower in the past decade. And they largely explain, I submit, the considerably more marked slowing in growth of real GDP per head of total population. Total population grew faster than the population of people realistically available for work; those working continued the existing trend of working slightly fewer average hours; the growth of their productivity per hour was a bit slower; and the limits of our ability to generate demand in a private sector already carrying a good deal of debt meant we have been a little short of full employment in the most recent few years. The effect of much slower per capita GDP growth was obscured for a period by income effects of the terms of trade boom, but as we know that force has been in reversal for some years now. With that assessment of the past, let me turn then, very tentatively, to the future. I have already noted that Australia's trend growth rate has probably slowed a little. The demographic effects that are working to slow it are likely to continue over the coming decades. All of this points to the need not only to calibrate our assumptions about future growth prudently, but also to maximise our efforts in those areas that can lift potential growth. This is not just an academic debate about 'reform' among 'elite' opinion. It's not just about what a response might be to some theoretical future slowing of growth in living standards. Slower growth is here now and has been for a while. It's surely no coincidence that the path back to budget balance is turning out to be a very long one. At present, very low nominal GDP growth looms large in subduing revenue growth, because of the terms of trade decline. But when the terms of trade stabilise, weaker potential real growth per head of population will still be a problem. Many difficult choices will need to be made along the path of budgetary adjustment. At present, general public debate starts with commitment to the need for reform and for putting public finances on a sustainable medium-term track. But when specific ideas are proposed that will actually make a difference over the medium to long term, the conversation quickly shifts to rather narrow notions of 'fairness', people look to their own positions, the interest groups all come out and the specific proposals often run into the sand. If we think this rather other-worldly discussion will not have to give way to a more hard-nosed conversation, we are kidding ourselves. That will occur should there be a moment of crisis, but it would be better if it occurred before then. In addition, and this may complicate the fiscal discussion, we can't just assume that monetary policy can simply dial up the growth we need. We need some realism here. Through a combination of extraordinary circumstances, the central banking community globally has found itself doing unprecedented things. We in Australia have done fewer such things, but we are connected to the world, and the effects of policies adopted elsewhere condition the policy choices available to us. Although we have not implemented 'unconventional policies', we nonetheless have interest rates at levels lower than any of us have seen before in our lifetimes. Moreover, the 'return to normal' at the global level looks like being a very, very slow process. And normal is a different place now. As would be clear from my utterances over the past couple of years, I have serious reservations about the extent of reliance on monetary policy around the world. It isn't that the central banks were wrong to do what they could, it is that what they could do was not enough, and never could be enough, fully to restore demand after a period of recession associated with a very substantial debt build-up. Certainly easy monetary policy can reduce the burden on debtors through the cash flow channel, at the expense of savers. This is probably still expansionary in net terms, though possibly less so than it used to be. But in the end, the most powerful domestic expansionary impetus that comes from low interest rates surely comes when someone, somewhere, has both the balance sheet capacity and the willingness to take on more debt and spend. The problem now is that there is a limit to how much we can expect to achieve by relying on already indebted entities taking on more debt. So for policymakers looking to use low interest rates to boost growth, the question is: which entities, if any, in the economy can accept higher leverage safely? In some countries there may be no safe way of borrowing and spending because debt, both public and private, is just too high. In Australia, gross public debt, for all levels of government, adds up to about 40 per cent of GDP. We are rightly concerned about the future trajectory of this ratio. But gross household debt is three times larger - about 125 per cent of GDP. That is not unmanageable - but nor is it a low number. It's an interesting question which sector would have the greater capacity to take on more debt, in the event that we were to need a big demand stimulus. Let me be clear that I am not advocating an increase in deficit financing of day-to-day government spending. The case for governments being prepared to borrow for the right investment assets - long-lived assets that yield an economic return - does not extend to borrowing to pay pensions, welfare and routine government expenses, other than under the most exceptional circumstances. It remains the case that, over time, the gap in the recurrent budget has to be closed, because rising public debt that is not held against assets will start to be a material problem. The point I am trying to inject here is simply that popular debate in Australia about government debt and how we limit or reduce it seems so often to be conducted while largely ignoring the size of private debt. To outside observers this seems odd. Foreign visitors to the Reserve Bank over the years have tended to raise questions about household debt much more frequently than they have raised questions about government debt. So the way ahead is going to have to involve a rather more nuanced consideration of all these issues. What about the future of inflation targeting? For more than 20 years this framework as we have practised it has delivered the desired degree of price stability and has greatly contributed to overall macroeconomic performance. But some people have asked: is it a framework whose usefulness has now come to an end? All frameworks come under stress sooner or later. Circumstances occur that were not envisaged when the system was put in place. When that happens, frameworks that are inflexible tend to break. The gold standard and countless exchange rate pegs in history are examples. Various fiscal rules in Europe have been 'honoured in the breach'. And so on. On the other hand, frameworks that have a degree of flexibility, that can bend with the circumstances but retain their essential integrity, like an aircraft wing in turbulence, stand a reasonable chance of coming through. I think the inflation target as we have operated it has the requisite degree of flexibility. The irony is that when we first started talking about inflation targeting, it was our insistence on that very flexibility that made people think we weren't serious. The 2-3 per cent was not a hard-edged band. We were not promising that the Governor would be sacked, or have their salary reduced, if the target was missed. Many critics preferred the hard-edged, electric-fence style targets in vogue elsewhere at the time. Now, it seems some people are concerned we are committed. They worry that, in a period of very low inflation, the Bank may do things with monetary policy, in an effort to increase inflation back to the target in short order, that might create more problems than they solve. I can assure you that the Board has been very conscious of that possibility and, accordingly, has proceeded very carefully. Of course we have run some risks from pushing interest rates so low, but then there are always risks in any course of action, including inaction. Our job is not to avoid all risk; it is to balance the various risks. To date, I think we have done that, aided by supervisory and regulatory actions by APRA and ASIC. Moreover, with the whole developed world in such a prolonged period of ultra-low rates, it would have been fanciful to think we were not going to be affected. But in the end, we are living in a world in which the ability of monetary policy alone to boost growth sustainably is very likely to be a good deal more limited than we might wish. I think most people can sense this. So we need realism about how much we can expect monetary policy to do, including pushing inflation up quickly. If it were the case that undershooting the target for a period while achieving reasonable growth was the 'least bad' option available, the inflation targeting framework has the requisite degree of flexibility to allow such a course. That is all for the future and for others to judge. My time is up. To conclude, over the past decade and in a very volatile world, Australia has achieved the inflation target, avoided a major economic downturn, seen remarkably little variability in real economic activity in the face of enormous shocks, experienced a fairly low average rate of unemployment, and had a stable financial system as well. Looking ahead, challenges remain for Australia, not least sustaining a stronger growth outlook over the longer term. More than adjustments to interest rates will be needed to secure that. The Reserve Bank will, I am confident, go from strength to strength under the leadership of its new Governor. We will be in very good hands. It remains to thank all of you very much for coming to this event, and this series of events, in support of the Anika Foundation. Thank you again to the ABE and Macquarie Securities Australia for their support. I also want to say thank you to many of you here who have been supporters of the Reserve Bank, and of me personally, over the years. There are always critics, but I've found there are many, many more who carry enormous goodwill towards the Bank and want us to succeed for the sake of the country. Quite a number of you here today are among that group. I have appreciated that support more than you can know.

r160922a_BOA

australia

lowe

Chair and members of the Committee These hearings have become a significant part of our calendar. They are an important way through which the Reserve Bank is accountable to the public. I, myself, have been attending these hearings for more than a decade in various roles. I look forward now, in my new capacity as Governor, to continuing the tradition of productive engagement between the Committee and the Reserve Bank. You can be assured that I will do my best to answer your questions constructively and I look forward to regular hearings over coming years. In my opening remarks, I would like to cover three sets of issues. The first is the monetary policy framework. The second is recent economic developments in Australia and elsewhere. And the third is the major projects that the Reserve Bank is currently undertaking. Earlier this week, the Treasurer and I released an updated . These statements - the first of which was released in 1996 - record the common understanding between the Reserve Bank and the Government on key aspects of Australia's monetary and central banking policy framework. They also set out agreed arrangements that promote the transparency and accountability of the Bank. Over recent times, there has been quite a lot of public commentary in Australia and elsewhere about monetary policy frameworks. As you would expect, we are always studying the various arguments and have followed the recent debate carefully. Our view is that a flexible medium-term inflation target remains the right monetary policy framework for Australia. This was reaffirmed in the new , which has also been endorsed by the Reserve Bank Board. The goal remains for CPI inflation to average between 2 and 3 per cent over time. The current framework was introduced in the early 1990s and has served Australia well. It provides the community with a reasonable degree of certainty about how the average level of prices is likely to change over the medium term. This helps people when making decisions about their savings and investments. Low and stable inflation remains an important precondition for strong and sustainable growth in employment and incomes. It is worth emphasising that ever since the adoption of the current framework, the Reserve Bank has been a proponent of what is known as inflation targeting. We have not seen our job as always keeping inflation tightly in a narrow range. We have not been what some have called 'inflation nutters'. We have had a more balanced perspective, recognising that some degree of variability in inflation from year to year is both inevitable and appropriate. In particular, a flexible medium-term target is the best way for us to deliver low and stable inflation in a way that contributes to our other broad responsibilities, including employment and preserving financial stability. We want to ensure that we deliver an average rate of inflation in Australia of between 2 and 3 per cent over time. It is in the public interest that we do this. It is also in the public interest that we pursue this objective in a way that promotes good employment outcomes for the country and preserves financial stability. In this way, we can best contribute to the economic prosperity and welfare of the Australian people as required by the Reserve Bank Act. Our judgement, then, is that a flexible medium-term inflation target remains the right monetary policy framework for Australia. While there are arguments for other types of arrangements, none of them is sufficiently strong to move away from the current framework, which has helped promote stability and confidence in the Australian economy. So the new represents continuity with the previous . The main drafting change is to make the link between monetary policy and financial stability a little more direct. In the previous , monetary policy and financial stability were dealt with in separate parts of the document. Yet, over the years, financial stability considerations have been a factor in our monetary policy deliberations. Recently, for example, we have considered that a very quick return of inflation to the 2 to 3 per cent range at the cost of a material deterioration in the health of private sector balance sheets was unlikely to be in the public interest. The revised drafting recognises that our inflation target is pursued in the context of the Bank's broader objectives, including financial stability. I would now like to turn to the recent economic data. Our economy continues its transition following the boom in commodity prices and mining investment. According to the latest national account, GDP increased by 3.3 per cent over the year to June. This was a better outcome than was widely expected a year ago. It is also a little above most estimates of trend growth in our economy. Partly reflecting this above-trend growth, the unemployment rate has declined by around 1/2 percentage point over the past year. Again, this is a better outcome than was thought likely a year ago. As is always the case, these aggregate outcomes mask significant variation across industries and regions. Those parts of the economy that benefited most from the resources boom are now experiencing difficult conditions, while other areas are doing considerably better. In these other areas, business conditions have improved, employment has increased and there are some signs of a modest pick-up in private investment. Overall, the economy is adjusting reasonably well to the unwinding of the biggest mining investment boom in more than a century. This is a significant achievement. We are managing this adjustment partly because of the flexibility of the exchange rate and the flexibility of wages and through the support provided by monetary policy. The story on income growth has been less positive, with growth in nominal GDP being disappointing. Over the past five years, nominal GDP has increased at an average rate of around 3 per cent per year. To put this number in context, between 2000 and 2007, nominal GDP grew at an average rate of 7 1/2 per cent per year. This is quite a change. It goes some way to explaining the sense of disappointment in parts of the community about recent economic outcomes. The main reason for the weak income growth over recent times is the large fall in the prices received for our exports. Since the September quarter 2011, export prices have fallen by around one-third. This fall, though, does need to be kept in perspective. Export prices remain considerably higher than they were in the 1990s and early 2000s, relative to the price of our imports. And of course, some of the fall in prices is because of increased production from Australia. So while we are receiving lower prices for our exports, we are selling more. The recent news on commodity prices has been a bit more positive than it has been for a while. Over the past couple of months, the prices of some of our key exports have risen, partly in response to production cutbacks by high-cost producers elsewhere in the world. While it is difficult to predict the future, if these increases were to be sustained then we could look forward to the drag on national income from falling commodity prices coming to an end. A second factor that has weighed on growth in nominal GDP is the slow rate of wage increases. This is a common experience across most industrialised countries at present, even those with strong employment growth. In Australia, the current rate of wage growth is the slowest in around two decades. It is part of the adjustment following the resources boom. Importantly, it means that many more people have jobs than would otherwise have been the case. The low wage growth and lower commodity prices have meant that CPI inflation has been quite low over recent times. Inflation has also been held down by increased competition in parts of retailing and cost reductions in some supply chains. Slow growth in rents has also played a role. The low inflation outcomes have provided scope for monetary policy to provide additional support to demand. The Reserve Bank Board decided to reduce the cash rate by 25 basis points in May and again in August this year. Lending rates have come down as a result. Deposit rates have, of course, also come down. The Board is very conscious that this means lower interest income for savers. Overall though, our judgement is that this easing in monetary policy is supporting jobs and economic activity in Australia, and thus improving the prospects for sustainable growth and inflation outcomes consistent with the medium-term target. Looking forward, we expect the economy to continue to be supported by low interest rates and the depreciation of the exchange rate since early 2013. Importantly, the drag from the fall in mining investment will also come to an end. While mining investment still has some way to fall, our estimate is that around three-quarters of the total decline is now behind us. Inflation is expected to remain low for some time, but then to gradually pick up as labour market conditions strengthen further. One issue that has attracted a lot of attention of late is the housing market. The construction cycle has a bit more momentum than we expected earlier. This is adding to the supply of housing in the country, which partly explains the slow growth in rents. The rate at which established housing prices are increasing has also moderated, although there remain some pockets where prices are increasing briskly. Credit growth and turnover in the housing market are also lower than they were a year ago. Under APRA's guidance, lending standards have also been tightened. Overall, then, the situation is somewhat more comfortable than it was a year ago, although we continue to watch things carefully. If I could now turn to the international environment. The overall picture is as it has been for some time. The global economy is continuing to expand, but at a rate a little below average. Growth in global trade and investment is subdued. Inflation is also generally low and below most central bank targets. And interest rates in many countries are still very low. One issue that continues to attract a lot of attention is the global monetary environment. As we have talked about on previous occasions, at the global level there has been a very heavy reliance on monetary policy to stimulate growth. Some central banks have taken extraordinary actions, including large-scale money creation and setting negative policy interest rates. This has had global ramifications. While these actions have generally not been taken with the direct intention of influencing exchange rates, they have, inevitably, affected international capital flows and exchange rates. We have seen the effects here in Australia. The monetary expansion elsewhere and the low rates on offer overseas have meant that foreign investors have found Australian assets, with their relatively higher returns, attractive. In this way, what is happening elsewhere affects us here in Australia. In the past 24 hours, there have been much-anticipated policy meetings by the Bank of Japan and by the Federal Reserve in the United States. These meetings followed a reassessment in markets about the potential for further stimulus from some major central banks, which saw bond yields rise from their historically low levels. In the event, the Bank of Japan and the Federal Reserve did not make material changes to their policy stances. In both cases, policy remains highly accommodative. The Federal Reserve's statement did note, though, that the case for an increase in the federal funds rate had strengthened. Another area that continues to be watched closely is the unfolding transition in the economy of our largest trading partner, China. As we have discussed previously, growth in China has slowed as China too makes a difficult economic transition: in its case, from growth being driven by large investments in industrial capacity and property to a more consumption-focused and service-based economy. China is also dealing with the consequences of a large build-up of debt in the private and state-owned business sectors. Overall, the latest available data suggest that there has not been a major interruption to growth, although this is partly because the economy is being supported by fiscal policy, including expenditure on infrastructure. So the Chinese authorities face a difficult trade-off: measures to address industrial overcapacity and high debt levels are necessary over the longer term, but are not helpful in the short term. We all have a strong interest in them managing this trade-off smoothly. Finally, I would like to say a few words about three of the major public-interest projects that the Bank has been working on recently. You will - I hope - have noticed that a new $5 banknote was issued on 1 September. We are very proud of it. It has innovative security features, including the world's first clear top-to-bottom window. If you have had one in your hands you will have also noticed a tactile feature to assist the vision impaired. We anticipate releasing a new $10 banknote next year and then the banknote in highest circulation - the $50 - after that. The rationale for introducing new banknotes is that we want to make sure that counterfeiting rates in Australia remain low. Our current banknotes have stood the test of time, but as technology has improved so have counterfeiting capabilities, and there has been some increase in counterfeiting. Our investment in new, high-tech banknotes will help ensure that Australians can continue to have confidence in our banknotes. As part of this project, we are also building a new large vault and a technologically sophisticated, more efficient cash processing facility in Craigieburn in Victoria, as our existing arrangements are running up against capacity constraints. A second major project is the New Payments Platform. This project has been under the guidance of the Reserve Bank's Payments System Board. It is a cooperative effort between the Bank and the payments industry to modernise key parts of our electronic payments system. When this work is completed we will all be able to make instantaneous payments to one another, with the money transferring between accounts in a matter of seconds, even if the funds have to move between banks. Addressing will be simplified; an email address or a mobile phone number will be able to be used instead of a payer needing to know an account number and BSB. We will also be able to send a lot more information with payments. The first payments using this new system should be able to be made late next year. As one part of our contribution to this project, the Reserve Bank is building the necessary infrastructure to allow funds to be transferred between financial institutions in real time. A third major project is the renovation of our banking infrastructure. The Reserve Bank is the main transactional banker for the Australian Government. Like other financial institutions, we need to keep investing in technology so that we can provide a high level of service to our customers. As part of this work, we are developing systems so that the government can use the New Payments Platform to make, and receive, some of its payments. So it is a busy time at the Reserve Bank. Further details on these and other projects that we are working on will be available in the Bank's annual report, which will be tabled in parliament and released mid next month. Thank you. My colleagues and I are here to answer your questions.

r161018a_BOA

australia

Inflation and Monetary Policy

lowe

I would like to thank Citi for the invitation to speak at this year's Investment Conference. I am very pleased to be here. This is my first speech as Governor of the Reserve Bank of Australia, so I would like to organise my remarks around the topic of inflation and monetary policy. Nominal interest rates around the world have been at record low levels for some years and there has been extraordinary balance sheet expansion by a number of the world's major central banks. Yet, at the same time, inflation rates in most advanced economies remain below target. There are also concerns in some economies that inflation expectations have declined too far and are perhaps stuck at levels that are too low. This is quite a different world to the one that has existed over the past half-century. Indeed, I am the first Governor of the RBA to have taken office where the concern of the day is more that inflation might turn out to be a bit too low rather than a bit too high. This morning I would like to focus on three interrelated issues. The first is why we have seen these low inflation outcomes across much of the world. The second is how we think about the low inflation outcomes in Australia in the context of our flexible medium-term inflation target. And the third is decisions on monetary policy by the Reserve Bank Board over recent times. It is always useful to start with the facts. This first graph (Graph 1) shows the average rate of inflation for a range of countries over the past two years (the blue bars) as well as the average rate over the past 20 years (the black dots). In almost all economies, inflation has recently been noticeably below its long-term average. This second graph (Graph 2) shows a time series of headline and core inflation rates averaged across the major advanced economies. Again, the picture is clear. While headline inflation has picked up a little recently, the outcomes over recent years have been the lowest for many decades, with the exception of a short period during the global financial crisis. Core inflation rates have also been low, although not as remarkably so, as they do not capture the large fall in oil prices over recent years. This third graph (Graph 3) shows inflation rates for Australia. The two measures shown are headline CPI inflation and the trimmed mean measure. We too have now joined the club of countries with headline inflation noticeably below the medium-term average, although we are a more recent member than many others. Headline inflation here is 1 per cent and measures of underlying inflation are running at around 1 1/2 per cent. These low inflation outcomes globally and in Australia are coexisting with low wage outcomes. In many industrialised countries, wage growth has been close to multi-decade lows and below what historical relationships with the unemployment rate would suggest. So why has this been happening? There are three main factors at work. The first - and the most conventional - explanation is that the low inflation reflects the economic slack in the global economy. Economic growth has generally disappointed since the global financial crisis, weighed down by an overhang of debt. The result is that excess capacity exists in many parts of the global economy. Broad measures of labour utilisation continue to suggest ongoing slack, despite unemployment rates in some industrialised economies being the lowest in some decades. And in parts of Asia, there is considerable overcapacity in some manufacturing industries. This collective economic slack has reduced upward pressure on both prices and wages. The second factor is a self-reinforcing dynamic originating from the decline in headline inflation caused by the fall in commodity prices, including oil prices. With headline inflation rates so low, many workers have agreed to smaller wage increases than would have otherwise been the case, especially where expectations of future inflation are also low. The low wage increases have in turn reinforced the low inflation outcomes. The third factor is that there has been a shift in the perceived pricing power of many workers and businesses. This could simply be the consequence of the increased economic slack but, in my view, there is something more structural going on, driven by the globalisation of markets and technology. Perhaps the strongest effect of globalisation is that it increases competition. This is one reason why open markets can be such a positive force for our collective good. But, in many cases, increased competition means less pricing power, which means a lower level of prices. Open markets and advances in technology mean that more businesses feel that if they put their prices up, they will not only lose market share to domestic competitors but to foreign competitors as well. Many workers have a similar feeling. For some decades, workers in the manufacturing sectors in most industrialised economies have felt the pressure of competition from international trade. Today, many workers in the services sectors are now also feeling this same pressure, as they too are exposed to the increased competitive pressure from globalisation and technology. And faced with more potential competitors, workers, like firms, are less inclined to put their prices up. Another contributing factor is that many workers and companies still carry scars from the financial crisis. The crisis generated a lot of uncertainty and increased the value placed on job security. This occurred just at the time that other structural changes in the economy were making jobs less secure. This increased value put on job security has made many workers less inclined to push for large wage rises. So the low inflation outcomes in the advanced economies reflect a combination of three factors - excess capacity, lower commodity prices and perceptions of reduced pricing power. I would like to offer some reflections on these three factors from an Australian perspective. First, excess capacity. While the Australian economy has performed better than many others over the past decade, we still have some spare capacity. Determining exactly how much is difficult, but Bank staff estimate that the current unemployment rate of 5.6 per cent is around 1/2 percentage point or a bit more above full employment. While this gap has narrowed over the past year, we do still have some spare capacity. Looking at broader measures of labour market utilisation reinforces this point (Graph 4). Over the past year, the Australian Bureau of Statistics' (ABS) measure of underemployment has risen, not fallen, so that overall labour market underutilisation has been little changed. This largely reflects the fact that many of the people finding work recently have been employed in part-time jobs and report that they would like to work more hours. The second factor is the decline in commodity prices. The most direct effect is the fall in petrol prices. Over the past two years, the price of petrol in Australia has declined by around 20 per cent. This has lowered the year-ended rate of headline inflation by almost 0.4 percentage points over each of these years. More broadly though, the decline in commodity prices has perhaps had a bigger effect in Australia than elsewhere, given that it has weighed on our aggregate income and thus demand. Over the past five years, the prices of Australia's commodity exports have fallen by more than 50 per cent and Australia's terms of trade have fallen by 35 per cent as a result, which is the main reason that growth in national income has been weak over recent years. The third factor is the feeling of reduced pricing power, partly from greater competition. One good example of this is in the retail sector, where the entry of foreign retailers has made a real difference in groceries and clothing. Over recent times, food price inflation has been unusually low and the prices of many goods have not risen as quickly as suggested by the conventional relationship with import prices. Increased competition has forced existing retailers to find efficiencies to lower their cost bases and, in turn, their prices. Reflecting this, there has been a pick-up in the rate of productivity growth in the retail sector, which is good news for consumers. More broadly, though, many Australian workers are facing some of the insecurities that workers in other advanced economies are facing. The effects of these three factors - excess capacity, lower commodity prices and reduced pricing power - are evident in the wage outcomes in Australia. In particular, the wage price index (WPI) has increased by just over 2 per cent over the past year, which is the slowest rate of increase since the series began in the late 1990s (Graph 5). The Reserve Bank and the ABS have been working together to obtain some additional insight into what is happening here. Together we have looked at the wage increases for all the 18,000 individual jobs that the ABS uses to construct the WPI. The results are interesting. Over recent years, there has been a decline in the frequency of wage increases and, when wage increases do occur, the average size is lower (Graph 6). The decline in the average size of increases is largely due to a very sharp drop in the share of jobs where wages are increasing at what, by today's standards, would be considered a rapid rate. For example, six years ago, almost 40 per cent of the 18,000 individual jobs being tracked by the ABS received a wage increase in excess of 4 per cent (Graph 7). In contrast, over the past year, less than 10 per cent of jobs got this type of wage increase. And almost half of the individual jobs tracked by the ABS had a wage increase of between 2 and 3 per cent. The low CPI and wage outcomes in Australia have seen some decline in inflation expectations, although not to the levels seen in many other countries. Consumer inflation expectations are lower than they were some years back, but are not at unprecedented levels (Graph 8). Market-based measures of long-term inflation expectations have also declined, but they remain consistent with the inflation target. Looking to the future, we expect that the various factors holding inflation down will continue for a while yet. But this does not mean that we have drifted into a world of permanently lower inflation in Australia. Domestic demand is expected to strengthen gradually as the drag on our economy from the decline in mining investment comes to an end. As this happens, the excess capacity, including in the labour market, is likely to be wound back. Some pick-up in wages and prices could then be expected. In addition, commodity prices, after having declined over the preceding four years, have increased this year. If sustained, this will boost national income and falls in petrol prices will no longer be having a significant effect on headline inflation. In terms of the downward pressure on prices and wages from increased competition, this is likely to continue for a while yet, but it is probable that this pressure will lessen at some point as domestic demand strengthens. Putting all this together, our central forecast remains that inflation in Australia will gradually pick up over the next couple of years, although it is still likely to be closer to 2 per cent than 3 per cent by the end of this period. I would now like to turn to the monetary policy framework as this provides the structure within which the Reserve Bank Board makes its decisions. The centrepiece of this framework is a flexible medium-term inflation target, with the objective of delivering an average rate of inflation over time of between 2 and 3 per cent. By achieving this we can provide a strong medium-term anchor for people's inflation expectations and reduce one element of uncertainty in the economy. This is an important precondition to sustainable growth in employment and incomes. Most people can cope without too much difficulty with a bit of variation in inflation from year to year, but it is the medium-term uncertainty that is really damaging to planning. I hope that it is well understood that our framework allows for temporary deviations of inflation from the medium-term target. In this regard, we have a degree of flexibility not available to some other central banks that have a singular focus on inflation. Some of these central banks have felt that given their mandates they had little choice but to take whatever measures were available to them to push inflation higher. We have never thought of our job as keeping the year-ended rate of inflation between 2 and 3 per cent at all times. Indeed, since June 1993, CPI inflation has been below 2 per cent for 24 per cent of the time, and coincidentally above 3 per cent for 23 per cent of the time. What is important is that we deliver an rate of inflation consistent with the medium-term target. Given the flexibility in our arrangements, it is a perfectly reasonable question to ask what degree of variation in inflation is acceptable. I can't give you a precise quantitative answer here. What I can do, though, is explain how we think about this issue. The general starting point is to ask: what is in the public interest? The medium-term inflation target is pursued as way of achieving our broad goals as set out in legislation. This legislation, which was passed in 1959, states that the Reserve Bank Board must exercise its powers in a way that best contributes to: (i) the stability of the currency of Australia; (ii) the maintenance of full employment in Australia; and (iii) the economic prosperity and welfare of the people of Australia. These are lofty goals and, in my new position, I feel the weight of them. So when thinking about what type of variation in inflation is acceptable, it is natural for us to start by asking ourselves: what is in the public interest? Granted, this can be hard to define and opinions can differ. But, when thinking about the issue, there are two factors that have particular prominence. These are employment and the stability of the financial system. When we find ourselves with inflation that is either lower, or higher, than normal, we want to feel confident that, over time, inflation will return to more normal levels. There is, however, always a choice about the exact path we take. When thinking about that choice, developments in the labour market and in balance sheets in the economy have particular importance. Take the current situation of low inflation as an example. Over recent times, we have considered the impact of our decisions not only on the future path of inflation, but also on the health of the balance sheets in the economy. Achieving the quickest return of inflation back to 2 1/2 per cent would be unlikely to be in the public interest if it came at the cost of a weakening of balance sheets and an unsustainable build-up of leverage in response to historically low interest rates. Conversely, the case for moving more quickly would be strengthened in a world where the labour market was deteriorating and people were having increasing difficulty finding jobs. To be clear, our core objective is to deliver a rate of inflation that averages between 2 and 3 per cent over time. But we want to do that in a way that best serves the public interest. A flexible medium-term inflation target, paying close attention to the labour market and keeping a wary eye on balance sheets in the economy is the best way of doing this. This framework has served Australia well for more than two decades now. And, in my view, it remains the right monetary policy framework for Australia. This might all be less tightly defined than some people would like. But given the uncertainties in the world, something more prescriptive and mechanical is neither possible nor desirable. Inevitably, judgement has to be exercised. Successive governments have appointed nine dedicated Australians to the Reserve Bank Board to exercise that judgement in the public interest. I recognise that not everybody agrees with the decisions that the Board makes. The best way of dealing with this is for us to communicate as clearly as possible the reasons for the decisions that we have made. I am committed to doing that to the best of my ability. So this is an appropriate point to talk about the Reserve Bank Board's decisions over recent times. Over the course of this year the Board has lowered the cash rate twice, in May and August. These reductions followed inflation outcomes early in the year that were lower than expected as well as an assessment that inflation was likely to remain quite low for some time, for the reasons that I have discussed. The easing in policy was not in response to concerns about economic growth. If anything, the growth outcomes over the past year, as measured by real GDP or the trend in unemployment, have been a bit better than expected. In easing policy, the Board has been conscious that interest rates are already low - very low in fact, by historical standards. These low rates are, in part, a consequence of what has been happening abroad. Monetary settings elsewhere in the world have affected international capital flows and exchange rates, and interest rates here in Australia too. The Board has also been conscious that the low rates mean low returns for many savers. In addition, the Board has paid close attention to developments in household balance sheets and the housing market. Over the course of 2016, there has been some lessening of the concerns that were building up last year. Aggregate credit growth slowed, as did the rate of housing price appreciation. Lending standards were also tightened. These developments meant that the Board felt that the lowering of the cash rate would improve prospects for sustainable growth and achieving the inflation target without creating unacceptable risks on the financial side. Over the past couple of months, the Board has held the cash rate steady at 1.5 per cent. We have continued to carefully examine the incoming flow of data. On balance these data suggest that the economy is continuing to adjust reasonably well to the downswing in mining investment. This downswing still has some way to go, but the end is now in sight. And recently, commodity prices have picked up, which is a marked change from the large declines in prices we have seen for some years. Measures of business and consumer sentiment are also slightly above average. In terms of inflation, we have been looking carefully at the various measures of inflation expectations, which have clearly declined, although not to unprecedented levels. The experience elsewhere suggests that we do need to guard against inflation expectations falling too far, for if this were to occur it would be more difficult to achieve the inflation target. Of course, one of the key influences on inflation expectations is the actual outcomes for inflation. We will get an important update next week, with the release of the September quarter CPI. In terms of the labour market, as I said earlier, the picture is mixed. The unemployment rate has drifted down, but growth in hours worked is weak and many part-time workers would like to work longer hours. Wage pressures remain weak, although there are some signs that the downward pressure on average wages from workers moving out of high-paying mining-related jobs might be coming to an end. The recent data on the housing market are also mixed. Prices seem to be increasing quite briskly again in some areas, although are falling in others. Growth in rents is very low and there is a big increase in housing supply still to come. To add to the picture, credit growth is still exceeding income growth, although by a smaller margin than last year. It is also noteworthy that much of this credit is being used to finance new housing construction rather than consumption. It is a complex picture. So these are the issues we have been focused on. At its most recent meeting, the Board reached the judgement that holding the cash rate at 1.5 per cent was consistent with sustainable growth in the economy and achieving the inflation target over time. We will, of course, continue to review that judgement at future meetings. We continue to live in unusual times. Inflation is quite low and growth in labour costs has been very subdued. While this largely reflects the usual cyclical factors, to some extent there is more than that going on. The low inflation outcomes around the world have posed some challenges for policy frameworks, including inflation targeting. But our flexible medium-term target has served us well. The Reserve Bank can contribute to stability and confidence in the Australian economy by continuing to be guided by this framework, which has proved its worth for over two decades now, and to use the flexibility afforded by the framework to respond sensibly to the situation we face. Of course, we have to explain that response and I hope these remarks today have assisted in that regard. I remain confident that the framework we have, sensibly operated, will guide us to prudent decisions in pursuit of what is, after all, the ultimate goal of our policy: the welfare and prosperity of the people of Australia. Thank you.

r161115a_BOA

australia

Buffers and Options

lowe

It is an honour to be able to address CEDA's Annual Dinner. It became a tradition under the previous Governor, Glenn Stevens, to speak at these dinners about prosperity: what it looks like and how Australia might continue to secure it in the uncertain world in which we live. This is a tradition that I would like to continue. I could understand why you might not have guessed that looking at the title of my remarks this evening: 'Buffers and Options'. You might have feared that this was going to be an esoteric talk about finance. But that is not what I have in mind. Instead, I chose this title because it summarises the one element of securing prosperity that I want to focus on tonight. Glenn spoke in detail about the various things that we can do to lift our average growth rate. Rather than repeating these, I would like to focus on another element of the challenge. And that is managing risk and ensuring resilience. To provide some context I would like to begin with two observations. The first is that Australia's economic success over recent decades reflects both the underlying fundamentals and our ability to ride out various shocks. The fundamentals that have helped us are well known. They include our openness to trade and investment, our generally favourable demographics, our diverse and talented people, our abundance of natural resources, our ability to undertake structural reform to boost productivity and our links with the fast-growing Asian region. But also important to our prosperity is the fact that over the past quarter of a century, our economy has not been seriously derailed by economic shocks. After all, nothing undermines prosperity like a severe recession in which large numbers of people lose their jobs and see their wealth decline. It is not as if there has been a shortage of shocks that could have derailed us. There was the Asian crisis, the bust of the US tech boom and the global financial crisis. We also experienced a once in a century surge in our terms of trade and the subsequent decline. The point is that we have been able to ride out these and other shocks without too much difficulty. In part this is because of the flexibility of our exchange rate, monetary policy and the labour market. We have also avoided the build-up of large financial imbalances. But this resilience is also because when the shocks hit we have had buffers to absorb them. Because of these buffers, we had options that not all other countries have had. The second observation is that today many business people tell us they feel the heavy weight of uncertainty. The long list of factors we hear includes: uncertainty about the transition in the Chinese economy; the future direction of technology; the political environment, both abroad and at home; the impact of high debt levels on future consumer demand; and uncertainty about where the extraordinary global monetary expansion will ultimately end. Understandably, when people feel uncertain, they sometimes feel that it's best to delay making decisions, especially if those decisions are difficult to reverse. We want to seek out more information before proceeding. We want to wait. So, to draw these two observations together: Australians have managed pretty well over the past quarter of a century, but we feel a bit uncertain about the future. In my view, despite the uncertainties, we should still be looking forward to the future with some optimism. Here in Australia, with our long track record of good economic growth and our demonstrated ability to adjust to a changing world, we have a set of advantages that not all countries have. Our collective challenge is to capitalise on those advantages. Ensuring a strong focus on lifting productivity is surely the key here. As we work out how to do this, though, we obviously can't ignore the uncertainties. But neither can we let those uncertainties force us to retreat, to withdraw from the world. If we do this, then we, and our children, will be poorer as a result. Rather, we need to deal with, and prepare for, those uncertainties. This brings me back to the title of my remarks, 'Buffers and Options'. Part of our preparation is to ensure that we have adequate buffers in place to deal with future shocks wherever they come from. These buffers provide us with options when challenges arise. I would like to talk about buffers in three broad areas: the financial system, the fiscal arena and household finances. One area where it is particularly important to have adequate buffers is in the financial sector. The financial sector can either act as a cushion for adverse shocks or it can act as an amplifier. Which one it turns out to be depends upon how well the system is prepared to deal with bad events. If the system has skimped on liquidity and is carrying too little capital, then it is likely to amplify shocks. Conversely, if the financial system has adequate buffers, it is better able to support the economy in difficult times. The aftermath of the global financial crisis is a good example of what can happen. This chart (Graph 1) shows how bank lending has grown - or in the case of Europe, contracted - since the financial crisis in 2008. Many banks in Europe and the United States simply did not have large enough buffers for the events that unfolded. Even today, capital levels remain an issue for some European banks. Insufficient capital means that some banks are constrained in their ability to provide finance and helps explain why banks have not taken advantage of the European Central Bank's offer to lend them money at an interest rate below zero. The European economy has suffered as a result. In the United States, the picture is more positive, partly because there were more successful efforts early on to rebuild the buffers in the system. In Australia, it has been a different story. The banking system did have the capacity to support the economy during the global crisis, although it is important to point out that it did this with the assistance of the Australian Government through various guarantee schemes following the freezing of global capital markets. Around the world, the experience of recent years has rightly caused banks and their regulators to think again about how large the buffers should be. And the answer has been that they should be larger than they were before. This has been true in Australia too, despite the starting point here being better than in many other countries. Since the beginning of 2015, the major banks have raised around $28 billion from new equity and retained earnings, significantly increasing their capital relative to their assets (Graph 2). Banks are also holding a larger share of their assets in liquid form and have changed the composition of their funding towards more stable sources (Graph 3). During 2016, liquid assets have accounted for around 20 per cent of the major Australian banks' total assets, up from an average of around 15 per cent in the years preceding the financial crisis. Banks have also increased their use of deposits and long-term debt and reduced their use of short-term debt. These are positive developments and they provide us with an extra degree of insurance against future shocks. Of course, this insurance does not come for free. Higher capital, more liquidity and more expensive, stable funding all have a price. We need to keep an eye out to make sure that this price is not too high and that we don't constrain the ability of the financial system to do its job. My view is that this has not been the case in Australia and that the changes have increased the resilience of our system. There is, though, a legitimate discussion to be held as to who pays the price. We see this issue frequently debated in our media. One possibility is that the cost falls on the bank shareholders in the form of lower returns on equity. Another is that it falls on borrowers in the form of higher interest rates on bank loans relative to the cash rate. Ultimately, the balance is for the market to sort out, but it would seem unlikely that the cost will fall entirely on one side or the other. Over time, shareholders and borrowers will both benefit from these larger buffers to the extent that they contribute to economic stability. The shareholders should experience less volatile returns and borrowers should be more likely to be supported during difficult times. The larger buffers provide a form of insurance to all. A second area where buffers are important is on the fiscal front. Again, the events of the past decade provide a useful illustration. In Europe, we saw examples of what can happen when public finances are not in order when difficult times strike. In some countries, when troubles arrived, governments felt that they had little choice other than to impose austerity measures to restore the fiscal accounts, despite the fact that these measures added to the immediate downturn in the economy. Australia, again, provides a counter example. When the shockwaves of the global financial crisis hit us, the Australian Government did have the capacity to support the economy through a fiscal expansion. This support was one of a number of factors that helped us get through this period. The ability to provide the stimulus was enhanced by the sound fiscal position that had been built up over previous years (Graph 4). While the exact nature of the stimulus remains a matter of debate, regardless of where you stand on that debate the fiscal buffers that we had did provide us with options that not all other countries had. Since the financial crisis in 2008, the budget has been in deficit and debt levels have moved higher. Under current projections, net debt is expected to peak in 2017/18 at 19.2 per cent of GDP and a balanced budget is not expected until 2020/21. This would still leave the fiscal accounts in better order than those in many other countries. Importantly, this means that fiscal policy still retains capacity to support the economy in difficult times. But this capacity is less than it once was. We have a smaller buffer than we once did and a smaller buffer means fewer options. So from a risk-management perspective, there is merit in rebuilding our buffers on the fiscal front. This is a task that can be undertaken over time and it requires difficult choices to be made. As Secretary to the Treasury John Fraser reminded us in a recent speech, the task is made more difficult by slow growth in nominal income. But it is important that we ensure our public finances are on a sustainable track. This requires a better balance to be established, over time, between recurrent spending and revenue. It is worth pointing out that this does not preclude government spending on infrastructure, where this is backed by a strong business case. Such spending can provide support for the economy and can help generate the productive assets that a prosperous economy needs. Done well, infrastructure spending is not inconsistent with establishing a better balance between recurrent spending and revenue. The third set of buffers that I would like to talk about are those in household balance sheets. These buffers too are important as they influence how households respond to difficult economic times. Ideally, in such times, people are able to draw on their savings a bit, and perhaps even access credit, so that they don't have to cut their consumption sharply. Of course they can do this only if their balance sheets are in reasonable shape. Again, overseas experience is relevant here. In the United States when the recession hit in 2008 some households found that they had simply borrowed too much. What followed was a period of defaults by some, less new borrowing and faster repayment of some debt. The result was a more severe downturn and a more protracted recovery than otherwise would have occurred. Given this and other experiences, we need to pay close attention to household balance sheets here in Australia too. Debt levels, relative to income, are high in Australia and are much higher than they once were (Graph 5). Currently, household debt is equivalent to 185 per cent of annual household disposable income, a record high and up from around 70 per cent in the early 1990s. If we net off the household sector's holdings of cash and deposits the pattern looks somewhat different. It is important, though, to recognise that the households with the debt typically are not the same ones with the large deposits. The reasons for the large increase in household debt have been well documented. The lower nominal interest rates that followed lower inflation in the 1990s allowed people to borrow more, as did the liberalisation of the financial system. As a nation, we took advantage of these new opportunities to borrow. As a result, we ended up with both higher levels of debt and higher housing prices. Given the low level of interest rates and ongoing employment growth, most households are managing the higher levels of debt, but many feel that they are closer to their borrowing capacity than they once were and have adjusted their behaviour accordingly. Since the financial crisis, there has been a noticeable increase in the household saving rate. We are not using our houses like ATMs in the way that we were in the decade to the mid 2000s. Gone are the days when higher housing prices were a sign that we should go to the bank and borrow more to spend. One illustration of this change in behaviour is the large increase in balances held in mortgage offset accounts and redraw facilities. In aggregate, households now have balances in these accounts equivalent to 17 per cent of total outstanding housing loans, which is a buffer worth 2 1/2 years of scheduled repayments at current interest rates (Graph 6). From the survey data we look at, we can see that over recent years more households in all income brackets have got ahead on their mortgages (Graph 7). This more prudent behaviour is a positive development. Given the high and rising levels of debt, though, we need to watch things carefully. It is important that we avoid a build-up of financial imbalances in household balance sheets. We can never know with certainty exactly what level of debt is sustainable. It depends on income growth, lending standards and asset prices. But it surely must be the case that the higher is the debt, the greater is the risk. Given this, as I said recently when explaining our monetary policy decisions, it is unlikely to be in the public interest, given current projections for the economy, to encourage a noticeable rise in household indebtedness, even if doing so might encourage slightly faster consumption growth in the short term. So in each of the three areas I have talked about this evening - the financial sector, the fiscal arena and household balance sheets - the story is broadly similar. Stronger buffers give us more options. And more options promote stability and prosperity. If we skimp on the buffers then we expose ourselves to more risk. It is true that building these buffers does not come for free. In the financial sector, it might mean lower returns on equity or higher lending margins. In the fiscal arena, it means difficult trade-offs about recurrent spending and taxation. And in the household sector, it means consumption growth is slower for a time than it might otherwise be. But this is the nature of insurance. You pay a premium for protection against future uncertainties and to provide resilience. Of course, we need to make sure that this premium is not too high. But it is surely better to pay the insurance premium when the sun is shining than when the storm clouds are building or, worse still, to seek insurance when it is too late. I am very conscious that this evening I have spoken a lot about providing resilience against future shocks. Before finishing, I want to point out that I am doing so not because we are predicting difficult times ahead. The Reserve Bank's central scenario for the Australian economy remains a relatively positive one. Instead, my focus tonight probably reflects the inherent cautiousness of a central banker. Just as the past 25 years have seen numerous shocks to the global economy, chances are, so too will the next 25 years. In the past, we have been served well by the economy's flexibility and the buffers that we had. Being realistic, we will probably need these buffers again some time in the years ahead. At the moment, though, our economy is adjusting better than many predicted to the unwinding of the mining investment boom. Over the next year, we are expecting the economy to grow at around its potential rate, before picking up a bit in the following year. We also expect some further modest progress in lowering unemployment, although spare capacity remains. The low interest rates are helping to support the economy. And the decline in the exchange rate over recent years has assisted a number of industries. Survey measures of business conditions and consumer confidence generally remain above average. The prices for our commodity exports have also lifted since the start of 2016. As a result, for the first time in some years, Australia's terms of trade have moved higher. This will help to boost incomes and fiscal revenues. Inflation remains low, but the latest reading did not suggest that it was moving lower still. There remain reasonable prospects that inflation will return to around average levels over the next couple of years. Finally, to repeat an earlier point, despite the uncertainty in the world, we should be looking forward to the future with some optimism. Australians can continue to enjoy a level of prosperity enjoyed by relatively few people around the world. We have a strong set of fundamentals and a demonstrated ability to adjust to a changing world. We should also take some comfort that our system retains buffers against future shocks. Strengthening these buffers makes sense in the uncertain world in which we live. Thank you.

r170209a_BOA

australia

Dinner Remarks to A50 Australian Economic Forum

lowe

I would like to offer you all a very warm welcome to Sydney for the A50 Forum. To those of you who have travelled to our shores from afar, thank you for visiting. I am confident that you will find your investment in time a worthwhile one. In just a short period, you will hear from the leaders in the worlds of politics, business, the policy institutions and the investment community. You will find an openness and transparency that is not always seen elsewhere around the world and you will experience a genuine desire to share perspectives. You also find a country that is prosperous and wealthy; Australians enjoy a standard of living that relatively few people around the world enjoy. You find a country that has grown consistently for some decades now, despite a pretty volatile global environment. Australia's year-ended growth rate has been in positive territory since 1991. You find a country that has a strong and stable banking system. We have deep and liquid financial markets. The public here question why banks are so profitable, not why they performed so badly during the global financial crisis. You find a country that is well placed to benefit from growth in Asia, not only because of our natural resources base, but also because of stronger demand for our food and a wide range of services. You find a country with a growing and diverse population and one that has a high degree of social cohesion. Our population has recently been growing at around 1 1/2 per cent a year, and around 40 per cent of us were either born overseas or have one parent born overseas. This brings a dynamism that isn't there in countries with stagnant and less diverse populations. You also find a country with strong public institutions and whose economy is resilient and flexible. We have a demonstrated capacity to address our problems and to adjust to the changing world that we live in. In the past decade, our flexibility has meant that we have been able to maintain economic stability through the biggest investment boom in the resources sector in more than a century, and the subsequent unwinding of that boom. You also find a country with positive interest rates and a conventional monetary policy framework. The central bank is independent, analytical and pragmatic. Our inflation target is focused on medium-term outcomes. This approach means that we have the flexibility to pursue our price stability objective while taking into account developments in balance sheets in a way that can be difficult to do in more rigid monetary policy frameworks. So that is Australia. Welcome. There is a lot to like here. In the spirit of openness and transparency though that I mentioned a moment ago, we are not without our challenges. I will talk about a few of those in a moment. I first want to say a few words about openness to trade and investment and its role in Australia's prosperity. Australia is a country that has benefited greatly from the open international trading system. Our ability to sell to the rest of the world goods and services that we can produce really well has boosted our living standards. We also benefit from being able to buy goods produced overseas. And the need to compete with others is one of the things that leads us to strive to do things better. Australians have also benefited from the relatively free flow of financial capital. Year after year, for more than two centuries now, capital from the rest of the world has helped build our country. If we had had to rely on just our own resources, we would not be enjoying the prosperity that we do today. Our asset base and our productive capacity would be lower, and so too would our standard of living. As investors, Australians have also benefited from being able to diversify our portfolios by buying foreign assets and by building strong businesses overseas. So, again, that is Australia. We provide a very good illustration of how a medium-sized country that is committed to an open international order, has a strong role for markets and a floating exchange rate, a largely open capital account and a dynamic and innovative financial sector can prosper in today's complex world. I promised openness and transparency. So now to some of the issues, or challenges, that we face. The first is to reinvigorate productivity growth. Australia, like many other advanced economies has experienced slower productivity growth over the past decade. In our case, this has been partly due to a large increase in mining investment in response to soaring commodity prices. In recent years though, as the new production made possible by all this investment has come on stream, the productivity figures have improved. This is clearly good news, although underlying productivity growth remains relatively modest. A number of structural factors are at work here. If we do not address these factors, then we will have to adjust to noticeably slower growth in our average incomes than we have become used to. In some ways, this adjustment has already started and it is proving difficult. On the more positive side, there is no shortage of things that could be done to lift our performance. The challenge is that most of these ideas require difficult political trade-offs. A related challenge is how best to capitalise on the opportunity that the economic development of the Asian region provides. We have benefited from the surge in commodity prices driven by the rapid industrialisation of China, and from the increased demand for our food products, tourism, education and other services as incomes in Asia have grown. But it is a competitive world out there, and other countries see these opportunities too. So we need to find ways of building upon our strengths to bring goods and services to growing Asian markets at competitive prices. Lifting our productivity is a good place to start. A third issue is the task of providing adequate high-quality infrastructure to help our citizens be as productive as they can and enjoy a high quality of life. As I said earlier, our population is growing strongly which is a source of dynamism for our economy. But this growth can put strains on our infrastructure, including on transport infrastructure. These strains can reduce public support for a growing population. They can also impair our ability to compete and to be as productive as we can be. Good transport infrastructure, for example, opens up opportunities for people and opens markets. It also improves communities. Investment in transportation infrastructure can also play an important role in addressing housing affordability, which is an increasingly important issue. Infrastructure investment does of course need to be paid for. The positive news here is that there is no shortage of finance for the right projects. The task we face then is to identify the best possible projects, harness the planning capacity of government, design the best deal structures to attract private finance where it makes sense to do so, make sure that the construction process is as efficient as possible and price use appropriately. These are challenging things to do, but they are not beyond our capabilities. The final issue that I will mention this evening is that of ensuring that our public finances are on the right track. Australia has a good historical record here. Net government debt, as a share of GDP, is still low, although it is higher than it used to be. Our good record has provided us with a form of insurance. It meant that when difficult times did strike last decade, fiscal policy had the capacity to play a stabilising role. We had options that not all other countries enjoyed. Looking forward, we need to make sure that we continue to have this insurance. We can do this by rebuilding our fiscal buffers. This too is a challenging thing to do, particularly given the additional demands being placed on government. A related complication is that simultaneously we need to make sure that our tax system is internationally competitive. One example of this complication is in the area of corporate tax, where there is a form of international tax competition going on in an effort to attract foreign investment. Like other countries, we face the challenge of responding to this, while achieving a balance between recurrent spending and fiscal revenue. So those are some of the issues we face. Of course, there are others too. No doubt you will discuss these over the course of this conference. I would like now to turn to the near-term outlook for the Australian economy. The Reserve Bank will be releasing updated detailed forecasts tomorrow in our quarterly . For 2017 and 2018, these forecasts will show little change from our earlier forecasts. Over the next couple of years we expect GDP growth to be around the 3 per cent mark. In both years it will be boosted by a significant pick-up in LNG production. And the headwinds that we have been experiencing from the unwinding of the biggest mining investment boom in a century will blow themselves out. Indeed, we are already around 90 per cent of the way through the fall from the peak to expected trough in mining investment. Another headwind we have had over recent years - that is the decline in our terms of trade - has already stopped. Since earlier last year, a rise in global commodity prices has provided a boost to our national income. And the improvement in the global economy since late last year should also help us. So, with the end of the unwinding of the mining investment boom in sight, the economy is in reasonable shape. Unexpectedly, GDP did fall in the September quarter last year, but this largely reflected a confluence of temporary factors. We expect that in the December quarter, the economy returned to reasonable growth. Inflation remains low, running at around 1 1/2 per cent in both headline and underlying terms. Importantly, inflation is not expected to fall further. Instead, our central forecast is for underlying inflation to gradually rise over the next couple of years, and for headline inflation to increase a bit more quickly, boosted by increases in oil and tobacco prices. We continue to pay close attention to the housing market and to household balance sheets. The picture varies widely across the country. Prices for houses in Sydney and Melbourne are rising strongly, but apartment prices in some cities, including Perth and Brisbane have fallen. The population is growing strongly, but there is a large number of additional dwellings to come onto the overall market this year. Growth in rents is weak, but vacancy rates in most markets are not unusually high. And investor demand looks to have strengthened in the closing months of 2016. So it is a complex picture. One reason for trying to understand this complex picture is that the level of household debt is relatively high. Overall, households are coping reasonably well with this. But there are clearly risks. So it is a positive development that over the past couple of years, banks have tightened their lending standards in some areas. This tightening was partly prompted by the supervisory measures put in place by the prudential regulator, APRA, and the Reserve Bank and APRA continue to work closely together monitoring developments. Another issue that we are paying close attention to is developments in the labour market. Employment growth slowed over 2016 and the growth that did take place was almost entirely in part-time employment. As is the case with the housing market, conditions vary across the country. Looking forward, the number of job vacancies and job ads suggest that some strengthening in employment growth might be in prospect. Our central forecast though is for the unemployment rate to remain close to its current level for some time to come. In summary then, the Bank's central scenario is for some pick-up in economic growth and for inflation to move gradually higher. As always, though, there are risks around that outlook. As our record demonstrates, our economy does have a degree of resilience and flexibility that has allowed us to maintain stability during a pretty difficult time in the global economy. There is no reason that this can't continue. But we do need to continue to build that resilience, while we take advantage of the considerable advantages that we have as a nation. Thank you. Welcome again. I hope you enjoy your time in Australia.

r170222a_BOA

australia

Australia and Canada – Shared Experiences

lowe

Thank you for inviting me to address this year's Australia-Canada Leadership Forum. It is a real pleasure for me to be here. The original plan for this session was to have Bank of Canada Governor, Steve Poloz, also speak. But the timing of the Bank of Canada's next regular monetary policy meeting has meant that this wasn't possible. Like us, the Bank of Canada has a blackout period around their policy meetings. So this means that I will need to wait for a future occasion to welcome Governor Poloz to Australia. The Bank of Canada and the Reserve Bank of Australia enjoy a very warm relationship. Many of the issues we face are similar and our perspectives are often very close to one another. This is partly because of the similarities in our economies. But it is also because Australians and Canadians are both pragmatic and open-minded people and we don't take ourselves too seriously. So, there is a natural affinity. On the economic front, we are both medium-sized trading nations. We are both rich in natural resources. We have both had to come to terms with volatile prices for our key exports. We both have strong and resilient banking systems. We both have floating exchange rates and we operate flexible inflation targets. We are both attractive places for non-residents to invest their savings. We both have growing populations. And we both have had to deal with very large increases in housing prices in some of our cities. With all this in common, it is not surprising that we find much to talk about and experiences to share. Australia and Canada are also both countries that have benefited greatly from international trade. We are both strong supporters of a rules-based open international trading system. Too often these days, a commitment to open international trade, integration into global capital markets, a strong role for markets and a dynamic financial sector are seen as liabilities, not as assets. Australia and Canada provide strong counter examples. We show that openness can deliver both prosperity and resilience. We both enjoy standards of living that relatively few people elsewhere in the world enjoy. And while our economies have had their ups and downs, they have also proved to be pretty resilient. Australians and Canadians also understand that the benefits from openness can fall unevenly across our communities. We recognise that while openness makes the size of the pie bigger, it can also affect the distribution of the pie in a way that our societies feel uncomfortable with. This is something that we have both tried to address and have had more success on this front than some other countries. With that introduction, the main focus of my remarks this morning is on the outlook for the Australian economy. I would like to talk about this outlook in the context of three issues that I hope will have strong resonance with the Canadians in the audience. The first of these is the cycle in investment in the resources sector. The second is developments in the housing market and household borrowing. And the third is inflation targeting in a low inflation, low interest rate environment. The RBA released its latest economic forecasts a couple of weeks ago. We expect economic growth to be around 3 per cent over the next couple of years. This is a little faster than our current estimate of the potential growth of our economy. Despite this, we do not expect much change in the current rate of unemployment, which stands at around 5 3/4 per cent. This is because some of the above-potential growth is a result of the expansion of LNG production, which does not employ that many people. Given this outlook, we expect underlying inflation to increase, but to do so only gradually. Wage growth remains subdued, but is not expected to decline further, and spare capacity is likely to remain in the economy for some time yet. Our central forecast is for headline inflation to increase to above 2 per cent later this year, boosted by increases in oil and tobacco prices. The increase in underlying inflation is expected to be a bit more gradual. The first of the three issues that I expect will strike a resonance with Canadians is the shifts in commodity prices and investment in the resources sector. This is a major factor that has shaped economic outcomes in both our countries. While the general stories are similar, the details are different. One area of difference is the size of the movements in the prices of our main exports, summarised in the terms of trade (Graph 1). Australia's terms of trade almost doubled over the first decade of this century and in 2011 reached their highest level since the gold rushes of the 1850s. The increase in Canada was also large in a historical context, although it was not as large as that in Australia. This difference reflects two factors. The first is that the prices of Australia's main commodity exports - iron ore and coal - increased by significantly more than the price of Canada's main commodity export, oil. The short-run supply curve in iron ore and coal tends to be very steep, so the prices for these steel-making commodities increased very sharply when Chinese investment in property and infrastructure really took off. The second factor is that commodities make up a larger share of Australia's total exports than is the case for Canada. Both of our countries have also experienced a pronounced cycle in mining investment. Not surprisingly, reflecting the larger movement in our commodity prices, the cycle has been bigger in Australia. Here, mining investment went from 2 per cent of GDP in the early 2000s to 9 per cent in 2012 (Graph 2). Another difference with Canada is that our main export partner, China, has grown at an average rate of almost 10 per cent over this period, compared with just 2 per cent average growth in Canada's main export partner, the United States. Both our countries accommodated the increase in mining investment without overheating. Our flexible exchange rates played an important role here. Given the larger cycle in mining investment here, the impact on the rest of the economy has been more pronounced. While many parts of our economy did well from the boom in mining investment, others did not as they dealt with the higher exchange rate and found it difficult and more expensive to hire workers. One illustration of this broad impact is the substantial decline in Australia in non-mining investment as a share of GDP from the mid 2000s (Graph 2). By way of contrast, Canadian non-mining investment has shown much less variation. For some time, a major factor shaping our forecasts for the Australian economy has been a rebalancing of investment between the resources and non-resources sectors. We estimate that the decline of mining investment back to normal levels is around 90 per cent done. So this headwind, which has been weighing on GDP growth for some time, will blow itself out before too long. Another headwind we have had for some years is the fall in commodity prices, but this has turned into a gentle tailwind since mid last year. Since then the prices of all our main commodity exports have risen. This is good news for us, although we are not expecting the higher prices to lead to the type of pick-up in investment in the resources sector that might once have occurred. There has already been a very large expansion in supply capacity and we expect some unwinding of the recent increase in prices as supply increases. The higher prices, though, are providing a boost to our national income and this is expected to have some flow-through effects to the rest of the economy. The other part of the story has been the expected pick-up in non-mining investment. This pick-up has been a long time coming. As in Canada, the picture is complicated by significant differences across regions. In those parts of Australia where mining investment has been declining, non-mining investment has also been falling because of the significant spill-over effects (Graph 3). Elsewhere, the picture is more encouraging. Non-mining investment has now picked up in New South Wales and Victoria. Survey measures of capacity utilisation have increased and so too have broader-based measures of business conditions. So while the near-term outlook for non-mining investment for the country as a whole remains subdued, we continue to forecast a pick-up later in the forecast period. I would now like to turn to a second issue that I think will strike resonance with Canadians: housing prices and borrowing. This is an issue that is discussed a lot in both our countries. We have both had strong housing markets over recent years and there are concerns about the level of household indebtedness. There are some similarities in the factors at work. One is that our populations have been growing quickly for advanced industrialised countries. In Australia, population growth has averaged 1.7 per cent over the past decade, while in Canada it has averaged 1.1 per cent. Over the past couple of years the growth rates have moved closer together. Another similarity is that there has been strong demand from overseas residents for investments in residential property, particularly in our wonderful Pacific-rim cities. Not only are these cities attractive places to live, but we also offer investors security of property rights and economic and financial stability. Given the strong demand and its impact on prices in some areas, some state and provincial governments have recently levied additional taxes on foreign investors in residential property. Our housing markets have also been affected by the global monetary environment. We both run independent monetary policies, but the level of our interest rates is influenced by what happens elsewhere in the world. With interest rates so low and our economies being resilient, it is not so surprising that people have found it an attractive time to borrow to buy housing. Another characteristic that we have in common is that at a time of strong demand from both residents and non-residents, there are challenges on the supply side. I understand that zoning is an issue in Canada, just as in Australia. In some parts of Australia, there has also been underinvestment in transport infrastructure, which has limited the supply of well-located land at a time when demand for such land has been growing quickly. The result is higher prices. We are also both experiencing large differences across the various sub-markets within our countries. The strength in housing markets in our major cities contrasts with marked weakness in the mining regions following the end of the mining investment boom (Graph 6). The increase in overall housing prices in both our countries has gone hand in hand with a further pick-up in household indebtedness (Graph 7). In both countries the ratio of household debt to income is at a record high, although the low level of interest rates means that the debt-servicing burdens are not that high at the moment. In Australia, the household sector is coping reasonably well with the high levels of debt. But there are some signs that debt levels are affecting household spending. In aggregate, households are carrying more debt than they have before and, at the same time, they are experiencing slower growth in their nominal incomes than they have for some decades. For many, this is a sobering combination. Reflecting this, our latest forecasts were prepared on the basis that growth in consumption was unlikely to run ahead of growth in household income over the next couple of years; in other words the household saving rate was likely to remain constant. This is a bit different from recent years, over which the saving rate had trended down slowly (Graph 8). This interaction between consumption, saving and borrowing for housing is a significant issue and one that I know both central banks are watching carefully. It is one of the key uncertainties around our central scenario for the Australian economy. It was also cited as one of the key risks for the inflation outlook in the Bank of Canada's latest . We are still learning how households respond to higher debt levels and lower nominal income growth. I would now like to turn to a third issue where there is some commonality of experience: that is dealing with an extended period of low inflation. For a few years now, both countries have experienced low rates of inflation (Graph 9). Many of the same factors have been at play. Wage growth has been subdued given the ongoing slack in the labour market. We have both also seen downward pressure on retail prices from intensified competition. In its latest , the Bank of Canada noted that this was one issue affecting food prices. The same is true in Australia, but the experience here is broader, with new entrants, including overseas retailers, putting downward pressure on the prices of a wide range of goods. We are both expecting inflation to increase, but only gradually so. In our case, we expect the disinflationary effects of the earlier decline in commodity prices and the competitive pressures in retailing to wane. Some pick-up in wages growth is also expected, although wage increases are likely to remain below average for some time yet. Our liaison with businesses does not suggest that a pick-up in wage growth is imminent, but nor does it suggest that a further slowing is in prospect. Over recent times, both central banks have had to think about the implications for their monetary policy frameworks of sustained low inflation and rapid increases in borrowing and housing prices. Both have recently reaffirmed that inflation targeting remains the right monetary policy framework. We have also emphasised that our inflation targets are flexible, not rigid straightjackets. In our case, the emphasis is very much on medium-term outcomes, rather than the outcome over any particular period. While there are some differences in emphasis in language, there is a high degree of commonality in our approaches. Governor Poloz has said on a number of occasions that the Bank of Canada takes a 'risk management approach' to monetary policy. This strikes a very strong resonance with us at the Reserve Bank of Australia. At any point in time there are quite a few possible paths that the cash rate could follow to achieve Australia's inflation target, which is to achieve an average rate of inflation over time of 2 point something. Consistent with the Reserve Bank Act, we set out to choose the path that, in our judgement, best promotes the welfare of the Australian people. In our risk management exercises, we have been seeking to balance the risks from having inflation low for a longer period against the risks from attempting to increase inflation more quickly, which would partly occur through encouraging more borrowing. If inflation is low for a long period of time, it is certainly possible that inflation expectations adjust, making it harder to achieve the objective. At the moment though, I don't see a particularly high risk of this in Australia. The recent lift in headline inflation is helpful here and most measures of inflation expectations are within the range seen over recent decades. In relation to the risks from additional borrowing, it is possible that continuing rises in indebtedness, partly as a result of low interest rates, increase the fragility of household balance sheets. If so, then at some point in the future, households having decided that they had borrowed too much, might cut back consumption sharply, hurting the overall economy and employment. It is difficult to quantify this risk, but it is one that is difficult to ignore. As I said, our focus is on the medium term, not just the next year or so. Another consideration in thinking about the risks are the trends in the labour market. All else constant, if the unemployment rate is high and rising, the stronger would be the case for policy to pursue a quicker return of inflation to the midpoint of the target. To date, we have been satisfied that the labour market is heading in the right direction, if not as quickly as we'd like. After declining over 2015, our unemployment rate has been broadly steady, with employment growth concentrated in part-time jobs. And like the housing market, the labour market outcomes vary significantly across the country. So it is an area that we continue to watch carefully. In summary then, flexible inflation targeting with a medium-term focus remains the right monetary policy framework for Australia. In both Australia and Canada our monetary policy frameworks have played important roles in our economic stability of recent times. As I mentioned at the start of my remarks, we also share other strengths - a rich commodity base, strong and resilient banking systems, an attractive destination for foreign investment, flexible exchange rates and a commitment to openness and competitive markets. But overall, Australia and Canada provide pretty good advertisements for flexible inflation-targeting frameworks. Thank you and I look forward to your questions and comments.

r170224a_BOA

australia

lowe

Members of the Committee Thank you for the opportunity to appear today to explain how we see the Australian economy as well as to discuss some of the work we have been doing at the Reserve Bank. At the equivalent hearing a year ago, the tone of the global economy was pretty sombre. We had seen turbulence in Chinese financial markets. Commodity and equity prices were declining. Some overseas central banks had pushed their interest rates into negative territory. And global growth forecasts were being lowered again. Twelve months on, the global economy looks to be on a firmer footing. In China, the growth target for 2016 was achieved despite the nervousness early in the year. In the United States, growth has strengthened and the economy is operating at close to full employment. And in Europe, the recovery is continuing, although it has a fair way to go in some countries. The Federal Reserve increased interest rates in December and further rises are expected this year. Elsewhere in the major economies there is no longer an expectation of further monetary easing, although some central banks are still continuing to expand their balance sheets. Commodity prices have moved higher. Long-term bond yields have also increased and most investors are no longer paying governments to look after their money for 10 years. Headline inflation has risen in most countries, and is much closer to target than it has been for some years. And forecasts for global growth have been revised up over recent months. This is the first time this has happened for quite a few years. So, overall it is a more positive picture. That is the good news. There are, though, still a number of significant risks on the horizon. In China, the growth target was achieved last year partly through a further build-up in debt especially to finance infrastructure investment and property development. This strategy was clearly helpful in the short run and it supported commodity prices, and Australia has benefited from that. But it runs counter to the Chinese authorities' goal of addressing the high levels of debt and getting domestic finances on a more stable footing. So we can't be sure about the longer-run implications. Recently, the Chinese authorities have taken some steps to tighten things up a bit. They have also been managing a depreciation of their currency against the US dollar and increased capital outflows as Chinese citizens send funds abroad. It's a difficult balancing act. Turning to the United States, we can't be confident about how things will play out. It is possible that the new administration's policies could boost US and global growth. More infrastructure investment, tax reform and deregulation could all work to that end. On the other hand, if there were to be a retreat from the open international trading system, that would be damaging to the global economy, including to us here in Australia. We have much to lose if this were to occur. It is too early to tell which way things will go. Like others, we are in 'wait and see' mode. In Europe, while there have been no major problems for some time, there are still a number of faultlines. Some of these could be put under pressure in the year ahead, in many cases depending on the outcomes of elections. So there are still a number of risks in the global economy, although they no longer seem tilted to the downside. There are reasonable scenarios in which global growth picks up further and other scenarios in which it disappoints again. I would now like to turn to the domestic economy. A year ago, we were expecting the Australian economy to grow by around 2 1/2 -3 per cent in 2016. We haven't yet received the final figures for the year, but the outcome is likely to be lower, at around 2 per cent. The September quarter was surprisingly weak, largely reflecting temporary factors. We are not expecting a repeat of this for the December quarter, with most of the available indictors suggesting a return to reasonable growth in the quarter. Looking forward, we still expect the Australian economy to grow by around 3 per cent this year and next. For most of the time since 2012 we have been facing headwinds from declining mining investment and falling commodity prices. Then, around the middle of last year, the headwind from falling commodity prices turned into a gentle tailwind as commodity prices lifted. And the headwind from falling mining investment should blow itself out before too long as mining investment returns to more normal levels. We will also benefit over the next few years from large increases in production of liquefied natural gas. Economic conditions continue to vary significantly across the country. They are weaker in those parts of the country adjusting to the lower levels of mining investment and they are stronger elsewhere. Nationally, measures of business conditions have picked up noticeably recently. For some time we have been waiting for a lift in non-mining business investment. It has been a long time coming. Encouragingly, in New South Wales and Victoria we have now seen a reasonable pick-up in investment. However, we are yet to see this in most other states, where the unwinding of the mining investment boom continues to affect the overall business climate. With the decline in mining investment coming to an end, we hope to see a broader pick-up over time. One area that we are watching closely is the cycle in residential construction activity, as the upswing has helped support the economy over recent years. The rate of new building approvals has slowed, but there is a large amount of work still in the pipeline, particularly for apartments, so we still expect some further growth in this part of the economy this year. There has, however, been some tightening in conditions for property developers in some markets. In the broader housing market, the picture remains quite complicated. There is not a single story across the country. In parts of the country that have been adjusting to the downswing in mining investment or where there have been big increases in supply of apartments, housing prices have declined. In other parts, where the economy has been stronger and the supply-side has had trouble keeping up with strong population growth, housing prices are still rising quickly. In most areas, growth in rents is low. And recently we have seen a pick-up in growth in credit to investors, which needs to be watched carefully. In terms of consumer prices, a year ago we had expected the inflation rate to remain above 2 per cent. It has turned out to be lower than this last year, at around 1 1/2 per cent. Wage growth has been quite subdued, reflecting spare capacity in the labour market and the adjustment to the unwinding of the mining investment boom. We anticipate the subdued outcomes to continue for a while yet. Increased competition in retailing is also having an effect on prices, as is the low rate of increase in rents. We do not expect the rate of inflation to fall further. Our judgement is that there are reasonable prospects for inflation to rise towards the middle of the target over time. The recent improvement in the global economy provides some extra assurance on this front. Headline inflation is expected to be back above 2 per cent later this year, boosted by higher prices for petrol and tobacco. The pick-up in underlying inflation is expected to be more gradual. Since we appeared before this Committee last September, the Reserve Bank Board has kept the cash rate unchanged at 1.5 per cent. At its recent meetings the Board has been paying close attention to the outlook for inflation as well as two other issues: trends in household borrowing and in the labour market. One of the ways in which monetary policy works is to make it easier for people to borrow and spend. But there is a balance to be struck. Too much borrowing today can create problems for tomorrow, because debt does have to be repaid. At the moment, most households with borrowings do seem to be coping pretty well. But the current high level of debt, combined with low nominal income growth, is affecting the appetite of households to spend, and we are seeing some evidence of this in the consumption figures. The balance that is required is to support spending in the economy today while avoiding creating fragilities in household balance sheets that could cause problems for the economy later on. This is also something we need to watch carefully. Trends in the labour market are also important. As in the housing market, the picture in the labour market varies significantly around the country. Overall, the unemployment rate has been steady now for a little over a year at around 5 3/4 per cent. In a historical context this would have been considered a good outcome, although, today, a sustainably lower unemployment rate should be possible in Australia. The other aspect of the labour market that is worth noting is the continuing trend towards part-time employment. Over the past year, all the growth in employment is accounted for by part-time jobs. There is a structural element to this, but it is also partly cyclical. We expect that the unemployment rate will remain around its current level for a while yet. The Reserve Bank Board continues to balance these various issues within the framework of our flexible medium-term inflation target, which aims to achieve an average rate of inflation over time of 2 point something. Our judgement is that the current setting of the cash rate is consistent with both this and achieving sustainable growth in our economy. We will continue to review that judgement at future meetings. I would like to turn to some other aspects of the work we do at the Reserve Bank. In the area of payments, the Reserve Bank is continuing to work with industry on the development of the new payments infrastructure that will allow us all to move money around and make electronic payments more easily. The Bank is building part of the infrastructure that stands at the centre of this new system that will allow funds to be exchanged instantaneously so that customers can have very quick access to their funds. Our work is on schedule and is now being used in industry testing. Financial institutions are also working hard on their internal systems so that customers can take advantage of the new system. Developments look to be on track to allow the first payments to be made through this new system towards the end of the year. A related focus of the Payments System Board is the important role that new technologies can play in promoting efficiency and competition. In recent meetings the Board has discussed the opportunities that distributed ledger technology could offer in the payments system and in financial market infrastructures. And it is also interested in the potential for fintech to deliver improved customer experiences. The Board is therefore taking a keen interest in the work being done by the Australian Payments Council on digital identity and customers' access to their banking and payments data. I hope that you have all come across the new $5 banknote, which was issued by the Bank from early September last year. The note was well received by the community. You might also have noticed that last Friday we released the design for the new $10 banknote. Like the new $5, the new $10 will have world-leading security features, including the clear top-to-bottom window and a rolling colour effect that changes as the banknote is tilted. It will also have two raised bumps to assist people with vision impairment. Just like the current $10 note, the new note will feature two of Australia's most famous writers, Dame Mary Gilmore and Banjo Paterson. The printing presses are busy printing the new notes and they will be issued from September this year. We are also finalising the design of the new $50 banknote, which we plan to issue next year. One other matter that I would like to bring to your attention is that we are in the process of commissioning an external review of the efficiency of our operations. We want to make sure that we are continuously improving as an organisation and we are seeking outside assistance to identify opportunities for improvement. The review will be focused primarily on operational and administrative matters and not on our policy frameworks. It will commence within the next month and I will be in a position to share the key conclusions with the Committee when we meet later in the year. Finally, at previous hearings members of the Committee asked about the number of women at senior levels of the Reserve Bank. I am pleased to be able to report that we have made further progress here. Of the three assistant governors responsible for monetary and financial policies at the Reserve Bank, two are women. And women run over a third of the departments in the Bank, including those responsible for the Bank's economic analysis function and for the implementation of monetary policy. So it's quite a big change from days gone by when almost all of these important positions were held by men. I want to highlight these changes in the hope that they might provide some inspiration to women who are thinking of studying economics, finance and business. There are fantastic career opportunities out there and it would be great to see more women studying these disciplines, and perhaps considering a career at Australia's central bank. We are currently working on some initiatives to encourage this, at both the school and university level. Thank you. My colleagues and I are here to answer your questions.

r170404a_BOA

australia

Remarks at Reserve Bank Board Dinner

lowe

Good evening. On behalf of the Reserve Bank Board I would like to warmly welcome you all to this dinner. We are very pleased that leaders from the worlds of politics, academia and the community sector, as well as from business, have been able to join us tonight. Having leaders join us from right across the community is important to us, as the decisions made by the Reserve Bank Board and by the Bank affect all Australians. Price stability, financial stability, sustainable growth and employment, and a well-functioning payments system matter to all of us. Each of these is important to our collective prosperity. So thank you all for being here tonight. This is the first of these dinners that I have had the honour of hosting. A particular privilege is to be able to do so in Melbourne, where we had our Board meeting today at our offices on the corner of Exhibition and Collins streets. Four of our nine Board members are based in Melbourne, with Carol Schwartz recently joining Cath Tanna, Kathryn Fagg and Ian Harper on the Reserve Bank Board. It was more than 30 years ago that we last had four residents of Melbourne on this Board and, on that occasion, it was only for a very short period. At our meeting today, the Board decided to leave the cash rate unchanged at 1.50 per cent. As usual, the reasons for our decision were set out in the statement issued shortly after the meeting. I don't propose to run through all the issues that were considered by the Board. But there are two issues that I would like to talk about. The first is the improvement in the global economy. Business and consumer sentiment have lifted in many countries and global trade and industrial production have picked up as well. Commodity prices are also higher than they were for most of last year. Headline inflation rates have returned to near normal levels in many countries, boosted by higher oil prices. And the point of maximum global monetary stimulus looks to have passed. Given all this, at the G20 meetings that the Treasurer and I attended in Baden-Baden in Germany two weeks ago, the tone was much more positive than it had been at previous meetings. Encouragingly, over recent months forecasts for global growth have been revised up, not down as has been the case for the past four years. So this is a better position than we found ourselves in this time last year. There are, of course, still some clouds on the horizon. One that dominated discussion at the G20 meetings was a possible retreat from an open rules-based international trading system. If this were to occur it would, clearly, be bad for Australia and the world economy. The positive aspect, though, of these discussions is that they have generated a renewed focus in some countries, including in most emerging market economies, on the importance of the open international trading system. We have a lot riding on this being the outcome. The improvement in the global environment is helping us here in Australia. Commodity prices are up and there has been some improvement in business sentiment as well. And investment outside the resources sector looks to be gradually lifting after being weak for many years. So this is positive news. Labour market conditions, though, remain pretty soft. Growth in employment is slow and wage growth is the lowest in some decades. We will want to see an improvement here before we can be confident that growth in the overall economy is strengthening. We will also need to assess the effects on the economy from the damage and disruption from Cyclone Debbie in Queensland and the floods in northern New South Wales. It is still too early though for a full assessment to be made. The second issue that I would like to talk about is the level of household debt and the housing market. This is something we have been focused on for some time. The level of household debt in Australia is high and it is rising. Over the past year the value of housing-related debt outstanding increased by 6 1/2 per cent. This compares with growth of around 3 per cent in aggregate household income. The result has been a further rise in the ratio of household debt to income, from an already high level. In aggregate, households are coping reasonably well with the higher debt levels. Arrears rates remain low and many households have built up sizeable buffers in mortgage offset accounts. At the same time, though, slow growth in wages is making it harder for some households to pay down their debt. For many people, the high debt levels and low wage growth are a sobering combination. In the housing market, conditions continue to vary considerably across the country. The Melbourne and Sydney markets are very strong and prices are increasing briskly. In contrast, conditions are more subdued in most other cities and, in some areas, most notably Perth, prices have declined. Nationally, growth in rents is the lowest for some decades. So it's a complex picture and there is not a single story that applies across the country. But, as is often the case in economics, it largely comes down to supply and demand. On the demand side, population growth in Australia - especially in our largest cities - picked up unexpectedly in the mid 2000s and it is only in the past couple of years that the rate of home building has responded. This imbalance was compounded by insufficient investment in the transport infrastructure needed to support our growing population. Nothing increases the supply of well-located land like good transport links. Underinvestment in this area is one of the factors that has pushed housing prices up. Put simply, the supply side simply did not keep pace with the stronger demand side. The result has been higher prices. Not surprisingly, the rising prices have encouraged people to buy residential property as an investment in the hope of ongoing capital gains. With global interest rates so low, many investors have found it attractive to borrow money to invest in appreciating residential property. This has reinforced the upward pressure on prices. This configuration of ongoing increases in indebtedness and rising housing prices has been discussed at length by the Council of Financial Regulators. This council, which I chair, brings together the heads of the RBA, APRA, ASIC and the Australian Treasury. The concern has not been that these developments have posed a risk to the stability of our financial system. Our banks are resilient and they are soundly capitalised. Instead, the concern has been that the longer the recent trends continued, the greater the risk to the future health of the Australian economy. Stretched balance sheets make for more volatility when things turn down. Given this, over the past couple of years there has been a concerted effort by APRA to encourage lenders to strengthen their lending standards. This followed deterioration in these standards a few years ago. Also, at the end of 2014, when growth in investor lending was accelerating, APRA announced that it would pay very close attention to lenders whose investor loan portfolios were growing faster than 10 per cent. It did so with the full support of the RBA. This guidance helped pull the whole system back and has made a positive contribution to overall financial stability. So too has ASIC's focus on responsible lending. These measures constrained some higher-risk lending and reinforced the message to lenders that they need to take a system-wide focus in their risk assessments. Notwithstanding this, given recent trends and the heightened risk environment, APRA announced some further measures last Friday. Again, it did this with the full support of the Council of Financial Regulators. There are two parts of APRA's announcements that I would like to draw your attention to. The first is the need for lenders to have a very strong focus on serviceability assessments. Despite the focus on this area over recent times, too many loans are still made where the borrower has the skinniest of income buffers after interest payments. In some cases, lenders are assuming that people can live more frugally than in practice they can, leaving little buffer if things go wrong. So APRA quite rightly has said that lenders can expect a strong supervisory focus on loans with a very low net income surplus. The second area is interest-only lending. Over the past year, close to 40 per cent of the housing loans made in Australia have not required the scheduled repayment of even one dollar of principal at least in the first years of the life of the loan; only interest payments are required. This is unusual by international standards. In some countries, repayment of at least some principal is required on all housing loans for the entire life of the loan. In other countries, interest-only loans are available only if the borrower has already contributed a fair degree of equity. So this is one area where Australia stands out. We are not unique in this area, but we are unusual. There are a couple of factors that help explain the popularity of interest-only loans in Australia. One is the flexible nature of Australian mortgages. Many people with interest-only loans make significant payments into offset accounts rather than explicitly paying down principal. This flexibility, which is of value to many people, isn't available in most countries. A second factor is the taxation arrangements that apply to investment in residential property in Australia. Last week APRA stated that it expected that new interest-only loans should account for no more than 30 per cent of the flow of new loans. It also stated that institutions should place strict limits on interest-only loans with high loan-to-valuation ratios. Like the earlier 'speed limits' on investor lending, these new requirements should help the whole system pull back to a more sustainable position. A reduced reliance on interest-only loans in Australia would be a positive development and would help improve our resilience. With interest rates so low, now is a good time for us to move in this direction. Hopefully, the changes might encourage a few more people to think about the merit of taking out very large interest-only loans when interest rates are near historical lows. So the RBA welcomes these latest changes. It is important, though, that we are all realistic about what these and other prudential measures can achieve. As I said before, the underlying driver in our housing market is the balance between supply and demand. The availability of credit is undoubtedly a factor that can amplify demand, but it is not the root cause. This assessment is consistent with the observation that housing market dynamics currently differ significantly across the country, despite Australia having nationwide financial institutions and the level of interest rates being the same across the country. It is hard to escape the conclusion that we need to address the supply side if we are to avoid ever-rising housing costs relative to our incomes and to avoid the attendant incentive to borrow that is created by rising housing prices. The various prudential measures do not address the underlying supply-demand issues. But they can reduce the risk from the financial side of the housing market while the underlying issues are addressed. These prudential measures help lessen the amplification of the cycle we get from borrowing and reduce the risk of developments on the financial side weakening the resilience that our economy has exhibited for many years. Ideally, this would be achieved by financial institutions acting themselves, without the need for prudential guidance. But sometimes prudential guidance can help the whole system adjust. The calibration of this guidance is not precise or straightforward so we need to keep matters under review. The Council of Financial Regulators will continue to assess how the system responds to the various measures so far. It would consider further measures if needed. As I have said, though, in the end addressing the supply side of the housing market is likely to prove a more durable way of dealing with the concerns that people have about debt and housing prices than detailed supervisory guidance. So that is enough on debt and housing. Before finishing, I would like to recognise that tomorrow we are having the official opening of our new banknote distribution centre and vault at Craigieburn, in outer Melbourne. This new centre is an important investment for us in Victoria. It will help us manage the task of issuing and storing banknotes nationally for many years to come. The new facility is built around a very large vault and as you can imagine, it is highly secure. It also uses the latest technology and is our first major investment in banknote storage and distribution for decades. As I hope you are aware, we are currently in the process of upgrading our banknotes to stay ahead of counterfeiters. Counterfeiting rates in Australia remain pretty low but they are creeping up. The new $5 note came out in September last year and the public reaction has been favourable. We are proud of these new notes, not just of the design but also of the high-tech security features. The new $10 will be issued from September and the $50 next year. As you can imagine, issuing a new series of banknotes is a huge logistical exercise. There are currently 1.5 billion individual banknotes on issue. That averages 62 per person in Australia. We also hold large contingency stocks, which we needed during the financial crisis when the demand for banknotes surged. It might come as a surprise to you to learn that, despite all the talk of a cashless society and electronic payments, the value of banknotes on issue in Australia, relative to GDP, is the highest that it has been in 50 years. Australians have come to rely on our secure and high-quality banknotes. Our new state of the art facility at Craigieburn will help us manage the storage and distribution of these notes. Thank you and enjoy your dinner and conversation.

r170427a_BOA

australia

Renminbi Internationalisation

lowe

It is an honour for me to be able to speak at this Renminbi (RMB) Global Cities Dialogue. I would like to congratulate the Department of Premier and Cabinet in New South Wales and the Sydney for RMB Committee for putting this dialogue together. I would also like to offer a very warm welcome to Sydney to those of you who have travelled from afar, especially those of you from other offshore RMB centres. We are all here to discuss the internationalisation of the Chinese currency. This is an important topic. I say this for two reasons. The first is that the internationalisation of the RMB and the associated liberalisation of the Chinese capital account have significant implications for the global financial system. Indeed, it is likely that the internationalisation of the RMB will be one of the biggest forces shaping the global financial system over the next decade or so. The second reason is that as the RMB becomes a truly global currency it is likely to change the way the Chinese economy operates. Australia's experience provides an example here. In our own case, the internationalisation of the Australian dollar played an important role in shaping the development of the Australian economy over the past three decades or so. The internationalisation of our currency was a by-product of the move to a floating exchange rate and the abolition of capital controls. For us, it has been a positive experience. My expectation is that one day China too will be able to make the same claim. It is easy to appreciate why the Chinese authorities have sought to have an internationalised currency. As one of the world's largest economies - and one that continues to grow in relative importance - it is understandable that China wishes to see the RMB take its place as one of the world's truly global currencies. There are some clear advantages of being in this position. Mainland China's financial markets will be deeper and more liquid, lowering the cost of finance to business. And there's an advantage in being able to use your own currency in international trade and have global prices quoted in your currency. Being a major reserve currency can also help lower the cost of external financing. So China's ambition is readily understandable. China is clearly making progress towards achieving this ambition. Given this, tonight I would like to talk first about that progress and then about some of the challenges and opportunities that lie ahead. When we speak of an internationalised currency, what we typically have in mind is a currency that is used frequently in international trade and investment transactions between residents and non-residents and also in transactions that involve only non-residents. An internationalised currency can't be achieved overnight. It takes time. It takes time for non-residents to be comfortable using another currency. They need to have the hedging instruments available to manage risk effectively and a degree of familiarity with the foreign currency. It also takes time for the home authorities to be comfortable allowing their currency to be freely bought and sold by non-residents. So internationalisation is not something that occurs quickly. For the RMB there has been more progress in the use of the currency in transactions between residents and non-residents than there has been in its use for transactions between non-residents only. This is particularly so on the trade side, as the Chinese authorities have been encouraging the use of the RMB for trade invoicing and settlement for quite some time. The use of the RMB for trade transactions has been facilitated by the establishment of offshore RMB centres, which provide a link between offshore markets and the mainland. As you are aware, these centres are a unique feature of the RMB internationalisation process and are an obvious impetus for this dialogue. Importantly, market participants should have the confidence to use the RMB freely within these centres, as many of these centres have RMB swap facilities with the People's Bank of China (PBC). As such, they play a role in facilitating RMB transactions between non-residents. That said, there has recently been a decline in some measures of offshore RMB activity, which I will touch on in a moment. Consistent with the experience of other currencies, the increased use of the RMB in trade transactions has led to an increase in RMB-denominated financial transactions between mainland residents and non-residents. Most foreign financial institutions now have access to China's bond markets, including, since last year, in the way previously available only to central banks and sovereign wealth funds. Nevertheless, domestic bonds purchased by foreign investors only account for around 1-1 1/2 per cent of the market, although the market itself has expanded quickly. The authorities also intend to create a link between the bond markets in mainland China and Hong Kong later this year. In addition, as of earlier this year foreign investors are permitted to participate in the domestic foreign exchange derivative market to hedge the currency risk they take on as part of their bond investments. Foreign investors also have access to China's equity markets through programs such as the Shanghai and Shenzhen Stock Connect schemes with Hong Kong. The stock connect schemes have facilitated capital outflows from China, alongside other schemes allowing institutional investors to invest offshore. Reflecting the progress that has been made, last year the RMB entered the basket of currencies that determine the value of the IMF's Special Drawing Right. This followed the IMF's decision in late 2015 to designate the RMB as 'freely usable'. Not surprisingly, an increasing number of countries, including Australia, invest a portion of their foreign reserves in RMB. I note, however, that according to the IMF's latest figures, the total value of foreign reserves invested in Australian dollars is still significantly higher than invested in RMB. I expect this to change over time. Our local RMB market has also been developing, albeit from a low base. Recently published survey data collected by the RBA show that the value of RMB deposits held with Australian-resident banks rose strongly over 2015 and has been broadly unchanged over the past year, at around RMB30-40 billion. Consistent with this, annual data from the Australian Bureau of Statistics show that the share of Australia's trade with China invoiced in RMB has continued to rise in recent years. In contrast to the experience here in Australia, the share of China's total trade settled in RMB has declined over recent times. After peaking at almost 30 per cent in mid 2015, that share is currently around 15 per cent. The decline in the share of RMB payments for imports has contributed to a decline in the stock of RMB deposits in the offshore centres given that supply of RMB to these centres is largely through RMB trade payments. As Dr Ma touched on earlier today, part of this rise and subsequent fall in offshore RMB deposits reflects changed expectations about the future path of the RMB. But there has also been some underlying growth in demand for offshore RMB deposits for transactional purposes, with investors actively seeking to manage their exposure to exchange rate fluctuations. So putting all this together, there has been significant progress on many fronts. Indeed, there has been more progress than many observers expected. There is, though, still some way to go for the RMB to be a truly internationalised currency. An obvious question then is how to build on the progress that has been made. One lesson from experience elsewhere is that having an internationalised currency requires an open capital account. It requires allowing domestic citizens to buy and sell assets overseas and allowing non-residents to buy and sell domestic assets. The flows associated with these transactions generate depth in financial markets and provide a stimulus to the development of hedging markets. This then encourages more transactions: a form of virtuous circle develops. This was certainly the case here in Australia with the internationalisation of our currency. Interestingly, though, at no point did we have a strategic objective of having an internationalised currency. Instead, it happened rather organically as a result of market forces in an open system. China has been gradually moving in this direction, but the process of opening up has its challenges. Two of these are worth pointing out. The first is managing the volatility in capital flows that can be associated with a more open capital account. The second is managing the implications for global markets and investment patterns. The first of the challenges is one that faces any country moving from a highly constrained system to a more liberal system. As the constraints are lifted, people adjust their portfolios in ways they previously could not. These adjustments can lead to sharp and disruptive movements in market prices, particularly exchange rates, especially when markets are still not fully mature. To date, the Chinese authorities have largely avoided this volatility in market prices, although changes in expectations for the path of the exchange rate have affected capital flows into and out of China. For a number of years up until mid 2014, the RMB had been considered a 'one-way' bet to appreciate against the US dollar. Foreign capital flowed into China as investors sought to take advantage of the higher returns available, but also the appreciation of the RMB. As this capital flowed into China, the central bank offset some of the upward pressure on the exchange rate by purchasing foreign currency and buying foreign assets. Over the past couple of years, though, things have changed, with the RMB depreciating against the US dollar, alongside persistent expectations for further depreciation. Chinese residents have taken advantage of some new freedoms to increase foreign investment and the depreciating exchange rate has increased their incentive to do this. Mainland companies also appear to have delayed their export receipts and pre-paid for imports in anticipation of the RMB being weaker in the future. And they have also boosted their foreign currency deposits by holding onto foreign currency trade receipts (rather than converting them to RMB) and using them to repay foreign currency loans. In response to these changes, the Chinese authorities have sold some of the foreign assets they purchased previously. As a result, China's foreign currency reserves have declined from a peak of US$4 trillion in mid 2014 to around $US3 trillion now. Fewer foreign assets are now held by the central bank and more are being held by other Chinese entities. As the People's Bank of China has stated, this is a desirable shift. The Chinese authorities are understandably concerned that, left unchecked, the turnaround in capital flows could be destabilising. As a result, there has been some tightening up in the ability of Chinese residents to purchase foreign assets. The available data, as well as reports from China, suggest that these measures have slowed the outflow of capital. It should not come as a surprise that the Chinese authorities are proceeding cautiously and have sought temporarily to slow outflows or inflows from time to time. While many countries have liberalised their capital account and made their exchange rate more flexible, few, if any, have done so without causing at least some disruption to their domestic financial system. Short-term controls arguably can have a positive effect on financial stability in China by reducing the risk of a disorderly currency adjustment and pressures in Chinese financial markets. But there is a balance to be struck here, as tightening up controls runs counter to the longer-run goal. One consideration is the signal that a tightening of controls, after several years of liberalisation, could send to investors about how the government perceives the balance of risks facing the economy. A broad based and persistent tightening of capital controls might also exacerbate domestic vulnerabilities, by causing domestic liquidity to be greater than might be desired from a strict macroeconomic management perspective. Ultimately, balancing these competing risks is a difficult task. The second challenge for China is dealing with the implications for the global financial system. Unlike the challenge of dealing with volatility, this challenge is not one that most other countries have faced. It is an issue for China because of its size. When Australia opened its capital account the rest of the world hardly paid attention. But this is not the case for China. The rest of the world is watching and it has a strong interest in the outcome. Chinese gross portfolio flows remain small relative to the size of its economy. As my predecessor, Glenn Stevens, noted, if China's gross portfolio flows were equivalent to 5 per cent of GDP in 2015 - the figure for many other countries in Asia and a bit less than that for Australia - China would account for a little more than one-fifth of global portfolio flows. Because of China's size, investment by Chinese entities abroad has the potential to affect the prices of many assets significantly. We have already seen some signs of this with, for example, housing prices in some cities being affected by the inflow of Chinese money. The nature of the foreign assets owned by Chinese entities is also changing, as the central bank has a different portfolio composition from that of most other Chinese entities. In many countries, a related issue is the purchase of domestic assets by Chinese state-owned enterprises. There have been a few high-profile cases where governments have blocked deals by Chinese state-owned enterprises. But, by and large, most countries, including Australia, have welcomed Chinese investors in a wide range of sectors. Chinese capital is helping to build businesses and stronger trade links. So there are a lot of issues to be managed here. To conclude, China is going through an important transition. It was not that long ago that the Chinese currency could be used only within China's borders. In contrast, today China has the ambition of having a global currency. The effects of this transition - involving the internationalisation of the RMB and the opening up of the capital account - could ultimately be as wideranging as were the effects of China's ascension to the World Trade Organisation. Managed well, this transition can be a win-win for both China and the rest of the world. Thank you.

r170504a_BOA

australia

Household Debt, Housing Prices and Resilience

lowe

Thank you for the invitation to address the Queensland branch of the Economic Society of Australia. It is a pleasure to be in Brisbane again today. This afternoon I would like to talk about household debt and housing prices. This is a familiar topic and one that has attracted a lot of attention over recent times. It is understandable why this is so. The cost of housing and how we finance it matters to us all. We all need somewhere to live and for many people, their home is their largest single asset. Real estate is also the major form of collateral for bank lending. The levels of debt and housing prices also affect the resilience of our economy to future shocks. Beyond these economic effects, high levels of debt and housing prices have broader effects on the communities in which we live. The high cost of housing is a real issue for many Australians and can have serious side-effects. High levels of debt and high housing costs can also reinforce the existing distribution of wealth in our society, making social and geographic mobility more difficult. So it is understandable why Australians are so interested in these issues. At the Reserve Bank, we too have been focused on these issues in the context of our monetary policy and financial stability responsibilities. Our work has been in three broad areas. First, understanding the aggregate trends and their causes. Second, understanding how debt is distributed across the community. And third, understanding how the level of debt and housing prices affect the way the economy operates and its resilience to future shocks. This afternoon, I would like to make some observations in each of these three areas. This first chart provides a good summary of the aggregate picture (Graph 1). It shows the ratios of nationwide housing prices and household debt to household income. Housing prices and debt both rose a lot from the mid 1990s to the early 2000s. The ratios then moved sideways for the better part of a decade - in some years they were up and in others they were down. Then, in the past few years, these ratios have been rising again. Both are now at record highs. Although the debt-to-income ratio has increased over recent times, the ratio of debt to the value of the housing stock has not risen. This reflects the large increase in housing prices and the growth in the number of homes. Over recent times, there has also been a substantial increase in the value of households' financial assets, with the result that the ratio of household wealth to income is at a record high (Graph 2). So both the value of our assets and the value of our liabilities have increased relative to our incomes. Turning now to why the ratios of housing prices and debt to income have risen over time. A central factor is that financial liberalisation and the lower nominal interest rates that came with the lower inflation of the 1990s increased people's ability to borrow. These developments meant that Australians could take out larger and more flexible loans. By and large, we took advantage of this new ability, as we sought to buy the housing we desired. We could, of course, have used the benefit of lower nominal interest rates in the 1990s and the increased ability to borrow for other purposes. But instead we chose to borrow more for housing and this pushed up the average price of housing given the constraints on the supply side. The supply of well-located housing and land in our cities has been constrained by a combination of zoning issues, geography and inadequate transport. Another related factor was that our population was growing at a reasonable pace. Adding to the picture, Australians consume more land per dwelling than is possible in many other countries, although this is changing, and many of us have chosen to live in a few large coastal cities. Increased ability to borrow, more demand and constrained supply meant higher prices. So we saw marked increases in the ratios of housing prices and debt to household incomes up until the early 2000s. At the time, there was much discussion as to whether these higher ratios were sustainable. As things turned out, the higher ratios have been sustained for quite a while. This largely reflects the choices we have made as a society regarding where and how we live (and how much at least some of us are prepared to spend to do so), urban planning and transport, and the nature of our financial system. It is these choices that have underpinned the high level of housing prices. So the changes that we have seen in these ratios are largely structural. Recently, the ratios of housing prices and debt to household income have been increasing again. Lower interest rates both in real and nominal terms - this time, largely reflecting global developments - have again played some role. But there have also been other important factors at work over recent times. One of these is the slow growth in household income. During the 2000s, aggregate household income increased at an average rate of over 7 per cent (Graph 3). In contrast, over the past four years growth has averaged less than half of this, at about 3 per cent. Slower growth in incomes will push up the debt-to-income ratio unless growth in debt also slows. This partly explains what has happened over recent years. A second factor is that some of our cities have become major global cities. Reflecting this, in some markets there has been strong demand by overseas investors. A third factor has been stronger population growth. Population growth picked up during the mining investment boom and, although it subsequently slowed, it is still around 1/2 percentage point faster than it was before the boom (Graph 4). For some time the rate of home-building did not respond to the faster population growth; indeed, the response took the better part of a decade. The rate of home-building has now responded and we are currently adding to the housing stock at a rate not seen for more than two decades. Over time, this will make a difference. It is Melbourne and Sydney where population growth has been the fastest over recent times. Not surprisingly, it is these two cities where the price gains have been largest, and these price gains have helped induce more supply. Indeed, Victoria and New South Wales account for all of the recent upward movement in the national housing price-to-income ratio (Graph 5). In the other states, the ratio of housing prices to income is below previous peaks. So there is not a single story across the country. This is despite us having a common monetary policy for the country as a whole. Factors other than the level of interest rates are clearly at work. In summary then, the supply-demand dynamics have been pushing aggregate housing prices in our largest cities higher relative to our incomes. With interest rates as low as they have been, and prices rising, many people have found it attractive to borrow money to invest in an asset whose price is increasing. The result has been strong growth in borrowing by investors, with investors accounting for 30 to 40 per cent of new loans. This borrowing is not the underlying cause of the higher housing prices. But the borrowing has added to the upward pressure on prices caused by the underlying supply-demand dynamics. It has acted as a financial amplifier in some cities, adding to the already upward pressure on prices. The borrowing by investors is also obviously contributing to the rise in the aggregate debt-to-income ratio. Just like in the early 2000s, there is again a discussion as to whether these increases will continue and whether they are sustainable. I would now like to turn to the distribution of housing debt across households. This is important, as it is not the 'average' household that gets into trouble. At the Reserve Bank we have devoted considerable resources to understanding this distribution. One important source of household-level information is the survey of Household Income and Labour Dynamics in Australia (HILDA). If we look across the income distribution, it is clear that the rise in the debt-to-income ratio has been most pronounced for higher-income households (Graph 6). This is different from what occurred in the United States in the run-up to the subprime crisis, when many lower-income households borrowed a lot of money. It is also possible to look at how the debt-to-income ratio has changed across the age distribution. This ratio has risen for households of all ages, except the very youngest, who tend to have low levels of debt (Graph 7). Borrowers of all ages have taken out larger mortgages relative to their incomes and they are taking longer to pay them off. Older households are also more likely than before to have an investment property with a mortgage and it has become more common to have a mortgage at the time of retirement. We also look at the share of households with a debt-to-income ratio above specific thresholds. In 2002, around 12 per cent of households had debt that was over three times their income (Graph 8). By 2014, this figure had increased to 20 per cent of households. There has also been an increase, although not as pronounced, in the share of households with even higher debt-to-income ratios. Another dataset that provides insight into distributional issues is one maintained by the Reserve Bank on loans that have been securitised. This indicates that around two-thirds of housing borrowers are at least one month ahead of their scheduled repayments and half of borrowers are six months or more ahead (Graph 9). This is good news. But a substantial number of borrowers have only small buffers if things go wrong. At the overall level, though, nationwide indicators of household financial stress remain contained. This is not surprising with many borrowers materially ahead on their mortgage repayments, interest rates being low and the unemployment rate being broadly steady over recent years. At the same time, though, the household-level data show that there has been a fairly broad-based increase in indebtedness across the population and the number of highly indebted households has increased. I would now like to turn to the third element of our work: the implications of all this for the way the economy operates and its resilience. It is now commonplace to say that housing prices and debt levels matter because of financial stability. What people typically have in mind is that a severe correction in property prices when balance sheets are highly leveraged could make for instability in the banking system, damaging the economy. So the traditional financial stability concern is that the banks get in trouble and this causes trouble for the overall economy. This is not what lies behind the Reserve Bank's recent focus on household debt and housing prices in Australia. The Australian banks are resilient and they are soundly capitalised. A significant correction in the property market would, no doubt, affect their profitability. But the stress tests that have been done under APRA's eye confirm that the banks are resilient to large movements in the price of residential property. Instead, the issue we have focused on is the possibility of future sharp cuts in household spending because of stretched balance sheets. Given the high levels of debt and housing prices, relative to incomes, it is likely that some households respond to a future shock to income or housing prices by deciding that they have borrowed too much. This could prompt a sharp contraction in their spending, as they try to get their balance sheets back into better shape. An otherwise manageable downturn could be turned into something more serious. So the financial stability question is: to what extent does the higher level of household debt make us less resilient to future shocks? Answering this question with precision is difficult. History does not provide a particularly good guide, given that housing prices and debt relative to income are at levels that we have not seen before, and the distribution of debt across the population is changing. Given this, one of the research priorities at the Reserve Bank has been to use individual household data to understand better how the level of indebtedness affects household spending. The results indicate that the higher is indebtedness, the greater is the sensitivity of spending to shocks to income. This is regardless of whether we measure indebtedness by the debt-to-income ratio or the share of income spent on servicing the debt. If this result were to translate to the aggregate level, it would mean that higher levels of debt increase the sensitivity of future consumer spending to certain shocks. The higher debt levels also appear to have affected how higher housing prices influence household spending. For some years, households used the increasing equity in their homes to finance extra spending. Today, the reaction seems different. This is evident in the estimates of housing equity injection (Graph 10). In earlier periods of rising housing prices, the household sector was withdrawing equity from their housing to finance spending. Today, households are much less inclined to do this. Many of us feel that we have enough debt and don't want to increase consumption using borrowed money. Many also worry about the impact of higher housing prices on the future cost of housing for their children. As I have spoken about previously, higher housing prices are a two-edged sword. They deliver capital gains for the current owners, but increase the cost of future housing services, including for our children. This change in attitude is also affecting how spending responds to lower interest rates. With less appetite to incur more debt for current consumption, this part of the monetary transmission mechanism looks to be weaker than it once was. There is, however, likely to be an asymmetry here. When the interest rate cycle turns and rates begin to rise, the higher debt levels are likely to make spending more responsive to interest rates than was the case in the past. This is something that we will need to take into account. In terms of resilience, my overall assessment is that the recent increase in household debt relative to our incomes has made the economy less resilient to future shocks. Given this assessment, the Reserve Bank has strongly supported the prudential measures undertaken by APRA. Double-digit growth in debt owed by investors at a time of weak income growth cannot be strengthening the resilience of our economy. Nor can a high concentration of interest-only loans. I want to point out that APRA's measures are not targeted at high housing prices. The international evidence is that these types of measures cannot sustainably address pressures on housing prices originating from the underlying supply-demand balance. But they can provide some breathing space while the underlying issues are addressed. In doing so, they can help lessen the financial amplification of the cycle that I spoke about before. Reducing this amplification while a better balance is established between supply and demand in the housing market can help with the resilience of our economy. There are some reasons to expect that a better balance between supply and demand will be established over time. One is the increased rate of home-building. As we are seeing here in Brisbane and some parts of Melbourne, increased supply does affect prices. This increase in supply is also affecting rents, which are increasing very slowly in most markets. A second reason is the increased investment in some cities, including in Sydney, on transport. Over time, this will increase the supply of well-located residential land, and this will help as well. And a third reason is that at some point, interest rates in Australia will increase. To be clear, this is not a signal about the near-term outlook for interest rates in Australia but rather a reminder that over time we could expect interest rates to rise, not least because of global developments. Over recent years, the low interest rates in Australia have helped the economy adjust to the winding down of the mining investment boom. They have helped support employment and demand through a significant adjustment in the Australian economy. We should not, though, expect interest rates always to be this low. It remains to be seen how the various influences on housing prices play out. Other policies, including tax and zoning policies, also have an effect. But increased supply and better transport could be expected to help address the ongoing rises in housing prices relative to incomes. These changes and some normalisation of interest rates over time might also reduce the incentive to borrow to invest in an asset whose price is rising strongly. To the extent that, over time, a better balance is established, we will be better off not incurring too much debt, and having housing prices go too high, while this is occurring. I want to make it clear that the Reserve Bank does not have a target for the debt-to-income ratio or the ratio of nationwide housing prices to income. As I spoke about earlier, there are good reasons why these ratios move over time. My judgement, though, is that, in the current environment, the resilience of our economy would be enhanced by an extended period in which housing prices and debt outstanding increased no faster than our incomes. Again, this is not a target or a policy objective of the Reserve Bank, but rather a general observation about how we build resilience. Many of you will be aware that these issues have figured in the deliberations of the Reserve Bank Board for some time. This is entirely consistent with our flexible medium-term inflation targeting framework. With a medium-term target, it is appropriate that we pay attention to the resilience of our economy to future shocks. In the current environment of low income growth, faster growth in household debt is unlikely to help that resilience. We have also been watching the labour market closely. The unemployment rate has moved up a little over recent months and wage growth remains subdued. Encouragingly, employment growth has been a bit stronger of late and the forward-looking indicators suggest ongoing growth in employment. We will want to see a continuation of these trends if the overall growth in the economy is to pick up as we expect. Stronger growth in incomes would of course also help people deal with the high levels of debt and housing prices. Overall, our latest forecast is for economic growth to pick up gradually and average around 3 per cent or so over the next few years. To conclude, I hope these remarks help provide some insight into the Reserve Bank's thinking about housing prices and household debt. As household balance sheets have changed, so too has the way that the economy works. Both from an individual and an economy-wide perspective, we need to pay attention to how the higher level of debt affects our resilience to future shocks. Thank you. I look forward to your questions.

r170726a_BOA

australia

The Labour Market and Monetary Policy

lowe

In today's remarks, I would like to talk about these labour market issues in an Australian context. My remarks will be in three parts. I will first talk about trends in employment in Australia. I will then discuss recent wage outcomes. And finally, the implications for monetary policy. On a number of measures the Australian labour market has performed well over recent times. Over the past decade and a half, the unemployment rate has moved up and down within a narrow range of around 2 percentage points and its average level has been considerably below that in the previous 30 years (Graph 1). Most other countries have seen considerably larger swings in their unemployment rates over recent times. The relative stability in Australia's unemployment rate is despite us experiencing the biggest terms of trade and mining investment booms in a century. It is a considerable achievement and a testament to the flexibility of the Australian economy. If we look at just the past few months, there has been a welcome pick-up in employment growth right across the country, after a period of softness. The forward-looking indicators suggest that employment growth will continue. Job ads, job vacancies and hiring intentions have all lifted. Businesses are also reporting better conditions than they have for some years. This is good news, particularly given that the unemployment rate is still around 1/2 a percentage point above estimates of full employment in Notwithstanding these outcomes, there are other labour market developments that are causing concern in the community. There is a degree of underemployment, wage growth is slow and job security is an issue for more people. The nature of work is also changing, in both the way we work and the industries in which we work. Over the medium term, two trends in particular stand out. The first is the growth of part-time employment. And the second is the growth of employment in the services sector. The number of Australians working part time has grown rapidly (Graph 2). Since the 1960s, the share of part-time workers has increased threefold to nearly one-third of total employment, with the pace of this shift picking up over recent years. Since 2013, growth in part-time employment has averaged 3 per cent per year, while growth in full-time employment has averaged less than 1 per cent. This shift in working patterns reflects both supply and demand factors. On the supply side, many people want to work part time. Indeed, in many workplaces, employees have long been asking for greater flexibility, including the ability to work fewer hours. Part-time work leaves time for other activities, including education, caring for others and leisure. Some insight into why people work part time can be gained from the HILDA Survey, which asks people for the main reason that they work part time (Graph 3). The most common response is that they are studying. Other frequent responses are that they are caring for children or that they simply prefer parttime work. For many people, part-time work is what they want. The fact that we have been able to accommodate this desire is a positive feature of our labour market. There are demand factors at work as well. Many businesses benefit from having employees who work part time. But there is an element to the demand side that is not so positive. Some people are working part-time because they can't find a full-time job and others are working part-time because of job requirements. While most part-time workers are not seeking full-time employment, around one-quarter want to work more hours than they currently do. On average, they are looking to work an additional 14 hours per week, although many are not taking active steps to secure those additional hours. So many people want to work part time, but some of these would like more hours than they currently have. This represents an additional source of unused capacity in our labour market that is not reflected in the unemployment rate. Given this, as part-time employment has grown, the RBA has paid additional attention to alternative measures of labour market slack. One measure that has conceptual appeal is an hours-based underutilisation rate, which measures the additional hours sought by workers (including those currently unemployed) relative to the total number of hours that workers would like to work. This measure shows the same general pattern as the unemployment rate, although the gap has tended to Now turning to the second longer-term trend shift we have seen in our labour market - the shift to Today, almost 80 per cent of Australians work in service industries, broadly defined. By way of contrast, in the 1950s only around 50 per cent of employed Australians worked in the services sector. In the past, it was common to have a full-time job producing goods. In our more modern economy, this is no longer the case. In an effort to better understand the growth in services-sector employment, one of the exercises that we have done at the RBA is to classify around 300 individual service-sector occupations into jobs that pay hourly wages that are below average, around average and above average. We have then tracked employment growth for each of these three groups since 2000 (Graph 6). The picture is pretty clear. The growth in service-sector employment has been strongest in those occupations with above-average rates of pay. Since 2000, over a million new higher-paying jobs have been created in the services sector. Some of the occupations where there have been large gains in employment are: medical professionals, IT managers, project administrators and sales managers. There has also been strong employment growth in occupations with lower rates of pay. We have also conducted the same analysis for the business services and household services sectors separately (Graph 7). The growth of higher-paying jobs has been much more pronounced in business services, than it has been in household services. For the household services sector, the growth has been strongest in jobs with below-average wages. Some of the occupations where there has been a big increase in employment here include: baristas and waiters, childcare workers and aged-care workers. So it's a mixed picture. I am often asked where future jobs growth will come from. The short answer is that it will come mainly from where it has come from in the recent past - from the myriad of occupations in the services sector. Some of these jobs will attract relatively low rates of pay, but, if our experience is a useful guide, more of these jobs will be higher-paying high-skill jobs. With most of us working in the services sector, it's in our national interest to lift productivity growth in these industries and to develop more higher-paid high-skill jobs. Technology is important here but so too is investment in human capital. It seems probable that the next wave of growth in Australia will be driven by us building on our expertise in services. This requires investment, including in human capital. I would now like to turn to another element of the labour market story - the slow growth in wages. Over the past year, the Wage Price Index has increased by 1.9 per cent. This is the slowest rate of increase since this series commenced in 1997. The same picture is evident in the broader measure of average hourly earnings from the national accounts. To help see the longer-term trends, Graph 8 shows average annual growth in hourly earnings over a rolling four-year period. The most recent observation is the lowest for many decades. From the mid 1990s until a few years ago, Australians got used to average hourly earnings increasing by around 4 per cent a year. Over recent years, growth has been a bit less than half of this. These lower wage increases have persisted for some time now. One consequence of this is that there has been a decline in expectations of future income growth. This decline is seen as more than just temporary. It is one of the factors that has been weighing on consumption growth over recent times. As households have revised down their expectations of future income growth, they have adjusted their spending too. A downward revision to expectations of income growth also means debt obligations stay higher for longer than was originally expected. Why is this happening, both here and elsewhere in the world? There is no single answer. Part of the story in Australia is that our labour market has some spare capacity and we are unwinding some of the effects on wages of the mining investment boom. But this isn't the whole story, and neither spare capacity nor a mining boom explain low wages growth in some other advanced economies. Another part of the story, particularly overseas, is slower productivity growth. In the United States, for example, low growth in wages is being matched with low productivity growth. In Australia, productivity growth has also slowed somewhat. Here, however, the slowing in earnings growth has been more pronounced than that in productivity. The result has been a decline in labour's share of national income. None of these reasons alone appears sufficient to explain the weakness in wage growth. This suggests that there is something else going on, and that it has a global dimension. Many workers in advanced economies feel like they face more competition. A basic principle of economics is that when you face more competition, you are less inclined to put your price, or as a worker, your wage, up. This perception of greater competition is coming from two sources. The first is globalisation. One of the positives of globalisation is that it increases the size of market that a firm can tap. At the same time, though, globalisation increases the number of competitors that can tap market; it increases competition. The second source is changes in technology. In some industries, advances in technology have led workers to worry about the competition from robots. At the same time, advances in technology have made more areas of the economy subject to international competition; there are fewer truly non- traded industries any more. Perhaps as a consequence of this extra competition - or perhaps as a consequence of other forces within our societies - many workers in advanced economies feel that the world is less secure - less secure economically and less secure politically. This means that security is valued more highly. With a greater premium on security, it's plausible that workers are less inclined to take a risk by seeking larger wage increases. One related aspect of the current labour market is a decline in job mobility. Data published by the ABS suggest that the share of employed people changing employers is around the lowest in recent decades (Graph 9). It is likely that in an environment of less job security, fewer people are inclined to switch employers. There is also a demand-side effect, with fewer firms attempting to attract workers from other firms. This is consistent with subdued wage growth. When I spoke about this set of issues in a recent panel at the Crawford School at ANU, I made the point that some pick-up in aggregate wage growth over time would be a welcome development. Some commentators saw this as the Reserve Bank Governor making a rather unusual call to arms: a call for workers to demand larger wage increases from their employers. My intention was less dramatic. It was simply to make the point that a gradual pick-up in aggregate wages growth would be a positive development. The best outcome for both workers and firms is for any pick-up to be underpinned by a lift in productivity growth and more high-skill jobs. But even the current rate of productivity growth could sustain some increase in wages growth over time. Indeed, some pick-up is incorporated into the Bank's forecasts for the economy. A gradual lift in wage growth is a central element in our forecast for inflation to return to around the mid-point of the medium-term target range. I would now like to turn to some of the implications for monetary policy, both globally and in Australia. The persistent slow growth in wages is creating a challenge for central banks. It is contributing to an extended period of inflation below target. In years gone by, the more standard challenge was to keep wage growth in check, so as to stop upward pressure on inflation, which could lead to restrictive monetary policy. No advanced economy faces this challenge at present. It is possible that things could change in the not too distant future, particularly in those countries at, or near, full employment. It may be that the lags are just a bit longer than usual. If so, we could hit a point at which workers, having had only modest pay increases for a run of years, decide that it is time for a catch-up. If such a tipping point were reached, inflation pressures could emerge quite quickly. In this scenario we could see a period of turbulence in financial markets, given that markets are pricing in little risk of future inflation. This scenario can't be completely discounted. It would seem, though, to have a fairly low probability in Australia, especially in light of the continuing spare capacity in our labour market. The more likely case here is that wage growth picks up gradually as the demand for labour strengthens. Globally, an alternative scenario is that the period of slow wage growth turns out to be much more persistent, partly for the reasons that I discussed earlier. In this scenario, wages growth eventually picks up, but it takes quite a while longer. If so, inflation stays low for longer, although there are other factors that could push inflation higher. This scenario is one in which the Phillips Curve is flatter than it once was. It is one in which inflation is harder to generate. We can't yet tell though whether the Phillips Curve in Australia has become flatter, given that we have experienced relatively little variation in the unemployment rate over recent times. The combination of a flatter Phillips Curve and inflation below target raises a challenge for central banks: how hard to press to get inflation up? For a central bank with a single objective of inflation, the answer is relatively straightforward. Inflation is too low, so you do what you can to get inflation up. If inflation doesn't increase, you need more monetary stimulus. This approach does carry risks, though. A flatter Phillips Curve means that the monetary stimulus has relatively little effect on inflation, at least for a while. At the same time, however, the monetary stimulus is likely to push asset prices higher and encourage more borrowing. Faced with low inflation, low unemployment and low interest rates, investors are likely to find it attractive to borrow money to buy assets. This poses a medium-term risk to financial stability. Australia's monetary policy framework is better placed to deal with this world than some others. We have a flexible medium-term inflation target that allows financial stability considerations to be taken into account in the setting of monetary policy. Over recent times you would have noticed that we have been paying close attention to the risks in household balance sheets. Household debt is high and rising faster than the unusually slow growth in incomes. These developments have had a bearing on the setting of monetary policy. We have not sought to stimulate a rapid lift in inflation. The fact that the labour market has been generating sufficient jobs to keep the unemployment rate broadly steady has allowed us to be patient. Our judgement has been that seeking a more rapid pick-up in inflation through yet further monetary stimulus was likely to add to the medium-term risks. Our central scenario remains for underlying inflation to pick up gradually as the economy strengthens. Elsewhere in the world, some central banks are now starting to increase interest rates and others are considering when to withdraw some of the monetary stimulus that has been put in place. This has no automatic implications for monetary policy in Australia. These central banks lowered their interest rates to zero and also expanded their balance sheets greatly. We did not go down this route. Just as we did not move in lockstep with other central banks when the monetary stimulus was being delivered, we don't need to move in lockstep as some of this stimulus is removed. Our decisions will continue to be made within the framework of our medium-term inflation target. We are intent on delivering Australians an average rate of inflation over time of between 2 and 3 per cent. We are seeking to do this in a way that supports sustainable growth in the economy and that best serves the public interest. To do this we need to understand developments in Australia's labour market and to take account of our decisions on balance sheets in the economy. Thank you for listening. I look forward to your questions.

r170811a_BOA

australia

lowe

Members of the Committee It is a pleasure to be here in Melbourne to explain our thinking on the Australian economy. My colleagues and I view this as an important part of the accountability process for the Reserve Bank. As usual, we look forward to answering your questions. Since we last met in February, the global economy has strengthened. As a result, in most advanced economies, economic growth has been sufficient to push unemployment rates down further. A number of countries now have unemployment rates that are close to, or below, conventional estimates of full employment. Conditions have also improved in many emerging market economies, partly due to an increase in global trade. Commodity prices have mostly risen over recent months. In China, growth has surprised on the upside a little of late. The main challenge there continues to be containing the risks from the build-up of debt, while at the same time keeping growth on a steady path. This remains a work in progress. Economic growth has also picked up in the euro area, with conditions the best they have been since the euro area crisis in 2012. On the other side of the ledger, though, in the United States the earlier optimism that the new administration's fiscal policies would spur stronger growth has dissipated. Since we last met, the Federal Reserve has increased interest rates twice and the policy rate in the United States now stands at 1 1/4 per cent. Despite this, the US dollar has depreciated in global markets, which has surprised many observers. The Bank of Canada has also increased its interest rate, reversing some of the policy insurance it took out earlier when the outlook was less positive. Elsewhere, there is no longer an expectation that central banks will announce yet further monetary stimulus and some central banks have indicated that they may scale back some of the current stimulus if conditions continue to improve. This is a positive development. As well as this change in the outlook for global monetary policy, another prominent theme in discussions of the global economy of late has been the slow growth in wages. Despite the success that a number of countries have had in generating jobs, wage growth remains low. This is contributing to a continuation of inflation rates that are below target in most advanced economies, although in headline terms they are mostly higher than a year ago. The reasons for the low growth in wages are complex. The fact that it is a common experience across countries suggests some global factors are at work. One possibility is that workers feel a heightened sense of potential competition; either from advances in technology or from international competition. More competition means less opportunity to put your price up. In the case of workers, it means slower rates of increase in wages. At the same time, many workers feel an increased sense of uncertainty and they feel less secure. This too is contributing to slow aggregate wage growth. The slow growth in wages is underpinning the low inflation outcomes in much of the world. It is possible that these effects will pass and that the normal relationship between tighter labour markets and higher wages will reappear. It is also possible that the current environment turns out to be quite persistent. How things turn out on this front is likely to have a significant bearing on the next stage in the global economic cycle. I would now like to turn to the Australian economy. The most recent GDP data are quite dated now and are for the March quarter. They showed growth weaker than we had earlier expected. This, however, partly reflected temporary factors, including weather-related disruptions to production and quarter-to-quarter volatility in resource exports. Since then, the recent run of data has been consistent with a pick-up in growth. There has been an improvement in survey-based measures of business conditions and capacity utilisation has increased. Employment growth has also picked up and retail spending has been a bit stronger of late. Financial conditions remain favourable, with interest rates remaining low and banks willing to lend. The Reserve Bank released its latest forecasts for the economy last Friday. In summary, our central scenario is for GDP to grow at an average of around 3 per cent over the next couple of years. This would be better than we have seen for some time. The transition to lower levels of mining investment following the mining investment boom is now almost complete. This means that falling levels of mining investment will not be a drag on the economy for much longer. Instead, with some large LNG projects reaching completion soon, GDP growth is expected to be boosted by a lift in LNG exports. For some time we have been looking for a strong pick-up in private business investment outside the resources sector. This is taking longer to occur than expected. While we do see positive signs in parts of the economy, many firms still show some reluctance to commit to significant investment, often citing a range of uncertainties. It is possible that this reluctance will continue for a while yet. But it is also possible that the improvement in business conditions that we have seen will give firms the confidence to invest more, after a period of under-investment. We have incorporated a middle path into our own forecasts. On the investment front a positive development has been an increase in spending on public infrastructure, particularly transport. This is directly supporting aggregate demand and is having some positive spin-offs elsewhere in the economy. It is also addressing earlier under-investment and should improve the supply side of the economy. Another factor that has a bearing on the outlook is the behaviour of households. There is an adjustment going on, with many people getting used to lower growth in their real wages. Many now see this as more than just a temporary development, with wage increases of 2 point something per cent now the norm. In my view, the underlying drivers of the slower wage growth in Australia are much the same as we are seeing overseas. At the same time, the household sector is also dealing with higher levels of debt relative to income. Higher electricity prices are also affecting household budgets. This all means that consumer spending behaviour is something we continue to watch carefully. One positive development in this area over recent times has been a pick-up in employment growth, which should boost incomes. A little while ago, employment growth was on the weak side and the unemployment rate had ticked up. In contrast, in recent months employment growth has been noticeably stronger and more people have entered the labour force. Encouragingly, the gain in jobs is evident in all states, including in Western Australia and Queensland, which have been adjusting to lower levels of mining investment. Our central scenario is for the national unemployment rate to move gradually lower, although it is likely to be some time before we reach what could be considered full employment in Australia. Another area that we continue to watch closely is the housing market. Conditions continue to vary significantly across the country. The Melbourne and Sydney markets have been much stronger than elsewhere. There are some signs of slowing in these two markets, although these signs are not yet definitive. In some markets, a large increase in the supply of new dwellings is expected over the next year as new buildings are completed. This increase in supply is expected to have an effect on prices. In terms of inflation, when we last met I suggested that inflation was at a trough and was expected to increase gradually. Recent outcomes have been consistent with this. Both headline and underlying inflation have risen and are currently running a little under 2 per cent. Inflation is likely to continue to move higher gradually, with the headline measure boosted by higher prices for tobacco, electricity and gas. A consideration working in the other direction is increased competition in the retail sector, particularly from new entrants. This is likely to continue for a while yet. The low wage increases are also contributing to the subdued inflation outcomes. One factor that is influencing the outlook for both economic growth and inflation is the exchange rate. The recent appreciation means lower prices for imported goods and it is weighing on the outlook for domestic output and employment. Further appreciation, all else constant, would cause a slower pick-up in inflation and slower progress in reducing unemployment. Since August last year, the Reserve Bank Board has held the cash rate steady at 1.5 per cent. This setting of monetary policy is supporting employment growth and a return of inflation to around its average rate of the past couple of decades. The Board is seeking to do this in a way that does not add to the medium-term balance-sheet risks facing the economy. It has been conscious that a balance needs to be struck between the benefits of monetary stimulus and the medium-term risks associated with rising levels of debt relative to our incomes. As a result, the Board has been prepared to be patient. The fact that the unemployment rate has been broadly steady has allowed us this patience. We have preferred a prudent approach, which is most likely to promote both macroeconomic and financial stability consistent with the medium-term inflation target. The Reserve Bank has continued to work closely with APRA through the Council of Financial Regulators to address financial risks. Our assessment is that the various supervisory measures - including a focus on lending standards and placing limits on investor and interest-only lending - will work to strengthen household balance sheets over time. Financial institutions have adjusted to the new requirements and these requirements are contributing to the resilience of the system as a whole. I would now like to briefly mention three matters related to the Bank's other functions that may be of interest to the Committee. The first is that the banking industry is in the final stretch of developing the New Payments Platform (NPP). As we have spoken about previously, this new payments infrastructure will provide Australians with the ability to make real-time, information-rich payments on a 24/7 basis. It will also make addressing of payments much simpler, using email addresses and mobile phone numbers, rather than BSB and account numbers. It has been a complex project and the Reserve Bank has played an important role, both in policy terms and as a provider of a key part of the infrastructure. As the government's bank, the Reserve Bank will also make the new payment capabilities available to its government banking customers. The new system is expected to commence processing payments later this year. It is likely to start off small and gradually ramp up next year as financial institutions gain experience with a new way of operating 24/7. The second matter is that when we met in February, I said that I had commissioned an external review of the efficiency of the Bank's operations. That review has now been completed. It concluded that our support areas were functioning well and assisted the achievement of the Bank's important public policy objectives. At the same time, it suggested some areas for us to focus on. One was the development of a shared internal services centre to drive continuous improvement. Another was further evolution in our approach to IT as some of our major IT-related projects come to an end. These projects are in the banking and payments areas and have been undertaken in the national interest. As these projects wind down we are looking to make sure that the size and structure of our IT function remains appropriate. More broadly, as some of these projects finish this year, the Bank's overall staff numbers will decline. Finally, I would like to take this opportunity to announce that we will be releasing the new $10 banknote next month, on 20 September. Printing of the new notes has been completed at our printing works in outer Melbourne. The new notes contain the same world-leading security features as the new $5 note that we issued last September, including the clear top-to-bottom window, and the tactile feature so that it can be recognised by vision-impaired members of the community. Construction has also recently been completed on our new banknote storage and processing facility at Craigieburn, which will soon commence operations. Thank you. My colleagues and I are here to answer your questions.

r170905a_BOA

australia

Remarks at Reserve Bank Board Dinner

lowe

Good evening. On behalf of the Reserve Bank Board I would like to warmly welcome you all to this community dinner. Thank you for your interest in the RBA and for joining us this evening. As you are probably aware the Reserve Bank Board had its monthly meeting here in Brisbane today, at our offices on I would like to take the opportunity of this dinner to welcome Mark Barnaba to the Reserve Bank Board. This was Mark's first Board meeting and he brings a wealth of experience in the resources and banking sectors to the table. Mark replaces John Akehurst who retired from the Board last week after a decade of public service in this role. Over those 10 years, John made an outstanding contribution to our deliberations. It's fair to say that he served through interesting times, perhaps a little too interesting: a global financial crisis, the biggest mining investment boom in over a century, and central banks worrying that inflation was too low, not too high. All that, in just 10 years. Mark, I hope your time on the Board is not quite as interesting! At our meeting today we had the usual review of the global and Australian economic and financial data, as well as a thorough discussion of recent developments in Queensland. We know that the Queensland economy has gone through a difficult period following the wind-down of the mining investment boom, and that the pain has been concentrated in some regional communities. We are also watching the Brisbane property market carefully, particularly the effect on prices of the large increase in the supply of new apartments. More broadly, a range of indicators, including employment and retail trade, suggest that there has been a recent improvement in economic conditions in Queensland. The lower exchange rate is helping, particularly in the tourism, education and rural industries. An appreciating exchange rate would not be helpful from this perspective. You have probably heard that the Board decided today to leave the cash rate unchanged at 1.5 per cent. This is unlikely to have come as a surprise to many people; the cash rate has been at 1.5 per cent since August last year and financial market pricing suggests market participants expect it to remain there for some time yet. As usual, the reasons for the decision were released shortly after the meeting. For some time, the Board has been seeking to balance the benefits of stimulatory monetary policy with the medium-term risks associated with high and rising levels of household debt. The current low level of interest rates is helping the Australian economy. It is supporting employment growth and a return of inflation to around its average level. Encouragingly, growth in the number of Australians with jobs has picked up over recent months and the unemployment rate has come down a bit. The investment outlook has also brightened. Inflation has troughed and it is likely to increase gradually over the next couple of years. These are positive developments. Even so, it will be some time before we are at what could be considered full employment in Australia and before underlying inflation is at the mid-point of the medium-term target range. This means that stimulatory monetary policy continues to be appropriate. The Board has been conscious that attempting to achieve faster progress on unemployment and inflation through yet lower interest rates would have added to the risks in household balance sheets. Lower rates would have encouraged faster growth in household borrowing and added to the medium-term risks facing the economy. Our judgement has been that it was not in the public interest to encourage an already highly indebted household sector to borrow even more. More borrowing might have helped today, but it could come at a future cost. So the Board has been prepared to be patient and has not sought to overly engineer or fine-tune things. In our view, the balance we have struck is appropriate and it is likely that the economy will pick up from here as the drag from declining mining investment comes to an end. Our central scenario is for growth of around 3 per cent over the next couple of years and for the unemployment rate to move lower gradually. In striking the appropriate balance in our policy setting, we have paid close attention to trends in household borrowing, given the already high levels of debt. Over the past four years, household borrowing has increased at an average rate of 6 1/2 per cent, while household income has increased at an average rate of just 3 1/2 per cent. Given this, the RBA has worked closely with APRA to ensure that lending practices remain sound. Rightly, APRA has had a strong focus on loan serviceability calculations. In some cases, loans were being made where the borrower had only the slimmest of spare income. APRA has also introduced restrictions on growth of investor loans and restrictions on interest-only lending. This has been the right thing to do. One might ask why lenders themselves did not do more to constrain their activities in these areas, given the earlier trends were adding to risk in the overall system. When everything is going well, it appears that any single institution has difficulty pulling back. Each worries about their competitive position and about the market reaction. Individual institutions are also more likely to focus on their own risks, rather than the risks to the system as a whole. This means that supervisory measures can be useful in helping the whole system pull back. Ideally, such measures would not be needed, with instead the appropriate level of restraint coming out of lenders' holistic risk assessments. But when this does not occur, supervisory measures can play a constructive role. Most lenders are now operating comfortably within the new restrictions and these measures are not unduly restraining the supply of overall housing credit. One of the factors that has a bearing on current discussions of household debt is the slow growth in household incomes. Over the past four years, nominal average hourly earnings have grown at the slowest rate in many decades. This means that borrowers haven't been able to rely on rising incomes to reduce the real value of the debt repayments in the way they used to; debt-service ratios will stay higher for longer. This is something that both lenders and borrowers need to take into account. The slow growth in wages is a common experience across most advanced economies today. It lies behind the sense of dissatisfaction that is being felt in many communities. The reasons for this slow growth in wages are complex. Part of the explanation is a perception of greater competition from both globalisation and technology. An increased sense of uncertainty among workers is also likely to be playing a role, as is a change in the bargaining environment. The slow growth in wages is contributing to low inflation outcomes globally. My expectation is that this is going to continue for a while yet, given that the structural factors at work are likely to persist. But I am optimistic enough that I don't see it as a permanent state of affairs. It is likely that, as our economy strengthens and the demand for labour picks up, growth in wages will pick up too. The laws of supply and demand still work. Even at the moment, we see some evidence through our liaison program that in those pockets where the demand for labour is strong, wages are increasing a bit more quickly than they have for some time. The Reserve Bank's central scenario is that, over time, this will become a more general story. On another matter, over the past few months there has been quite a lot of interest in the regular special papers considered by the Board. This followed the release of the minutes of the July meeting, which recorded that the Board had held a discussion of the neutral interest rate (that is, the rate at which monetary policy is neither expansionary nor contractionary). The main conclusion from that discussion was that, in future, it was likely that the average level of the cash rate would be lower than it was before the financial crisis. This reflects slower trend growth in the economy and a shift in the balance between savings and investment. When people want to save more and invest less, the return on the risk-free asset is lower. These same forces are at work around the world, so that the average level of interest rates globally is likely to be lower than before the financial crisis. A second conclusion from our discussion was that the cash rate is around 2 percentage points below our current estimate of the neutral rate. As we make further progress on both unemployment and inflation, we could expect the cash rate to move towards this neutral rate over time. It is worth repeating that the Board's consideration of these issues carries no particular message about the short-term outlook for monetary policy. The discussion was part of our regular in-depth reviews of important issues. As is appropriate, these discussions are reflected in our minutes. I hope that you see Australia's central bank as transparent, analytical, rational and independent. We seek to look at issues in detail and from different angles and to explain our thinking to the public. While not everybody agrees with our decisions, we do our best to explain those decisions and the framework we use to make them. This month's special discussion was on the Chinese economy. One focus was on the difficult trade-off facing the Chinese authorities. There is a clear need to, and a desire by the authorities to, address the high and rising levels of debt in China. At the same time, though, the authorities are committed to achieving growth targets that are still quite high. It remains an open question as to whether both of these objectives can be achieved. Here in Australia, we have a strong interest in the right balance being achieved. Another focus of our discussions was the Chinese authorities' progress in implementing the structural reforms announced in 2013 at the Third Plenum. The one-child policy has been relaxed and the government has expanded funding for social security and health care. The value-added tax has been broadened and there has been some deregulation of interest rates. So there has been progress on a number of fronts. But, on the other hand, there is still some way to go to meet the goal of allowing market forces to play a decisive role in resource allocation. Reform of state-owned enterprises has been slower than many had hoped for and the state, rather than market prices, still has a strong influence in allocating resources in parts of the economy. Looking forward, the pace and nature of future reform in these areas are likely to be influenced by the outcomes of the 19th Congress of the Chinese Communist Party later this year. On one final matter, I would like to take this opportunity to remind you that our new $10 note will be issued in just a couple of weeks, on 20 September. The new note contains the same world-leading security features as the new $5 note that we issued last September, including the clear top-to- bottom window, and the tactile feature so that it can be recognised by vision-impaired members of our community. For me personally, the new $10 note will be a particularly special note, as it is the first note with my signature. We have printed a couple of hundred million of these notes, so it has been a busy time for John Fraser and me recently! The new note will continue to feature Mary Gilmore and Banjo Paterson, two of Australia's most famous writers. Both grew up in southern New South Wales. Indeed, Mary Gilmore spent time at schools in both Cootamundra and Wagga Wagga, just as I did. Both of these writers also have a connection to Queensland. For many years, Mary Gilmore's husband ran a farm near Cloncurry in northern Queensland. And of course, Banjo Paterson is said to have written the words to Waltzing Matilda during a trip to Dagworth station near Winton. We are proud to have these two great Australian writers on our banknotes. Again, thank you for your attendance tonight. I hope you enjoy your dinner and the conversation.

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australia

Remarks at the Bank of China Sydney Branch's 75th Anniversary Celebration Dinner

lowe

Acknowledgement of special guests and hosts] It is an honour to be here this evening to celebrate the 75th anniversary of the opening of the Bank of China's first branch in Australia. On behalf of the Reserve Bank of Australia, I would like to pass on our warmest congratulations. The story of how the Bank of China came to establish a branch in Australia in 1942 is a story of resilience and friendship. Over recent weeks I have had the opportunity to read about this story through the yellowed pages of the Reserve Bank's archives. When conflict came to Singapore in 1942, Mr Parkane Hwang from the Bank of China's Singapore branch decamped to what was then known as Batavia. From there, he sought a visa to travel to Australia to establish a branch of the Bank of China in Sydney. It must have been a difficult and stressful time. True to Australia's welcoming nature, especially to those in need, the visa was granted. By midyear, the branch was in operation, with Mr Hwang's deputy from the Singapore branch, Mr S.C. Lu, as its representative. In those days it was quicker to get a banking licence than it is today! It is clear from our archives that the granting of this licence was a significant sign of friendship by Australia towards China. It was very unusual at the time to grant such licences. Upon the licence being granted, one of my predecessors as Governor - Governor H.T. Armitage of the Commonwealth Bank of Australia, which at the time carried out central banking functions - wrote to Mr Lu to congratulate the Bank of China on the new branch. I would like to read from that letter, as 75 years later I could not have put it better myself. Governor Armitage wrote: 'I feel sure that the entry of your Bank into the Australian Banking System will not only be of inestimable value in facilitating business relationships between China and Australia, but will also help to foster the increasing bond of friendship between our respective countries.' Seventy-five years on, this sentiment remains just as valid as it was in 1942, despite the tremendous change in both our countries since. Our files show that it was some years before the Bank of China's branch in Australia was able to turn a profit - a problem that has now been fixed. When the branch was first established, it was very restricted in its operations. It was limited to operating accounts for the Chinese Government and officials and for Chinese nationals visiting Australia. Notwithstanding these restrictions, it quickly established a presence in Australia. In May 1944, less than two years after operations began, Governor Armitage wrote to the Secretary to the Treasury stating: 'The Bank of China has proved to be a useful adjunct to the banking system in Australia, particularly in regard to facilitating the handling of remittances on behalf of Chinese citizens. They have faithfully observed the conditions under which they are allowed to operate.' Today, of course, the Bank of China continues to facilitate currency exchange between China and Australia, but it is on a much larger scale. In 2014, the Bank of China was appointed the official RMB clearing bank for Australia, affording it more direct access to China's onshore financial markets and hence the ability to provide RMB liquidity in the Australian market. The establishment of the clearing bank has promoted the role of the RMB in trade among Australian companies and the development of the pool of local RMB deposits. This is an important development. The Bank of China is also providing an important source of finance for Chinese companies operating in Australia as well as for Australian companies. It is making trade easier between our two countries by providing trade finance. It is also helping on the investment side, with securities and investment banking services. The growth of Bank of China's operations from currency exchange to facilitating trade and now, more recently, to facilitating investment is mirrored in the deepening relationship between China and On the trade side, in 1942 there was negligible trade between our two countries. Today, we are important trading partners. The deepening of the financial relationship is a more recent development and still has some way to go. China is an important source of direct investment in Australia and there are an increasing number of investment channels available to Australian entities looking to invest in Chinese financial markets. As one example of this, the RBA holds around 5 per cent of our foreign reserves in China. I expect that, as the Chinese capital account is liberalised, the financial relationship between our two countries will deepen further. As we know from our own experience in Australia, the journey of financial liberalisation is a difficult one, but it is one that is well worth undertaking. As I have said on a number of previous occasions, the internationalisation of the RMB and the associated capital account liberalisation in China is likely to be one of the biggest forces shaping the global financial system over the next decade or so. The Bank of China will help Australia be part of that. Finally, again, I would like to congratulate the Bank of China on the occasion of the 75th anniversary of establishing a branch in Australia. The story of how the branch was established is one of resilience and friendship. In 1942 there was a hope that granting the Bank of China a banking licence would help build ties between our two countries. This hope has been realised. Our hope today is that the same will be true for the next 75 years. Thank you.

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australia

The Next Chapter

lowe

I would like to thank the American Chamber of Commerce in Australia for the invitation to speak today. It is a pleasure to be in Perth again. This lunch is being held at a time when one chapter in Australia's economic history is drawing to a close and another is about to start. A main theme in the chapter that is about to come to an end is the mining investment boom. That boom, and its unwinding, has been central to the story of the Australian and Western Australian economies for more than a decade now. The new chapter will, almost certainly, have a different central theme. Today, I would like to provide a sketch of some of the likely plot lines of the next chapter. Before doing that, though, I will reflect on the current chapter. The storyline of the current chapter is well known. It has had two main plot lines. The first was a troubled global economy. A decade ago we had the global financial crisis and the worst recession in many advanced economies since the 1930s. A gradual recovery then took place, but it was painfully slow. Recently, things have improved noticeably and unemployment rates in some advanced economies are now at the lowest levels in many decades. Throughout this chapter, central banks have mostly worried that inflation rates might turn out to be too low, not too high. Interest rates have been at record lows. And workers in advanced economies have experienced low growth in their nominal wages. So it's been a challenging international backdrop. The second plot line was the resources boom. Strong growth in China saw strong growth in demand for resources. Prices rose in response, with Australia's terms of trade reaching the highest level in at least 150 years (Graph 1). Then an investment boom took place in response to the higher prices, with investment in the resources sector reaching its highest level as a share of GDP in over a century. And now we are seeing the dividends of this, with large increases in Australia's resource exports. Overall, it has been a reasonably successful chapter in Australia's economic history. Real income per person is around 20 per cent higher than it was in the mid 2000s and real wealth per person is 40 per cent higher. Australia is one of the few advanced economies that avoided a recession in 2008. And the biggest mining boom in a century did not end in a crash, as previous booms did. Our interest rates remained positive, unlike those in many other advanced economies. Since the mid 2000s, the unemployment rate has averaged 5 1/4 per cent, a better outcome than in the previous three decades. Inflation has averaged 2 1/2 per cent. And over this period, GDP growth has averaged 2 3/4 per cent, higher than in most other advanced economies. So, taking the period as a whole, it is a positive picture. At the same time, though, as the chapter draws to a close, we do face some issues. I would like to highlight three of these. The first is the recent slow growth in real per capita income. For much of the past two decades, real national income per person grew very strongly in Australia (Graph 2). We benefited from strong productivity growth, higher commodity prices and more of the population working. In contrast, since 2011 there has been little net growth in real per capita incomes. This change in trend is proving to be a difficult adjustment. The solutions are strong productivity growth and increased labour force participation. A second issue is the unusually slow growth in nominal and real wages. Over the past four years, the increase in average hourly earnings has been the slowest since at least the mid 1960s (Graph 3). This is partly a consequence of the unwinding of the mining boom but there are structural factors at work as well. The slow growth in wages is putting a strain on household budgets and contributing to low rates of inflation. A third issue is the high level of household debt and housing prices. Over recent times, Australians have borrowed a lot to purchase housing. This has added to the upward pressure on housing prices, especially in our two largest cities, where structural factors are also at work. Australians are coping well with the higher level of debt, but as debt levels have increased relative to our incomes so too have the medium-term risks. The very high levels of housing prices in our largest cities are also making it difficult for those on low and middle incomes to buy their own home. So as we turn the final pages of this chapter, these are some of the issues we face. But as we turn these pages, we also see improvements on a number of fronts. Business conditions, as reported in surveys, are at the highest level in almost 10 years. There are also growing signs that private investment outside the resources sector is picking up. We have been waiting for this for some time. For a number of years, animal spirits had been missing, with many firms preferring to put off making decisions about capital spending. It appears that some of this reluctance to invest is now passing. According to the June quarter national accounts, private nonmining business investment increased strongly over the first half 2017, to be around 10 per cent above the level at the start of 2016. Non-residential building approvals have increased to be above the levels of recent years and there is a large pipeline of public infrastructure investment to be completed (Graph 4). The decline in mining investment has also largely run its course. There has also been positive news on the employment front. Over the past year, the number of people with jobs has increased by more than 2 1/2 per cent, a positive outcome given that the working-age population is increasing at around 1 1/2 per cent a year. Growth in full time employment has been particularly strong. The various forward-looking indicators suggest that labour market conditions will remain positive in the period immediately ahead. Here in Western Australia, there are also some signs of improvement after what has been a difficult few years. The drag from declining mining investment is diminishing. Businesses are feeling more positive than they were a year ago and employment has been rising after a period of decline. At the same time though, conditions in the housing market remain difficult, with housing prices and rents continuing to fall in Perth. Weak residential construction has also weighed on aggregate demand over the first half of this year, although building approvals and liaison reports point to some stabilisation in For Australia as a whole, the recent national accounts - which showed a healthy increase in output of 0.8 per cent in the June quarter - were in line with the Bank's expectations. These, and other recent data, are consistent with the Reserve Bank's central scenario for GDP growth averaging around the 3 per cent mark over the next couple of years. This is a bit faster than our current estimate of trend growth in the Australian economy, so we expect to see a gradual decline in the unemployment rate. This should lead to some pick-up in wage growth, although we expect this to be a gradual process given the structural factors at work that I have spoken about on previous occasions. We can also expect to see a gradual increase in inflation back towards the middle of the 2 to 3 per cent mediumterm target range. There are clearly risks around this central scenario. We would like to see the improvement in business investment consolidate and a continuation of job growth at a rate at least sufficient to absorb the increase in Australia's workforce. Some pick-up in wage growth in response to the tighter labour market would also be a welcome development. So these are some areas to watch. But as things stand, the economy does look to be improving. I would now like to lift my gaze a little and turn to the next chapter in our economic story. I would like to sketch out four of the possible plot lines, acknowledging that, as in all good stories, there are likely to be plenty of surprises along the way. A first likely plot line, as it has been in previous chapters, is the ongoing shift in the global economy. Here, changes in technology and further growth in Asia are likely to be prominent themes. In some quarters there is pessimism about future prospects for the global economy. The pessimists cite demographic trends, high debt levels, increasing regulatory burdens that stifle innovation and political issues. They see a future of low productivity growth and only modest increases in average living standards. It's right to be concerned about the issues that the pessimists focus on, but I am more optimistic about the ability of technological progress to propel growth in the global economy, just as it has done in the past. We are still learning how to take advantage of recent advances in technology, including the advances in the tools of science. In time we will do this and new industries and methods of production will evolve, some of which are hard to even imagine today. So there is still plenty of upside. The challenge we face is to make sure that the benefits of technological progress are widely shared. How well we do this could have a major bearing on the next chapter. Beyond this broad theme, it is appropriate to recognise the important leadership role that the United States plays in the global economy. If the US economy does well, so does most of the rest of the world. The United States has long been a strong supporter of open markets and a rules-based international system. It has been the breeding ground for much of the progress in technology. And it has been a safe place for people to invest and an important source of financial capital for other countries. It is in our interests that the United States continues to play this important role. A retreat would make our lives more complicated. Another important influence on the next chapter is how things play out in China. While growth in China is trending lower, the share of global output produced in China will continue to rise, as per capita incomes converge towards those in the more advanced economies (Graph 6). As this convergence takes place, the structure of the Chinese economy will change and so too will China's economic relationship with Australia. Exports of resources will continue to be an important part of that relationship, but increasingly trade in services and other high value-added activities, including food, will become more important. Notwithstanding this, there are risks on the horizon, with the Chinese economy going through some difficult adjustments. One of these is the switch from a growth model based on industrial expansion to one based more on services. Another is managing an increasingly large and complex financial system. Australia has a strong interest in China successfully managing these challenges. Another shift in the global economy that could shape the next chapter is the growth of other economies in Asia. Developments in India and Indonesia bear especially close watching. Both of these countries, especially India, have very large populations, and per capita incomes are still quite low. In time, the effects of economic progress in these countries and others in the region could be expected to have a substantial effect on the Australian economy, just as the development of China has. A second likely plot line of the next chapter is a return to more normal monetary conditions globally. Since the financial crisis we have been through an extraordinary period in monetary history. Interest rates have been very low and even negative in some countries. Central banks have greatly expanded their balance sheets in order to buy assets from the private sector (Graph 7). This period of monetary expansion is now drawing to a close. Some normalisation of monetary conditions globally should be seen as a positive development, although it does carry risks. It is a sign that economic growth in the advanced economies has become self-sustaining, rather than just being dependent on monetary stimulus. It would also lift the return to many savers who have been receiving very low returns on interest-bearing assets for a decade now. On the other side of the ledger, periods of rising interest rates globally have, historically, exposed over-borrowing somewhere in the global system. Investment strategies that looked sensible when interest rates were very low tend not to look so good when interest rates are higher. We can take some comfort from the major efforts over the past decade to improve the resilience of the global financial system. But at the same time, investors have increasingly been prepared to take more risk in the search for yield. Many continue to expect a continuation of low rates of inflation and low interest rates, despite quite low unemployment rates in a number of countries. So this is an area that is worth watching. If higher interest rates are the result of a surprise increase in inflation, financial markets could be in for a difficult adjustment. A rise in global interest rates has no automatic implications for us here in Australia. Notwithstanding this, an increase in global interest rates would, over time, be expected to flow through to us, just as the lower interest rates have. Our flexible exchange rate though gives us considerable independence regarding the timing as to when this might happen. This brings me to a third plot line: that is, how we deal with the higher level of household debt and higher housing prices, especially in a world of more normal interest rates. It is likely that higher levels of household debt change household spending patterns. Having increased their borrowing, households are less inclined to let consumption growth run ahead of growth in incomes for too long. Higher levels of debt also mean that household spending could be quite sensitive to increases in interest rates, something the Reserve Bank will be paying close attention to. To date, households have been coping reasonably well with the higher debt levels. The aggregate debt-to-income ratio has trended higher, but the ratio of interest payments to income is not particularly high, given the low level of interest rates (Graph 8). Housing loan arrears remain low, although they have increased a little recently, especially here in Western Australia. Over recent times, one issue that the Reserve Bank has focused on is the build-up of medium-term risks from growth in household debt persistently outpacing that in household income. Our concern has been that, in this environment, a small shock could turn into a more serious correction as households seek to repair their balance sheets. We have been working with APRA through the Council of Financial Regulators to address this risk. The various measures are having a positive impact in improving the resilience of household balance sheets. The fourth likely plot line is a broadening of the drivers of growth in the Australian economy. How the next chapter in our economic history turns out depends partly on our ability to lift productivity growth across a wide range of industries. The resources sector will, no doubt, continue to make an important contribution to the Australian economy, but it is unlikely that it will shape the next chapter in our economic history as it did the current chapter. With another major upswing in the terms of trade unlikely and the working-age share of our population having peaked as the population ages, improving productivity will be key to growth in our national income. The drivers of growth are changing: they increasingly depend on our ability to produce innovative goods and services in a rapidly changing world. In this world, it is difficult to make precise predictions about where the jobs and growth in our economy are going to come from in the future. But it seems clear that we will be best placed to take advantage of whatever possibilities arise if businesses and our workforce are innovative and adaptable. Australia is fortunate to have a natural resource base that provides an important source of national income, and this will remain the case. But in this next chapter we will need to look more directly to the skills of our workers and our businesses to drive economic growth. If we are to take advantage of the opportunities that are offered by technology and growth in Asia, we need a flexible workforce with strong skills in the areas of problem solving, critical thinking and communication. Investment in human capital will be one of the keys to success. We also need a competitive business environment that encourages innovation. How well the next chapter turns out will depend on how we do in these areas. So, in summary these are some of the themes we might expect to see in the next chapter - the impact of technology and the growth of Asia; the normalisation of monetary conditions; the effects of higher levels of household debt; and the capability of our workforce and businesses to be flexible, innovative and adaptable. This is, obviously, not a complete list. There are clearly other factors that could have a major influence on the storyline, including how geopolitical tensions are resolved and how we adjust to climate change. And no doubt there will be surprises as well. But overall, I remain optimistic about how this next chapter might unfold. While we have our challenges, some of which I have talked about, we also have some advantages. We have a strong institutional and policy framework, a skilled, growing and diverse population and a wealth of mineral and agricultural resources. We have strong links to Asia, the fastest growing part of the global economy. We also have a flexible economy with a demonstrated capacity to adjust to a changing world. These factors should give us confidence about our future. But we can't rest on this and there are a number of significant risks. The world is a competitive place and the global economy is continuing to go through some challenging adjustments. If we are to do well in this world, we need to keep investing in both physical and human capital. We also need to keep investing in policy reform. Finally, I have said relatively little about monetary policy today. This is partly because there are other forces that are likely to be more important in shaping the next chapter of the Australian economy. Monetary policy has an important role to play in supporting the economy as it goes through the current period of adjustment. It can also help stabilise the economy when it is hit by future shocks. Monetary policy can make for a more predictable investment climate by keeping inflation low and stable. Having a competent, analytical, transparent and independent central bank can also be a source of confidence in the country. But beyond these effects, monetary policy has little influence on the economy's potential growth rate. Over recent times, the Reserve Bank Board has not sought to overly fine-tune things. We have provided support and allowed time for the economy to adjust to the new circumstances. In its decisions, the Board has been careful to balance the benefit of providing this support with the risks that can come from rising household debt. As things currently stand, we look to be on course to make further progress in reducing unemployment and moving towards the midpoint of the mediumterm inflation target. This would be a good outcome. Thank you for listening and I look forward to answering your questions.

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australia

Some Evolving Questions

lowe

It is a pleasure for me to speak at the annual dinner of the Australian Business Economists. I have spoken at this dinner three times before: in 2010, 2012 and 2014. Thank you for inviting me back. When I spoke in 2012 the title of my remarks was 'What is Normal?' On that occasion, I talked about a recalibration in expectations about what was considered normal in the Australian economy. I also suggested that the normal level of interest rates might be lower than it was in the past. Five years on, we are still searching to understand what is normal. In a number of countries, low rates of unemployment are coexisting with below-average inflation. Low inflation, in turn, means low interest rates. Many investors judge that this unusual combination of low unemployment and low inflation can persist for quite some time - perhaps, that it is now normal. With inflation rates having surprised on the downside for a few years now, there is unusually low compensation for future inflation risk in many financial markets. Real income growth for many households has also been unusually slow in many countries. Not surprisingly, these households, including many here in Australia, wonder whether this slow growth in incomes is now the new normal, or whether in time it will pass. Much depends upon the answer to this, including households' appetite and ability to spend and borrow. So we are still searching for what is normal. Tonight, I would like to use this opportunity to reflect on some of the questions we have been grappling with at the RBA over the year or so that I have had the privilege of being the Governor. A number of these questions go to what could be considered normal these days. While I am not able to give you a full suite of answers, I hope that you find the transparency around our thinking useful. There are three sets of questions that have occupied much of our time over the past year. The first is how the final stages of the transition to lower levels of mining investment would play out. The second is the degree to which an improving labour market would translate into a pick-up in wage growth and inflation. And the third is the nature of risks stemming from high and rising levels of household debt and how to deal with those risks. I will talk about each of these three issues and then conclude with how they have influenced the Reserve Bank Board's decisions on monetary policy over the past year or so. For a number of years we have been describing the economy as being in transition: a transition from very high levels of mining investment to something more normal. It is now time, though, to move to a new narrative. The wind-down of mining investment is now all but complete, with work soon to be finished on some of the large liquefied natural gas projects. Mining investment, as a share of GDP, is now back to something more normal (Graph 1). This means that, as I talked about in a recent speech, it's time to open a new chapter in Australia's economic history. Over recent times, our judgement has been that this transition to lower levels of mining investment was masking an underlying improvement in the Australian economy. The decline in mining investment generated substantial negative spillovers to the rest of the economy. These spillovers were most evident in Queensland and Western Australia, where, for a while, growth in employment, investment and income were all quite weak. The good news is that these negative spillovers from lower levels of mining investment are now fading. This was first evident in Queensland, where the labour market began to improve in 2015 (Graph 2). It is now evident too in Western Australia, where conditions in the labour market have improved noticeably since late last year. Elsewhere, there has been steady growth in employment for a number of years. The fading of the negative spillovers is one reason why growth in the Australian economy is expected to strengthen over the period ahead. Another is the higher volume of resource exports as a result of all the mining investment. We expect GDP growth to pick up to average a bit above 3 per cent over 2018 and 2019 (Graph 3). If these forecasts are realised, it would represent a better outcome than has been achieved for some years now. This more positive outlook is being supported by an improving world economy, low interest rates, strong population growth and increased public spending on infrastructure. All these things are helping. Encouragingly, the outlook for business investment has brightened. For a number of years, we were repeatedly disappointed that non-mining business investment was not picking up. Part of the explanation was the negative spillover effects that I just spoke about, although, as my colleague Guy Debelle spoke about last week, there were other factors at work as well. Now, though, a gentle upswing in business investment does seem to be taking place and the forward indicators suggest that this will continue. It's too early to say that animal spirits have returned with gusto. But more firms are reporting that economic conditions have improved and more are now prepared to take a risk and invest in new assets. This is good news for the economy. The improvement in the business environment is also reflected in strong employment growth. Over the past year, the number of people with jobs has increased by around 3 per cent, the fastest rate of increase for some time (Graph 4). This pick-up in jobs is evident across the country and has been strongest in the household services and construction industries. It is also leading to a pick-up in labour force participation, especially for women. Business is feeling better than it has for some time and it is lifting capital spending and creating more jobs. At the same time, though, growth in consumer spending remains fairly soft. Indeed, for a number of years consumption growth has been weaker than we had originally forecast. This is evident in this chart, which shows our forecasts for consumption growth at various points in time as well as the growth has been weaker than forecast and it has not exceeded 3 per cent for quite a few years. The most likely explanation for the ongoing subdued consumption outcomes is the combination of weak growth in real household income and the high level of household debt. Given the persistence of these factors, our latest forecasts have incorporated a flatter profile for consumption growth than has been the case in previous forecasts. An important issue shaping the future is how these cross-cutting themes are resolved: businesses feel better than they have for some time, but consumers feel weighed down by weak income growth and high debt levels. Our central scenario is that the increased willingness of business to invest and employ people will lead to a gradual increase in growth of consumer spending. As employment increases, so too will household income. Some increase in wage growth will also support household income. Given these factors, the central forecast is for consumption growth to pick up to around the 3 per cent mark. This would be above the average growth of consumption for the current decade, but below the average for the period prior to the financial crisis. I would like to turn to the second question that has occupied us over much of the past year: the degree to which an improving labour market will translate into a pick-up in wage growth and inflation. A distinguishing feature of Australia's recent economic performance has been the slow growth in wages. The Wage Price Index has increased by just 2 per cent over the past year. Whereas in earlier years, Australians had got used to average wage increases of around the 3 1/2 -4 per cent mark, 2- 2 1/2 per cent is now the norm (Graph 6). Growth in average hourly earnings has been weaker still: in trend terms it is running at the lowest rate since at least the 1960s. Not only are wage increases low, but some people had been moving out of high-paying jobs associated with the mining sector into lower-paying jobs. We have heard from our liaison program that there has been downward pressure on non-wage payments, including allowances, and an increase in the proportion of new employees hired on lower salaries than their predecessors. As I noted earlier, subdued growth in wages is also occurring in a number of other countries. Understanding this is a major priority. Low growth in wages means low inflation, which means low interest rates, which means high asset valuations. So a lot depends on understanding the reasons for slow growth in nominal and real wages. The answer is likely to be found in a combination of cyclical and structural factors. In Australia, we are still some way short of our estimates of full employment of around 5 per cent, so it is not surprising that wage growth is below average. But structural factors are likely to be at work as well. Foremost among these are perceptions of increased competition. Many workers feel there is more competition out there, sometimes from workers overseas and sometimes because of advances in technology. In the past, the pressure of competition from globalisation and from technology was felt most acutely in the manufacturing industry. Now, these same forces of competition are being felt in an increasingly wide range of service industries. This shift, together with changes in the nature of work and bargaining arrangements, mean that many workers feel like they have less bargaining power than they once did. But this is not the full story. It is likely that there is also something happening on the firms' side as well. In other advanced economies where unemployment rates are below conventional estimates of full employment, the normal tendency for firms to pay higher wages in tight labour markets appears to be muted. Businesses are not bidding up wages in the way they might once have. This is partly because business, too, feels the pressure of increased competition. One response to this competitive pressure is to have a laser-like focus on containing costs. Over recent times there has been a mindset in many businesses, including some here in Australia, that the key to higher profits is to reduce costs. Paying higher wages can sit at odds with that mindset. Given these various effects, it is plausible that, at least for a while, the economy is less inflation prone than it once was. Both workers and firms feel more competition, and it is plausible that the wage- and price-setting processes are adjusting in response. This, of course, does not mean that the normal forces of supply and demand have been abandoned. Tighter labour markets should still push up wages and prices, even if it takes a little longer than we are used to. We are starting to see some hints of this in the Australian labour market. Business surveys report that firms are having more difficulty finding suitable labour than they have for some time (Graph 7). In the past, when firms found it difficult to find suitable labour, higher growth in wages resulted. Consistent with this, we are hearing reports through our liaison program that in some pockets the stronger demand for workers is starting to push wages up a bit. We expect that as employment growth continues, these reports will become more common. Another factor that has a significant bearing on the outlook for inflation is the increased competition in the retail industry. I spoke a few moments ago about how, globally, increased competition is affecting pricing dynamics. Australian retailing provides a very good example of this. Competition from new entrants is putting pressure on margins and is forcing existing retailers to find ways to lower their cost structures. Technology is helping them to do this, including by automating processes and streamlining logistics. The result is lower prices. For some years now, the rate of increase in food prices has been unusually low. A large part of the story here is increased competition. The same story is playing out in other parts of retailing. Over recent times, the prices of many consumer goods - including clothing, furniture and household appliances - have been falling (Graph 8). Increased competition and changes in technology are driving down the prices of many of the things we buy. This is making for a tough environment for many in the retail industry, but for consumers, lower prices are good news. A question we are grappling with here is how much further this process has to run. It is difficult to know the answer, but our sense is that the impact of greater competition on consumer prices still has some way to go as both retailers and wholesalers adjust their business models. So this is likely to be a constraining factor on inflation for a while yet. Putting all this together, we expect inflation to pick up, but to do so only gradually (Graph 9). By the end of our two-year forecast period, inflation is expected to reach about 2 per cent in underlying terms, and a little higher in headline terms because of planned increases in tobacco excise. Underpinning this expected lift in inflation is a gradual increase in wage growth in response to the tighter labour market. The third question we have focused on over recent times is the implications of the high and rising level of household debt. The growth in household debt has been outpacing the very low growth in household incomes for a few years now. As a result, the household debt-to-income ratio has risen, although if account is taken of the increased balances held in offset accounts the rise is less pronounced (Graph 10). The low level of interest rates means that even though debt levels are higher, the share of household income devoted to paying mortgage interest is lower than it has been for some time. Perhaps reflecting this, as well as the recent decline in the unemployment rate, aggregate indicators of household financial stress remain quite low. The central issue here is how the high levels of debt affect the stability of the economy over the medium term. Our concern has not been the stability of the banking system; the banks are strong and they are well capitalised. Rather, the concern has been that as the household sector takes on ever-more debt relative to its income, the risk of medium-term problems increases. This is especially so when this debt is taken on in an unusually low-interest rate environment. It is difficult to be precise about exactly how much this risk has increased, but our judgement has been that, should earlier trends have continued, the risk of future problems would have continued to increase. A scenario we have focused on is the possibility of a future shock that causes households to abruptly reassess their past borrowing decisions. In this scenario, consumption might be wound back sharply to put balance sheets on a sounder footing. If this occurred, it could turn an otherwise manageable shock into something more serious. One way of guarding against this risk is for lenders to maintain strong lending standards. The various steps taken by the Australian Prudential Regulation Authority (APRA) - with the strong support of the Council of Financial Regulators - have worked in this direction. Growth in lending to investors has slowed, fewer loans are being made with very high loan-to-valuation ratios, debt-servicing tests have been tightened and fewer interest-only loans are being made. The latest data suggest that the banks have more than succeeded in reducing interest-only lending to below the 30 per cent benchmark (Graph 11). These are all positive developments but it is an area we, together with the Council of Financial Regulators, continue to watch closely. Recently, we have also seen some cooling in the Sydney property market. This reflects a combination of factors, including increased supply of new dwellings, some tightening of credit conditions, higher interest rates on loans to investors and some reduction in offshore demand. The increasing unaffordability of prices for many people has also probably played a role. In Melbourne, where the population is growing very strongly, housing prices are still increasing faster than incomes, although the rate of increase has slowed. Elsewhere, housing prices have been little changed over recent months. Conditions are subdued in Brisbane, where the supply of apartments has increased significantly, and remain weak in Perth, owing to slowing population growth following the unwinding of the mining investment boom. It is important to be clear that the RBA does not have a target for housing prices. But a return to more sustainable growth in housing prices does reduce the medium-term risks. These risks have not gone away, but the fact that they are not building at the rate they have been is a positive development. I would like to conclude with what all this has meant for monetary policy over the past year or so. As you are aware, the Reserve Bank Board has kept the cash rate unchanged at 1.5 per cent since August last year. In the early part of that period, a central issue was balancing the need to support the economy in the final days of the transition to lower levels of mining investment against the risks stemming from rising household debt. Lower interest rates might have provided a bit more support, but would have done so partly by encouraging people to borrow yet more money, thus adding to the risks. The Board's judgement was this would not have been consistent with its broad mandate for economic stability. Accordingly, with the economy expected to pick up and the unemployment rate to come down gradually as the mining investment transition came to an end, the Board judged it appropriate to hold the cash rate at 1.5 per cent. We were prepared to be patient in the interests of mediumterm economic stability. As the year progressed, we became somewhat more confident that the expected pick-up in growth would materialise. The strengthening in the global economy has helped here. So too has the lift in employment and the better outlook for investment. This improvement meant that the case for lower interest rates weakened over the year. Also, as the year progressed, one issue the Board paid increasing attention to was the persistently weak growth in wages and household incomes and the implications for consumption. A related issue is the effect of increased competition on the wage and price dynamics in the economy. As I said earlier, we are still trying to understand this. It does, though, look increasingly likely that these factors will mean that inflation remains subdued for some time yet. We still expect headline inflation to move above 2 per cent on a sustained basis, but it is taking a bit longer to get there than we had earlier expected. So, in summary, over the past year or so there has been progress in moving the economy closer to full employment and in having inflation return to the 2 to 3 per cent range. Both of these are positive developments and suggest a more familiar normal is still in sight. Progress on these fronts has been made while also containing the build-up of risks in household balance sheets. We still, though, remain short of full employment, and inflation is expected to pick up only gradually and remain below average for some time yet. This means that a continuation of accommodative monetary policy is appropriate. If the economy continues to improve as expected, it is more likely that the next move in interest rates will be up, rather than down. But the continuing spare capacity in the economy and the subdued outlook for inflation mean that there is not a strong case for a nearterm adjustment in monetary policy. We will, of course, continue to keep that judgement under review. Thank you for listening and I look forward to answering your questions.

r171213a_BOA

australia

An eAUD?

lowe

Thank you for the invitation to speak at this important summit. It is an honour for me to be able to join you. Over recent times, the payments system has evolved tremendously and AusPayNet has been at the centre of this evolution. In particular, it has played an important role in coordinating the industry's response to the Strategic Review of Innovation conducted by the Payments System Board. As a result of this work, same-day settlement for direct entry transactions was introduced, the was developed. I would like to thank both past and current members of the AusPayNet team for your contribution to this effort. If we look back over a slightly longer period, a clear lesson from history is that as people's needs change and technology improves, so too does the form that money takes. Once upon a time, people used clam shells and stones as money. And for a while, right here in the colony of New South Wales, rum was notoriously used. For many hundreds of years, though, metal coins were the main form of money. Then, as printing technology developed, paper banknotes became the norm. The next advance in technology - developed right here in Australia - was the printing of banknotes on polymer. No doubt, this evolution will continue. Though predicting its exact nature is difficult. But as Australia's central bank, the RBA has been giving considerable thought as to what the future might look like. We are the issuer of Australia's banknotes, the provider of exchange settlement accounts for the financial sector, and we have a broad responsibility for the efficiency of the payments system, so this is an important issue for us. Today I want to share with you some of our thinking about this future and to address a question that I am being asked increasingly frequently: does the RBA intend to issue a digital form of the The short answer to this question is that we have no immediate plans to issue an electronic form of Australian dollar banknotes, but we are continuing to look at the pros and cons. At the same time, we are also looking at how settlement arrangements with central bank money might evolve as new technologies emerge. As we have worked through the issues, we have developed a series of working hypotheses. I would like to use this opportunity to outline these hypotheses and then discuss each of them briefly. As you will see, we have more confidence in some of these than others. There will be a further significant shift to electronic payments, but there will still be a place for banknotes, although they will be used less frequently. It is likely that this shift to electronic payments will occur largely through products offered by the banking system. This is not a given, though. It will require financial institutions to offer customers low-cost solutions that meet their needs. An electronic form of banknotes could coexist with the electronic payment systems operated by the banks, although the case for this new form of money is not yet established. If an electronic form of Australian dollar banknotes was to become a commonly used payment method, it would probably best be issued by the RBA and distributed by financial institutions, just as physical banknotes are today. Another possibility that is sometimes suggested for encouraging the shift to electronic payments would be for the RBA to offer every Australian an exchange settlement account with easy, lowcost payments functionality. To be clear, we see no case for doing this. It is possible that the RBA might, in time, issue a new form of digital money - a variation on exchange settlement accounts - perhaps using distributed ledger technology. This money could then be used in specific settlement systems. The case for doing this has not yet been established, but we are open to the idea. So these are our five working hypotheses. I would now like to expand on each of these. An appropriate starting point is to recognise that most money is already digital or electronic. Only 3 1/2 per cent of what is known as 'broad money' in Australia is in the form of physical currency. The rest is in the form of deposits, which, most of the time, can be accessed electronically. So the vast majority of what we know today as money is a liability of the private sector, and not the central bank, and is already electronic. With most money available electronically, there has been a substantial shift to electronic forms of payments as well. There are various ways of tracking this shift. One is the survey of consumers that the RBA conducts every three years. When we first conducted this survey in 2007, we estimated that cash accounted for around 70 per cent of transactions made by households. In the most recent survey, which was conducted last year, this share had fallen to A second way of tracking the change is the decline in cash withdrawals from ATMs. The number of withdrawals peaked in 2008 and since then has fallen by around 25 per cent (Graph 2). This trend is likely to continue. The third area where we can see this shift is the rapid growth in the number of debit and credit card transactions and in transactions using the direct entry system. Since 2005, the number of transactions using these systems has grown at an average annual rate of 10 per cent (Graph 3). This stands in contrast to the decline in the use of cash and cheques. The overall picture is pretty clear. There has been a significant shift away from people using banknotes to making payments electronically. Most recently, Australia's enthusiastic adoption of 'tapand-go' payments has added impetus to this shift. In many ways, Australians are ahead of others in the use of electronic payments, although we are not quite in the vanguard. It is also worth pointing out, though, that despite this shift to electronic payments, the value of banknotes on issue is at a 50year high as a share of GDP (Graph 4). Australians are clearly holding banknotes for purposes other than for making day-to-day payments. This shift towards electronic payments, and away from the use of banknotes for payments, will surely continue. This will be driven partly by the increased use of mobile payment apps and other innovations. At the same time, though, it is likely that banknotes will continue to play an important role in the Australian payments landscape for many years to come. For many people, and for some types of transactions, banknotes are likely to remain the payment instrument of choice. In Australia, the banking system has provided the infrastructure that has made the shift to electronic payments possible. In some other countries, the banking system has not done this. For example, in China and Kenya non-bank entities have been at the forefront of recent strong growth in electronic payments. A lesson here is that if financial institutions do not respond to customers' needs, others will. At this stage, it seems likely that the banking system will continue to provide the infrastructure that Australians use to make electronic payments. This is particularly so given the substantial investment made by Australia's financial institutions in the NPP. The new system was turned on for 'live proving' in late November and the public launch is scheduled for February. It will allow Australians to make payments easily on a 24/7 basis, with recipients having immediate access to their money. The RBA has built a critical part of this infrastructure to ensure interbank settlement occurs in real time. Payments will be able to be made by just knowing somebody's email address or mobile phone number and plenty of information will be able to be sent with the payment. This system has the potential to be transformational and will allow many transactions that today are conducted with banknotes to be conducted electronically. Importantly, the new system offers instant settlement and funds availability. It provides this, while at the same time allowing funds to be held in deposit accounts at financial institutions subject to strong prudential regulation and that pay interest. This combination of attributes is not easy to replicate, including by closed-loop systems outside the banking system. However, the further shift to electronic payments through the banking system is not a given. It requires that the cost to consumers and businesses of using the NPP is low and that the functionality expands over time. If this does not happen, then the experience of other countries suggests that alternative systems or technologies might emerge. One class of technology that has emerged that can be used for payments is the so-called cryptocurrencies, the most prominent of which is Bitcoin. But in reality these currencies are not being commonly used for everyday payments and, as things currently stand, it is hard to see that changing. The value of Bitcoin is very volatile, the number of payments that can currently be handled is very low, there are governance problems, the transaction cost involved in making a payment with Bitcoin is very high and the estimates of the electricity used in the process of mining the coins are staggering. When thought of purely as a payment instrument, it seems more likely to be attractive to those who want to make transactions in the black or illegal economy, rather than everyday transactions. So the current fascination with these currencies feels more like a speculative mania than it has to do with their use as an efficient and convenient form of electronic payment. This is not to say that other efficient and low-cost electronic payments methods will not emerge. But there is a certain attraction of being able to make payments from funds held in prudentially regulated accounts that can earn interest. In principle, a new form of electronic payment method that could emerge would be some form of electronic banknotes, or electronic cash. The easiest case to think about is a form of electronic Australian dollar banknotes. Such banknotes could coexist with the electronic account-to-accountbased payments system operated by the banks, just as polymer banknotes coexist with the electronic systems today. The technologies for doing this on an economy-wide scale are still developing. It is possible that it could be achieved through a distributed ledger, although there are other possibilities as well. The issuing authority could issue electronic currency in the form of files or 'tokens'. These tokens could be stored in digital wallets, provided by financial institutions and others. These tokens could then be used for payments in a similar way that physical banknotes are used today. In thinking about this possibility there are a couple of important questions that I would like to highlight. The first is that if such a system were to be technologically feasible, who would issue the tokens: the RBA or somebody else? The second is whether the RBA developing such a system would pass the public interest test. In terms of the issuing authority, our working hypothesis is that this would best be done by the central bank. In principle, there is nothing preventing tokenised eAUDs being issued by the private sector. It is conceivable, for example, that eAUD tokens could be issued by banks or even by large non-banks, although it is hard to see them being issued as cryptocurrency tokens under a bitcoin-style protocol, with no central entity standing behind the liability. So, while a privately issued eAUD is conceivable, experience cautions that there are significant difficulties and dangers associated with privately issued fiat money. The history of private issuance is one of periodic panic and instability. In times of uncertainty and stress, people don't want to hold privately issued fiat money. This is one reason why today physical banknotes are backed by central banks. It is possible that ways might be found to deal with this financial stability issue - including full collateralisation - but these tend to be expensive. This suggests that if there were to be an electronic form of banknotes that was widely used by the community, it is probably better and more likely for it to be issued by the central bank. If we were to head in this direction, there would be significant design issues to work through. The tokens could be issued in a way that transactions could be made with complete anonymity, just as is the case with physical banknotes. Alternatively, they might be issued in a way in which transactions were auditable and traceable by relevant authorities. We would also need to deal with the issue of possible counterfeiting. Depending upon the design of any system, we might be very reliant on cryptography and would need to be confident in the ability to resist malicious attacks. This brings me to the second issue here: is there a public policy case for moving in this direction? Such a case would need to be built on electronic banknotes offering something that account-toaccount transfers through the banking system do not. We would also need to be confident that there were not material downsides from moving in this direction. Our current working hypothesis is that with the NPP there is likely to be little additional benefit from electronic banknotes. This, of course, presupposes that the NPP provides low-cost efficient payments. One possible benefit of electronic banknotes for some people might be that they could have less of an 'electronic fingerprint' than account-to-account transfers, although this would depend upon how the system was designed. But having less of an electronic fingerprint hardly seems the basis for building a public policy case to issue an electronic form of the currency. So there would need to be more than this. Among the potential downsides, the main one lies in the area of financial stability. If we were to issue electronic banknotes, it is possible that in times of banking system stress, people might seek to exchange their deposits in commercial banks for these banknotes, which are a claim on the central bank. It is likely that the process of switching from commercial bank deposits to digital banknotes would be easier than switching to physical banknotes. In other words, it might be easier to run on the banking system. This could have adverse implications for financial stability. Given these various considerations, we do not currently see a public policy case for moving in this direction. We will, however, keep that judgement under review. Another possible change that some have suggested would encourage the shift to electronic payments would be for the central bank to issue every person a bank account - for each Australian to have their own exchange settlement account with the RBA. In addition to serving as deposit accounts, these accounts could be used for low-cost electronic payments, in a similar way that third- party payment providers currently use accounts at the RBA to make payments between themselves. Some advocates of this model also suggest that the central bank could pay interest on these accounts or even charge interest if the policy rate was negative. On this issue, we have reached a conclusion, rather than just develop a hypothesis. The conclusion is that we do not see it as in the public interest to go down this route. If we did go down this route, the RBA would find itself in direct competition with the private banking sector, both in terms of deposits and payment services. In doing so, the nature of commercial banking as we know it today would be reshaped. The RBA could find itself not just as the nation's central bank, but as a type of large commercial bank as well. This is not a direction in which we want to head. A related consideration is the same financial stability issue that I just spoke about in terms of electronic banknotes. In times of stress, it is highly likely that people might want to run from what funds they still hold in commercial bank accounts to their account at the RBA. This would make the remaining private banking system prone to runs. The point here is that exchange settlement accounts are for settlement of interbank obligations between institutions that operate third-party payment businesses to address systemic risk - something that is central to our mandate. A decision to offer exchange settlement accounts for dayto-day use would be a step into a completely different policy area. One final possibility is for the RBA to issue Australian dollars in the form of electronic files or tokens that could be used within specialised payment and settlement systems. The tokens could be exchanged among members of a private, permissioned distributed ledger, separate from the RBA's Real-time Gross Settlement (RTGS) system, but with mechanisms for the tokens to be exchanged for central bank deposits when required. Such a system might allow the payment and settlement process to become highly integrated with other business processes, generating efficiencies and risk reductions for private business. As part of this, the tokens might also be able to be programmed and sit alongside smart contracts, enabling multi-stage transactions with potentially complex dependencies to take place securely and automatically. This seems to be the general model that some people have in mind when they talk about 'putting AUD on the blockchain', although other technologies might be able to achieve similar outcomes. Whether a strong case for the development of these types of systems emerges remains an open question. We need to better understand the potential efficiencies for private business and why it would be preferable for such a settlement system to be provided by the central bank, rather than the private sector; why privately issued tokens or files could not do the job. We would also need to understand why any efficiency improvement could not be obtained by using the existing Exchange We would also need to understand whether and how risk in the financial system would change as a result of such a system. It remains unclear which way this could go. On the one hand, these types of processes could use a very different technology from the current system, which is based on accountto-account transfers, so they could add to the resilience of the overall payments system. But there would be a whole host of new technology issues to manage as well. To help understand these various issues, Reserve Bank staff have been liaising closely with fintechs and financial institutions. We also regularly talk with other central banks that have tested distributed ledger technologies in some related contexts. We are also currently working with some external entities to observe or participate in proof-of-concepts similar to those of other central banks. So this area remains a work in progress for us. This brings me to the end of the elaboration of my set of five working hypotheses. I would like to conclude by summarising. There is a lot going on in the world of payments. Much of this is being driven by advances in technology. These advances are opening up possibilities that were difficult even to dream about a little while ago. These changes are leading to much greater use of electronic means of payment and the development of new electronic payment methods. This process has much further to run, although physical banknotes are likely to remain an important part of the payments landscape for many years to come. This shift to electronic payments is most likely to occur through products offered by the banking system. The NPP is a very big step here. If it had not been developed it is likely that non-bank solutions would have gained wide acceptance. This may still happen. But it seems plausible that Australian households and businesses will continue to hold the bulk of their money in the form of commercial bank deposits, which come with flexible, low-cost electronic payment options, earn interest and are prudentially regulated. But this will require the banks to offer the services that customers want at a reasonable price. The case for adding an electronic form of Australian banknotes to the payments mix has not been established, even if it were technologically feasible. My working hypothesis here is that the NPP will serve this purpose. The RBA is in close contact with our peers in other countries on this issue and few see electronic banknotes on the horizon. We do not see a case for the RBA offering every Australian a bank account for the purposes of making payments. Doing so would fundamentally change our banking system in a way that would not promote the public interest. A convincing case for issuing Australian dollars on the blockchain for use with limited private systems has not yet been made. It is certainly possible that this type of system could lead to more efficient, lower-cost business processes and payments. My working hypothesis here is that such a case could develop, although we need to work through a range of complex operational and policy questions. As we work though these various issues, we look forward to an ongoing dialogue with the payments industry and other interested parties. Finally, before I finish I would like to briefly highlight three other issues that I know are of current interest to the payments industry as well as the Payments System Board. the importance of allowing merchants to route debit card transactions through the least-cost network the need to address rising rates of fraud in card-not-present transactions the need to develop a strong system of digital identity that can be used in the financial sector, and perhaps elsewhere. In the Payments System Board's view, it is in the public interest that timely progress be made in all three areas. The Board's preference is that this progress be made by industry participants, without the need for regulation. In the event that this did not occur, the Board would need to consider what steps it might take to promote the public interest. Thank you for listening and I am happy to answer questions.

r180208a_BOA

australia

Remarks to A50 Dinner

lowe

Thank you for the invitation to speak at the A50 Dinner. I would like to offer a particularly warm welcome to those of you who are visiting Australia. The A50 Forum provides a unique opportunity to hear directly from leaders in the worlds of business, politics and Australia's policy institutions. You will find us open and transparent, not only in our assessments of the opportunities that Australia faces, but also the challenges confronting us. One of the facts that visitors to Australia most frequently remark upon is that Australia has experienced 26 years of economic growth. Over those 26 years we have certainly experienced some slowdowns and periods of rising unemployment, but this long record of economic expansion and stability is not matched elsewhere among the advanced economies. Importantly, it has been accompanied by a long period of stability in our financial system. These are significant achievements. This is especially so in light of the very large structural changes that have occurred in the global economy since the early 1990s, and the instability we have witnessed elsewhere. A country doesn't experience these types of outcomes without some good fortune and, importantly, without sensible policy and strong institutions. In Australia, we have had all three. Partly through sensible and pragmatic policy, the Australian economy has developed the flexibility to adjust to a changing world. An important element of this flexibility is our floating exchange rate. Another is our labour market, which has developed the flexibility to adjust to changes in the economic landscape. A third element is the fact that both monetary and fiscal policy have maintained their ability to adapt to changing circumstances. All these things have helped us adjust to some very large shifts in the economy. Australia has also benefited from our openness to the world. We are an outward-looking country. Over many decades, our prosperity has been built on our ability to trade in open and competitive markets, to attract investment and ideas from abroad, and to attract talented people to Australia. We have benefited tremendously from an open, inclusive and rules-based international system. We have as much at stake as any other country in the continuation of this system. Our location on the globe and our mineral and energy resources have both given us a deal of good fortune. In earlier generations, our location was seen as a liability - we were simply too far from the major engines of global growth. Today, though, our location is seen as an asset. We live in the most dynamic region of the global economy and we have capitalised on this with strong trade and personal links with Asia. Over recent times, we have benefited significantly from these links. The most obvious example is the very strong growth in exports of our resources. But increasingly, it is also being seen in the growth of exports of high-quality services, food and manufactured goods to Naturally enough, after 26 years of economic expansion people wonder what the future holds. This is an issue that often comes up in discussions with overseas investors. So I would like to use the opportunity of this dinner to address three related questions that we are frequently asked. These questions are: What are the next few years likely to hold for the Australian economy? What are the challenges facing the Australian economy? As other central banks reduce monetary accommodation won't the RBA have to, too? For a while now we have been expecting the Australian economy to grow more strongly in 2018 and 2019 than it did, on average, over recent years. There are a number of reasons for this. We are all but through the decline in mining investment to more normal levels, there is a large pipeline of urban infrastructure work to be done, the global economy is experiencing a solid upswing, commodity prices are up and financial conditions remain accommodative. All this is helping. The RBA will be releasing our latest economic forecasts tomorrow in the . These forecasts will be largely unchanged from the previous set of forecasts. The RBA's central scenario remains for the Australian economy to grow at an average rate of a bit above 3 per cent over the next couple of years. This outlook has not been affected by the volatility in the stock market over recent days. Indeed, it is worth keeping in mind that the catalyst for this volatility was a reassessment in financial markets of the implications of strong growth for inflation in the United States. For some time, many investors had been working under the assumptions that unusually low inflation and unusually low volatility in asset prices would persist, even with above- trend growth at a time of low unemployment. A reassessment of these assumptions now appears to be taking place against the backdrop of strong economic conditions globally. Looking beyond these financial events, the data we have received on the real economy over the summer have been consistent with our assessment that GDP growth will pick up over 2018. Taken together, the recent domestic and global data on the real economy suggest that 2018 has started on a more positive note than did recent years. Particularly noteworthy has been the labour market, with employment increasing by 3 1/4 per cent over the past year. This strong performance has been accompanied by a large number of people joining the workforce, so that the participation rate has returned to around the level reached at the peak of the mining investment boom. There have been noticeable increases in the participation rates of both women and older Australians. At the same time, the unemployment rate has declined to around 5 1/2 per cent and a further gradual decline is expected over the next couple of years. Business conditions are around their highest level since before the global financial crisis and there has also been an improvement in business confidence. Non-mining business investment has been stronger than we had expected a year ago and the investment outlook has brightened. One ongoing area of uncertainty, though, is consumer spending. Household incomes are growing slowly and debt levels are high. I will return to these issues in a moment. On the prices front, we continue to experience subdued outcomes, although inflation is higher than it was a year ago. Over 2017, inflation was a bit under 2 per cent, in both headline and underlying terms. Last week's data provided further confirmation of trends we have been witnessing for some time. Increased competition in retailing is contributing to price declines for many consumer durables. And subdued wage increases are contributing to low rates of inflation for a range of market services. The rate of rent inflation also remains low. The immediate outlook is for a continuation of these broad trends, but for inflation to pick up gradually as the economy and labour market strengthen. We are expecting CPI inflation to be in the 2 to 2 1/2 per cent range over the next couple of years. Underlying inflation, which is less affected by the scheduled increases in tobacco excise, is expected to be a bit lower than CPI inflation. I would now like to touch on a couple of issues that we are paying close attention to and that could have a significant bearing on the outlook for growth and inflation over the next couple of years. The first of these is wage growth. Not only are most workers experiencing low wage increases, but following the resources boom some people have moved out of highly paid jobs. The result is that after many years of Australians experiencing strong growth in real incomes, growth in average nominal and real incomes has been much slower over recent times. The effects of low real wage growth on the economy work in different directions. On the one hand, the restrained growth in labour costs is one of the factors that has boosted employment. But, on the other hand, the slow growth in incomes has weighed on spending, including by making it harder for some households to pay down their debts. On balance, though, in the current environment, some pick-up in wage growth would be a welcome development. Ideally, this would be on the back of stronger productivity growth. But even if productivity growth were to be around the average of recent years, a faster rate of wage increase should be possible. Indeed, a lift in wage growth is likely to be necessary for inflation to average around the midpoint of the 2-3 per cent medium-term inflation target. Stronger growth in real wages would also boost household incomes and create a stronger sense of shared prosperity. Our central scenario is for this pick-up in wage growth to occur as the economy strengthens, but to do so only gradually. Through our liaison with business we hear some reports of wage pressures emerging in pockets where labour markets are tight. We expect that over time we will hear more such reports. After all, the laws of supply and demand still work. I have spoken previously about the factors affecting wages, and they have a global dimension. Globalisation and advances in technology have increased competition, and greater competition means less pricing power. Given the strength and pervasiveness of these forces, it is unlikely that they are going to disappear quickly, so the pick-up in wage growth is likely to be fairly gradual. A second factor shaping the outlook is the level of household debt. Indeed, the high level of household debt in Australia is remarked upon by international investors almost as often as the fact of 26 years of growth. A while back we had become quite concerned about some of the trends in household borrowing, including very fast growth in lending to investors and the high share of loans being made that did not require regular repayment of principal. Our concern was not that developments in household balance sheets posed a risk to the stability of the banking system. Rather, it was more that they posed a broader macro stability risk - that is, the day might come, when faced with bad economic news, households feel they have borrowed too much and respond by cutting their spending sharply, damaging the overall economy. We have worked closely with APRA, including through the Council of Financial Regulators, to address these issues. This work, together with other steps taken by APRA, has helped improve the quality of lending in Australia. In the housing market, there has also been a change. National measures of housing prices are up by only around 3 per cent over the past year, a marked change from the situation a couple of years ago. This change is most pronounced in Sydney, where prices are no longer rising and conditions have also cooled in Melbourne. These changes in the housing market have reduced the incentive to borrow at low interest rates to invest in an asset whose price is increasing quickly. On balance then, from a macro stability perspective, the situation looks less risky than it was a while ago. We do, however, continue to watch household balance sheets carefully as there are still risks here. I would now like to move to the second question that I get asked frequently. Beyond the short term, what are the challenges facing the Australian economy? When I spoke at this forum last year I talked about four challenges: the need to reinvigorate productivity growth finding ways of capitalising on the opportunities in Asia providing the infrastructure needed for a growing population and to support productivity making sure that our public finances were on the right track and that our tax system was internationally competitive. This is by no means a complete list; at a minimum, you could add some of the issues I have just spoken about. But it remains a reasonable list and I thought it useful to offer an update. Improving our productivity remains the key to further improvement in our living standards. Average growth in labour productivity has been a bit higher since the peak in the mining boom than it was in the preceding five years, although capital deepening has been an important part of the story here. Late last year the Productivity Commission provided some guidance about how we might lift our performance with the release of the first of its five-yearly reports - the report. This is another example of Australian policy institutions tackling important issues through serious and systematic reviews. A central theme of the report is the importance of services and cities. Most Australians now work in the service sector and live in cities, so how we deliver services and how our cities function have a major influence on our future living standards. This is yet another area where we will benefit from a strong innovation mindset. On building our links with Asia, we continue to see progress. New trade agreements are opening up new opportunities for Australian business in the region and the share of Australia's exports going to Asia continues to rise. Last year, the value of Australia's merchandise exports increased by more than 15 per cent to each of China, Japan, Korea, Taiwan, Indonesia and the Philippines. Exports of resources have been an important part of the story, but it is broader than that, with strong growth in exports of services too. Person to person links also continue to deepen, with half of all international visitors to Australia last year coming from Asia. On infrastructure, the story is also a positive one. Increased public investment in infrastructure in our largest states is currently providing a boost to the economy and it is also building productive capacity for the future. With our population continuing to grow at a relatively fast rate for an advanced economy - around 1 1/2 per cent a year - this is an area for us to continue to focus on. As we do this, we need to pay close attention to the governance of decisions around project selection, the control of construction costs, usage pricing and the allocation of risk between the public and private sectors. Good governance is important in these areas to support sound decision-making and to retain public trust and confidence in governments' spending plans. Finally, on the fiscal side, the latest estimates are that things are on track to meet the Australian Government's projection of returning the budget to balance by 2020/21. Australia's record of careful management of public finances meant that when the financial crisis hit a decade ago, fiscal policy was able to play a role stabilising the economy. Ensuring that our public finances are on a sustainable footing is important to ensuring that we have similar flexibility in the future. The issue of how the tax system affects the competitiveness of Australia as a destination for investment is one of ongoing political debate. There have been some cuts in company tax and parliament is considering further changes. I would now like to turn to the final question that I often get asked: as other central banks raise interest rates, won't the RBA have to, too? It is understandable that this question is asked. Over time, there is a common element to movements in interest rates around the world. The level of interest rates in all countries is influenced by movements in the neutral global real interest rate. During the financial crisis, the neutral global rate fell and this has had an important influence on the setting of interest rates in all countries, including here in Australia. If we had not lowered our interest rates as global rates fell, the Australian economy would have grown by less and inflation would have been even lower than it turned out to be. The fact that there is a common element in interest rates, however, does not mean that interest rates need to move in lock-step with one another. Countries with a floating exchange rate, like Australia, still retain considerable flexibility to set interest rates based on their domestic considerations. We did not lower our interest rates to the extraordinarily low levels seen elsewhere after the financial crisis. Our circumstances were different: we didn't have a meltdown in the financial system and we experienced a very large cycle in commodity prices and mining investment. Just as we did not move in lock-step on the way down, we don't need to do so in the other direction. It's understandable that some other central banks are raising rates. They lowered their rates by more than us and, in a number of countries, the unemployment rate is now below conventional estimates of full employment at a time when above-trend growth is expected. Our circumstances are a little different. We are still some way from what could be considered full employment and our central scenario for inflation is for it to remain below the midpoint of the medium-term target range for the next couple of years. We expect, though, to make further progress in reducing unemployment and having inflation return to the midpoint of the target range. If we do make that progress, at some point it will be appropriate for interest rates in Australia to also start moving up. So, given recent developments in Australia and overseas, it is likely that the next move in interest rates in Australia will be up, not down. If this is how things play out, the likely timing will depend upon the extent and pace of the progress that we make. As I have discussed, while we do expect steady progress, that progress is likely to be only gradual. Given this, the Reserve Bank Board does not see a strong case for a near-term adjustment in monetary policy. It will of course keep that judgement under review at future meetings. I hope that these remarks this evening have helped you understand the Australian economy, our opportunities and some of the challenges we face. I look forward to answering your questions.

r180216a_BOA

australia

Opening Statement to the House of Representatives Standing Committee on Economics

lowe

Members of the Committee My colleagues and I welcome these opportunities to explain our thinking on the Australian economy and to answer your questions. We view it as an important part of the accountability process for the Reserve Bank. Since we last met in August, the improvement in the global economy has continued and forecasts for world growth have been revised up. Rather than just one or two economies doing better, the improvement has been broadly based, with a synchronised upswing taking place. Partly as a result, both international trade and commodity prices have picked up and this is helping the Australian economy. The stronger economic growth has resulted in unemployment rates falling further. In a number of countries, the unemployment rate is now below conventional estimates of full employment. Inflation has remained low, partly reflecting the fact that wage growth has been quite subdued despite the low unemployment rates. Low inflation has meant low interest rates. And for much of past year, volatility in asset prices was also unusually low. Over recent times, many investors have been proceeding on the basis that this combination of strong growth, low unemployment, low inflation and low interest rates would persist. Many also expected the low volatility in asset prices to continue. A couple of weeks ago we saw a re-evaluation of some of these assumptions by some investors, with the catalyst being a pick-up in wage growth in the United States. The result has been an increase in bond yields, a decline in equity prices and increased market volatility. While the exact timing of changes in investors' assumptions is difficult to predict, the fact that some reassessment took place, at some point, is not that surprising. Above-trend growth at a time of low unemployment should be expected to see inflation lift, even if that lift is gradual because of factors that are affecting wage and price pressures globally. To add to the mix, fiscal policy in some countries, most noticeably the United States, is becoming more expansionary. So I expect rising inflation pressures will figure more prominently in discussions of the global economy than they have for some time. Another important international influence on our economy is what happens in China. Like other economies, China is benefiting from the global upswing. At the same time, there are ongoing efforts to increase the sustainability of China's economic growth, both in terms of its financing and the environment. These efforts are affecting both the structure of finance in the Chinese economy and commodity markets. The Chinese authorities face the difficult challenge of getting the balance right between containing medium-term risks and supporting near-term growth, and we continue to watch developments there closely. I would now like to turn to the Australian economy. On balance, the news over the summer has generally had a more positive tone than it has had for a while. For some time we had been expecting GDP growth to be a bit stronger in 2018 and 2019 than in the recent past. The recent data have been consistent with this. Over this year and next we expect GDP growth to be a bit above 3 per cent, which is faster than our current estimate of trend growth for the Australian economy. This outlook has not been affected by the recent volatility in the equity market. The Australian labour market has been noticeably stronger than we were expecting, which is good news. Over the past year, the number of people with a job increased by 400 000, and there has been a marked increase in the participation rate for women. We don't expect a repeat of these very strong outcomes in 2018, but we do expect employment growth to be fast enough to see a further gradual reduction in the unemployment rate. The unemployment rate, though, is likely to remain above conventional estimates of full employment in Australia for some time. A range of business indicators have also improved since we last met. Business conditions have lifted and so too has the outlook for capital expenditure. It would be an exaggeration to say that animal spirits have fully returned, but the mood has certainly brightened in much of the business community. There are a number of reasons for this, but in parts of the country the lift in mood is being helped by the large infrastructure projects underway. Not only are these projects creating jobs today, but they are building much needed productive capacity for the future. Against this general backdrop of improving conditions, one uncertainty remains the strength of consumer spending. In the September quarter, spending growth was quite weak, especially for discretionary items. More recently, the retail trade figures have been better and suggest a stronger outcome for the December quarter. Most households are experiencing only slow growth in their incomes and many expect that this will continue for some time yet. This lowering of expectations about income growth is likely to be affecting spending, especially in an environment of high levels of household debt. A pick-up in income growth, by way of ongoing increases in jobs and stronger wage growth should help here. We continue to look carefully at household balance sheets. On balance, our assessment is that there has been some containment of the build-up of risk in this area. This is a positive development. Lending standards are stricter than they were previously and there has been a welcome decline in the share of interest-only loans, following measures taken by APRA. Housing credit growth has also slowed a bit, especially to investors. In the property market, prices are no longer rising in Sydney, and have fallen for higher-priced houses. The Melbourne market has also cooled somewhat. Increased supply of housing, changes in the nature and availability of financing, and some reduction in foreign demand have all played a role. While the Reserve Bank does not target housing prices or household debt, it would be a good outcome if we now experienced a run of years in which the rate of growth of housing costs and debt did not outstrip growth in our incomes in the way that they did over the past five years. In terms of CPI inflation, the picture is pretty much the same as it was when we met six months ago. Inflation, in headline and underlying terms, is still running at a little under 2 per cent. This is higher than the inflation rate a year ago, but inflation does remain low. The most recent data confirmed themes that we have been seeing for some time. Strong competition from new entrants and changes in retailers' business models are putting downward pressure on the prices of consumer durables and groceries. The prices of many of these goods are lower than they were a few years ago. This is good news for consumers, although not for some retailers. We do expect to see some lessening of this downward pressure on prices at some point, although not for a while yet. The second ongoing theme is higher prices for utilities and tobacco. Both of these have added materially to the CPI over the past year, and further increases are expected. The third theme is the subdued increase in wages feeding through into subdued price increases, particularly for a range of market services. This, too, is likely to continue for a while yet. We have discussed on previous occasions the reasons for the subdued wage increases. These include the continuing spare capacity in the economy after the unwinding of the mining investment boom; the heightened sense of competition due to globalisation and technological change; and changes in bargaining arrangements. These factors are still at work, although through our liaison program we hear reports of pockets where the labour market is tight and firms are finding it hard to find workers with the right skills. In some of these areas wages are now rising more quickly than previously, but many firms remain wary of adding to their cost base in the current environment. Over time, we expect wage growth to pick up as the labour market strengthens further. The pick-up, though, is likely to be gradual. This increase in wage growth and the more general reduction in spare capacity in the economy are expected to contribute to inflation picking up as well. But to continue the theme, this pick-up, too, is expected to be only gradual. This year and next, we expect CPI inflation to be between 2 and 2 1/2 per cent. As you would be aware, the Reserve Bank Board has held the cash rate at 1 1/2 per cent since August 2016. This represents an accommodative setting of monetary policy, aimed at supporting the economy and employment, and returning inflation towards the mid-point of the medium-term target range. As we have discussed with this Committee on previous occasions, the Board has sought to strike a balance between these benefits of monetary stimulus and the medium-term risks associated with the increase in the already high level of household debt. We have sought to steer a middle course, promoting sustainable growth in the economy. Over the past year the economy has been moving in the right direction. Progress has been made in reducing unemployment and having inflation return to around the mid-point of the target range. And on the financial side, the build-up of risks in household balance sheets has been contained, although risks there remain. Over the coming year we expect to make further progress. Our central scenario for the Australian economy is for a further reduction in the unemployment rate and an increase in inflation towards the mid-point of the target range. Of course, this is just the central scenario, and there are other scenarios as well. But if this is how things play out, at some point it will be appropriate to have less monetary stimulus and for interest rates in Australia to move up, as is already happening in some other countries. In other words, it is more likely that the next move in interest rates will be up, rather than down. The timing of any future move will depend upon the extent and pace of progress that we make in reducing the unemployment rate and having inflation return to target. As things currently stand, we expect that progress to be steady, but to be only gradual. Given this assessment, the Reserve Bank Board does not see a strong case for a near-term adjustment of monetary policy. We will, of course, keep that judgement under review at future meetings. Before finishing, I would like to mention a couple of developments on the payments side of the Bank's responsibilities. The first is the launch this week of the New Payments Platform. This is a major piece of national infrastructure, which will benefit households and businesses. Its development is the result of a very complex collaborative industry effort over many years. This new payment system will allow Australians to make faster, simpler and smarter payments on a 24/7 basis. One element of this is the use of PayIDs instead of having to know BSBs and account numbers for many transactions. A major focus of the development effort has been security and to protect people from fraud. The process for initially registering PayIDs, which is now underway, requires users to verify their identity. The new platform also requires users to confirm the recipient before a payment is completed. We would be happy to discuss further details of the new arrangements during the course of this hearing. The second development on the payments side is the release yesterday of the design of the new $50 banknote. This new banknote will be issued into circulation from October this year. There are more $50 banknotes in circulation than any other note, so it is a big task. All up, there are 700 million $50s on issue - they are used heavily in transactions as well as being the main ATM banknote. The new $50 banknote will feature the same world-leading security features as the $5 and $10 banknotes, including the clear top-to-bottom window. It will also have four bumps to help people with impaired vision recognise the note. As with the current $50 banknote, the new one honours two very significant Australians: David Unaipon and Edith Cowan. While these two Australians came from very different backgrounds, they were both significant pioneers. David Unaipon was Australia's first published Aboriginal author, writing about, in his owns words, Aboriginal 'customs, beliefs and imaginings'. The micro-text on the banknote is an extract from his book, the . Edith Cowan was the first female member of an Australian parliament, being elected to the Western Australian Parliament in 1921. I am pleased to be able to say that the new banknote contains text from her first speech to that parliament. We are proud to have these two distinguished Australians on our most widely used banknote. Thank you. My colleagues and I look forward to answering your questions.

r180307a_BOA

australia

The Changing Nature of Investment

lowe

Thank you for the invitation to speak at this year's AFR Business Summit. It is very good to be here. The underlying question being asked at this summit is: how does Australian business prosper in today's changing world? This is an important question to be asking. A strong and prosperous business sector is central to Australia's economic success. It is businesses - both small and large - that employ the bulk of Australians. It is businesses that have to compete globally and find new markets around the world for the goods and services that we produce here in Australia. And it is businesses that are responsible for most of the investment spending in the country. So it is in our collective interest to have a prosperous business sector. This morning I would like to talk about the importance of investment in helping deliver that prosperity. It is through investment that firms develop new products, find better ways of doing things and expand their productive capacity. This means that the investment climate and the level and nature of investment have an important bearing on our future prosperity. My remarks will be in three parts. First, I will focus on recent cyclical developments in non-mining investment, including the recent lift in investment. Second, I will discuss some structural changes in the nature of investment in the Australian economy, including the increasing importance of investment in technology and knowledge-based capital. I will finish with some remarks about the investment climate and the role the RBA can play. Over the past decade or so, the resources sector has been the dominant investment story in Australia. This investment has greatly expanded productive capacity in the resources sector, and this is flowing into increased exports. This story is well known so I will not go over it again today. Instead my focus is on non-mining investment. During the mining investment boom it was understandable that investment in the rest of the economy was subdued. But as the boom unwound, the pick-up in non-mining business investment was slow to come. For a few years, a common theme in commentary from the RBA was that nonmining investment was weaker than we had been expecting. Indeed, for six or seven years the level of non-mining investment did not change very much (Graph 1). During this period, the RBA highlighted high hurdle rates of return and a lack of animal spirits. And the businesses we spoke with cited numerous uncertainties: uncertainty about the global economy, technology, politics and the level of household debt, among other things. For many firms, these uncertainties were a reason to delay investment spending; to wait for more clarity before proceeding. Over the past year the picture has begun to change. While we don't get the final investment figures for 2017 until later this morning, we estimate that over the past year, non-mining business investment increased by around 9 per cent. This is stronger than we were expecting a year ago and would be the largest increase since the onset of the global financial crisis. We expect to see further growth over this year. While businesses still face some significant uncertainties, including the future strength of consumer spending in a world of low real income growth and high household debt, the picture is a better one than it has been for some time. The pick-up in investment reflects a combination of factors. One is the stronger global economy, which has boosted demand and reduced some of the uncertainties that businesses face. Another is the continuation of accommodative monetary policy in Australia; borrowing costs here remain low and finance is available. The ongoing growth in Australia's population has also played some role. Since 2008, Australia's population has increased by 3 1/2 million people, or 16 per cent. This growth, combined with low levels of investment, has started to put pressure on capacity utilisation (Graph 2). It is also relevant that businesses are reporting stronger business conditions than at any time since before the financial crisis. Another important part of the investment story recently is strong growth in investment in public infrastructure (Graph 3). The pick-up has been particularly noticeable in spending on transport infrastructure in the eastern states and the pipeline of work to be completed is large. The extra investment is directly creating demand in the economy today and adding to tomorrow's productive capacity. The Bank's analysis is that there are positive spillovers to the rest of the economy from the spending on public infrastructure, especially given that we still have some spare capacity. In our business liaison, a number of firms report that they are investing more to meet the extra demand from infrastructure projects. So it is a positive story. I would now like to take a more structural perspective and highlight two changes in the structure and nature of investment. The first is the increasingly important role played by investment in information technology. And the second is a change in the industries in which investment is occurring. Over recent times, one of the central themes in the RBA's discussions with businesses has been the much greater use of information technology to increase productivity. Among other things, we hear about the possibilities and the challenges of data analytics, machine learning, artificial intelligence, the better use of sensors to control production and the automation of processes and production methods. A similar picture emerges from a survey undertaken by Ai Group last year, where CEOs were asked about their main investment priority for the year ahead. At the top of the list were investment in technology and the staff training that is needed to support that investment (Graph 4). Next on the list was investment in research and development (R&D). Further down the list was investment in physical assets. If we look back at previous surveys, it's clear that this focus on investing in technology has increased over time. This is not to underplay the importance of investment in physical assets. This remains critical. We need places to work, live, shop and play, and investment in buildings & structures and machinery & equipment remains central to this. But increasingly, investment decisions in these areas are also often just as much about technology as they are about other things. In every industry - in manufacturing, mining, agriculture, the health sector and business services - businesses are having to make investments in information technology to remain competitive. This is changing the way we think about investment. Tracking this shift in investment for the economy as a whole is complicated by some limitations in the available data. The ABS does, however, publish separate figures for investment in buildings & These data show that over the past couple of decades, investment in intellectual property has grown noticeably faster and more consistently than investment in buildings & structures and machinery & equipment. This is particularly so since 2009/10. Over this period, the weakness in overall non- mining investment is explained by there being almost no growth in investment in tangible assets. In contrast, investment in intellectual property has grown at an average rate of 5 per cent. Following this sustained period of strong growth in investment in intellectual property, this component now accounts for around 20 per cent of total non-mining investment, in nominal terms. By way of comparison, this share was just 3 per cent in the early 1980s (Graph 6). Conversely, the share of investment spending on machinery & equipment has declined over time. This is partly, but not wholly, explained by the steady decline in the relative price of machinery & equipment. These shifts are significant and are consistent with the rising importance of investment in information technology. Within the broad heading of intellectual property, we can further disaggregate the data strongest growth has been in investment in software, with investment in this area doubling over the past seven years. The picture for R&D is a little different; investment in R&D has not grown for a few years now, but this follows earlier strong growth. The impact of the increased investment in technology is also evident in the figures for output growth by industry. In particular, since the early 1990s, the fastest growing industries in the Australian economy have been information, media & telecommunications and professional, scientific & technical services. Both have grown faster than the mining industry, recording compounded average growth of around 5 per cent per year. The effects are also evident in the labour market, with strong demand for various types of workers in information technology. Indeed, some of the pockets of the Australian labour market in which wage growth has picked up over recent times are in professional, scientific & technical roles. The second structural change that I want to highlight is a shift in the industries in which investment is taking place. This shift can be seen in this next graph, which shows the share of non-mining investment accounted for by various industries (Graph 8). In the 1980s, the manufacturing industry accounted for around one quarter of non-mining investment in Australia. At that time, manufacturing required high levels of investment in machinery & equipment, not only to expand capacity, but to offset fairly high rates of depreciation. So investment in the manufacturing industry accounted for a large share of total investment. But since the mid 1990s, manufacturing has accounted for a steadily declining share of non-mining investment. Today, that share stands at just 11 per cent. In contrast, the shares of investment accounted for by information, media & telecommunications and professional, scientific & technical services have increased significantly. Combined, these two industries now account for about 16 per cent of non-mining investment, up from around 8 per cent in the early 1990s. Investment in health, education and transport has also increased as a share of total investment. Given these structural changes, one question that sometimes gets asked is: do we need less investment than we used to? This question has also been raised in the context of the subdued levels of non-mining investment over recent years: perhaps we simply don't need to devote the same share of output to investment as we once did? There isn't a straightforward answer to this question, but our analysis points to a couple of conclusions. The first is that the increased emphasis on technology and the shift to an increasingly serviceoriented economy explains some - but only some - of the subdued levels of investment spending over recent years. Rather, the bulk of the explanation for low levels of investment lies in what has been going on within individual industries, not shifts across industries. In most industries, the ratio of investment spending to output has been relatively low over recent years (Graph 9). The second conclusion is that, from a longer-term perspective, it is plausible that non-mining investment will account for a lower share of GDP than used to be the case. This largely reflects the decline in manufacturing as a share of the economy and the fact that the ratio of investment to output in the manufacturing industry is higher than in most other industries. While putting precise numbers on the size of any change is difficult, we estimate that this shift away from manufacturing could reduce the steady-state ratio of non-mining business investment to GDP by 1 to 2 percentage points. It is important, though, to point out that this does not mean the ratio of total investment to GDP will necessarily decline by this amount. This is because of what has happened in the resources sector, where there has been a very large increase in the capital stock. This higher capital stock means more depreciation, and more depreciation requires more investment to maintain the higher capital stock. So it is likely that the amount of investment in the resources sector, as a share of GDP, will be higher than it was before the mining investment boom. We are already seeing some evidence of this, with increased spending on 'sustaining' the capital stock being one of the factors behind the recent improvement in the Western Australian economy. The main point of all these facts and figures is that the nature of investment in the Australian economy is changing. There is a much greater focus on information technology and a shift to investment in the service industries. This has implications for how we think about investment and the measures necessary to create an environment that supports investment in our modern economy. This brings me to the third issue I raised at the outset: that is the importance of a positive investment climate. No matter what type of investment a firm is considering, the environment in which the decision is being made has a major bearing on the decision to invest or not. Australia's long record of economic and financial stability is a positive from this perspective. So, too, are our strong legal system and our well-established institutions. To this list I could add the opportunities offered by our links to the fastest-growing part of the global economy and our skilled, diverse and flexible workforce. All these things make Australia an attractive place to invest. But we can't rest on these advantages. It is a competitive world out there and the nature of comparative advantage is changing. Once upon a time, comparative advantage came largely from a country's endowments or resources. Indeed, in our own case, the big waves of investment in Australia have been to capitalise on our natural endowments. These resources have made us wealthy and they are central to our continued prosperity. But in today's world, comparative advantage is just as likely to be built, as it is to come from endowments. It is likely to be built through innovation, creativity and ingenuity. And it is likely to be built through investing in information technology and the skills of our labour force. Creating a positive environment that encourages this investment is a joint responsibility of government and private business. The government certainly has an important role to play, but so does business. A business culture that highly values innovation and competition and that is not afraid of taking risk will surely help in creating this positive environment. There are no simple answers here. But a recent report by Innovation and Science Australia provides some guideposts. The report's subtitle is 'A plan for Australia to thrive in the global innovation race'. It is worth a read. The report rightly focuses on the importance of education and the accumulation of human capital. Our ability to innovate rests on the skills of our workforce, so investing in these skills is central to building a positive investment climate. The report also discusses the way we go about research and development and how we can support innovative firms. It also discusses the importance of culture and ambition. Over recent times there has also been quite a lot of discussion about the effect of tax on the investment climate and international competitiveness. This is an important discussion to have as Australia does need to remain an attractive place for global capital to invest. As we have this discussion, it is also important that we keep focused on the other issues I just touched on, as these areas play an important role in building durable comparative advantage and prosperity. I would like to finish with a few words about the role of the RBA in contributing to a positive investment climate. We obviously have no role in influencing the structural considerations that I just spoke about. We do, though, have an influence on the overall environment within which business investment decisions are made. At the highest level we seek to be a source of stability and confidence. Having strong credible institutions in the country helps provide the community with a degree of confidence. We seek to build and maintain this credibility through developing a reputation for being a central bank that is transparent, independent, pragmatic and analytical. Beyond this contribution, the investment climate is obviously better if we are able to deliver on our core goals of monetary and financial stability. Investors should have confidence that, over time, CPI inflation in Australia will average between 2 and 3 per cent. They can expect some variation from year to year, but over the medium term the average inflation rate will be 2 point something. As I have spoken about on previous occasions, we pursue that objective in a way that promotes sustainable growth in the economy and pays close attention to financial stability risks. You may have noticed that at yesterday's meeting, the Reserve Bank Board left the cash rate unchanged at 1 1/2 per cent, where it has been since August 2016. Our assessment is that the economy is moving in the right direction. We expect stronger growth in 2018 than in 2017 and a further reduction in the unemployment rate. We also expect inflation to increase a little from its current low rate. These developments should help support the climate for business investment. With the economy moving in the right direction, and interest rates still quite low, it is likely that the next move in interest rates in Australia will be up, not down. Having said that, the expected progress in reducing unemployment and having inflation return to target is likely to be only gradual. With only gradual progress expected, the Board does not see a strong case for a near-term adjustment of monetary policy. We will, of course, keep that judgement under review at future meetings. Thank you for listening. I am happy to answer questions.

r180411a_BOA

australia

Regional Variation in a National Economy

lowe

Perth - I would like to thank the Australia-Israel Chamber of Commerce for the invitation to speak at this lunch today. It is great to be back in Perth again. I look forward to learning more about how the Western Australian economy is going. Later this year, the full Reserve Bank Board will be here for our monetary policy meeting on the first Tuesday in September. When I was in Perth six months ago I gave a speech titled 'The Next Chapter'. In that speech I explored some of the likely plot lines in the next chapter of Australia's economic history. I would like to continue that broad theme today. For most of the past decade, a common shorthand description of the Australian economy was that it was a 'two-speed' economy. For some time, Western Australia and Queensland were growing very quickly on the back of investment in the resources sector, but growth in the other states was subdued. And then things turned around: growth was weak in Western Australia and Queensland, and stronger elsewhere. So it's understandable that people have talked about a 'two-speed' economy. In a country as large and diverse as Australia, it is not surprising that we experience differences like this from time to time. It is important that the Reserve Bank understands these differences and, indeed, we devote considerable resources to doing this. But today, rather than focus only on the differences across regions, I also want to focus on the similarities. I would like to do this from two perspectives. The first is from a cyclical perspective and the second is from a structural perspective. From the cyclical perspective, the good news is that conditions have improved across most of Australia over the past year. And from a structural perspective, over time the differences in the structure of output and employment across regions are tending to become smaller, rather than larger. So I would like to talk about this. There are, of course, still important differences across the country and I will discuss some of these as well. Finally, I will finish with some comments about the recent monetary policy decisions of the Reserve Bank Board. Over the past year, when discussing the national economy, the Reserve Bank has focused on a number of themes. I would like to highlight four of these again today (Graph 1). The first is the strong growth in employment. Over the past year, the number of Australians with jobs has increased by 3 1/2 per cent, which is a very positive outcome. Labour force participation has also increased, especially by women. The unemployment rate has also fallen over the past year, although it has been steady at around 5 1/2 per cent over the past six months. The second theme is a pick-up in non-mining business investment. We had been waiting a long time for this to occur, but in 2017 the long-forecast lift in investment finally took place. Over the year, non-mining business investment increased by 12 1/2 per cent, the largest rise in a decade, and a further increase is expected. The third theme is an improvement in business conditions, as reported in surveys. These surveys are currently more positive than they have been at any time since the financial crisis. They also suggest that capacity utilisation has been increasing. The fourth theme has been slow growth in wages. Wage increases around 2 per cent have become the norm in many parts of the country. This is in contrast to the 3 to 4 per cent increases that were the norm for most of the past two decades. This change is having a sobering effect on the finances of many households. It is also contributing to inflation being low. The latest data suggest that the rate of wages growth has now troughed, with a pick-up evident in the most recent quarter. A further lift is expected, but it is likely to be only gradual. So the overall picture for the national economy is one of gradual improvement: businesses are feeling better than they have for some time and they have increased their investment and hiring. It is therefore reasonable to expect that economic growth in 2018 will be stronger than the 2.4 per cent outcome we saw last year. This improvement in the economic climate has occurred across the country, not just in one or two areas. There are, of course, regional differences, but these four themes are evident across the country, although to varying degrees. Over the past year, employment has risen in all states (Graph 2). This is a different picture than we've seen for some time. Here in Western Australia, there was virtually no employment growth for more than four years after the peak in mining investment. Over this period, Western Australia went from having an unemployment rate of two point something to six point something. Recently, though, the labour market here has begun to improve, with employment increasing by 2 1/2 per cent over the past year and the unemployment rate having come off its peak. There has been strong growth in jobs in education and health, as there has been around the country. Turning to investment, the state-level data are less timely. We do know, however, that in most states business investment picked up through 2017, with particularly strong growth in non-residential construction (Graph 3). Here in Western Australia, the picture is a little different, given the ongoing unwinding of the mining investment boom. Over the past year, total business investment in Western Australia has been broadly steady, after earlier sharp declines. There has, however, been a pick-up in non-residential building approvals, which suggests that a turning point in non-mining business investment has now been reached. One area, though, that does remain weak is investment in dwellings, with the level of activity here in the west standing in contrast to the high level of dwelling investment in the eastern states. The third theme - the pick-up in survey-based measures of business conditions - is also evident across the country. For sake of simplicity, this next graph shows business conditions for Western Australia only and the rest of Australia (Graph 4). The direction of change is the same, even if conditions here are not as bright as elsewhere. In all states, including in Western Australia, reported business conditions are now currently above their long-term averages. The final of the four themes is weak wages growth. This, too, is a national story. Over the past year, the wage price index increased by around 2 per cent or less in all states (Graph 5). For a number of years, growth in wages in Western Australia was running considerably above that in the rest of the country, with the result that the average level of wages here rose noticeably above that in other states. In the past couple of years, this differential has narrowed, with growth in wages here below the national average. It is also worth pointing out that the most recent data show slightly stronger growth in wages in all states. This is a positive development. So the cyclical themes that we are seeing at the national level are playing out right across the country, although to differing degrees. We are now all moving in the same direction. I would now like to turn to the structural perspective. The main point is that, abstracting from the cyclical dynamics, there is a longer-run trend towards more similarity, rather than more divergence, in the underlying economic structure across the country. An important area where this can be seen is the labour market. Over time, there has been a marked reduction in the dispersion of unemployment rates across the country (Graph 6). In particular, the standard deviation of the unemployment rate across the 87 individual regions for which the Australian Bureau of Statistics (ABS) publishes data is markedly lower than it was at the turn of the century. It is also worth noting that the average unemployment rate outside the capital cities is lower than the average unemployment rate in the capital cities for the first time in a long while (Graph 7). The gap between the participation rates for prime-aged workers in the capital cities and outside the capitals has also narrowed. So there has been a convergence of sorts. There are a number of possible explanations for this. One is that the labour market has become more flexible, including through the movement of people. Another is that the economic shocks experienced have become less region specific. It is hard to be definitive, but both explanations are likely to have played some role. The improved flexibility of the Australian labour market is no doubt part of the story, and the willingness of people to move for jobs is part of this. However, the propensity of people to move interstate, or within their state, has declined over the period that the dispersion in unemployment rates has declined (Graph 8). For the two decades to the mid 2000s, around 2 per cent of us moved states each year. Over recent times that share has fallen to 1 1/2 per cent. Another important part of the story is overseas migration. This is evident in this next graph, which shows the contribution to employment growth from interstate migration, overseas migration and people already living within the state (Graph 9). The role that overseas migration played in the adjustment process here in Western Australia is clear. When the boom was in full swing the workforce in Western Australia was boosted significantly by workers from overseas. And then after the boom, the flow of immigrants slowed considerably. It is also clear that, over recent years, more people have been moving from Western Australia to other states than vice versa. This is in stark contrast to the boom years. The overall conclusion here is that the movement of people has helped even things out across the economy. The other possible explanation for the reduced dispersion in unemployment rates is that many of the economic shocks we experience nowadays are less regionally concentrated - with the mining investment boom being an obvious exception! - perhaps because of less variation in the structure of regional economies. It is difficult to test this idea rigorously, especially the nature of the shocks. But we can look at the variation across the country in the industries in which people work and the type of jobs they have. My colleagues at the RBA have done this using Census data for the more than 300 separate geographical areas in Australia. Using these data, they have constructed indices of how different the various regions are in terms of the industries that people work in and the occupations that they have. I will spare you the technical details of these calculations. My colleagues have also calculated how these indices have moved through time and they have conducted the exercise both including and excluding the regions with a heavy concentration in mining. The results are shown in The main conclusion from this work is that, on average, regions are becoming more similar. Over time, the industries we are working in, and our occupations, are becoming more alike across Australia, not more different. There are, of course, still large differences across regions, but they are smaller than they once were. One important reason for this is the increasing relative importance of service industries, and the decline in the relative importance of manufacturing. Both of these are national phenomena. Using the data from the 300-plus individual regions, it is clear that the variation across the country in the share of the workforce employed in the manufacturing industry has declined since the early 2000s (Graph 11). In 2016, the distribution is more tightly clustered around a lower average than it was in 2001. It is also clear from the Census data that those regions that had a relatively high share of workers employed in manufacturing in 2001 have tended to have faster growth in services employment than have other regions. So we are becoming more alike. None of this is to say that there are not big differences across our country. There clearly are, and I will come to some of these in a moment. But, on average, the growth of the services industries has meant that the differences in industrial structures across regions have narrowed over time. I would expect that this would continue. As I have spoken about on previous occasions, the growth of services and increasing investment in technology mean that investment in human capital is critically important to the country's future success. This needs to be a national focus. We are making progress, but there is more to be done, with investment in human capital central to building comparative advantage. This next graph shows the distribution across regions in the share of the population with an advanced qualification, defined here as a Certificate III or higher (Graph 12). There has been a marked shift to the right in the distribution. By 2016, there were only a few regions in which less than half of all 25-44 year olds held an advanced qualification. This is a noticeable change from the early 2000s and suggests the lift in qualifications is broadly based across regions. If anything, the dispersion across regions has also lessened over time. So far I have spoken about the commonalities in the cyclical and structural stories. It is important, though, to recognise that there are significant differences across regions. One illustration of this is the different average level of wage income across the country, which we can calculate from individual tax returns (Graph 13). There is considerable variation across the country, with some regions having average wage income more than 50 per cent above the national average. Wage income also tends to be higher in the capital cities than elsewhere. In part, this is explained by the types of jobs available in larger cities. For example, the capital cities are home to over 80 per cent of all IT, business, HR and marketing professionals, while only around 65 per cent of people live in these cities. On average, these business-service roles attract higher wages than many other occupations. Another notable difference across regions is the level of housing prices. This reflects not just differences in average incomes, but the underlying demand and supply dynamics. This next graph shows the standard deviation in housing prices across the country, using data for around 330 separate regions (Graph 14). The picture is pretty clear: the dispersion in housing prices is currently larger than it has been in a very long time. This mostly reflects the big run-up in housing prices in Sydney and Melbourne at a time when price growth in the rest of the country has been subdued. It's clear from this graph that, in the past, this measure of variation has had a cyclical element: it increases for a while and then declines. It is understandable why this happens. When prices increase a lot in one area, relative to another, some people relocate to where prices are lower, especially if jobs are available. This certainly happened in the late 1990s/early 2000s, when there was a marked pick-up in people moving from New South Wales to Queensland following the big increase in housing prices in Sydney. It's too early to tell whether the same type of adjustment will happen this time, but the number of people moving from New South Wales, where housing prices are highest, to Queensland (and, to a lesser extent, Victoria) has begun to pick up. I would now like to turn to monetary policy. The Reserve Bank's responsibility is to set monetary policy for Australia as a whole. We seek to do that in a way that keeps the national economy on an even keel, and inflation low and stable. No matter where one lives in Australia, we all benefit from this stability and from being part of a national economy. This is so, even if, at times, in some areas, people might wish for a different level of interest rates from that appropriate for the national economy. In setting that national rate, I can assure you we pay close attention to what is happening right across the country. As you are aware, the Reserve Bank Board has held the cash rate steady at 1 1/2 per cent since August 2016. This has helped support the underlying improvement in the economy that I spoke about earlier. In thinking about the future, there are four broad points that I would like to make. The first is that we expect a further pick-up in the Australian economy. Increased investment and hiring, as well as a lift in exports, should see stronger GDP growth this year and next. The better labour market should lead to a pick-up in wages growth. Inflation is also expected to gradually pick up. So, we are making progress. There are, though, some uncertainties around this outlook, with the main ones lying in the international arena. A serious escalation of trade tensions would put the health of the global economy at risk and damage the Australian economy. We also have a lot riding on the Chinese authorities successfully managing the build-up of risk in their financial system. Domestically, the high level of household debt remains a source of vulnerability, although the risks in this area are no longer building, following the strengthening of lending standards. The second point is that it is more likely that the next move in the cash rate will be up, not down, reflecting the improvement in the economy. The last increase in the cash rate was more than seven years ago, so an increase will come as a shock to some people. But it is worth remembering that the most likely scenario in which interest rates are increasing is one in which the economy is strengthening and income growth is also picking up. The third point is that the further progress in lowering unemployment and having inflation return to the midpoint of the target zone is expected to be only gradual. It is still some time before we are likely to be at conventional estimates of full employment. And, given the structural forces also at work, we expect the pick-up in wages growth and inflation to be only gradual. The fourth and final point is that, because the progress is expected to be only gradual, the Reserve Bank Board does not see a strong case for a near-term adjustment in monetary policy. While some other central banks are raising their policy rates, we need to keep in mind that their economic circumstances are different and that they have had lower policy rates than us over the past decade, in some cases at zero or even below. A continuation of the current stance of monetary policy in Australia will help our economy adjust and should see further progress in reducing unemployment and having inflation return to target. Thank you very much for listening. I look forward to your questions.

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australia

Remarks at Reserve Bank Board Dinner

lowe

Good evening. It is great to be back in Adelaide today. On behalf of the Reserve Bank Board, I want to warmly thank you all for joining us at this community dinner. These dinners provide an opportunity for you to hear directly from the members of the Reserve Bank Board and for us to hear from you about how things are here in South Australia. So, welcome. I would like to begin by paying tribute to Kathryn Fagg. Kathryn's five-year term on the Board comes to an end next week and so today was her final meeting. Over those five years, Kathryn has made an outstanding contribution to the Board's deliberations, drawing on her extensive experience in many different industries. Kathryn has also served as chair of the Board's Audit Committee and has been the Board's representative on the board of Note Printing Australia Limited. She has carried out these roles, not only to the highest professional standards, but also with the greatest humanity. Kathryn, you are going to be missed by your many friends and admirers at the Reserve Bank. As you are aware, at our meeting today, the Board kept the cash rate unchanged at 1 1/2 per cent. It has been at this level since August 2016 - that is for 21 months - which is the longest period without a change. I sometimes read that the Board's job has become very easy: we just meet and do nothing. No doubt, the Board members here tonight will tell you a different story. They will assure you that each month when we meet, we diligently assess the pulse of the Australian economy. We also deliberate carefully over what setting of monetary policy will best deliver low and stable inflation in Australia. As we conduct those deliberations, we are conscious that our ultimate objective is enhancing the economic prosperity and welfare of the Australian people. This objective has been part of the since it was written in 1959. Such a broad objective became unfashionable in most central banking circles around the world over recent decades. But in my view, it is an important part of the Australian policy framework and it has more than stood the test of time. At today's meeting, when we measured the pulse of the Australian economy, we assessed it to be stronger than a year ago. Business conditions are around their highest level for many years and the long-awaited pick-up in non-mining business investment is taking place. There has been a large pickup in infrastructure spending in some states. The number of Australians with jobs has also grown strongly over the past year. The unemployment rate is lower than it was a year ago, although there has been little change for the past six months. Growth in consumer spending has been solid, although it is lower than it was before the financial crisis. Here in South Australia, we heard how the pulse has also quickened over the past year. This follows a number of years of difficult structural adjustment after the closure of the car industry. But over the past year, domestic final demand in South Australia increased by 5 per cent, which is a very positive outcome. As we have seen nationally, there has been a pick-up in business conditions and investment in South Australia. There are positive signs in a number of areas, including tourism, high- value food and beverage production and some parts of advanced engineering and manufacturing. Helping the economy here in South Australia and elsewhere in Australia are the positive outcomes at the international level. Investment has picked up around the world and international trade is stronger than it has been for some time. As a group, the advanced economies are growing faster than trend and unemployment rates are low. And the Chinese economy is still growing strongly, although at a lower rate than in the past. So, at the moment, the international backdrop is pretty positive. At our meeting today, we also discussed the latest inflation data, which showed that both CPI and underlying inflation were running marginally below 2 per cent. This was in line with our expectations and provides further confirmation that inflation has troughed, although it remains low. Strong competition in retailing is holding down the prices of many goods: for example, over the past year, the price of food increased by just 1/2 per cent, the price of clothing and footwear fell 3 1/2 per cent and the price of household appliances fell 2 1/2 per cent. Importantly, these outcomes are helping to offset some of the cost of living pressures arising from higher electricity prices, which nationally are up 12 per cent over the past year. Another factor influencing recent inflation outcomes is the subdued growth in wages. Increases in wages of around 2 per cent have become the norm in Australia, rather than the 3-4 per cent mark that was the norm a while back. This is an issue we have been discussing around our board table for some time. While low growth in wages has helped boost employment, it has also put the finances of some households under strain, especially those who borrowed on the basis that their incomes would grow at the old rate. And in terms of the inflation target, it is difficult to see how a continuation of 2 per cent growth in wages is compatible with us achieving the midpoint of the inflation target - 2 1/2 per cent - on a sustained basis. So from that perspective alone, a pick-up in wages growth over time would be welcome. Perhaps more importantly, sustained low wages growth diminishes the sense of shared prosperity that we have in Australia. In our liaison with businesses, including here in Adelaide, many tell us about the very competitive environment in which they are operating. They tell us about how this competitive environment means that they have limited ability to pay bigger wage increases. At the same time, though, we are hearing a few more reports of larger increases in those areas where there is a shortage of workers with the necessary skills. After all, the laws of supply and demand still work. We also see evidence in the aggregate data that wages growth has troughed and we expect to see a further pick-up. This is likely to be a gradual process, though. At today's meeting, the Board also reviewed the staff's latest forecasts for the economy. These will be published on Friday in our quarterly . Those of you who are close readers of this document will notice some changes in this issue, as we seek to make the report more thematic. The latest forecasts should not contain any surprises, with only small changes from the previous set of forecasts, issued three months ago. This year and next, our central scenario remains for the Australian economy to grow a bit faster than 3 per cent. This would be a better outcome than the average of recent years. If we are able to achieve this, we will make inroads into the remaining spare capacity in the economy and see a further modest decline in the unemployment rate. Inflation is expected to remain low, at around its current level for a while yet, before gradually increasing over the next couple of years, towards 2 1/2 per cent. A key element here is the pick-up in wages growth that I just mentioned. So, in summary, there has been progress in lowering unemployment and having inflation return to around the middle of the target range, and we expect further progress in these two areas over the next couple of years. The other key point is that the progress we are making is only gradual: our central scenario is for a gradual pick-up in wages growth, a gradual lift in inflation, and a gradual reduction in the unemployment rate. While we might like faster progress, it is encouraging that things are moving in the right direction and are likely to continue to do so. If this is how things turn out, it is reasonable to expect that the next move in interest rates will be up. This would reflect conditions in the economy returning to normal. In our discussions today, though, the Board again agreed that there was not a strong case for a near-term adjustment in the cash rate. This reflects our view that the progress in moving towards full employment and having inflation return to the middle of the target range is likely to be only gradual. The Board's view is that while this progress is occurring, the best contribution we can make to the welfare of the Australian people is to hold the cash rate steady and for the Reserve Bank to be a source of stability and confidence. So that is where we are at the moment. At our meeting we also discussed some of the risks around this general outlook. These lie largely in the international arena. One of the prominent ones is a possible escalation of protectionist measures in the United States and elsewhere. The very clear lesson from history is that this would be bad for growth. As a country that has prospered through openness, Australia has a lot resting on this not happening. We also have a lot resting on the Chinese authorities successfully managing the very significant build-up of debt in their economy. Over recent times, they have paid increasing attention to this issue, which is a positive sign. Given the importance of this issue, it was the subject of an extensive discussion at our Board meeting today. Domestically, for some time, we have seen the main risk to be related to household balance sheets. For a while, trends in household credit were quite concerning. On this front, things now look less worrying than they were a while back, although the level of household debt remains very high, which carries certain risks. In terms of financing, we also discussed the potential for some tightening in financial conditions in Australia. In the United States, the cost of US dollar funding has increased for reasons not directly related to monetary policy and this increase is flowing through into higher money market rates in Australia. We expect some of this to be reversed in time, although it is difficult to tell by how much and when. It is also possible that lending standards in Australia will be tightened further in the context of the current high level of public scrutiny. We will continue to watch these issues carefully. So these are the issues we worked through today. I hope that they give you the sense that, even if we have not changed interest rates for a long time, we have a lot on our plate. Before I finish, I'd like to say a few words about some of the Reserve Bank's other activities. You would be aware that the Bank issues Australia's banknotes. We are currently undertaking a major exercise to issue a new high-tech series to make sure that we stay a few steps ahead of counterfeiters. We have already issued new $5 and $10 banknotes and the new $50 note will be issued later this year. This is a very big logistical exercise. All up, there are more than 700 million individual $50 notes on issue - that averages out to around 30 for every person in Australia. Not all of these, of course, are in active circulation. Many are located in ATMs and some are used as a store of wealth, perhaps stored under mattresses. The $50 note is of special significance for South Australia. I say this because on one side it has the portrait of David Unaipon, a great Australian. David Unaipon was a Ngarrindjeri man born at Point McLeay in the Lower Murray Lakes and Coorong region and lived most of his life in South Australia. He was a great pioneer in many areas, pushing back against the injustice experienced by the Aboriginal people. David Unaipon was also Australia's first published Aboriginal author writing about, in his owns words, Aboriginal 'customs, beliefs and imaginings'. He was a tireless advocate for Aboriginal people, and wrote and spoke eloquently about how to make things better. And in what spare time he had he worked on various inventions - right up until his 90s - so much so that he earned a reputation as 'Australia's Leonardo Da Vinci'. So we are very proud to have David Unaipon on our $50 note. And we are equally proud to have Edith Cowan on the other side of the note, who was the first female member of an Australian parliament. The first $50 note was introduced into circulation 45 years ago, in 1973. In today's money, it was worth almost $500 at the time, 10 times today's value! Reading back through our archives, the main argument for introducing such a high-value banknote was that it would help people conveniently pay for large household purchases, like cars, whitegoods, etc. It is yet another sign of just how much the world has changed. Today, most of us don't need banknotes to make these types of payments. Many of us make the bulk of our small and large payments electronically. This is one reason why today's highest value banknote - the $100 note - is worth only a fifth of what the $50 note was worth when it was introduced. This shift to electronic payments is being helped by another project the Reserve Bank has been involved in - that is the New Payments Platform. The Bank played an important policy role in getting this new system off the ground and has built a core piece of the supporting infrastructure. This new payments system allows near-instantaneous payments between bank accounts. Ultimately, it will provide the rails for innovative new payment services using its fast payments functionality. But its first service allows people to make payments to one another that will be received within seconds simply knowing somebody's mobile phone number or email. I hope that many of you have registered your PayID, which makes it easy to use this system. So far, almost 1.4 million Australians have done exactly this and they are now able to make efficient low-cost payments 24/7. If you have not already done so, I encourage you to look into it and register your PayID as soon as your bank offers you the service. That is as close as I am allowed to get to giving you financial advice, so I think it is time to have dinner. Again, thank you very much for joining us tonight.

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australia

Australia's Deepening Economic Relationship with China: Opportunities and Risks

lowe

Thank you very much for the invitation to address the Australia-China Relations Institute. It is an honour for me to be here with so many China experts. What happens in China is important to Australia, and to the broader global community. This is as true in the world of economics as it is in other areas. So we all have a strong interest in understanding China. For some years now, China has been Australia's largest export destination. This is likely to remain so for the foreseeable future. China's share of global GDP is also likely to continue to rise as average living standards in China improve further. Given that China's population is roughly four times that of the United States, the Chinese economy will be roughly twice the size of the US economy when average per capita incomes in China reach just half those in the United States - something which should be achievable. It will take some time to get to this point, but it is clear that what happens in China matters to us all, and increasingly so. Given this, the Reserve Bank of Australia has devoted considerable resources to understanding China and its economy. We have three staff in Beijing and they work closely with the team here in Sydney, including in our Asian Economies Research Unit. We have more staff looking at China than any other single overseas economy. This reflects not just the importance of the Chinese economy to us, but also the fact that Australia and China have different political systems, different governance arrangements and different financial systems. Understanding these various differences is important to understanding the Chinese economy, and we are devoting considerable resources to doing this. In this evening's talk I would like to elaborate on two issues. The first is the depth of Australia's economic relationship with China. Too often this relationship has been viewed largely through the prism of resource exports. These exports are certainly important, but this perspective is too narrow. Over time, we are seeing a broadening and deepening of our economic relationship with China and I would like to talk about this. The second issue is the Chinese financial system. Among the largest economic risks that Australia faces is something going wrong in China. And perhaps the single biggest risk to the Chinese economy at the moment lies in the financial sector and the big run-up in debt there over the past decade. Given the significance of this risk and the RBA's natural interest in finance, we study this area very closely. Indeed, at the most recent Reserve Bank Board meeting we had a deep dive into the Chinese financial system. I would like to share some of this analysis with you this evening. The facts about Australia's trade links with China are well known. Our trade with China has expanded very rapidly over the past decade, to the point where China is now Australia's largest trading partner. China accounts for nearly one-third of our exports and around one-fifth of our imports (Graph 1). Our trade relationship with China is sometimes summarised as: we export resources to China and we import manufactured goods. It's understandable that people have used this shorthand: after all, exports of resources account for around two-thirds of our exports to China, with iron ore and coal alone accounting for 57 per cent. But it would be a mistake to view the trade relationship solely in these terms. Our exports to China are much more diverse than this. In many individual categories, we now export more to China than any single other destination. So what happens in China is now directly relevant to a broad spectrum of Australian industries. One area where this is obvious is in the export of services (Graph 2). Over the past decade, Australia's service exports to China have grown at an average annual rate of 15 per cent. As a result, our service exports to China are now greater than those to the United States and the United Kingdom combined. The growth has been particularly strong in the areas of tourism and education (Graph 3). There has also been strong growth in exports of business services. Last year there were 1.4 million visitors from China to Australia, up from around 400,000 a decade ago. In 2009, just four passenger airlines flew between China and Australia. Today, there are 15 airlines and last year there were more than 15,000 direct flights between our two countries. On average, Chinese visitors tend to stay longer in Australia and spend more money than other visitors. As a result, they now account for around 25 per cent of total visitor expenditure in Australia, a considerably larger share than any other country (Graph 4). This shift is having a significant effect on the tourism industry. On the education front, there are currently around 200,000 Chinese students studying in Australia (Graph 5). Education exports to China now account for around one-third of Australia's total education exports, up from around one-fifth in 2009. Most of the students are studying at the tertiary level, but there has also been an increase in enrolments in Australian schools and vocational education programs. Even so, more than half of all Chinese tertiary enrolments in Australia are in the broad fields of management and commerce. For many educational institutions, foreign students, including those from China, have become an important source of fee revenue, with foreign students paying higher fees than domestic students. Moving beyond services, China has become the largest single export market for a range of Australia's manufactured food items (Graph 6). Exports of dairy products and alcoholic beverages have grown especially strongly, as have a range of other food and health-related products (of which vitamin sales are often remarked to be growing strongly). And more broadly, there has also been strong growth in exports to China of scientific instruments, pharmaceuticals and some telecommunication products. On the financial side, there has also been a broadening and deepening of the relationship, although it is not as developed as the trade side. Currently, Chinese investment accounts for only a small share of the total stock of outstanding foreign investment in Australia - just 3 per cent. In contrast, the United States accounts for the largest share, at around 30 per cent. Over time, though, there has been an increase in the amount of Chinese investment in Australia. There was a large wave of investment in the resources sector during the mining investment boom (Graph 7). Since this tailed off, there has been significant investment in other areas, including transport infrastructure and commercial property, although investment in commercial property has slowed recently, partly due to tighter Chinese restrictions in this area. The large Chinese banks now operating in Australia have helped facilitate this investment, and they are also providing banking services to a wide range of businesses in Australia. The RBA sees first-hand the stronger financial relationship between our two countries. Since 2012, the RBA has had a currency swap agreement with the People's Bank of China, with the goal of giving market participants in Australia confidence that renminbi (RMB) will be available for trade settlement and other payment obligations. The RBA also now holds 5 per cent of our foreign currency reserves in RMB. Furthermore, in 2014, the Bank of China was designated the official RMB clearing bank in Australia so as to better facilitate cross-border transactions in RMB. So there has been a lot happening on the financial side too. One other dimension of the deepening relationship that I would like to draw your attention to relates to people. Over the past decade, the Chinese-born resident population in Australia has grown at an average rate of around 8 per cent per year (Graph 8). This builds on the long history of Chinese migration to Australia, which has contributed to the rich multicultural society we are today. According to the latest Census, people born in mainland China account for 2 per cent of Australia's population (around 510,000 people), and there are more than one million people who identify themselves as having some Chinese ancestry. It is not surprising, then, that Mandarin is now the second most commonly spoken language in Australian homes and Cantonese the fourth most common. The overall picture, then, is one of a broader and deeper economic relationship with China. Of course, the same could be said for many other countries in our region. This means that China is important to us not just because of our substantial direct links, but also because of the indirect links through our other regional trading partners. The deepening of our economic relationship with China has greatly benefited Australia. It has created new opportunities for us and significantly boosted our national income. It was also one of the factors that helped our economy through the global financial crisis. The deepening relationship has also benefited China in many ways. This means that both countries have a strong interest in managing this important relationship well. It is in our mutual interests to do this. Together, we can also be a strong voice for the importance of an open international trading system and for effective regional cooperation. We will, of course, have differences from time to time, but we will surely be better placed to deal with these if we understand one another well. Building strong connections across business, finance, politics, academia and the community more generally is important to deepening this understanding. I would now like to turn to an issue that the RBA has focused on over recent times: that is the Chinese financial system. Understanding what is going on here is important. If a major economic shock were to originate from China over the coming years, its origin is most likely to be in the Chinese financial system. Not surprisingly, addressing this risk has become a priority of the Chinese authorities. We all have a strong interest in their efforts being successful. I would first like to provide some background by briefly reviewing the development of the Chinese financial system. I will then discuss the risks, including those that have built up in the shadow banking sector. And then finally, I will turn to the recent measures taken by the Chinese authorities to address these risks. If we go back to just 1978 - which is not that long ago - China's financial system was very undeveloped; there were no equity, bond or funding markets, and most of the country's limited banking services were provided by just one bank - the People's Bank of China. It is fair to say that the financial system played only a rudimentary role in the Chinese economy. Since then things have changed a lot. In the initial reform years, post 1978, some of the functions of the People's Bank of China were carved out into state-owned commercial banks and later into specialised policy banks. It was during these years that the Chinese financial system developed some particular characteristics. Two are worth highlighting. The first is that the system was very government centric. It was configured with the objective of channelling China's very high household savings into state-owned enterprises (SOEs) through government-owned banks. And it did this on very favourable terms to the SOEs. This was part of the strategy of fast-tracking industrial development and urbanisation. The second characteristic was that there was very heavy financial repression - extensive capital controls, low deposit rates for savers, extensive restrictions on what banks could and could not do, a lack of alternative investment opportunities for savers, and limited access to finance for the fledgling private sector. There was, of course, some progressive liberalisation and financial market innovation over time, but up until fairly recently the evolution was relatively modest. Things, though, began to change more noticeably around the time of the global financial crisis, and the result has been an extraordinarily large increase in debt since then. This change was part of the effort by the Chinese authorities to boost internal demand, when exports fell during the financial crisis. As part of this effort, there was a very large lift in spending on infrastructure and construction. In other countries this might have been financed on the government's balance sheet, but in China it was financed mainly through the financial system. Achieving this required some lessening of the long-standing constraints on the supply of credit. The end result was a big increase in debt, with the ratio of debt to GDP rising significantly to its current This increase in the debt ratio over the past decade has been larger than in any other major economy. This can be seen in this next chart, which shows the increase in this ratio since 2009 for a range of countries and the current level of that ratio (Graph 10). China clearly stands out. The stock of credit outstanding in China, relative to the size of the economy, is now unusually high by emerging market standards. And this ratio is already higher than in many advanced economies. So what has happened in China is quite different to the normal pattern. Over the period of rapid credit expansion, there was a series of reforms to modernise the Chinese financial system. Interest rate controls have been relaxed, although there is still 'guidance'. A deposit insurance system has been introduced and the regulatory system has been strengthened. The capital markets are playing a more prominent role in the financial system. The large state-owned banks are now listed on stock exchanges in China and Hong Kong. It is also now somewhat easier for private firms to obtain equity finance. Controls on capital flows have also been relaxed somewhat over the last decade. It is worth recognising that, taken together, these are significant changes. A decade ago, many outside observers were sceptical that the Chinese authorities would undertake reforms across many of these fronts. Yet they have made significant progress. Despite this progress, there is still much to be done before the Chinese financial systems looks like financial systems we see in the advanced economies. One area where the Chinese financial system is moving towards a more modern form is in households' access to mortgage finance. Prior to the late 1990s, mortgages were essentially non- existent. But in recent years, households have progressively enjoyed increased access to finance, which has helped lift the share of consumption in national income. At the same time, as property prices have risen households have taken on larger mortgages. As a result, there has been a doubling of the ratio of household debt to GDP (Graph 11). Relative to other emerging market economies, household debt is no longer low in China, although it is much lower than in the advanced economies. Putting all this together, the Chinese financial landscape and Chinese balance sheets look very different from a decade ago. At the same time, though, the financial system retains elements of its distinguishing characteristics: a heavy focus on state-owned banks providing credit to SOEs and relatively limited banking services for small to medium private businesses. I would now like to turn to the risks that have built up in this system. The historical cross-country experience is reasonably clear. The experience is that the build-up of financial risks like those seen in China is almost always followed by a marked slowdown in GDP growth or a financial crisis. It is important to point out that these outcomes are not inevitable and that China is able to learn from the experience of other countries, including Australia. Even so, it is understandable that concerns have been raised. One of these concerns is that during the big run-up in debt, a lot of bad loans were made. Assessing the extent of this issue is made more complicated by the particular nature of the Chinese financial system. On the one hand, the influence of the state and the incentives within financial institutions have almost surely distorted credit allocation and led to some poor lending decisions. For example, rapid credit expansion supported excess capacity developing in some heavy industries, with large loss- making enterprises kept afloat with additional borrowing. Provincial authorities also borrowed heavily through opaque off-balance sheet structures, so as to meet their growth targets. It is not unreasonable to suggest that many of these loans would have failed to meet credit standards in other banking systems. So these are reasons to be concerned about future problem loans. On the other hand, though, the involvement of the state can make it easier to work through problems when they arise, and we have seen past examples of this in China. The state has the capacity, and the demonstrated willingness, to address financial problems when they occur. However, this has also tended to add to the moral hazard in the system. Whether this willingness to extend assistance to troubled borrowers and lenders will extend into the future is therefore difficult to tell. So it is complicated. Another concern is the growth of the so-called 'shadow banking' system - that is, credit extended outside the formal banking system. The growth in non-bank financing is evident in this next graph, which again shows the ratio of debt to GDP, but broken down into the type of entities that are providing the credit (Graph 12). The picture is pretty clear. Most of the growth in debt has occurred outside the formal banking sector; non-bank financing now accounts for 45 per cent of total debt, up from 25 per cent a decade ago. This growth of shadow banking reflects a few factors. Many entities in China, including private businesses and provincial governments, have had restricted access to credit through the large state- owned banks. As a result, they have sought finance outside the formal sector and they have been prepared to pay higher rates. On the other side of the equation, many investors have sought higher returns on their savings than those available through holding conventional deposits in the formal banking sector. Over time, thousands of smaller banks and other financial institutions emerged to connect those seeking to borrow outside the formal sector with those seeking higher returns. Many of these connections were very innovative and were often made through opaque structures, sometimes in off-balance sheet vehicles. Hence, the term, shadow financing. It is useful to provide a couple of examples. One is so-called 'entrusted loans' (Graph 13). These loans effectively involve one entity (say, a business) lending to another entity (say, another business), rather than the loan being intermediated through a bank balance sheet. Notwithstanding this, a bank would normally act as a trustee to the transaction and there can be a perceived promise by the bank to absorb any credit losses. So in some respects it is like a bank loan, but structured in a way that sidesteps some of the restrictions on lending and on interest rates paid to depositors. The popularity of these 'entrusted' loans increased greatly over the past decade. Another example of shadow financing is wealth management products. These products were sold in bank branches, again often with an implicit guarantee from the bank. They are effectively an investment vehicle, offering investors a fixed rate of return in excess of bank deposits, and investing in a range of assets such as loans and securities. Much of this financing operated in a very similar way to bank loans, but just in another legal form and packaged differently. The products again offered a way of sidestepping some of the regulations and helped underpin the rapid growth of debt. They offered banks an important new source of income to partly offset the decline in net interest margins that followed deposit and lending rate liberalisation. The smaller banks have played an important role in the growth of shadow financing. This is evident in the rapid growth of their claims on non-bank financial institutions (Graph 14). There are now over 3,500 smaller institutions, with many of them channelling money to the shadow banking activities, including through trust companies in exchange for 'participation' or 'beneficiary' rights. They have been more active participants in the shadow banking industry because their thinner deposit base did not allow for a big increase in traditional loans. So it is a complex web of interconnections that has been built. New institutions have also emerged and a lot of this has been in the shadows, outside of the regulatory net. It's worth recalling that we saw a similar process here in Australia in the 1970s. As some of the regulations were eased here and more things became permissible, we too saw new institutions emerge - just has been the case in China - to sidestep the regulations that remained. In our case, this did not end well! This helps explain why we are watching things in China so carefully. The complex web that has developed in China is characterised by opaque risk transfers, implicit guarantees and complex connections. To the extent that experience elsewhere in the world is any guide, it is difficult to escape the conclusion that this complex web in a highly indebted economy is a risky situation. Dealing with this risk has become a key priority for the Chinese authorities. Reflecting this, at a recent policy meeting convened by President Xi Jinping, the leadership called for a gradual reduction in the debt-to-GDP ratio. This marked a significant change from earlier statements from officials suggesting the target was only to slow the growth in leverage. The authorities are clearly taking the issue seriously and they are making progress. The policy response, to date, has had a number of related elements. One is to subject shadow banking, including asset management activities, to more stringent oversight. The new rules include stricter leverage caps for investment products and restrictions on investment in certain types of non-standard credit assets. Another element of the response has been stronger guidance to banks regarding their exposures to non-bank financial institutions. As part of this, the People's Bank of China recently widened the scope of its quarterly Macro-Prudential Assessment (MPA) of banks to better assess and address shadow banking risks. The MPA now includes consideration of the risks to banks from exposures through off- balance sheet vehicles, including wealth management products. There have also been efforts to address the significant risks in local government financing, including by increasing transparency. As part of this effort, local governments have been participating in a 'debt swap' program, where off-balance sheet debt is swapped for local government bonds. The Ministry of Finance has also tightened off-balance sheet financing channels for local governments and their related entities. And at the National Financial Work Conference last year, it was suggested that officials would have 'lifelong accountability' for debt balances. This was designed to reduce incentives to pursue higher growth by increasing debt. Finally, the regulatory structure has been strengthened. In particular, a Financial Stability and Development Committee was established in June last year, with strong political backing. The committee is responsible for coordinating regulatory reforms and considering financial stability risks. The banking and insurance regulators have also been merged, partly to address the concerns about regulatory arbitrage. These various measures provide a strong signal that the Chinese authorities are serious about addressing the vulnerabilities. Consistent with this, the lower economic growth target for 2018 of 6.5 per cent suggests some tolerance for a gradual slowing in growth. This is a positive development, given that over recent years there was a concern that the authorities would fail to address the financial risks for fear of damaging the economy in the short term. While it is still early days, the evidence to date is that the various measures are having an effect (Graph 15). Growth in credit outstanding has slowed to be around the same pace as that in nominal GDP. This is the first time that this has been the case for some years. There has also been a sharp slowing in growth in shadow financing, as reflected in banks' claims on non-bank financial institutions. This tightening on the financial side, together with measures to reduce pollution, has led to some slowing in economic growth in China, although growth remains solid (Graph 16). The slowing is evident in fixed asset investment, although overall activity continues to be supported by strong conditions in the property sector and rapid growth in infrastructure investment. In addition, a number of structural developments are providing some offset to the tightening in credit conditions. In recent years, the services sector has become the strongest contributor to growth, and consumption has been resilient. The government is also promoting industrial upgrading, including through its 'Made in China 2025' policy to make China a global leader in numerous high-tech sectors. So there are a lot of moving parts at the moment. It is too early to tell whether the authorities will be successful in managing the transition from a growth model heavily dependent upon the accumulation of debt to one where credit is less central. It is a very significant task. The experience of other countries suggests caution and, elsewhere, there have been serious accidents along the way. The Chinese authorities can learn from this experience and are now moving in the right direction. China's challenge is made more complicated by the dual nature of the task to bring down debt levels while also reconfiguring the financial system so as to better meet the needs of the people. There are pressing needs to make financing more widely available to small and medium enterprises, to strengthen the pension system to bolster retirement incomes, to increase transparency and reduce implicit guarantees associated with local government and SOE borrowing. So there is still a lot to be done. At the RBA we are watching this process carefully. We know from our own experience here in Australia that the journey of financial reform can be a bumpy one. We also know that this journey is well worth undertaking, and leaves the financial system stronger, more efficient and better able to serve the needs of the real economy. I look forward to the day when China will be able to reach the same conclusion about its journey. Finally, it is worth repeating that Australia has a strong interest in this being the case. A stable and robust financial system in China is clearly in Australia's interest. So too is a prosperous China as part of a rules-based international system. As the economic relationship between our two countries broadens and deepens, developments in China are having a material impact on more and more Australian industries: it is more than just about resources. It is therefore important that we have a thorough understanding of one another. We all have a role to play in helping build that understanding. Thank you and I would be happy to answer your questions.

r180613a_BOA

australia

Productivity, Wages and Prosperity

lowe

I would like to thank Australian Industry Group (Ai Group) for the invitation to speak at this lunch today. I have participated in many Ai Group events over the years and I have always valued hearing from your members, so it is a pleasure to be here in Melbourne today. The title I have chosen for my remarks this afternoon is 'Productivity, Wages and Prosperity'. I know that these three issues are important to your members and they are also important to the broader Australian community. Australians enjoy a level of economic prosperity that few other people in the world enjoy. Per capita incomes here are high and so, too, is wealth per capita. We have also avoided bouts of high unemployment for over a quarter of a century now. Our banking system is strong, we have world- class natural resources and Australians have access to high-quality health care and education. So there is much for us to feel fortunate about. The question is how do we sustain this prosperity? This is an important question to be asking. At the moment, there is unease in parts of the community about the future of work, about competition from overseas and about the implications of technology - all issues that I know the members of Ai Group are dealing with every day. For others in our community, these concerns are being brought into sharp focus by unusually slow growth in wages. As we address these important issues, we also need to keep focused on the critical task of raising national productivity. After all, lifting productivity is the key to building on our current prosperity and ensuring sustained growth in wages and incomes. There is no shortage of good ideas to consider here. My remarks today will be in four parts. First, I will briefly cover the recent economic data. Then, with that context, I will talk about some of the reasons why wages growth has been as low as it has. I will then turn to productivity growth. Finally, I will say a few words about the recent monetary policy decisions by the Reserve Bank Board. Last week's national accounts contained positive news about the Australian economy. Over the past year, GDP rose by 3.1 per cent, which is a bit stronger than we were expecting (Graph 1). It is consistent, though, with the RBA's central scenario for the Australian economy to grow more strongly this year and next than it has over recent years. One pleasing feature of the national accounts was the ongoing rise in investment. Non-mining business investment increased by 10 per cent over the past year (Graph 2). This lift is consistent with current business conditions, which, as measured by Ai Group's own survey, are at the highest level in many years. Investment is also being boosted by increased spending on infrastructure, including in the areas of transport and renewable energy. One area that we continue to watch carefully is consumption growth. Over the year, household consumption rose by 2.9 per cent. This is a reasonable outcome, although growth in the March quarter was on the soft side. Stronger employment growth has contributed to a pick-up in wagerelated income and this is helping to support spending. At the same time, though, the level of household debt remains very high and the housing markets in Sydney and Melbourne are going through a period of adjustment, following the earlier very large increases in prices. Credit standards are also being tightened further. So we are paying close attention to household finances. On the international front, economic conditions remain strong. The US and Japanese labour markets are quite tight and Asia, including China, is benefiting from the global upswing in trade and investment. At the same time, though, recent developments have increased some tail risks. One of these is political developments in Italy, which have again put the spotlight on the debt dynamics and underlying tensions in the euro area. Another potential source of a financial shock is the increasing strains in several emerging market economies - including Argentina, Brazil and Turkey. And finally, there is the ongoing risk of an escalation in trade tensions sparked by the policies of the US administration. So, against what remains a reasonably positive international backdrop, these are some of the areas to keep an eye on. I would now like to turn to an issue that has received a lot of attention lately; that is wages growth. Over recent times, wages growth around the 2 per cent mark has become the norm in Australia. Some time back, the norm was more like 3 to 4 per cent. This downward shift in the rate of wages growth is clearly evident in the wage price index as well as in the more volatile measure of average hourly earnings in the national accounts (Graph 3). There are both cyclical and structural explanations for why this change has taken place. From the cyclical perspective, there is still spare capacity in the labour market. The unemployment rate has been around 5 1/2 per cent for a year now (Graph 4). While we can't be definitive about what constitutes full employment, most conventional estimates for Australia are that it means an unemployment rate of around 5 per cent. It is possible, though, that we could do better than this, especially if we approach the 5 per cent mark at a steady pace, rather than too quickly. Indeed, in a number of other countries, estimates of the unemployment rate associated with full employment are being revised lower as wage increases remain subdued at low rates of unemployment. We have an open mind as to whether this might turn out to be the case here in Australia too. Time will tell. Broader measures of underutilisation suggest another source of spare capacity in the labour market. Currently, around one-third of workers work part time, with most of these people wanting to work part time for personal reasons. However, of those working part time, around one-quarter would like to work more hours than they do; on average, they are seeking an extra two days a week. If we account for this, these extra hours are equivalent to around 3 per cent of the labour force. This suggests an overall labour underutilisation rate of 8 3/4 per cent, compared with the 5 1/2 per cent traditional unemployment rate measure based on the number of unemployed people. Recent experience also reminds us of another important source of labour supply; that is, higher labour force participation (Graph 5). As we have seen over recent times, when the jobs are there, people stay in the workforce longer and others, who had not been looking for jobs, start looking. So the supply side of the labour market is quite flexible, even more so than we expected. Another cyclical element that has affected average hourly earnings over recent years is the decline in very highly paid jobs in the resources sector as the boom in mining investment wound down. It looks, though, that this compositional shift has now largely run its course. These various factors go some way to explaining the low wages growth over recent times. When there is spare capacity in the labour market, it is understandable that wages growth is slow. Yet, alone, these cyclical factors don't fully explain what is going on. Some structural factors also appear to be at work, with perhaps the most important of these related to competition and technology. I will come back to this in a moment. The idea that structural factors are at work is supported by this next graph, which shows the wage price index and the responses to the NAB business survey where firms are asked whether the availability of labour is a constraint on output (Graph 6). While there is still spare capacity in the labour market, firms are finding it more difficult to find suitable workers. Yet despite this difficulty, wages growth has not responded in the way that it once did. A similar pattern is evident overseas. This next graph shows wages growth in the United States and the euro area as well as survey-based measures of labour market tightness (similar to those in the NAB survey) (Graph 7). In both economies, wages growth has picked up in response to tighter labour markets, but the response is not as large as it has been in the past. We are still trying to understand fully why things look different in so many countries and how persistent this will be. Part of the story is likely to be changes in the bargaining power of workers and an increase in the supply of workers as the global economy becomes increasingly integrated. But another important part of the story lies in the nature of recent technological progress. There are a couple of aspects of this progress that are worth pointing out. One is that it has been heavily focused on software and information technology, rather than installing new and better machines - or on intangible capital rather than physical capital. The second is that the dispersion of technology and productivity between leading and lagging firms has increased, perhaps because of the uneven ability of firms to innovate and use the new technologies. The OECD has done some very interesting work documenting this increasing productivity gap. Both of these aspects of technological progress are affecting wage dynamics. The returns to those who can develop and best use information technology have increased strongly. These returns, though, are often highly concentrated in a few firms and in only certain segments of the labour market. At the same time, the firms that are not able to innovate and take advantage of new technologies as quickly are slipping behind and they feel under pressure. As a way of remaining competitive, many of these firms are responding by having a very strong focus on cost control. In many cases this translates into a focus on controlling labour costs. This cost-control mentality does not make for an environment where firms are willing to pay larger wage increases. Over time, we can expect the diffusion of new technology to take place. This is what the historical record suggests. I am optimistic that this diffusion will boost aggregate productivity and lift our real wages and incomes. Advances in information technology, in artificial intelligence and in machine learning have the potential to reshape our economies profoundly and lift average living standards in ways that are difficult to envisage today. But the adoption and the diffusion of these new technologies is a gradual process; it takes time. While it is taking place, the benefits of new technologies are accruing unevenly across the community. In my view, this is one of the key structural factors at work. Whatever weight one places on these various factors constraining wages growth, it is clear that the slow growth in wages is affecting our economy. On the positive side of the ledger, it is one of the factors that has helped boost employment growth over recent times. Of course, there are other effects as well. One is that the low growth in wages is contributing to low rates of inflation in Australia. Indeed, if wages growth were to continue at around its current rate for an extended period, it is unlikely that the rate of inflation would average around the midpoint of the inflation target in the period ahead. Wages growth of 2 per cent and reasonable labour productivity growth are unlikely to make for 2 1/2 per cent inflation on a sustained basis. Another consequence is that real debt burdens stay higher for longer. Many people who borrowed expected their incomes to grow at something like the old rate rather than the current rate. With their expectations not being realised, the real value of the debt stays higher than they expected and this is likely to affect their spending decisions. And beyond these purely economic effects, the slow wages growth is diminishing our sense of shared prosperity. If this remains the case, it can make needed economic reforms more difficult. Given these various effects, some pick-up in wages growth would be a welcome development. It would help deliver a rate of inflation consistent with the target, it would help with the debt situation and it would add to our sense of shared prosperity. In my judgement, a return, over time, to a world where wage increases started with a 3 rather than a 2 is both possible and desirable. To be clear, this is not a call for a sudden jump in wages growth from current rates to 3 point something. Rather, we will be better off if this increase takes place steadily over time as the economy improves. There are some signs that we are starting to move in this direction, but it is likely to be a gradual process. Labour markets in most parts of the country have tightened over the past year. One piece of evidence in support of this is the responses to the NAB survey I showed earlier. There has been a sharp increase in the share of firms reporting the availability of labour as a constraint (Graph 6). The only other time in the past 25 years where this share has been as high as it is now was in the early stages of the resources boom. These survey results are consistent with what the RBA is hearing through our own business liaison program. One explanation for why firms are reporting that it is hard to find workers with the necessary skills is that the very high focus on cost control over recent times has led to reduced work-related training. With the labour market now tightening, we are perhaps starting to pay the price for this. On a more positive note, a number of businesses and industry associations are now starting to address the skills shortage. Some businesses also tell us that another factor that has made it more difficult to find workers with the necessary skills is the tightening of visa requirements. It's reasonable to expect that as the labour market tightens, wages growth will pick up. The laws of supply and demand still work. Consistent with this, we hear reports through our liaison program of wages increasing more quickly in areas where there are capacity constraints, although these reports are still not very common. As part of our liaison program we also ask firms about their expectations for wages growth over the next year: whether it will be lower, higher or about the same as the recent past. The results are shown in this next graph (Graph 8). There are now more firms expecting a pick-up in wages growth and fewer firms expecting a decline compared with recent years. So it is reasonable to expect growth in wages to pick up from here. To repeat the point, though, this pick-up is expected to be only gradual given both the spare capacity that still exists in our labour market and the structural factors at work. This is an appropriate segue to the issue of productivity. The best outcome is one in which a pick-up in wages growth is accompanied by stronger growth in labour productivity. That's because, ultimately, the basis for sustained growth in real wages is that we become more productive as a nation. The recent productivity data are difficult to interpret. Despite a positive outcome in the most recent quarter, there has been no net increase in measured labour productivity over the past two years. Over the past couple of years, output growth has been subdued, but employment growth has been strong. In other words, measured labour productivity growth has been weak (Graph 9). However, if we take a slightly longer period - say since the end of 2010 - labour productivity growth has been better, averaging 1.4 per cent per year, which is a reasonable estimate of the rate of productivity growth we could expect over the medium term. This outcome has been boosted by stronger labour productivity in the mining sector as new production comes on stream after the investment boom. It may be that the current lull in productivity growth is just noise in the data, which is quite common, but it may also be a sign of something more persistent. Again, time will tell. In trying to understand recent trends, it is useful to examine what has been happening in the broad industry groups: goods-related industries, business services and household services (Graph 10). Employment growth has been especially strong in household services over recent times, yet measured productivity growth in this area of the economy has been quite weak. Output per hour worked in this set of industries is only 4 per cent higher than it was in 2010. In contrast, over this period, output per hour worked is up 13 to 16 per cent in the other industry groups. This is quite a different picture. Almost 40 per cent of the workforce currently works in household services, so the weak productivity growth here is weighing on the outcome for the economy as a whole. It is possible that part of the story is the difficulty of measuring output in some service industries. Even so, last year's 'Shifting the Dial' report by the Productivity Commission highlighted some of the steps we could take to boost productivity in the delivery of services. One of these steps is ensuring a strong ongoing focus on training, education and the accumulation of human capital. As I have spoken about on previous occasions, our national comparative advantage will increasingly be built on the quality of our ideas and our human capital. This means that a continued focus on education and research is important. Investment in human capital also helps with two of the issues that I touched on earlier: the diffusion of new technologies and emerging skills shortages. One explanation for the widening gap between leading and laggard firms is the difficulty of employing new technologies. Successfully using these technologies requires both the right management capability and technical skills. Both of these can be difficult to acquire. It seems reasonable, then, to suggest that investment in human capital can both lift the rate of technical progress and accelerate its diffusion. It is therefore an important part of addressing the slow wages growth in many advanced economies, including Australia. Another way of encouraging the more rapid diffusion of technology is ensuring that there is strong competition in our economy. There are many other elements of the productivity debate that are also important. I don't plan to expand on them today, but the list of areas is well known. It includes: the design of the tax system; the provision and pricing of infrastructure; the way we finance innovation and new businesses; and our business culture around innovation, risk and entrepreneurship. We need to keep all these areas on the radars of both government and business if we are to build on the prosperity that we currently enjoy. I would like to close with a few words on monetary policy. At its meeting last week, the Reserve Bank Board again held the cash rate steady at 1 1/2 per cent, where it has been since August 2016. Subsequent to the Board meeting, the national accounts provided confirmation that the Australian economy is moving in the right direction. If this continues to be the case, it is likely that the next move in interest rates will be up, not down. It is, however, important to remember that the environment in which interest rates are increasing is also likely to be one in which people's incomes are growing more quickly than they are now. This will help. Any increase in interest rates, however, still looks to be some time away. The Board will want to have reasonable confidence that inflation is picking up to be consistent with the medium-term target and that slack in the labour market is lessening. At this stage, a sustained pick-up in inflation to around the midpoint of the target range is likely to require faster wages growth than we are currently experiencing. There are reasonable grounds to expect that this increase in wages growth will occur. But for the reasons I have spoken about today, this increase is likely to be only gradual. Given this, there is not a strong case for a near-term adjustment in monetary policy. With things moving in the right direction, the Board's view is that by holding rates steady, we can help promote a sense of stability and confidence. We hope that this helps Australians make the decisions that can help build the future prosperity of the country that we are so fortunate to live in. Thank you for listening. I am happy to answer your questions.

r180808a_BOA

australia

Demographic Change and Recent Monetary Policy

lowe

Address to Anika Foundation Luncheon supported by NAB and the It is a pleasure to be able to speak at the Anika Foundation lunch for a second time. As the father of three teenage children I know how important the work of the foundation is. Thank you all very much for your support. Today, I would like to talk about a long-run topic and a short-run topic. The long-run topic is Australia's demography and the short-run topic is current monetary policy in Australia. These might seem to be unrelated topics. But at the RBA, we are very aware that our decisions about interest rates are not made in a vacuum - that they are influenced by structural developments in our economy. And one of these important structural factors is changes in our demography. Indeed, Australia's demographic profile is more positive than those of many other countries. It is one of the factors that provides a basis for optimism about the future of our economy. Many countries are rightly concerned about their population dynamics, their ageing workforces and their rapidly rising old-age dependency ratios. We, too, need to keep an eye on these issues, but we are in a better position than many others. This, in part, reflects policy decisions, including about the level and composition of immigration, and retirement income policy. I would like to take this opportunity to talk about these issues, before turning to monetary policy. According to the latest estimates, there are now 25 million people living in Australia. Over the past decade, our population has grown at an annual rate of more than 1 1/2 per cent. This is faster than in previous decades and it is also noticeably faster than population growth in most other advanced economies (Graph 1). Over the past decade, most countries have experienced average annual population growth of less than 1 per cent and a number of countries have experienced stagnant or declining populations. This is an important difference, with Australia's faster population growth being one of the reasons our economy has experienced higher average growth than many other advanced economies. The increase in Australia's population growth over the past decade is largely due to increased immigration; the rate of natural increase has not changed that much (Graph 2). Over recent times, net overseas migration has, on average, added around 1 per cent to our population each year. The increase from natural sources has averaged around 0.7 per cent per year. There has been a reasonable amount of year-to-year variation in net overseas migration. Migration increased sharply at the height of the resources boom when demand for skilled labour was very strong, and then subsequently declined as the mining investment boom came to an end. In this way, migration has helped our economy adjust to large swings in the demand for labour. It has also helped address some particular skills shortages. A second factor that accounts for the step-up in the level of migration and the year-to-year variation is a marked increase in the number of overseas students studying in Australia and changes in the policies around student visas. There are currently more than 500,000 overseas students studying in Australia. Over recent times, it has been common for around one-sixth of foreign students to stay and live and work in Australia after completing their studies. This has boosted our population. It has also boosted the nation's human capital. People living in Australia who were born overseas are more likely than the average Australian to have a post-secondary school qualification (Graph 3). We also benefit from stronger overseas connections when foreign students return home after studying in The effects of faster population growth on our economy and society are complex and they are widely debated. As a number of commentators have noted, population growth has put pressure on our infrastructure. As a country, we were slow to increase investment in infrastructure to meet the needs of our more rapidly growing population. Investment in this area has now picked up, particularly in transport, which, in time, will help alleviate some of the pressures. We were also slow to increase the rate of home building in response to the faster population growth. Indeed, it took the better part of a decade for this adjustment to take place (Graph 4). This slow adjustment is one of the factors that contributed to the large increases in housing prices in some of our cities over recent times. The adjustment, though, has now taken place, with growth in the number of dwellings exceeding growth in the population over the past four years. I have spoken about these adjustments on previous occasions. Rather than cover this material again, I would like to focus on something that receives less attention, but is no less important - that is, how the changes in our population dynamics have affected some of Australia's key demographic indicators. Of particular importance is the fact that, on average, new migrants to Australia are younger than the resident population. Workers coming to Australia tend to be relatively young and so too, obviously, are most students. The median age of new migrants is between 20 and 25, which is more than 10 years younger than the median age of the resident population. Over the past five years, over 80 per cent of net overseas migration has been accounted for by people under the age of 35 This inflow of younger people through immigration has significantly reduced the rate of population ageing in Australia. The median age of Australians is currently 37. Back in 2002, Australia was expected to age quite quickly, with the median age projected to increase significantly to over 45 by 2040 (Graph 6). But after a decade of increased immigration of younger people, the latest estimate is that the median age in 2040 will be around only 40 years. This is a big change in a relatively short period of time, and reminds us that demographic trends are not set in stone. It is useful to put this change in an international context. To do this, the RBA's staff has examined demographic trends and projections over the next quarter of a century for 37 advanced economies using UN data. This next graph shows four key demographic variables for Australia and the range of outcomes across these countries (Graph 7). Australia stands out in a number of dimensions: First, our median age of 37 makes Australia one of the youngest countries among the advanced economies. We are also ageing more slowly than most other countries, which means that we are projected to stay relatively young. This is different from the earlier projections, under which we were expected to move to the middle of the pack. Second, we have a higher fertility rate than most advanced economies. Australians tend to have larger families than those in many other countries. Third, our average life expectancy is at the higher end of the range, and is expected to continue to rise. Fourth, the old-age dependency ratio is rising, but less quickly than in most other countries. Our relative youth and higher fertility rates mean that the dependency ratio is expected to remain lower than elsewhere over the next generation. Beyond that, on current projections, it is then expected to increase quite significantly. So, in summary, we are better placed than many other countries. The movement to Australia of large numbers of young people over the past decade has changed our demographic profile in a positive way. This has implications for future economic growth and the pressures on government budgets. This immigration has also boosted the nation's human capital. I would now like to turn to some of the implications for labour force participation of our changing demographics. While we remain a relatively young country, we are still ageing. Even with the large increase in relatively young migrants, the share of the Australian population aged 15-64 is declining, after increasing for many years (Graph 8). This decline is projected to continue for at least a generation, reflecting a combination of the ongoing transition of baby boomers into retirement ages, lower fertility rates and increased life expectancy. By 2040, around 20 per cent of the population is expected to be over 65, compared with 15 per cent currently. All else equal, as the population ages, the proportion of people who are working could be expected to decline. But all else is not equal. In Australia, we are seeing shifts in behaviour that have, to date, more than offset the effects of ageing on labour supply. In particular, the participation rates for men and women aged over 55 have increased significantly over the past two decades or so (Graph 9). This increase in the number of older Australians and the rise in their labour force participation means that nearly one in five employees are aged over 55 years. This compares with less than one in 10 in There are a range of factors that are at work here. One is the improvement in health outcomes for older people. One way of measuring this improvement is through the responses to an Australian Bureau of Statistics (ABS) survey in which individuals are asked to assess whether they have a health impairment that restricts their everyday activities (Graph 11). Over the past decade and a half there has been a significant decline in the share of people over 55 reporting that they have such an impairment. This improvement in health is allowing people to stay in the workforce longer. Greater acceptance of flexible work practices is also supporting this change. A related development is the ongoing shift in economic activity towards service industries, which tend to be less physically demanding on the body. On average, labourers have one of the youngest retirement ages and managers and professionals have the oldest retirement ages (Graph 12). As the type of work we do changes, it seems that more of us are in a position to spend more years working. Another factor that has encouraged increased participation by older workers is the changes to retirement income policies. In another ABS survey, the most common reason cited by retirees for their decision to retire is eligibility for superannuation and/or the age pension. The importance of this reason has increased through time, perhaps because other factors - such as health - have become less binding. It seems reasonable to suggest then that the increase in the pension eligibility ages, particularly for women, and the increase in the preservation age for those with superannuation are both likely to have boosted labour force participation. A third set of factors is related to other financial considerations. For some people, increased life expectancy could be expected to lead to delayed retirement because of the need to increase savings to finance a longer life. A loss of wealth during the global financial crisis is likely to have had the same effect. Another financial consideration influencing retirement decisions is the tendency for people to carry debt later in life (Graph 13). The causation here, though, runs both ways. An expectation that one will work for longer makes it possible to carry debt for longer. But for other people, the tendency to buy homes later in life and the fact that the real value of debt erodes more slowly than it used to, is likely to see them stay in the workforce longer. Finally, the increased participation of older women is also an extension of the ongoing increase in female labour force participation across nearly all age groups that has been boosting labour supply in Australia for many decades (Graph 14). This shift has been encouraged by policy changes related to parental leave and child care, and the increased prevalence of flexible and part-time work. Changing societal attitudes and increased time spent in education have also played a role. As a result, the labour force participation rates of younger women no longer display such a pronounced dip as they progress through their child-bearing years, because fewer leave the labour force entirely when they have children, although their hours worked do still show a dip. So, together, better health outcomes, changes in the nature of work and retirement income policies, financial incentives and the general trend towards greater female participation in the labour force are all boosting the participation rate for older Australians. The overall picture is one of constructive adjustment to our changing demographics. This is another illustration of the flexibility of the Australian economy. As our population continues to age, further adjustment is likely to be needed. But as I spoke about earlier, Australia is better placed to deal with population ageing than most other advanced economies. I would now like to shorten my gaze a little and turn to the near-term outlook for the Australian economy and the implications for monetary policy. The RBA will be releasing its latest forecasts for the economy on Friday. The outlook for GDP growth is little changed from that we have had for some time. Our central scenario remains for growth in the Australian economy to average a bit above 3 per cent in 2018 and 2019. The latest data have been consistent with this. We also still expect the unemployment rate to move lower over time and to reach 5 per cent at some point over the next few years. An unemployment rate of 5 per cent is the conventional estimate of full employment in Australia, but it is possible that we could go lower than this on a sustained basis. Time will tell. In terms of inflation, the latest data were in line with our expectations. Over the year to June, headline inflation was 2.1 per cent and, in underlying terms, inflation was close to 2 per cent. Both measures are higher than the average of recent years. Over the forecast period, we expect inflation to increase further to be close to 2 1/2 per cent in 2020. In the short term, though, we would not be surprised if headline inflation dipped a little, reflecting declines in some administered prices in the September quarter. Electricity prices in some cities have declined recently after earlier large increases, and changes in government policy are likely to result in a decline in child care prices as recorded in the CPI. There have also been changes to some state government programs that are expected to lead to lower measured prices for some services. Together, these changes mean that our forecast for headline inflation for 2018 is now 1 3/4 per cent. Looking beyond these short-run dynamics, inflation is still expected to rise as the economy moves closer to full employment. The labour market is gradually tightening and it is reasonable to expect that this will lead to a lift in both wages growth and inflation. This tightening of the labour market is evident in the steady increase in job vacancies, with the number of vacancies, as a share of the labour force, at the highest level in many years (Graph 15). It is also evident in the increase in the number of firms reporting that it is difficult to find workers with the necessary skills. As expected, the tighter labour market is leading to higher wage outcomes in certain pockets of the labour market. Over time, we expect that this will become a more general story, although this is going to take some time. In terms of the financial risks facing the economy, things have also been broadly moving in the right direction. For a number of years, risks were rising due to the nexus of high and rising levels of debt and escalating housing prices. Over the past year, though, housing price declines in the largest cities have reversed a small part of the earlier gains. Borrowing by investors has also slowed considerably, largely because of reduced demand by investors. There has also been a tightening of credit standards. While banks are competing strongly for customers with low credit risk, their appetite to lend to riskier borrowers has lessened a bit. Some of the non-bank lenders are providing credit to these borrowers. This change in financial trends has helped reduce the build-up of risk. It is helpful that this change is taking place at a time when the world economy is growing strongly, the unemployment rate is trending lower and the economy is recording good growth. This is assisting with the adjustment and means that, notwithstanding the changes in the housing market, we still expect consumption growth of around 3 per cent over each of the next couple of years. We do, though, need to keep a close eye on the housing market and housing finance. So, in summary, we see reasonable prospects that the economy will record good growth, the unemployment rate will come down gradually and that inflation will increase over time. This is a favourable outlook. If this is how things evolve, you could expect the next move in interest rates to be up, not down. As the economy strengthens and income growth and inflation lift, it would be natural for interest rates to return towards more normal levels. The timing of any future change in interest rates is dependent upon the speed of the progress that is made in reducing the unemployment rate and having inflation return to around the midpoint of the target range on a sustained basis. If we were to make faster progress than we currently expect, any future increase in interest rates is likely to be earlier. Conversely, slower progress would likely see a longer period without an adjustment. For the time being, the Reserve Bank Board's judgement remains that the best course is to maintain the cash rate at its current level. Given that the progress in reducing unemployment and lifting inflation is expected to be only gradual, the Board does not see a strong case for a near-term adjustment in monetary policy. The Board is seeking to be a source of confidence and stability to support the progress that the Australian economy is making. Thank you for listening and I welcome your questions.

r180817a_BOA

australia

Opening Statement to the House of Representatives Standing Committee on Economics

lowe

To inquire into and report on: Good morning, everyone. 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, and the media. Since the previous hearing with the RBA, in February 2018, monetary policy has remained accommodative, with a cash rate of 1.50 per cent following the RBA's recent decision to leave interest rates unchanged. In leaving rates on hold, the RBA governor said: The governor reported that 'the global economic expansion is continuing' with 'a number of advanced economies are growing at an above-trend rate' with low unemployment. The governor said that, while inflation has remained low globally, it has picked up in some countries and is expected to increase, given tight labour markets. The governor expects growth in the Australian economy to average just above three per cent in 2018 and 2019, which should further reduce spare capacity in labour markets. The RBA reported that business conditions in Australia remain positive and that non-mining business investment increased by 10 per cent over the year to the March quarter. The RBA expects mining investment to reach its trough in late 2018 or early 2019 before picking up moderately. In its August statement on monetary policy the RBA noted softer than expected inflationary pressures in the Australian economy in the near term and said it did not expect underlying inflation to reach the middle of its two per cent to three per cent target band until the end of its forecast period in 2030. The August statement also noted: The RBA said that, while the protectionist measures announced to date are unlikely to have a major effect on global trade and output, 'the risk is that uncertainty and the threat of further measures could weigh on growth through lower investment'. The committee will examine these issues in more detail and will ask the RBA whether it remains confident that current monetary policy settings will encourage growth and inflation consistent with the target for coming years. I remind witnesses 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. Dr Lowe, would you like to make an opening statement before we proceed to questions. Thank you very much, Chair and members of the committee. Good morning, it's a pleasure to be back in Canberra again. Thank you for the invitation to appear before this committee. These hearings are an important part of the accountability process for the Reserve Bank of Australia. As usual, my colleagues and I are here to answer your questions to the best of our ability. Since we last met, the Australian economy has continued to move in the right direction. According to the most recent data, GDP growth is 3.1 per cent, inflation is around two per cent and the unemployment rate is now clearly below 5 1/2 per cent. In the broad sweep of our economic history, these are a pretty good set of numbers. We would, of course, like them to be better. We're still short of full employment, and we would like to be more confident that inflation will be sustained at a level consistent with the target. But if things work out as expected we are likely to make further progress on both of these fronts over the next couple of years. Over the first part of this year the Australian economy looks to have grown quite strongly. GDP increased by one per cent in the March quarter, and a reasonable increase is expected in the June quarter. Business conditions are positive, and we're in the midst of an upswing in non-mining business investment. Increased spending on infrastructure is also helping the economy. Resource exports are also increasing strongly as the new capacity comes onstream, particularly for LNG. One important offsetting factor at the moment though is the drought in eastern Australia. While the prices of some farm products are currently quite high, which is helping farm incomes, the dry conditions are limiting farm production. I thought it might be useful to make some introductory remarks on four topics that the Reserve Bank Board has devoted considerable time to recently. The first of these is the global outlook; the second is household debt and the housing market; the third is wages growth; and the fourth is the outlook for inflation. The global outlook remains positive, although a number of risks have increased recently. The advanced economies are growing faster than trend and unemployment rates are at multidecade lows in many countries. A gradual pick-up in wages growth is also taking place. As is appropriate, the considerable monetary stimulus that has been place in the United States is gradually being withdrawn. At the same time though official interest rates in the euro area, Japan, Sweden and Switzerland are all still negative--and that's almost a decade after the onset of the financial crisis. In China growth has slowed a little. The authorities though have responded to this, but they're still facing the challenge of addressing risks in the financial system. There are a few uncertainties that I think are worth highlighting for you. One is the possibility of an escalation in global trade tensions. The measures announced so far are unlikely to derail the global expansion. Even so, in some countries businesses are now delaying investment because of increased uncertainty. It's possible that this becomes a more general story. If this were to occur, this could be the channel through which the trade tensions sap the current positive momentum in the global economy. Another uncertainty is the possibility of a large unexpected pick-up in inflation in the United States. The US economy is experiencing a sizeable fiscal stimulus at a time of limited spare capacity, so growth there could surprise on the upside. At the same time financial markets remain relaxed about the implications of this for inflation. I'd have to say that I am less relaxed. It is highly unusual to have such a fiscal stimulus at a time when the economy is already operating at very close to full capacity. One can't rule out the possibility that the Federal Reserve will have to withdraw monetary accommodation more quickly than currently projected, with possibly disruptive consequences for financial markets globally. A third set of global risks originates from a number of individual economies with country-specific structural and/or institutional vulnerabilities, including Argentina, Brazil, Italy and Turkey. Over the past month there have been episodes of market volatility associated with each of these countries. We are watching developments in each of them very closely, as a further escalation of problems could be the catalyst for a period of increased stress in the global financial system. The second issue is the Australian housing market and household debt. The housing markets in Sydney and Melbourne have clearly slowed and prices are coming down. While this has understandably concerned some people, we here do need to keep things in perspective. Not so long ago there was widespread concern in the community about rapidly rising house prices, rapidly rising debt and declining housing affordability. These earlier trends were not sustainable and they were posing a medium-term risk to our economy, so a pullback is a welcome development and it can put the market on a more sustainable footing. It's good news that this adjustment is taking place at a time when global growth is strong, the Australian labour market is positive and interest rates are low. All these things are helping with the adjustment in the housing market. We are, nonetheless, continuing to keep a close eye on housing market developments right across the country. The slowing in the housing market has reduced the demand for credit by investors. There has also been some tightening in the supply of credit, partly in response to the royal commission, although the main story is one of reduced demand for credit. The average variable interest rate paid by borrowers has declined further over the past six months to be around 10 basis points lower that it was a year ago. You would not have expected to see this if it was supply constraints that were the main reason for the slower credit growth. A third issue that the board has focused on recently is growth in wages. As I have discussed previously, a lift in aggregate wage growth would be a welcome development from a number of perspectives. It would contribute to inflation being closer to the mid-point of the inflation target; stronger income growth would also help in the context of high levels of household debt; it would also be of benefit to government finances and, more generally, it would strengthen our sense of shared prosperity; and, to the extent that stronger wage growth is backed by stronger productivity growth, it would boost our real incomes and our real living standards. We had another reading on the wage price index just a couple of days ago, which showed a welcome pick-up. Over the past year, the wage price index increased by 2.1 per cent, and the broader measure, which captures bonuses, increased by 2.5 per cent. Both figures are up from those a year ago. This week, we also received employment data for the month of July, while the month-to-month employment data are volatile, the unemployment rate has now fallen to 5.3 per cent, which is the lowest it has been for quite a few years. This is good news. Taken together, these data are consistent with our view that wage growth and inflation will pick up gradually over the next couple of years as the labour market continues to tighten. This tightening is already evident in a number of indicators: the number of job vacancies as a share of the labour market is at a record high; firms are reporting that it is harder to find workers with the necessary skills; and survey based measures of hiring tensions remain quite positive. In our liaison program, we also hear reports of larger wage increases for certain occupations where workers with the necessary skills are in short supply, and we expect that we will hear more such reports over time. Even so, the pick-up in wages growth is still expected to be fairly gradual. We still have some spare capacity in our labour market, including part-time workers who would like to work more hours. There are also structural factors at work arising from technology and from competition, and we've discussed these at previous hearings. So, it is likely to be a gradual process. The fourth and related issue is the outlook for inflation. The CPI inflation rate at 2.1 per cent is higher than it was a couple of years ago, although it is still below the medium-term average. Strong competition in retailing from new entrants is holding down the prices of many goods and low wage increases are holding down the prices of many services. Rent inflation across the nation is also at a very low level. Working in the other direction, over the past year there have been higher prices for electricity, fuel and tobacco. We're expecting inflation to move gradually higher over the next couple of years as the economy strengthens, and we remain committed to achieving an average rate of inflation over time of between two and three per cent. In the short term, though, we're expecting the headline rate of inflation to dip a little in the September quarter. Utility prices have declined recently in some cities and policy changes are likely to reduce the measured price of child care. There have also been some policy changes at the state government level that will influence some measured prices. Collectively, these changes will help with the cost of living pressures and free up income for households to spend on other things. From this perspective, these changes are good news, too. These are some of the main issues that the Reserve Bank board has been working through. As you are aware, the board has kept the cash rate steady at 1.5 per cent since August 2016. This setting of monetary policy is helping support economic growth, allowing for further progress to be made in reducing the unemployment rate and returning inflation towards the mid-point of the target range. We have not sought to fine-tune outcomes but rather to be a source of stability and confidence as the economy moves along this path. For most of this year, I have emphasised three points in communication about monetary policy. The first is that things are moving in the right direction. We are making progress towards full employment and having inflation return to around the midpoint of the target range, and further progress is expected this year and next. The second point is that, if we continue to make progress, you could expect the next move in interest rates to be up. With the central scenario being for the economy to continue on its recent track, it is more likely that the next move in interest rates will be an increase, not a decrease. The last increase in the cash rate was back in late 2010, so an increase, when it occurs, will represent a significant change for many people. It's important to remember, though, that higher interest rates will be accompanied by faster growth in incomes than we've have seen for quite a few years now. In this sense, it will be a sign that things are returning to normal. Of course, higher interest rates will also be welcomed by many depositors, who've been earning low rates of return on their savings over recent times. The third point I've been emphasising is that, because the progress that is being made is gradual and is expected to remain gradual, there is not a strong case for a near-term adjustment in interest rates. The board's view is that it is likely that we will hold steady for a while yet. It is likely to be some time before we are at full employment and that the inflation rate is comfortably within the target range on a sustained basis. We are prepared to maintain the current monetary policy stance until these benchmarks are more clearly in sight. So these are our three recent messages on monetary policy. On other matters, we are planning to release the upgraded $50 banknote in October. The new note will have the same high-tech security features as the new $5 and $10 notes. All up, there are around 700 million $50 notes on issue--that's around 28 per person--so it's a big logistical exercise. You may have read in the press that there has been an industrial dispute at Note Printing Australia, which manufactures Australia's banknotes in Craigieburn, Melbourne. I am pleased to be able to report that an in-principle agreement on a new enterprise bargaining agreement was reached earlier this week and that we have sufficient notes to launch the new $50 in October as originally planned. Finally, at previous hearings we have spoken about Australia's New Payments Platform--the new payments system that allows Australians to easily make information-rich, real-time, 24/7 payments to each other, without having to know BSB and account numbers. Since the system was launched in February, 1.8 million Australians have registered a PayID--usually their mobile phone number--that can be used easily to address payments in the new system. The take-up of the system has, however, been less than earlier industry projections. This partly reflects the fact that a number of the major banks have been slow to make the new system available to all of their customers. They are now making it available, so we expect take-up to increase. Interestingly, many of Australia's smaller financial institutions have done a better job, with more than 50 of them ready from day one. Despite the relatively slow start, we still expect that the new system will provide the bedrock upon which further innovation in Australia's payment system will be built. The Payments System Board is keeping a close eye on access arrangements so that those with new ideas and better ways of doing things can use the new system. Thank you very much. My colleagues and I are happy to answer your questions. Dr Lowe, thank you very much. Before I proceed to questions, I want to make a correction to my opening statement. I misread a year: when I referred to your August statement on monetary policy and the expectation that you would reach a two to three per cent target band until the end of its forecast period, I said 2030; I meant to say 2020, so just to correct that. I would like to begin by asking you about the most recent unemployment rate that was announced yesterday. Of course, we now have more than one million new jobs that have been created over the last five years. The unemployment rate is down to 5.3 per cent. Why do you think that the labour market has performed so well? Over the past year, the economy's been growing faster than trend. We've been eating into spare capacity. Growth of three per cent in the economy should see the unemployment rate come down, and that's what's happening. There are a few things that are supporting that. The global economy's actually doing quite well at the moment. Most of the major economies are growing faster than average. So the global backdrop for Australia is quite positive. Commodity prices are higher than they were a year ago, although they have fallen in the last month or so, and that's creating extra income in Australia. There's been a very strong lift in infrastructure investment, particularly in the eastern states, and we hear through our liaison program that that's having spin-off effects right through the economy, so that's a positive. The low level of interest rates is also helping. For many years during the resources boom, firms outside the resources sector weren't doing very much investment, so Australia's capital stock was depreciating. Now that the resources boom is over, there's more scope for businesses outside the resources sector to increase their capital spending, and they're doing that. Collectively, those factors are generating strong demand for labour, and we're now seeing that in the unemployment rate, which is very good news. Over the past year, employment's up nearly 2 1/2 per cent. The labour force is probably growing at 1 3/4 per cent, so that's seen the unemployment rate come down, and the participation rate's also rising. One of the factors that I've been talking about recently is the big rise in the participation by older workers, so the stronger labour market is creating opportunities for older people to stay in the labour market. Encouragingly, at the other end of the distribution, there's been a marked decline in youth unemployment in the last six months. Youth unemployment has been high for a long period of time, but it's finally starting to come down, which is good news. So the labour market is good. We have seen some very good indicators, and also the participation rate by women is up as well, which is a very significant factor. Can I ask you to expand on the positive sentiments that you've echoed this morning in your opening statement on wages growth? You've indicated that you're positive about wages growth heading on the right trajectory. Can you expand a bit more on that, please? I think it's heading in the right trajectory, but only slowly. At the moment, the number of job vacancies that firms have as a share of the labour force is the highest on record. Firms are advertising a lot of jobs. They're telling us that it's hard to find workers. In that environment, you would expect the laws of supply and demand to gradually kick in--that wage growth would pick up--and we do hear this in our business liaison program. In the areas of project management skills, IT security and some engineering occupations, where there's strong demand for workers and the supply of workers with the skills is not there, wages are starting to move. I think that will become a more general story, but it's going to be a fairly gradual process. Can you expand on the sectors of the economy where you are starting to see that tightening of the labour market. You've mentioned IT and engineering. What about construction and other sectors more generally? Not so much across the board in construction but in specific occupations that are linked to infrastructure, in particular, where there's a shortage of people with the necessary skills. In IT security and project management skills generally, there's strong demand for people with those skills and wages are picking up. But in many occupations wage increases still seem to be around the two per cent mark, and, in the most recent aggregate enterprise bargaining results, the increase was still quite low. But one imagines, as the economy grows above trend, the unemployment rate comes down and more and more firms say that it's hard to find workers, we will see firms bidding workers away from other firms, offering them higher wages or trying to keep their own workers by giving them bigger pay rises. That's how things normally work, and we're starting to see some signs that that's how it's working now, but it is going to be a gradual process. Female labour force participation has recently reached record highs, female wage growth has been relatively strong and the gender pay gap has reached record lows, although of course there is more work to be done. Can you make any observations about this data? Well, they're all positive developments, aren't they--the stronger labour market and the fact that firms are advertising jobs, people are finding them and, over recent times, more than the average share has gone to women and that's leading to higher labour force participation, as you suggest. There's a longer term structural change going on. Luci, do you want to talk about that? Each cohort, year after year, there's a greater share of women who stay in the labour force, and they stay in longer. Yes, that's right. One of the things you can do is track through the labour force participation by age and sex. For each given age group, through time, you tend to see higher participation rates through time. So each generation of women is participating in the labour force to a greater extent than the one that went before. Unlike in some other Western countries, that process is still continuing in Australia. You notice that particularly amongst women aged over 50, who had traditionally had quite low participation rates. You're seeing that come up quite noticeably. Overlaid on top of that longer term structural change is that, typically, when there are good labour market conditions, when employment growth is above average, you do see some increase in participation for cyclical reasons. When that happens, it's most obviously shown in the increased participation rates of women in their middle years, their child-bearing years, and older workers of both sexes. Essentially what's happening is that, for the older workers, they're staying in the workforce for longer--and that's also a longer term trend; the trend towards early retirement has diminished quite considerably. The governor talked about this in a recent speech, where he talked about the better health outcomes that may be driving that. But then, for women in their middle years, it's quite normal, during good economic times, that people notice that there are jobs available, and women who are currently not in the labour force decide to re-enter at a particular time. You can imagine that many of these women would have been out of the labour force, caring for children or studying--and, although it's interesting that most of the jobs that have been created in recent times, over the last year and half, have been fulltime jobs, a lot of those have been going to women. It's not irrelevant that employment in the health and social assistance sector has been growing quite strongly. Of course, that is a sector that employs a lot of women and typically hires people from out of the labour force rather than from unemployment. The flows are more likely to come from 'not in the labour force' into employment, rather than from unemployment into employment. Basically, you decide to get a job and you find the job, and you've already found the job by the time the ABS comes back and asks you whether you were looking but hadn't found a job yet. They find them pretty quickly if that's the case. This is actually one of the developments that's telling us that there's been a cyclical strong period in the labour market, because the areas where participation has picked up most recently have been the demographic groups where participation normally picks up during cyclical upswings in the labour market. But, as I mentioned, that's all overlaid over the longer term trend of stronger participation. Dr Lowe, the June quarter CPI came in at 2.1 per cent. You've made some comments today about falling electricity prices in some states, and in other states I think they've remained relatively constant. You've described these changes this morning--along with reduced costs of child care, obviously introduced because of the government's recent changes to childcare policy--as good news. Could you expand on what you mean by Many households have cost-of-living pressures. We hear about this all the time, and I'm sure you do as well. Lower electricity prices, lower cost of child care and, in New South Wales, lower cost for tolls and registration are all going to help with the cost-of-living pressures that households face. In the short term, they're going to lead to lower inflation. Some people will look at that and say, 'Inflation's too low, and this is going to make it even lower.' My perspective is a bit different. If we get lower inflation because of these reasons, it isn't because the economy's doing poorly and there's no pricing pressure; it's because of decisions that governments are making to reduce the cost-of-living pressures on households. In time, as those cost-of-living pressures come down, people will have more money to spend on other things. That will create more demand elsewhere in the economy and it will gradually lift spending and prices elsewhere in the economy. So it's good news in the short run. If you're looking for inflation to pick up quickly to 2 1/2 per cent, you might think it's not so helpful, but I think it's good news, even if it means inflation is going to be a bit lower for a bit longer. In the last hearing, Dr Lowe, you expressed some concerns about electricity prices. Are you comforted by the change in the trend, with the lower electricity prices that you've now seen? Well, is it a change in trend? We hope so, Dr Lowe. That's the plan. The trend has been up for a long period of time and we've seen in the current quarter a decline in Brisbane, and one would hope that we'll see further declines right across the board. It remains to be seen whether that will happen. For a number of years, rising electricity and gas prices have put upward pressure on the CPI. They've put upward pressure on people's cost of living. So it would be good if those days were behind us. I certainly hope so. It is really up to the parliament and the states to see whether that actually happens, but it will be good news if it does. It's not just the CPI; it's the cost of production for many businesses, making sure that Australian business is competitive. Having some uncertainty about the future energy market will help investment as well. A number of firms have been delaying investment over recent times because they're unsure. That's not helpful, and the general high cost of electricity has reduced the competitiveness of Australian business, which also isn't helpful. So, from the CPI prospective, it would be good. For the cost of doing business in Australia, it would be good, and creating greater certainty about the investment landscape would be good as well. Dr Lowe, you've previously told the committee that lower corporate tax rates shouldn't come at the expense of higher budget deficits but you were comforted by the fact that the budget is on a decent track. Are you still comfortable, given that the budget is now expected to return to surplus a year earlier than was previously I think it's good news that the budget is on a sustainable track. I say that from two perspectives. The first is from the insurance prospective. Australia has gone a long time without having a recession, which is very good news, but one day we will have one and it will come as a shock to many people when that happens, after we've had more than a quarter of a century without one. When that day comes, it would be useful if the government had the financial capacity to help stimulate the economy so that the job isn't just left to monetary policy. If the government is going to have that capability, it needs to run disciplined budgets in good times. So, to the extent that we'll be back to an operating balance or surplus fairly soon, I think that will help build future capacity to respond, which is very positive. We saw in the global financial crisis that the countries that did not have that capacity cut back on fiscal policy in the downturn, and that made things worse in Australia. Because we effectively paid the insurance premium over a decade, we were able to respond and that helped the economy. I'm a big believer in insurance and I want us to have that insurance again. I think we're on track to do that. The second perspective is as the father of three teenage children. I worry about intergenerational equity, whether it's right for our generation to keep on financing expenditure and services delivered by the public sector, using debt which our children will have to pay back. So, to the extent we're not doing that, I think it's a good story. In terms of the broader issue of corporate taxes, we've discussed it at this committee before. There is a form of international tax competition going on. The US has been the leader and there were big cuts. They have unambiguously stimulated the US economy and other countries are responding as well because they see the effect that it's had. It's really up to our parliament as to whether we respond as well. But, as you said, if we are to respond, then we need to make sure that, for the reasons that I articulated, the budget stays on a reasonable track, and at the moment it looks like it is. Dr Lowe, you made some comments about the royal commission this morning, that there has been some tightening in the supply of credit partly in response to the royal commission. Can I ask you to expand on that? And more generally, could you make some comments about the impact that the royal commission is having, particularly with respect to the banks given the role that they play in the Australian economy? Like most Australians, I have been following what's been happening very carefully. I would have to say, I'm incredibly disappointed and, in many cases, I've been appalled at the behaviour that's come out through the royal commission. I think the whole process is really showing the benefit of sunlight, showing a kind of microscope on behaviour. I think the community is getting a better understanding, and we'll get better outcomes in the financial sector as a result of this. Sunlight is acting as a very good disinfectant here. We need this disinfectant and it is actually working. We have talked at this committee before about what I see as the foundations of finance. They are really trust, delivering service and good risk management in financial institutions. I think what we have seen through the royal commission are deficiencies in all those three areas. The trust between financial institutions and the community has been strained. There has not been enough focus on customer service. It has been more of a sales mentality than a service mentality, and risk management has not been all that it should have been in financial institutions. We have seen a couple of common themes right through the royal commission. The first is the difficulty of dealing with conflicts of interest. They seem pervasive in the financial services sector, and dealing with those conflicts has not been top of mind in many financial institutions and it should have been. I think those conflicts can be dealt with, they can be managed but they need to be top of mind. If they're not top of mind in financial institutions then it continues to strain the bonds of trust between the institutions and the public. And there is not enough attention paid to kind of customer service, doing the right thing by the customer. So dealing with the conflicts of interest, I think, is a priority. The second common theme that I've detected through the hearings is the role that remuneration structures inside institutions play in driving behaviour. We all know this. Remuneration and incentives drive behaviour, and we have seen remuneration structures that have driven quite poor behaviour in many cases and they need to be looked as well. Just to clarify, the government has taken quite strong action in that respect through the BEAR regime. It has been recognised, and the head of APRA, Wayne Byres, talked about it. So dealing with those two sets of issues, the conflicts of interests and the remuneration structures within financial institutions seem to me to be high priorities because we need to rebuild trust and we need to have a very strong focus on delivering service rather than sales, and risk management. It's true that the royal commission has had some effect on the supply of credit. Financial institutions are becoming more risk averse; it's understandable. They now have very little appetite for internal process failures for the reasons we understand so they're doubling down on their processes, which is actually a good thing. But it does mean that it is a change from the previous process. The process for approving credit is slower, and more loans are probably getting rejected than previously would have been the case. Even still, isn't it important that it the banks don't turn their eye on to consumers, that they spend a fair bit of time looking and examining their own conduct and their own internal processes rather than just imposing all of that so-called burden on the banking consumers? I agree with you. It is incredibly important that they look at the processes from top to bottom and say how those processes are helping deliver good products to consumers. They're going through that process at the moment. The result of that is things are a bit tighter and that's inevitable. I don't think that's the main thing that's affecting the housing market or trends in credit. The main thing affecting the housing market is the shift in the underlying dynamics between supply and demand. There's been a lot of extra construction over recent years, and the number of dwellings is rising more quickly than it has for a long period of time. There's less demand from China. The level of price has got so high that people get to the point where they say, 'I'm just not prepared to keep bidding and pushing the price up further.' Those dynamics have changed, so prices are falling, and when prices are falling investors are not as keen to go to their bank to borrow to buy, because the value of the asset could be five per cent lower in six months time. There's been a reduced demand for credit from investors and that's having an effect on the flow of credit in the economy. In addition to that, there are these things on the supply side, but I don't think the supply side's the main story. In your opening statement, you mentioned the US economy and the sizeable fiscal stimulus that's still occurring there with limited spare capacity. You mentioned that markets appear to be relaxed about the inflation implications of that, but you're not so relaxed. You talk about possible disruptive consequences in financial markets. Is it your view that that stimulus has gone on for too long? I don't really want to pass judgement on it. I would make the observation though that in the United States the budget deficit as a share of GDP is now four or five per cent and is likely to stay there for the foreseeable future. This is at a time when the US economy is below full employment, growing above trend and has a very high level of public debt, partly as a legacy of the spending during the financial crisis and the inability of the US system to reform entitlements. I think public finances in the US are looking problematic. At this point in the cycle, with the economy doing well and very low unemployment, it's the time of the cycle that should be back to budget balance, or maybe even better than that, in order to build insurance, as I talked about before, for the next downturn. That's right--consolidation rather than expansion. And the US is doing exactly the opposite, and they're doing that in an economy that's already at full employment. We're also seeing, I would say, a similar trend emerge in a number of other countries, where governments responding to the disillusionment in the electorate and the international tax competition--kind of coming from the US--feel like they're having to respond as well, by having to either cut taxes or spend more money. Amongst the OECD economies, more than half are having a fiscal expansion this year at a time when the world economy is doing well, unemployment rates are low and levels of public debt are very high. Australia's not doing that, thankfully, but I think it's problematic. Is it fair to describe that situation in the US as unorthodox in terms of the way you approach economics? I think that's a fair characterisation. Normally you do not have a very big fiscal expansion when the economy is already at full employment. So where do you think this unorthodox approach is coming from? Is it coming I don't think it's coming from the Federal Reserve. The Federal Reserve are gradually tightening up as inflation rises, as is appropriate for them to do. In your statement, you also said, further on, that you think that there's the possibility of disruptive consequences in financial markets. Could you elaborate on what you mean there? What could those disruptive consequences be? Investors largely think that inflation is going to stay very low in the US. They think that the US economy can grow very strongly, have very low unemployment and low interest rates and that inflation will stay very low, and there's very little uncertainty. People in financial markets talk a lot about the term premium. This is the extra benefit, the extra return, you get from holding a long-term asset rather than rolling a short-term asset. Over long periods of time, you would normally expect maybe to get one per cent extra from holding a long-term asset, because there's more risk. At the moment, you actually get more in expectation by rolling short-term assets than holding long-term assets. So the term premium is very compressed. One reason for that is that people don't see very much risk in the future. It's very low. That's very unusual. And it's quite possible that we return to the normal sort of term premium. If that were to occur, then long-term bond rates would move up quite a lot. Many financial prices would have to be restruck. One reason that asset prices have been so high right around the world recently is that long-term bond yields are so low. Partly, this is the term premium story. So, if long-term bond yields were to rise a lot, there would have to be repricing of a lot of assets, and markets are not prepared for that. We've seen in the past that, when periods of repricing occur, it's quite disruptive. I'm not saying that's going to happen-- No, of course. but the probability of it happening is rising. A lot of Australians through their super funds have investments in some of those long-term assets that you've mentioned. Is this something that you think financial managers in Australia should be conscious of and, taking a prudent approach, should begin preparing for? I'm not going to give financial advice. The only advice I give is: be diversified and be prepared for a whole range of circumstances. I think that's as far as I can go, but it is concerning. Another consequence of the United States is that interest rates are beginning to rise. That's putting a differential in terms of where our rates are at. The Australian dollar has suffered as a consequence of the Turkish lira being hit in international markets. Are you concerned about what's going on with the Australian dollar, and do you think that there are further falls coming? Well, again, I don't predict the currency. That's a very difficult thing to do. But for some time I've been saying that a lower exchange rate would be better than a higher one. The reason I've been saying that is that a lower exchange rate would lift inflation, getting the inflation rate closer to the midpoint of the target, and it would also stimulate the economy. It would make our exports more competitive and imports less competitive, and that would create more jobs and wealth and income. So, from the perspective of getting back to full employment and getting inflation back to the midpoint of the target range, a lower exchange rate would be helpful. For some years, we have been hoping that what would happen is that the Federal Reserve would raise interest rates; the US dollar would appreciate as a result of that; the Australian dollar would depreciate; that would stabilise both inflation and jobs; and we could normalise interest rates. That process has taken a lot of time to occur. It may be that it's now occurring, although the Australian dollar has not moved that much. I still think a lower dollar would be helpful for both inflation and achieving full employment. To the extent that the Australian dollar has come down recently, I think that's actually good news. It would be problematic if it was depreciating in a crisis environment, but, outside that, I think some further depreciation would be helpful. Is there a level that you'd like to see the dollar at? I don't want to give a particular level. I just make the point again that a moderately lower currency would be helpful from the point of view of both inflation and employment. Two of the international uncertainties that you mentioned in your opening address were the Trump trade war and the China growth forecasts. How concerned are you about those two issues, and is it time, do you think, to start looking at lowering global growth forecasts on the basis of that disruption? I'm not sure that the governor used those exact terms, but I'm sure you'd like to clarify that. Well, it's interesting. In the IMF's very most recent global forecasts, after having revised up global growth for maybe a year and a half, there was just a slight kind of downgrade, but still at a very high level. The concerns about trade, I think, lie at the heart of this kind of small recent downgrade by the international forecasters. As I've said a number of times previously, I can't think of a single country that has made itself wealthier by building barriers. I can think of a lot that have made themselves wealthier by inviting the world in, having more competition, more capital, more people, more goods and services. I can think of one, in particular, that's done remarkably well from that, and that's Australia. So this is not a path to make ourselves or anyone wealthier. It's very hard for anyone to know how it's going to play out on the trade front. We, as well as others, have thought about the various scenarios. Probably the most benign scenario, and it is the most likely one, is that we have 10 or 25 per cent tariffs between the US and China that slows growth in both countries a little bit but doesn't derail the global expansion. In that world, Australia would be moderately affected, because growth in China would be slower, but I think it would be manageable. There is a much worse scenario, where these tensions escalate, that would lead to businesses around the world being very nervous about the future and deciding not to invest or delay investing. Business hates uncertainty. When there is a lot of uncertainty, it's a good reason to delay taking investment decisions. We're starting to see some of that in North America--not on a massive scale, but it's starting--and that could escalate. If that occurred at the same time that financial markets became very jittery, that could be a very damaging cocktail which sees world growth slow a lot. On the other side, if you put your rose-coloured glasses on, you can tell a positive outcome--that the tensions between the US and Europe lead to some liberalisation at the margin, that NAFTA gets reconfigured in a way that supports further integration--perhaps slightly different to what we have, but further integration--and, under pressure, the Chinese take more seriously the protection of intellectual property. So, if you put your rose-coloured glasses on, you can tell a scenario where this works out quite well. It's very hard to put probability on these three scenarios: a benign one, a terrible one and one that works out okay. I think we're all waiting and watching to see what happens. I can't see how anyone wins in a trade war, but anyway. I'll turn to domestic issues. You mentioned subdued wages growth once again. I want to quote to you some figures from the latest CPI report--and these are on annual basis for particular indices--housing, 3.4 per cent growth; health, 5. 2 per cent growth; transport, 5.2 per cent growth; education, 2.7 per cent growth. And we all know what's been going on with electricity prices. They're the staples of any household. At the same time, wages, according to the latest wage price index data: 2.1 per cent growth. That's been the story of Australia for the last five or six years. Can you understand why families are doing it tough and why they're feeling left behind in this environment, with those I can. It's largely an income story. It's not that the prices are going up too quickly in aggregate. In aggregate, prices are only going up two per cent, and we want them, on average, to go up 2 1/2 per cent. So, it's not that the aggregate price index is going up too quickly; it's the fact that our incomes are not going up quickly enough. If I can, I'll pass to Guy, because next week he's going to give a speech dissecting the CPI and its components. So, perhaps, Guy-- We're going to get a preview, are we? can preview some of those remarks. It will save everyone turning up next week to hear me speak! As the governor said, I think the main story is actually an income story rather than a price story. You quoted a number of prices which have been going up at rates higher than three per cent. One thing which is interesting is that the food basket basically hasn't moved in seven years. The food grocery basket hasn't moved. Your television set is a lot cheaper now than it was, so those prices have been falling. The cost of your phone has been coming down. The cost of your car has been coming down. So there's a bunch of other stuff which is falling; hence, the aggregate is what it is. The other thing that I think has had a particularly large effect is the cost of renting. If you're a renter--that's one-third of people-- it's barely moved for the last few years. There are other things, including some infrequent purchases--maybe once a year or once every couple of years--where the prices are falling. The CPI is based on what households actually spend, so it does a reasonably good job of reflecting those price movements. As Phil said, or as you said, in aggregate it's growing a bit above two. I don't think that's so much the story. There are, as you highlighted, some particular prices which are rising faster than that. But I think the main story is that income growth isn't growing any faster than that, so you're in a world where you're not seeing any benefit because the growth in your income is being eroded by those admittedly small rises in prices. I'd really emphasise the slow growth in income rather than the outcome on the price side, because the outcome on the price side is just above two per cent. It's actually about where want it. As you note, there are a number of--for want of a better term--high-profile prices which are rising quite a lot faster than that. The interesting ones, which we're looking at over the next period ahead--and we were talking about this earlier--are some of the utility prices. It looks quite conceivable that the dynamics on the electricity front are changing from where they've been over the last few years. We've already seen that. I think the visibility, in terms of the deals you can get from the electricity companies, is probably greater now than it has been for a while. That's not dissimilar to the story going on on the banking side, in terms of shopping around for a cheaper mortgage. That's a fairly important thing that people see a lot: the pricing dynamics may actually be changing in the period ahead. But there are some parts, and food is the most obvious one, where prices have basically been flat for the last seven years or so. I take your point about aggregate prices. The issue we hear about a lot from constituents is that those indices that have been increasing above the aggregate rate make up such a large proportion of the household budget, particularly housing, education and energy costs. That's why people feel that they're just being left behind. If you're a worker working in the hospitality industry on a minimum wage, you've had your weekend penalty rates cut; you've had no other increase in your income; your wages are around two per cent growth, on average. You can understand why those people are really jacked off and angry at the moment. Sure. But, as you just said, it's an income story. Even the prices you talked about have been going up. The rise in education cost is actually less than it's been for a while. The rise in insurance premiums is the lowest it's been in about 10 years. It's still decent. But I think it's primarily the income story. If people had higher income growth, I think you would be hearing a lot less of the story. The pain point is as much on the income side. Do you think that the parliament and organisations like the Reserve Bank haven't devoted enough attention to the issue of low income growth and that we could be doing more to assist families and workers in this area? I'm not going to say what the parliament should or shouldn't be doing. I have certainly been talking for a couple of years about the benefits of stronger wage growth. I was concerned at the beginning of last year that we'd slipped from 2 1/2 per cent wage growth to two per cent, and maybe we'd even slip to 1 1/2 , because we'd been hearing about some wage outcomes that were starting with a one and I thought that was problematic. The strategy from the Reserve Bank's perspective is two-fold. The first is to talk publicly about the benefits of stronger wage growth. That's controversial because most of my predecessors have had to talk about the dangers-- Do the opposite. Exactly--the opposite, saying that stronger wage growth would mean higher inflation, higher interest rates and a slowdown in the economy. It's a reflection of how much the world has changed that the central bank governor is speaking publicly about the benefits of stronger wage growth. At an analytical perspective, what I see myself doing is trying to stop wage expectations from falling further and perhaps even lift them. That's one part of our strategy. The second part is to keep interest rates low for a long period of time so that we get more and more pockets of tight labour markets where wages start moving. That becomes a general story and the aggregate wage growth lifts. They're the two things that the Reserve Bank of Australia can do. We can't do very much more than that. The parliament, if it so chooses, can do things. But I feel like we're doing what we can and should do. I have one follow-up question then. The current budget forecasts have the wage price index data for this financial year at 2 3/4 per cent growth and then for the financial year 2019-20 at 3 1/4 per cent growth. Do you think there's any hope that we'll reach those targets? Are they overly ambitious? I think that there is a prospect that average earnings can rise at that type of rate. Whether the wage price index rises at that rate, I don't know. There is quite a lot of compositional shift going on in our labour market and the wage price index doesn't capture that. There are kinds of bonuses and other payments that the standard measure of the wage price index doesn't capture. So I think it's possible and even probable that aggregate earnings per hour will grow at that rate. As I said in my introductory remarks, the wage price index, including bonuses, is currently already growing at 2 1/2 per cent. One of the things that's happening as the labour market is tightening up is that firms, rather than paying bigger wage increases right across the board, are finding particular workers that they want to give bigger bonuses to and are lifting their wages that way. You're now starting to see that in the wage price index. No disrespect to you-- Mr Thistlethwaite, I'm sorry, you don't have the call anymore. Your time-- but average workers don't get bonuses. Mr Thistlethwaite, I'm sorry, you don't-- They don't get bonuses. The majority of the workforce-- Mr Thistlethwaite, excuse me. The majority of the workforce don't get bonuses. Mr Thistlethwaite, you do not have the call. Your time has concluded. I'm sorry, Dr Lowe. I do now need to ask Mr Kelly to ask questions. Firstly, Dr Lowe, you mentioned the drought. What potential effect do you see that having on GDP? Has the Reserve Bank made any estimates of that? It's a very significant issue. We're watching it very carefully. The agricultural sector is a very important part of the economy. It accounts at the moment for between 12 and 15 per cent of our exports. Hundreds of thousands of people work in the rural sector, and the rural sector is a source of income for many regional communities. So it is a first-order issue. We're watching things carefully. At the last meeting of the Reserve Bank Board we saw rainfall maps for the country, and we haven't done that for a number of years. We're taking it very seriously. It's hard to come up with some specific numbers of the effect on the economy. We've looked back at the very serious drought around the turn of the century. In 2002 and 2003 farm output fell by around 25 per cent, and that knocked a full one percentage point off GDP growth. We saw large redundancies across the rural workforce. In that year food prices rose by 4 1/2 per cent, so it had first-order effects on the economy. The current drought is not as serious as that one, and we all certainly hope it won't be. Sorry, you are saying economywide the current drought is not as serious as the 2002 Yes, it's not. In Western Australia conditions are actually quite good at the moment. They've had a drought and it kind of broke last year. Yes, we seem to have good conditions in WA, but in some parts of New South Wales the drought would be as bad as it has ever been. Yes, that's right. Parts of Northern Queensland have had a reasonable amount of rain recently as well. So there are parts of the country that are doing okay, but, as I said, across New South Wales and into southern Queensland and Victoria it's a really big issue. We're trying to understand the implications of it. It looks at the moment that slaughter rates are increasing as farmers have to sell their livestock to markets, so we'll see in the short term some boost in our exports, but that's only a short-term boost. That will be offset to some degree because grain exports will be lower because production is lower and some grain has to be diverted to feed stock. There will be less income in rural communities so there will be less spending. We are trying to measure things as best we can. You talked about a hit to exports in the agricultural sector of about 15 per cent? No. At the moment rural exports account for up to 15 per cent of Australia's total exports, so it's a fair chunk of our exports. That will obviously be lower in the next couple of years. In the short term though it could be higher because we export more-- But over the next two or three years--depending on how long the drought goes-- I can't give you any specific numbers because it depends very much on the scenario you paint for rainfall. If things return to normal fairly soon, we could expect a rebound. But if it goes on like it did in the drought at the turn of the century then the effects on the economy are significant. You mentioned iron ore exports. You expect to see a decline, a softening, in the years to come? We are not expecting iron ore export volumes to fall from here. We have had a number of years of ramp-up in export volumes as some of the new production capacity came online. In the case of iron ore, that is more or less done. There is a little bit more to go because some of the sites seem to be able to get some productivity improvements. But essentially all of the expansion has happened. We hear of one or two projects that are on the drawing boards now or about to commence construction. That may expand production in further years. But, for the time being, we expect the volume of iron ore exports to remain broadly flat. So it is not that they are soft; it is just that they were expanding very quickly, by a very large percentage, to a level and we have more or less reached that level. That is also true for coal. There is still a little bit to go for LNG. So this year and next year we expect some boost to overall GDP growth because some of the LNG exports are still ramping up. By the time we get to 2020, we think that process will also have stabilised. In our statement on monetary policy that we put out in August, we had a box on some of the nonferrous metal exports that Australia is also quite an important producer of. They are a much smaller scale than coal and iron ore. They will be growing; we do expect quite strong growth in some of these minerals. There is a lot of interest in lithium at the moment, and a lot of expansion and exploration going on. But those are much smaller scale industries, so they won't add as much to exports growth and GDP growth as the two bulk commodities have done. What forecasts do you have for coal exports in the coming years? You are looking for volumes? Volumes and dollars. I am going to show a graph of that in my speech tonight. I don't have that graph right here. It is just that I have seen some headlines that coal will be our major export commodity. Metals and minerals, which is primarily iron ore, is running at about $18 billion to $20 billion a year in current dollars whereas coke coal and briquettes is more like $8 billion or $9 billion. Iron ore is bigger than coal in these numbers. This is resource export volumes. Is that just coking coal? That is coking coal and thermal coal. We mentioned in the statement on monetary policy that the main reason we have modestly upgraded our terms of trade forecast is that thermal coal prices have stayed a bit higher for a bit longer than we had previously anticipated. That is partly because there has been quite strong global demand, particularly in Asia. It has been a hot summer everywhere. That means people turn their air conditioners on, so they need more power. A lot of countries are trying to move to a less carbon intensive economy. That hasn't happened yet. So, at the moment, electricity demand means thermal coal demand. There have also been supply disruptions in Australia as well as in a couple of the other major producers--Russia and South Africa have also had some supply disruptions--and that has served to hold thermal coal prices above what we had previously been forecasting. We reflected that in our forecast this time round. On wages growth, there seems to be a bit of a disjoint between the public sector and the private sector. The public sector is growing a lot quicker than the private sector. Is there any explanation you can give for that trend? There is a difference but I wouldn't overstate the size of the difference. The private sector's WPI is two and the public is a bit higher than that. We're not talking huge differences. Within the public sector, there's quite different experiences. Here in Canberra, the increases are two or below and in some of the state government areas they are 2 1/2 to three. Some state governments, because their budgets are in reasonable state, are paying higher wages to nurses, teachers, police. Has that been a consistent trend over recent years? Yes, it has. That's right. For a number of years, public sector wages on average have been growing at least half a per cent faster than wages in the private sector; that's true. On the subject of the bank royal commission, are you concerned that there may be an overreaction or a swing of the pendulum too far the other way so that banks tighten up their loaning procedures, that loans for entrepreneurial projects that may have otherwise gone ahead might be stifled? Do you have any concern about an overreaction? It is certainly possible. At the moment, I don't think there's been an overreaction. There has been a reaction. But there probably needs to be some tightening up, and my hope is that we move back to something that is more sustainable than the previous set of arrangements. It's going to be particularly important what happens over the next six months with the recommendations that come from the royal commission. My understanding is that in round 7 of the hearings, the royal commission is going to turn its mind to what are the right policy responses and the recommendations are going to be critical. So you could imagine an overreaction coming out of this because the solution to the problems that we've currently seen, I don't think, is more and more regulation, but I can understand why that might be an outcome. There is a scenario where we regulate too much and stifle innovation in our financial system. Despite all the terrible stories, Australia has a very good financial system. From a safety and stability perspective, it's very strong. When I go overseas, people often ask me about the success of Australia's financial system. It's done a reasonable job of intermediating between savers and investors to have our economy grow for 27 years. So despite the terrible shortcomings, we have a productive and effective, safe and secure financial system and we need to keep that. In responding to the terrible examples of behaviour that we've seen, we need to strike a balance so the next six months and the recommendations from the commission are going to be critical there. You gave a speech, Dr Ellis, a week ago about infrastructure a few weeks ago. That's right. Does the Reserve Bank have any concerns about the efficiency of the infrastructure spending that's going on at the moment? When I look around our major cities, there's a lot of infrastructure and roadworks but the question is still out whether we are getting value for money on that expenditure. Thanks for the question. We aren't experts in project evaluation. Where Australia stands apart though is that we have an independent statutory authority staffed with experts on project evaluation and so, from a structural perspective, I would expect Australia to be less at risk from making poor project evaluation decisions than some other countries that don't have that kind of independent insight into project design. Infrastructure is a G20 priority this year and will be next year. It's something that's important for the ongoing economic development of the economy. The governor, in an even more recent speech, pointed out that we do have a strongly growing population so people need somewhere to live, and they need roads and railways to get them to places. Our cities are growing quite quickly, particularly Sydney and Melbourne, so there is a need to ensure that the infrastructure is developed in those cities to hold and service the population, particularly as we have quite physically spread out cities. Also in that speech, you commented on the investment in renewable energy, and you put a little chart up, I noticed, that shows something like $9 billion of finance for renewable energy in 2017. That seems to be contrary to what we're hearing about the need for certainty of investment in new electricity generation; there seems to be a massive amount of expenditure currently in new electricity generation. All I can say in that respect is that there's a sentence in that speech where I say that, according to the figures that we have available to us on the amount of private investment that's going into renewables at the moment or that's flagged for the current year, the amount that's going in is equivalent to the previous couple of years of annual investment in the entire electricity generation industry, whether that's generation or distribution and so forth. So it's in transition. On that, do you have some concerns that that may be artificially high number driven by I think one of the things that I've learnt over the last couple of years is just how much the relative price of renewable energy generation has dropped relative to that of carbon based electricity generation. I mentioned just before about high coal prices. Well, that's the alternative. So if that's getting more expensive to do and solar panels are getting cheaper to do-- On that, do you have an estimate of what the levelised cost of energy from rooftop solar panels is? I don't have that number in my head, but I'm pretty sure Infrastructure Australia does. Certainly, if you look at global costs of producing electricity through various means, renewable energy-- I'm running out of time. Is that a number you could perhaps find out for us? Yes, we can look. I know I've seen a graph of it, so we could definitely get it. Yes. It would be the levelised cost of rooftop solar panels, subsidised and unsubsidised. Thank you. Obviously you'll take that question on notice. If you could provide that further information, we'd be grateful. Welcome back to our hearing with the Reserve Bank of Australia. I'd now like to ask Ms Kearney to ask questions. I'd like to start by going back to my colleague Mr Kelly's questions and comments. He's not here, but I'll try to be as faithful as I can to his questions. He asked about the difference between the wage rises for those in the public sector and in the private sector. My view, and I think it's a strongly held view, and it's quite a proven view, is that organised workforces--those that have a high density of unionism and have some bargaining power--often have a wage premium, or pretty much always have a wage premium. I think that would probably answer Mr Kelly's question about the public sector. It does have high density and those areas you mentioned do have a bit of bargaining power. And there have been some reports recently, in and the , suggesting that one of the problems with wages growth is that we do have lower union density, and workers don't have the strong bargaining power and that the balance of power in the workplace has shifted in favour of employers, and we probably need to do a bit more to build up organised labour in Australia; that would help with the wages growth. Do you have any thoughts on that? I'm not sure that's the main thing going on. The reason I say that is that the phenomenon we are currently seeing in Australia we've seen in advanced economy after advanced economy over the past five or six years, despite having very different industrial relations systems. That, to me, suggests that there's something deeper going on. At the global level, one of the two big changes we've seen is increased technology, which is displacing jobs and changing the nature of the work. The other big change is increased global competition. Whether you're a worker or a firm, if you feel as though there's more competition you're going to have a lower price. I think that's affecting wage-setting dynamics in Australia and elsewhere, and that's leading to lower aggregate wage growth everywhere. The decline in bargaining power of labour because of changes in industrial relations is probably part of it, but I think there's this deeper thing that's going on. We all feel that there is more competition. Workers in Sydney, Melbourne and Canberra, who used to not worry about international competition, now have to worry about it, in many service occupations and in engineering. I even see examples of where large firms in Sydney have relocated their PAs to the Philippines, and they say they can do that because of technology: it's cheaper, and they can have the PA on a screen sitting outside their office, rather than have them physically outside the office. So, workers everywhere, because of changes in technology and globalisation, feel as though there's more competition, and somehow that affects the bargaining process. Do you think it also feeds into consumer confidence? We know that one of the indicators of confidence in the economy is labour mobility, and we're seeing less inclination of workers to leave their jobs, because they're not quite so secure that they're going to get another one, so they're staying where they are in perhaps a lower-paid job rather than moving on. You haven't really mentioned labour mobility. Do you think that's-- We've worked at that recently, because some data came out of the ABS last week. The rate of involuntary job separation--people basically having to leave their jobs when they didn't want to--is actually very low at the moment. In terms of our history, there are very few forced separations going on at the moment. I think that's because of the strength of the labour market. There are also relatively few people leaving jobs for voluntary reasons. Now, whether that's because they're too scared to or because they're actually happy in their current job, we don't really know. We just see that the rate of voluntary job turnover is low. I'm expecting that that trend starts turning around. The reason I say that is the number of job vacancies out there at the moment, relative to the size of the labour force, is the highest it's ever been. One imagines, in that environment, that workers start looking at alternative jobs, and firms actually might even pay them more to get them. But it is a puzzle why, in such a tight labour market, workers are not jumping firms in the way that they used to. Yes, so there are lots of indicators that aren't working the way they normally do. One of the messages I'm getting from you today is that the world isn't really operating as it quite should. Do you think that, because of that, it's time to readjust how we think about this? Is it time to change any of our indicators, like what actually is a marker of full employment? Do you ever think about changing the inflation target because, over time, the world isn't quite working as it should? Have you had those thoughts? Things are operating differently, but I don't think they are undermining the basic principles that we're using. Where labour markets are tight, wages still do move, so that basic principle of economics of supply and demand still works. We see examples of that in local labour markets; it's just taking time for that to work through the rest of the economy. In terms of the inflation target, if I can answer that--because there's been a reasonable amount of commentary in the press recently about the level of the inflation target--in the academic literature at the moment there's a debate that inflation targets should be raised, not lowered, that they should be maybe three or four rather than two. The academic argument, which I think has some merit, is that if you have a higher average inflation rate then you will have on average higher interest rates. That might not sound good; but if you have higher average interest rates then you have more scope to reduce them in a downturn. If you have a very low average rate of inflation or have low average interest rates, you therefore have limited capability to lower interest rates in a downturn. So some people say: have a higher average to give you greater capability to lower-- to leverage it. I'm not persuaded by that argument, particularly in the Australian context. We've had plenty of scope to lower interest rates to stimulate the economy. We haven't had to go to zero. We haven't had to do the unconventional things that other central banks have done. I think where we're placed at the moment is the right place to be. Another consideration here is, if we were to change the inflation target now, after having had it for more than 25 years and having it work quite well, people would legitimately wonder whether we might change it again in the future. If, because inflation is a bit lower, we say we'll lower the target, what happens when inflation is a bit high? We say, 'Oh well, it doesn't really matter. We don't want to slow the economy to get inflation down. We'll just live with the higher rate of inflation.' If people come to worry about that then we lose the benefit of anchored inflation expectations. People are unsure about the future rate of inflation. Then there's a premium in interest rates, because people have to get compensated for that uncertainty. I can't see a strong argument for changing the inflation target. Remember, as well, at the moment the inflation rate is 2.1 per cent. That's between two and three. We think over the next two or three years it will average between two and three and will deliver you, the community, an average rate of inflation of two point something. I think that's the right place to be, and I don't see the changes in the labour market as invalidating any of these arguments. Thank you for that. With low wages growth--and I know we're all frustrated by it, because we would all like to see it rise for all the reasons that you outlined--it has been suggested to us that any consumption growth has meant a dipping into savings. Are you seeing that and are you worried about that? No. I mean, the saving rate is still positive. People are still saving a fair share of their incomes. We partly see this in the build-up of balances in offset accounts that many people have against their mortgages. The rate of saving, though, is a bit lower than it was on the average of the last four or five years. It's lower, but people are still saving. It's not like people are running down their stock of wealth to support consumption. I think it suggests that people have some reasonable confidence about the future, which is good. They're prepared to spend a bit more today, because they see the economy picking up, and this is really what we want to happen. I'm not worried that people are running down their savings to support current consumption. Last week you indicated that the only thing that would trigger interest rate cuts would be a massive global shock. Do you think there's anything domestically that would trigger a cut? We try and think through scenarios, obviously, about what the future interest-rate profile looks like. We try to think about what would have to happen for us to lower interest rates. As I said the other day, the most likely thing that could lead to a cut in interest rates is something going wrong at the global level, particularly something going wrong in China--slowing in China reverberating right through East Asia; commodity prices being lower; confidence in financial markets being shaken; and the growth outlook in Australia deteriorating. That's the most likely scenario that would lead to lower interest rates in Australia. I think it has a low probability, but it's possible. It is much harder to think of what domestic shocks would cause us to lower interest rates, for growth to fall away and for the outlook for inflation to fall away. I struggle to think what those domestic-sourced shocks would be. The most likely, although still with a low probability, is the housing market--bigger falls there, that being a shock to confidence and people stopping spending as a result. That's possible but unlikely. As I said in my introductory remarks, if we were ever to have an adjustment in the housing market--and we do need one--the current environment is basically as good an environment as you could have for an adjustment in the housing market. The global economy is doing well. There are a lot of vacancies. The labour market is pretty firm. The unemployment rate is coming down. Interest rates are low. The housing construction cycle has probably peaked, so it's not like we're continuing to build too many houses. It's a fairly benign environment to have what I think is a needed adjustment. Dr Lowe, towards the end of your opening remarks you talked about stability, certainty and confidence, and you said that you want the RBA and its decisions to be a source of stability and confidence. This is a critical point, I believe, after a decade of volatility and unpredictability, including that emanating from this place since around the GFC. One of the most important things that the government and its agencies can do is think first about stability and confidence. People, households and small businesses need to be able to bank on a medium-term plan to make decisions and foster those animal spirits that we want to see in investments, spending, risk-taking and entrepreneurship. You said in your opening statement that the Australian economy is moving in the right direction. You said that before us is a pretty good set of numbers, and of course we want them to be even better. When you think about that key question around stability and confidence, how do we know that stability and confidence is growing? What measures, what data do you look at as proxies for that? In terms of the Reserve Bank's role, keeping interest rates constant or steady over a fairly long period of time and communicating that it's likely to stay that way--I think that does give people a sense of confidence that we're moving in the right direction and that we don't really have to worry about volatility and short-term interest rates for a while. It gives people confidence that we're going to keep on a steady path and communicate well in advance. We try and be predictable, logical, rational and reassuring. That's the role that I hope we're playing for the community--giving people confidence that things will gradually get better. I guess I'm thinking more about outputs than inputs? How to measure confidence? We track a lot of business surveys, and, at the moment, confidence is quite high. When you ask businesses about current conditions, they're actually reporting that conditions are above average, and it's right across the country, not just in New South Wales and Victoria. Business conditions have come off a little bit in the last couple of months, but they're at a high level. There are regular monthly, even weekly, surveys of consumers, and they show consumer confidence at a bit above average as well. So the hard metrics we can get--where firms and individuals are asked about how they feel, they are actually feeling okay at the moment. And they should be: there have been a lot of jobs generated, things are getting better, the economy is going above trend. There are a lot of positive things going on and people should be feeling positive about the future. In response to a question you were asked earlier about household finances you said that it was more of an income story--I think those were the words you used. And you might have expanded a little bit about that on one of the questions you were just asked about the household savings rate. Given your answers to those questions, wouldn't it be most accurate to say that this is a disposable income story? Wage growth is certainly one input but another input would be, say, the amount of tax paid. I guess I am looking for confirmation that personal income tax cuts like those that have just been passed by this parliament do assist individuals and households with their after-tax purchasing decisions and that income strength story. That will unambiguously help. People will have more money in their bank accounts as a result of the tax cuts, and some of that will be spent. Some of it will help repair the debt situation that some households have, but some of it will be spent. And that will stimulate the economy and help create jobs. So I agree 100 per cent with you. It still leaves the issue that nominal income growth of two per cent is problematic. My board is going to have trouble delivering for you an average rate of inflation of 2 1/2 per cent if wages are only growing at two per cent. We are still getting reasonable labour productivity growth in this country; it would be better if we got more, but we are getting reasonable labour productivity growth. Unit labour costs--nominal wage growth less productivity growth--are quite low and have been so for a number of years. The current growth of unit labour costs is unlikely to be consistent with 2 1/2 per cent inflation, so we do need a pick-up in nominal income growth as well. Dr Debelle, in answer to an earlier question, you talked a little bit about how the CPI measures work, how they aggregate different baskets of goods and services--some of which are going up, some of which are going down and some of which are stable. Are you confident that the measures of CPI, such as they are, do represent a good and accurate reflection of what people are actually spending their money on? Are you satisfied that they keep up-to-date with consumer and household spending trends, such as the trend towards more spending on services? Yes. But the other point to note--and it is also relevant to the question Mr Thistlethwaite asked earlier--is that the ABS, which obviously does all of this, is updating that basket more frequently than it did in the past, so that it is more a reflection of what is going on now. The other point is they also publish cost-of-living indices, which are slightly different from the CPI in conception. But they publish it for different groups. What this partly gets to is that some people say: 'That's not what I spend my money on.' They look at it across pensioners, across people in different parts of the income distribution--or whether you are a home owner or a renter. So they look at cost-of-living differences across those different groups. The bottom line is that right at the moment--but historically too--they are not telling you anything much different. So the answer is yes, I do think the ABS does a pretty good job of getting that basket about right. As I said, I think the other thing which goes on is that people are well aware of the stuff they are buying every week and what is happening there. They are obviously very well aware of their utility bills and what is happening with those. There are probably some other price movements-- the stuff they spend money on less frequently individually--which may be a bit less. I have a follow-up question in relation to utility bills. In your statement of monetary policy just released I was really interested to read some comments towards the end, under the heading 'Administered price inflation has slowed'. It says that competition in the energy sector and the recent declines in wholesale prices have started to put downward pressure on utility bills, which is exactly what the government's been intending with its actions. I'm reading here--and this is the quote: Can I get you to expand a little on that--where are we talking; what are we expecting? Queensland was going to be my answer--I'm just checking. Sort of flat to down in New South Wales and more noticeably down in Queensland. We're expecting there may be some price revisions also in Victoria in the March quarter--the timing for standing offer electricity contracts in Victoria is different from those other two states. First of January is when they offer-- Precisely, so it hits the March quarter. In addition to those cuts that have been announced for standing offers, increasingly, households are shopping around and the discounts that are available, the market offers, are getting bigger. More households are taking advantage of those market offers, and so, consequently, that's being reflected in the prices in the CPI. The ABS does take the market offers into account, not just the standing offers, and so that's also one of the factors that we've integrated into our September quarter forecast. Great; that's really good. We hear a bit of anecdotal evidence, so it's good to hear the authorities are also seeing that in their numbers. Can I change topic completely--just one last series of questions about the new payments platform. I think it's fair to say that the government hopes--and, indeed, probably lots of people in the community hope--that the new payments platform can help stimulate more competition in the banking sector to help encourage customer switching and provide innovative new systems to drive better offers and services. There were some comments in your opening remarks, Dr Lowe, about some of the major banks being slow to make the new system available to their customers. What reasons do you ascribe to their slowness? Is it okay if I hand this to Michele? The main reason for the slowness--at least for a couple of them--is simply that their build turned out to be more complicated than they thought, and they had problems with service providers. They had many, many years to get on top of this and so to discover, as we were going live, that they weren't ready, was a bit disappointing really. Having said that, a couple of the majors who have not been on board to date are coming online, and we're starting to see volumes rise. The key to this is that, because it's a network, unless you've got everyone on board, it's really not going to get used because I'm not really going to be interested in joining it if I can't pay someone who banks with someone else. It's really critical that we have everyone on board and, in the next month or so, we will have all the majors on board and I think that will be a big stimulus. Can I push you a little more on that response. Disappointment is one thing. Do you believe the bona fides of those explanations that were given about the complex build system? If the small banks, which are relatively unresourced by comparison, can be so ready and willing to participate from the opening, it surprises me that the most resourced banks would be the slowest. I put to you: there are claims that the major banks have been deliberately slow to roll out the new payments platform because they're afraid their customers will leave them when they are able to switch more easily or more easily become aware of new offers and services out there in the market. I think there might be two separate questions that we're thinking about here. The first is the potential impact of open banking, which I think is a separate question. On the issue of: do I believe the bona fides of the banks? Yes, I do believe them and I do believe they have been running very fast, because the banks that haven't actually implemented yet are feeling the pressure from their customers and they have been trying very hard to catch up. There was in fact a view that, if two major banks weren't ready to go, then no-one should go. The fact that the system launched without two major banks was a big signal to the banks: 'Pull your socks up because you've got to get on board with this, and we're not waiting for you.' I think that's a very good message. If we're always waiting for the slowest participant, we'll be waiting for a long time. I think it's really important that that message gets through. The Payments System Board has been very forthright in letting the banks know that they've not been happy about this. The Reserve Bank has spoken to the banks themselves, and we've been reassuring ourselves that they are not standing down their teams and that they are continuing to work on it. They just need that extra push to get over the line, and they will get over the line in the next month or so. Financial Regulators have a bit more transparency about their deliberations, similar to what occurs with the Reserve Bank Board and your publication of minutes. If there were more transparency and there were publications of deliberations of the Council of Financial Regulators, is that something that would be a positive in your view? There is already quite a lot of transparency. In the bank's six-monthly we have quite a long discussion of issues that the council has been grappling with over the previous six months, and that discussion has been beefed up over recent times. At the last council meeting, we did discuss the possibility of issuing a post-meeting statement, and I'm inclined to go in that direction. We have to work out how to do that. It would be inappropriate to publish minutes of that meeting, because sometimes we're discussing very confidential market-sensitive information and sometimes even about individual institutions, so I think it would be inappropriate to publish minutes. But I do think it would be appropriate for us to publish a statement that outlines the general issues that the council has been grappling with. I think it would help the community understand what we're working on, and hopefully we'll do this fairly soon. In much the same way, the Payments System Board issues a statement after each meeting which tells the community the issues we've been grappling with. I think the same model could be used for the Council of Financial Regulators. I look forward to reading the first one. In your speech last week to the Anika Foundation, you indicated that the RBA had considered other policies, apart from interest rates, to boost the economy. Can you elaborate on that a little bit? I'm not exactly sure what you're referring to. I think in the question-and-answer session you were asked about other policies, and you said that you'd considered other policies at the board level. Maybe that was in the context of if we had a very bad shock and the global outlook deteriorated and we had to lower interest rates and we lowered them down to zero. At times in other countries they've moved below zero. But, if we reached whatever the lower bound was, we have considered what other things we could do. We've looked very much in recent years at the experience of other countries, where the central banks have bought assets from the private sector, including government securities and, in some other countries, other assets as well. We've looked at the terms and conditions under which we could provide funding to the banking sector so that they could continue to provide the credit that the real economy needs. I think the probability of us having to do these things is low, but, as part of our contingency planning, we've studied the experience of other countries and we have a sense of what works and what doesn't work so that we're prepared in case we find ourselves there. In that speech you went into some detail about the features of population growth in Australia over recent years. I got the sense that you were making the point that population growth has had a positive effect on the economic development of Australia. Do you want to elaborate on that a little bit? Population growth has had a significant effect on our economy. It's having an effect on our society as well. I'm not advocating particularly for strong population growth or weak population growth. My job is to try to understand the effects of population growth on the economy. It's a first-order variable that's affected how the Australian economy performs. What I was trying to do was to outline for the community some of those effects. They would include stronger economic growth. We've had 27 years without a recession. There are a lot reasons for that, but one of those reasons is that the population has been growing, on average, 1 1/2 per cent a year. If our population had been growing at 0.2 per cent a year, as many other advanced economies have, we would have had less growth over that period. It's one of the first-order considerations in how the Australian economy has grown over recent times. The fact that we've had a lot of population growth has added to the country's human capital. Most of the migrants who come to Australia come because they have jobs here and they have skills we need or they're studying at Australian universities. One-sixth of those who come to study at our universities tend to stay afterwards and contribute to our society. That has helped our human capital. It's changed our demographics quite a lot. We are now one of the youngest of the advanced economies and we're going to stay one of the youngest countries for the next 20 years because of the immigrants. The median age of Australians is 37. The median age of new immigrants is somewhere between 20 and 25. We've been doing this for a decade and it's affecting the rate at which our country's ageing. We used to be ageing in the middle of the pack with other countries. The ageing over the next 20 years is going to be noticeably less than most other advanced economies. In 20 or 30 years, there'll be an echo effect of this. For the next 20 or 30 years, we're ageing quite slowly and that will help government finances. It helps the government budget. They're some of the effects that the strong immigration has had. I also talked about the pressure that it's put on infrastructure, on housing. It took a long time for housing construction to adjust to stronger population growth. In fact, it took the better part of a decade. Population growth picked up and the rate at which we were building houses or dwellings didn't pick up. That speaks to the problems in the planning process, probably at the local and the state level. That pushed up housing prices, I'm sure. But, for a number of years, we have been adding to the dwelling stock at quite a fast rate, and that's one reason that the housing price dynamics have changed in the country for the better. Another area where we were slow was infrastructure spending. As more and more people came into our cities, we didn't build the public and private transportation networks to move those people around efficiently. That did hurt our economy. It's one of the factors that has weighed on productivity. It made people's lives less pleasant and less productive. We're now starting to address that. It will take time, though. It has put pressure on our infrastructure, and I can understand why some in the community are unhappy about that. The effects are multilayered. What I was trying to do was set out some of those effects for the community. I'm not advocating one particular view or another; I just set the facts out. You also made the point that the birth rate had remained quite steady over that period and that there'd been a pick-up in immigration to cater for things like the mining boom and the demand for additional labour. What would be the effect of a significant reduction in immigration in the short term? Would that have an effect on economic growth? In a sense, mechanically it does. You can decompose the rate of growth of GDP into two components. The first is the rate of growth of the population or the workforce and the second is the rate of growth of productivity. If the population were to only grow at 0.7 per cent a year rather than 1.7 per cent, that would have a noticeable effect on our average growth rate. Some people would say, 'Does that really matter?' Arguably, what really matters is growth in income per capita. My own view is that the population has been growing strongly and the economy growing strongly has given people confidence. The pie is going to be bigger tomorrow. That gives you confidence to invest. I think another benefit we've got from immigration is that our society is more dynamic and more diverse, and that diversity is positive from the long-term perspective. In the most recent census, nearly 50 per cent of us either were born overseas or have one parent who was born overseas. So half the population have some direct connection to families and businesses living in other countries, and often they speak another language as well. I see that as one of Australia's huge assets. That diversity, those business connections and those overseas connections that we have are one of the country's great assets, and a slower rate of population growth over time would not build on that asset at the rate that we've been building on it. Thank you. The final question I have relates to the story on the front page of the today about the evidence that AMP gave in the royal commission yesterday, and it's about members on particular products in their super fund and about AMP being slow to transfer them over to products that cost less. Under questioning about that, Rick Allert, representing AMP, when he was asked why they weren't transferred over, said that they couldn't transfer them. This was the specific question: Mr Allert's response was 'no'. Is that true? Is it true that they can't ask them or that they didn't want to ask them? I don't know enough about the specifics to comment on them, but trustees have a fundamental duty to act in the best interests of members, not in their owner's interests and not in the best interests of related parties. Regrettably, we've seen too many cases where the trustees do not seem to have been acting in the best interests of the members. As to whether this is a case like that, I don't know enough about the detail. It's really problematic because it diminishes confidence in the system. Trustees actually need to do their job and, as I said in response to an earlier question, we're finding through the royal commission that entities inside financial institutions are having great trouble dealing with conflicts of interest. This is just another example of that. One of the things that need to come out of this whole process is that people within financial institutions need to take the conflict of interest issue incredibly seriously. It needs to be top of mind. It needs to be part of the culture of the financial institution: 'We've got this underlying fiduciary interest to our customers to provide service, and that needs to be top of mind.' It seems there are too many cases where that has not been top of mind. Top of mind has been maximising the financial return to the business. I think that's very problematic. The sunshine and the sunlight that the Royal Commission is bringing, I think, will lead to a change in culture in financial institutions, and I certainly hope so. Dr Lowe, just in finishing, I've just got a couple of questions for you. You've spoken earlier about global trade uncertainty. Can I just ask you: what are the implications for emerging economies as well as important is that relationship in light of what is happening at the moment globally? The relationship with the US is obviously incredibly important. The US and China are the two biggest economies in the world, so what happens in each of them is very important to global trade flows but also important to global financial markets. On the investment front, Australia has a very strong relationship with the US. That's very important. The US is a source of capital for Australia. The Australian banks obviously raise quite a lot of their funding in New York, and the US provides expertise, know-how and management technology to Australian businesses, so it's a very important relationship. We all have a very strong interest in China and the US working out their difficulties, and I think that requires movement on both sides. In China, there is a legitimate issue about the protection of intellectual property. The Chinese authorities have acknowledged that. They're moving, and the Americans are trying to push them more quickly. I think it's in the interests of both China and the United States for that issue to be resolved and for the trade tensions not to escalate. If they did escalate, the ramifications under some scenarios, as we talked about before, are significant. Slower growth in China would ripple right through the production chain in Asia. The US is talking about placing 25 per cent tariffs on imports of many Chinese goods. That obviously makes Chinese production into the US less competitive. There'll be less of that, and that will ripple right through the Asian supply chain. In some scenarios, the effects of that could be very large. So we have a strong interest in them both working that out. What can Australia do? The truth is, not very much, but we can be a loud voice for open, free, fair trade. In the international forums that I go to, that's one of the constructive roles that Australia can play: to speak up for the relatively free flow of goods, people and capital and to talk about how that makes us more prosperous and increases our living standards. And I think that has been one of the hallmarks of our government. We need countries to stand up in this environment and make those points. Australia, Canada and New Zealand are three countries that are ideally placed to do that. The three of us have a very positive story to tell about the benefits of openness. We are three very prosperous countries where people enjoy high living standards because of openness. So we have an important story to tell, and, in my own view, we should tell it. When I go to international meetings, I take every opportunity to tell that. Dr Lowe, I want to move to infrastructure spending. You've spoken about the importance of infrastructure and also the role that infrastructure investment by governments, including our government, has played in jobs growth. I come from a large regional area--part of Geelong, the Surf Coast and the Bellarine--and we're growing at a very fast rate in the Geelong region, above that of Melbourne. The population growth rate is around 2.7 per cent. In the last couple of years, I have really been pulling my hair out that we haven't seen enough infrastructure investment by the state in our region and other parts of regional Victoria, despite the best efforts of the Commonwealth to deliver very substantial investment in infrastructure spending, such as better roads and rail. As it's generally state governments which make these decisions and manage the infrastructure spend, what observations do you make about the importance of governments being ahead of the pack when it comes to infrastructure spending? Perhaps I can make two observations. One is linking back to the issue of population growth. Over five years, our population has gone up nine per cent. That's a lot of extra people. And, in your part of the country, it's growing more quickly than that. That area between Melbourne and Geelong has been growing very well. When the population's growing like that, we need to invest. If we don't, people's lives are not as rich as they otherwise could be. Our businesses are less productive, and we sit in traffic. You know the story. So it's incredibly important we find a way of doing that. For a number of years, I was frustrated that this investment was not taking place. From around 2013-14, both Glenn Stevens and I started talking publicly about it because we could see the pressures building. We could also see governments were very reluctant to borrow to build infrastructure, and we were trying to make it a bit easier to change the climate to allow governments to borrow to build infrastructure, hopefully with the support of the private sector. That's one observation. The second observation, which really touches on a point that Mr Kelly made before, is the importance of the governance of infrastructure. I still don't think we've got that right. One of the reasons the public in the past have not wanted governments to borrow to build infrastructure is they were worried the governments would waste the money. If we're honest, we've seen examples of where the project selection wasn't all that it should have been to maximise productivity and welfare, the construction risk has not been managed as effectively as it could have been--we've got a good example of that in New South Wales at the moment; I live in Randwick, so I'm living with the tram continuously--and the pricing and use of the infrastructure has often not been what it would have to have been to be the most efficient service. If we don't get the governance right then the public becomes distrustful of the government and the likelihood that the public will support large-scale infrastructure spending by the government is diminished. So, for a number of years, I've been repeating the point about the importance of devoting our collective minds to getting the governance of infrastructure investment right--the project selection, construction costs, management, the pricing and the risk sharing between the public and private sector. I think if we can do that then the public will have more confidence that when our money is ultimately used--and it's ultimately the taxpayers' money, often--we'll get value for money out of it. In the absence of being able to do that, there's this underlying scepticism in parts of the community, which I think is insidious. It's incredibly important, and the governance is important as well. That's the end of my lecture! Dr Lowe, I want to reflect a little bit on the circumstances in my own region. The Commonwealth government has announced and committed $150 million, and $100 million of that was announced more than a year ago in the budget. We've seen this also with airport rail, where our government announced $5 billion towards the construction of an airport rail link between the Melbourne CBD and Tullamarine airport. There's enormous frustration that we're having those major commitments announced and yet they're either not getting matching funding from the state or they're having enormous delays. Just today there was an announcement by the state of some matching funding for a project in Geelong, the Geelong rail duplication project. Getting that funding took two or three years, and that $150 million was just sitting on the table and not being spent, even though our government had committed it. As you can probably tell, I'm very frustrated about the failure, certainly of the Victoria government, to invest in infrastructure at a sufficient rate in the regions. I ask you to perhaps reflect further on that: how can we speed up the rate of investment by state governments? I don't know the answer to that, but I can understand your frustration. At a very high level, it comes back to the governance: how do we make the decisions about which project to do, get the money together, spend the money and spend it efficiently? That's the issue that you are grappling with. In other parts of the country, they are grappling with different pieces of that general picture. It's not my area of expertise--how to do governance of infrastructure--but I think it's in our collective interest to find a better way of doing it. The world faces lots of problems, doesn't it? This is not one of the biggest problems. Getting good governance around infrastructure should be something that, if we put our minds to it, we should be able to do. But it requires political commitment and very practical decisions to be made. I share your frustration, but it's not my core area of expertise. In summing up, can I perhaps put it this way: this has been a pretty good report card for the Australian economy today. Well, I would agree with that. As I said, growth of three per cent, inflation around two per cent and unemployment at 5.3 per cent--in the broad sweep of our history, it's a pretty decent outcome. I hope we can do better than that; I hope that when we meet next time it will be a bit better than that. But things are going well: the global economy is doing well and firms want to hire workers. Now we just need them to pay them a bit more! Dr Lowe, thank you very much, and thank you to all members of the Reserve Bank of Australia for appearing before our hearing today--we very much appreciate it. We look forward to seeing you next time. I now declare this public hearing closed. Resolved that these proceedings be published.

r180821a_BOA

australia

Remarks at the Breakfast event to launch ASIC's National Financial Capability Strategy 2018

lowe

I am very pleased to be here to participate in the launch of the National Financial Capability Strategy. All of us have to make choices about money every day. Do I spend, or save? If I spend, what do I buy and how do I pay for it? If I save, where should I invest; how much risk should I take? If I borrow, how much should I borrow and how quickly should I pay it back? In many ways these choices have become more complicated over time. We have more options than ever before - which is good - but these options can be bewildering. It is fair to say that many people find it hard to navigate their way through the myriad of possibilities out there. But we all do need to find a way to navigate through these choices. We all need to plan. For our own sake, and that of our families, we need to do this as well as we can. If we go in the wrong direction, it can have a major effect on our families and our welfare, perhaps for years. So it is really important we make well-informed financial decisions. And, we can all do with a bit of help to make sure we are going in the right direction. The strategy that is being launched today can provide that help by providing education, information and support for Australians as they manage and make decisions about their money, and plan and save for the future. I would like to congratulate the government and ASIC for the work they have done in putting this strategy together. At the Reserve Bank of Australia, we are also trying to play our part. As Australia's central bank, the RBA has a very strong interest in people being in control of their financial lives and making wellinformed choices. I say this from the perspective of the individual and the economy as a whole. At the individual level, each of us will be better placed in our lives if we make good financial choices. And at the collective level, the financial choices that the 25 million of us make about how much we spend, save and borrow can have a major bearing on the health of the overall economy. If enough of us make risky or bad choices, the whole community can eventually feel the effects. So it matters a lot. One of the things the RBA seeks to do is to provide balanced analysis about the economy and the financial system and where the risks lie. We hope that this helps people make informed decisions about their finances. We also have a public education program that is aligned with the school curriculum. As part of this, we are devoting significant resources to helping support the teaching of economics and finance in our schools. People can also visit the Reserve Bank's Museum, where they can learn about Australia's banknotes and economics more generally. The Bank has also been a partner in the recent upgrading of Australia's payment system, which is allowing you to make more timely payments. For many Australians, their biggest single financial decision is whether or not to borrow to buy a home. It is an important decision, one that can have a major bearing on your finances for years to come. I am not allowed to give financial advice, but I would like to make four brief points that we should all keep in mind. The first is that interest rates go up and down. It is nearly eight years since the previous increase in interest rates by the RBA. This means that many borrowers have never experienced a rise in official interest rates. They have mostly experienced lower rates. At some point this will change. Over recent times the Australian economy has been improving. This is good news. If we continue on this current improving track, as we expect we will, it is likely that the next move in official interest rates will be up, not down. This will not be welcomed by some, but it would be a sign that things are returning to normal. My advice here is to make sure your finances can withstand a lift in interest rates. The second point is that housing prices don't always go up; like interest rates, they go up and down. We are seeing an example of this in Sydney and Melbourne at the moment. And most of our cities have seen falls in housing prices at some point over the past decade. While I would expect housing prices to trend higher over time as our incomes increase, there is no guarantee that your home will be worth more tomorrow than it is today. So plan accordingly. The third point is closely related. Make sure you build adequate financial buffers into your plans. Things don't always turn out as we expect. So for most of us, having a buffer against the unexpected makes a lot of sense. We all need to prepare for that rainy day. It rarely makes sense to take all the credit that you are offered, whether on a credit card or when you apply for a loan. Many Australians with mortgages find the best way of building buffers is to put any spare money into their offset account. This makes a lot of sense. My fourth and final point is to shop around and don't be shy to ask for a better deal; whether for your mortgage, your electricity contract or your phone plan. There are very good deals out there if you look. We can all play a role in making our markets more competitive by being smart and informed in our choices. Again, I am pleased to be here at the launch of this important strategy. Congratulations to those who have worked so hard to put it together. Thank you.

r180904a_BOA

australia

Remarks at Reserve Bank Board Dinner with the Perth Community

lowe

Good evening. On behalf of the Reserve Bank Board I would like to warmly welcome you to this community dinner. It is very good to be in Perth again. The Board met this morning at our office on St Georges Terrace. This dinner is an opportunity for us to hear directly from you about how things are going in Western Australia. So thank you for joining us. As you have probably already heard, the Board left the cash rate unchanged at 1.5 per cent at its meeting this morning. I doubt that this decision surprised anybody. The cash rate has been at 1.5 per cent for more than two years now and the Board expects it to remain there for a while yet. Lest you think that keeping interest rates unchanged for an extended period means that life at the Reserve Bank of Australia must be very quiet, we are always closely tracking domestic and international developments and we have other important responsibilities that don't attract the same spotlight as our monthly interest rate decisions. The RBA is responsible for the issuing of Australia's banknotes. We are currently undertaking a major upgrade of our notes to protect against counterfeiters. All up, there are 1.6 billion individual banknotes on issue - that's an average of around 65 notes for each of the 25 million people in Australia. Despite the growth of tap-and-go and other forms of electronic payments, the value of notes on issue as a share of GDP is the highest in more than five decades. This highlights the continued importance of banknotes as a store of value as well as a payment mechanism. So the upgrade of the notes is a major logistical exercise. The RBA is also the banker for the Australian Government. We operate the government's core accounts and we are the transactional banker for many government departments. So if you get a Medicare or tax refund, it comes from the government's accounts at the RBA. We operate the core of Australia's payments system. The way that money moves from one bank to another is through the accounts that financial institutions hold at the RBA. In addition, we operate a key part of the infrastructure supporting Australia's new payments system, generally referred to as 'the NPP'. This system allows you to move money between bank accounts in real time on a 24/7 basis using an easily remembered 'PayID', such as a mobile number, to address the payment. BSBs and account numbers can still be used, but if you have not already done so, I encourage you to contact your bank to register a PayID, which makes it easier to use the new system. The RBA also regulates key parts of Australia's financial market infrastructure, including the central counterparties at the ASX. In addition, we have broad responsibilities to promote competition, efficiency and stability in Australia's payments system. As a result of decisions of the Bank's Payments System Board there have been significant changes to the ATM and debit and credit card systems over recent times. The RBA also operates in financial markets every day to ensure the system as a whole has adequate liquidity. We also have a broad responsibility for financial stability, including acting as the lender of last resort in a financial crisis to provide liquidity to solvent institutions. Finally, we manage Australia's foreign exchange reserves. These are all important functions that we carry out in the public interest. They are all critical to the functioning of our successful modern economy and financial system. I can assure you, we take these responsibilities very seriously. This means that even when interest rates are being held steady, we have a lot of things on our plate. But it is interest rates that mainly keep us in the news. At its meeting this morning, the Board's assessment was that the Australian economy is moving in the right direction. Over the past year, GDP increased by 3.1 per cent and inflation was around 2 per cent. The unemployment rate is currently 5.3 per cent, which is the lowest it has been in nearly six years. In the broad sweep of our history, these are a pretty positive set of numbers. We will get another reading on the pulse of the economy tomorrow with the release of the June quarter national accounts. We are expecting that this will confirm that over the first half of 2018, the economy expanded at a faster than trend pace, making inroads into spare capacity. Our central scenario is that economic growth this year and next will be a bit above 3 per cent, which should see the unemployment rate come down further. So things are moving in the right direction. One of the factors helping us is that the global economy is expanding quite strongly. Many of the advanced economies are growing quite strongly and unemployment rates in a number of them are at multi-decade lows. The Chinese economy is also growing solidly, although the pace of growth has slowed, partly as a result of efforts to put the financial sector on a more sustainable footing. The United States is most advanced in the process of monetary policy normalisation. This has led to a broad-based appreciation of the US dollar this year. As a consequence, the Australian dollar has depreciated. If sustained, this could be expected to improve the outlook for both inflation and growth. Notwithstanding the positive global picture, there are a number of international uncertainties that we are monitoring closely. One is the possibility of an escalation in the current trade disputes. If this were to happen, it would materially affect trade flows and investment plans around the world. As a country that has benefited greatly from an open rules-based international system, Australia has a strong interest in this not happening. Another uncertainty we are watching closely is the possibility of a material lift in inflation in the United States. The United States is experiencing a large fiscal stimulus at a time when the economy is at full employment and is growing quickly. This is an unusual combination to say the very least. Past experience suggests that it could lead to inflation increasing significantly. Financial markets are, however, heavily discounting this possibility, which means that if it did take place it would come as quite a surprise, with repercussions for markets and the real economy. We are also monitoring carefully the financial and economic problems in a number of emerging market economies with structural or institutional weaknesses, including Turkey, Brazil and Argentina. If these problems were to escalate, they could put strains on parts of the global financial system. So these are some of the international issues we are keeping an eye on at the moment. Domestically, the Board is closely monitoring housing markets across the country and trends in housing finance. Housing credit growth has slowed, which, from a medium-term perspective, is a positive development. Our assessment is that this slowing largely reflects reduced demand for credit by investors, although there has been some tightening in the supply of credit as well. With housing prices falling in a number of cities, largely due to a shift in the underlying fundamentals, investors no longer find it as attractive to invest in residential property as they once did. This is a normal part of the cycle. While credit standards have been tightened, mortgage credit remains readily available. I would note that some banks have increased their mortgage rates recently in response to somewhat higher interest rates in short-term wholesale markets. A much less remarked upon fact is that the average mortgage rate paid in Australia has fallen since August last year, as lenders have increased their discounts. I encourage anyone with a mortgage to shop around: there are some very good offerings out there. We can all play a role in promoting strong competition in our financial sector by shopping around and taking advantage of the good deals that are out there. Another set of issues that the Board continues to pay close attention to is the outlook for wages growth and inflation. Wages growth has been quite low recently. For some time my view has been that some increase in aggregate wages growth would be a welcome development, especially if it is backed by stronger productivity growth. Many business people that I speak to recognise that a pickup in overall wages growth would be a positive development from a macro perspective, although not from the perspective of their individual business. So there is a tension there. Our expectation is that wages growth will pick up from here, but the pick-up is likely to be only gradual. Firms are currently reporting a record number of job vacancies and increasingly telling us that it is hard to find workers with the right skills. One way of dealing with this increasing tightness in the labour market is, of course, to lift wages. We expect that as this happens, inflation will also lift towards the midpoint of the medium-term inflation target, although this, too, is likely to be a gradual process. Against this background, this morning the Board again decided to keep the cash rate steady at 1.5 per cent. We are seeking to be a source of stability and confidence, as further progress is made towards full employment and having inflation return to around the midpoint of the target range. As that progress is made, you could expect the next move in interest rates to be up, not down. This would be a sign that overall economic conditions are returning to normal and would take place against the backdrop of stronger growth in household income. But any move still seems some way off, given the gradual nature of the progress expected on unemployment and inflation. At this morning's meeting, as well as a thorough review of the international and Australian economies, we had a detailed discussion on the Western Australian economy. We pay close attention to what is going on here: Western Australia accounts for a little over 14 per cent of Australian GDP and 35 per cent of our exports, so it is important. Reflecting this, this is my third trip to, and public speech in, Perth in the past year. This morning we heard that while the Western Australian economy is still feeling the effects of a decline in the level of mining investment, there are some positive signs. The level of mining investment has further to fall as some large liquefied natural gas projects are completed. But elsewhere in the resources sector things are looking brighter. Sustaining capital expenditure, particularly in the iron ore sector, is picking up with positive spillover effects. Higher prices for a number of minerals have also led to increased exploration activity, including for gold and lithium, and an expansion of some existing mines is taking place. For the first time in a number of years, we are hearing reports through our liaison program in Western Australia that it is difficult for firms to find workers with the right skills, including project engineers and related occupations. Business conditions - as measured by surveys - have also risen significantly and are now above average. At our meeting, we also discussed the population dynamics here in Western Australia. At the peak of the resources boom, annual population growth reached almost 3 1/2 per cent, which is very fast. People moved here from overseas and from the rest of Australia to meet the needs of your rapidly growing economy. In contrast, over the past year, population growth has slowed sharply, to around 3/4 per cent, which is almost the slowest of any state in the country. There is now a considerable net flow of people from Western Australia to the eastern states. This change in population dynamics has had a significant effect on housing markets in Western Australia. The earlier strong growth in population contributed to a sharp rise in housing prices and rents, and then a bit later to a surge in housing construction. With the resources boom now in the past, some of the earlier increases in prices and rents have been reversed and residential construction activity has been low. Western Australia has seen this type of cycle before, and I expect it will see it again at some point in the future. Our liaison, though, suggests that a stabilisation of conditions is in prospect. If so, this should help support consumer confidence and household spending and reinforce the recent more positive news from the resources sector. Finally, as I mentioned earlier, we are currently upgrading Australia's banknotes. I am pleased to be able to announce that the new $50 note will be released on 18 October. We are proud to have a prominent West Australian on this note - Edith Cowan - as well as the Aboriginal writer and inventor David Unaipon. The redesigned $50 note celebrates the fact that Edith Cowan was the very first female member of an Australian Parliament. The microtext on the note will include an extract from her first speech to the Western Australian Parliament. When the note is released, those of you with great eyesight might be able to read this microtext without a microscope. But for those who will struggle to read it, I would like to quote a little from the text. In 1921 Edith Cowan said: Nearly one hundred years on, this sentiment is just as relevant as it was back in 1921. We are proud to have this text on the new $50 note and to recognise Edith Cowan's achievement. The note will also have a seating plan of today's Western Australian Legislative Assembly. It will also recognise Edith Cowan's lifelong advocacy of women. Western Australia's official bird emblem - the iconic black swan - will also appear on the note a number of times. If the note is tilted you will be able to see the colour of the swan change and its wings move. So I am sure that people here in Western Australia will feel a great affinity for the note and enjoy spending it. Once again, thank you for joining us and please enjoy the evening. I stand here to-day in the unique position of being the first woman in an Australian Parliament... If men and women can work for the same state side by side and represent all the different sections of the community... I cannot doubt that we should do very much better work in the community than was ever done before.

r181126a_BOA

australia

A Journey Towards a Near Cashless Payments System

lowe

Thank you for the opportunity to address the Australian Payment Summit. The world of payments has become increasingly exciting, so it is very good to be here today to share in that excitement. This morning I would like to speak about the shift towards electronic payments; or as the title of my remarks says, the journey towards a near cashless payments system. For some decades, people have been speculating that we might one day go cashless - that we would no longer be using banknotes for regular payments and that almost all payments would be electronic. So far, this speculation has been exactly that - speculation. But it looks like a turning point has been reached. It is now easier than it has been to conceive of a world in which banknotes are used for relatively few payments; that cash becomes a niche payment instrument. Given this, I would like to structure my remarks around three broad points. The first is that the shift to electronic payments is occurring quite quickly and it is likely to continue. This shift is a positive development that should promote our collective welfare. The second is that if we are to realise the benefits of moving to a near cashless payments system, the electronic system needs to offer the functionality, safety and reliability that people require. People need to have confidence that the electronic payment system will be operating when they want to make their payments and that it will deliver the payment services that they need. The third point is that as we undertake this journey towards a near cashless payment system, there will be a greater focus on the cost of electronic payments. If almost all payments are electronic, then the cost of making these payments matters more than it used to. The electronic system needs to be as efficient as it can be and to be characterised by strong competition. In my view, there is further work to be done here. The Reserve Bank conducts regular surveys of how Australians make their payments. The next survey will be undertaken in 2019. Until then, perhaps the best illustration of the declining use of cash for transactions is the sharp decline in the number and value of cash withdrawals through ATMs (Graph 1). Around the turn of decade, Australians went to an ATM, on average, around 40 times per year. Today, we go to an ATM around 25 times a year and the downward trend is likely to continue. At the same time as the use of cash for payments has been declining, the number of electronic transactions has been growing strongly (Graph 2). Today, Australians make, on average, nearly 500 electronic payments a year, up from around 100 per year around the turn of the century. New payment technologies are being developed that will further encourage this shift to electronic payments. Perhaps the most significant of these is the New Payments Platform, which has made it possible for people to make real-time person-to-person payments without using banknotes. A range of payment apps are also under development that would have the same effect. So the direction of change is clear. There also continues to be a decline in the use of cheques (Graph 3). In the mid 1990s, Australians, on average, made around 45 cheque payments per year. Today, we make around three per person. Given this trend is likely to continue, it will be appropriate at some point to wind up the cheque system, given the high fixed costs involved in operating the system. We have not reached that point yet, but it may not be too far away. Before we do, it is important that alternative payment methods are available. Progress has been made on this front, but more is required. It is worth pointing out that despite the decline in cash use, the value of banknotes on issue, relative to the size of the economy, is close to the highest it has been in fifty years. For every Australian there are currently around thirty $50 and fourteen $100 banknotes on issue (Graph 4). So there is an apparent paradox between the declining use of cash and the rising value of banknotes on issue. The main explanation is that some people, including non-residents, choose to hold a share of their wealth in Australian banknotes. The opportunity cost of doing this is less than it used to be because of the low level of interest rates. While it is difficult to predict the future, I expect that banknotes will remain part of our payments system for some time to come. In some situations, paying with banknotes is quicker and more convenient than paying electronically, although this advantage is less than it once was. Some people also simply prefer paying in cash - our 2016 survey indicated that around 14 per cent of Australians had a preference for using cash as a budgeting tool. Banknotes also allow payments to be made anonymously in a way that is not possible in systems that leave an electronic fingerprint. This privacy aspect is valued by some people. In some circumstances this desire for privacy is entirely legitimate, but in others it has more to do with tax evasion and illegal activities. Perhaps a more important source of ongoing demand is the fact that using cash does not require the internet to be up, electricity to be working and the banks' systems to be operational. Banknotes are therefore an important emergency or back-up payment instrument. They are particularly useful in the event of natural disasters or failure of the electronic system. Perhaps one day the various systems will be so reliable that a backup will not be needed, but that day still seems some way off. Overall, the shift to electronic payments that is occurring makes a lot of sense - it is similar to other aspects of our lives where things that used to be physical have been supplemented with, or replaced by, technology. This shift is likely to promote our collective welfare. I say that even though the Reserve Bank is the producer of banknotes and earns significant income, or as it's known, seigniorage, for the taxpayer from their use. The greater use of electronic payments can bring efficiency benefits, with lower costs and more functionality and choice for users. One example of this is the reduced tender time involved in card transactions due to contactless technology. There are also non-trivial production and distribution costs involved in the cash system. Some of these are fixed costs, so the average cost of cash transactions is likely to rise as the volume of cash transactions falls. Looking ahead, there is also more limited scope for fundamental innovation in the cash system compared with the scope for dynamic innovation in electronic payments. So this journey is in our national interest. I would now like to discuss three interrelated factors that will influence how quickly we undertake that journey. These are: the functionality offered by the electronic system; the safety of that system, and the reliability of that system. The other factor that is also relevant is cost, and I will touch on this a little later. The rapid adoption of contactless payments in Australia shows that Australians change how they pay quite quickly when new functionality is offered. Contactless card payments were slow to take off but once critical mass was established, they grew very quickly. In our 2013 consumer payment study they accounted for around over 20 per cent of point of sale card payments; three years later they accounted for over 60 per cent. So the functionality of the electronic payments system is key. The development of the electronic payment system took a major step forward earlier this year with the launch of the New Payments Platform (NPP). This system allows people to make payments 24 hours a day, 7 days a week, using just a simple identifier such as a mobile phone number or an email address. It also allows a lot of information to accompany the payment. I expect that over time this extra functionality will further reduce the use of cash in the economy and also improve the efficiency of the electronic system. The number of transactions through the NPP is steadily increasing (Graph 5). After a relatively lowkey start, there are now around 400,000 NPP transactions per day. Over 2 million PayIDs have also been registered, and we expect further growth as the banks continue to roll out services to their customers. The concept behind the NPP is that so-called 'overlay' services are developed, and that these overlay services offer new functionality that utilise the real time capability of the NPP. The first overlay service provides for a basic account-to-account payment. Among the subsequently planned overlay services are ones that will allow someone to send a request to pay, perhaps to a friend for their share of a meal out. Another overlay service would allow a link to a document to be sent with a payment; this could be a payslip or a detailed record of the transaction. It was originally anticipated that these two overlay services would be up and running not long after the NPP launch. Unfortunately, this timeline has slipped. A number of the major banks have also been slower than was originally expected to roll out NPP functionality to their entire customer bases. This is in contrast to the capability offered by smaller financial institutions, which from Day 1 were able to provide their customers with NPP services. Given the slow pace of roll-out by the banks, and the prospect of delays for additional overlay services, I recently wrote to the major banks on behalf of the Payments System Board seeking updated timelines and a commitment that these timelines will be satisfied. It is important that these commitments are met. It is worth observing that in other countries where banks have been slow to develop payment applications that meet the needs of the public, other possibilities emerge. China is perhaps the best example of this, with the emergence of QR-code-based payments. I expect that the NPP infrastructure will be the backbone of our electronic payments system for many years to come. But for this to be the case, the system will need to provide the functionality that people require, and it will need to do this on a timely basis. There are a range of fintech firms that are excited by the capabilities offered by the NPP and the potential for it to be used for innovative payment solutions. In October, the RBA issued a consultation paper seeking views on the functionality and access arrangements for the NPP. In particular we are interested in views on whether the various ways of accessing the NPP, and their various technical and eligibility requirements, are adequate for different business models. A topic that I get asked about from time to time is whether the functionality of the electronic system would be enhanced by the RBA issuing an electronic version of the Australian dollar, an eAUD. I spoke about this issue at this conference last year, concluding that we did not see a public policy case for moving in this direction at the time. In particular, it is not clear that RBA-issued electronic banknotes would provide something that account-to-account transfers through the banking system do not, particularly with the emergence of the NPP. Another important consideration was the implications for financial stability. A year on, our views have not changed. A second important influence on the rate at which we shift to a more electronic payments system is the public's confidence in the security of the system. Given this, a recent focus of the Payments System Board has been the high and increasing level of fraud in card-not-present transactions (Graph 6). Card-not-present fraud rose by 15 per cent in 2017 and now represents 87 per cent of total scheme card fraud losses. In contrast, the industry has had successes in addressing card-present fraud, with the introduction of chip technology and the switch to PINs. Despite this, growth in e-commerce activity has provided new opportunities for would-be fraudsters. The Payments System Board identified the rise in card-not-present fraud as a priority for the industry. In August this year, the Board was pleased to welcome AusPayNet's publication of a draft industry framework to mitigate card-not-present fraud, and supports continued collaboration on this issue. A separate but not unrelated priority for the industry is to progress work on digital identity. This is another area where barriers to effective coordination can arise. I am pleased that AusPayNet is undertaking work here, under the auspices of the Australian Payments Council. Digital identity is likely to become increasingly important as more and more activity takes place online. The RBA is highly supportive of industry collaboration on this issue and views it as important that substantive progress is made. More broadly, individuals, businesses, governments and financial institutions all need to be aware of cyber risks. In the RBA's most recent Financial Stability Review we noted the increasing sophistication of cyber attacks and that regulatory authorities have increased their focus on cyber issues. A third factor is the confidence that people have that they will be able to use the electronic system when they need to make their payments. As I noted earlier, people will still want to hold and use banknotes if they can't be sure that the electronic system will be available when they need it. In our consumer payments survey in 2016, we asked people about why they held cash in places outside of their wallet. The most common response, from nearly half of respondents, was that it was for emergency transaction needs. Over recent times, there have been a number of serious operational incidents that have interrupted the payments system. On some occasions these have been caused by problems with the telecommunications companies and at other times by problems at the banks. An operational incident at the RBA in August as a result of problems with a routine fire test also saw a number of RBA core systems unavailable for some hours, including the Fast Settlement Service supporting the NPP. We all need to do better here. As we rely less on cash, outages affecting retail transactions can have a significant impact on businesses and individuals. So continued effort needs to be made by all participants in the payments system to reduce operational problems. If this does not happen, then it is possible that the Payments System Board could consider setting some standards. My third broad point is about the cost of electronic payments and the importance of competition. As we move to a predominantly electronic world, there will be more focus on the cost of operating the electronic payments systems and how those costs are allocated between those making and receiving payments. Looking forward, I expect that over time the cost of electronic payments will decline further, due to both advances in technology and economies of scale. Even so, there are significant costs to operate the electronic systems, including costs for front- and back-end systems to maintain accounts, and to deliver functionality and convenience to users, as well as costs in preventing fraud and ensuring resilience. How these costs are managed and who pays for them will have a significant bearing on the efficiency of the overall system. In terms of card payments, merchants in Australia currently pay less than merchants in many other Australian merchants, on average, pay 0.8 per cent of the transaction value for Mastercard/Visa transactions. In the United States the figure is much higher at around 2.2 per cent. There are also differences in the cost of debit cards and American Express cards between the two countries. The main reason for the lower merchant costs in Australia is our lower interchange fees. These fees were reduced in Australia as a result of regulation by the Reserve Bank commencing in 2003. The RBA's reforms reduced average interchange fees in the Mastercard and Visa systems by around 45 basis points. This has been reflected in merchant service fees; indeed, these merchant fees have fallen by somewhat more than the cuts to interchange, likely reflecting an increased focus on card acceptance costs by merchants (Graph 8). In addition, as a result of competitive pressure, including from the removal of no-surcharge rules, fees on American Express and Diners Club have also fallen over time. Notwithstanding the reduction in interchange fees, these fees still represent, on average, around 60 per cent of the total merchant service fee on credit cards. So they remain an important part of the total cost to merchants. Conversely, these fees mean that the cardholder's bank gets paid each time the card is used. This has meant that the cost to consumers of using these cards is often low; in some cases, cardholders are actually subsidised to use their card, through reward points and/or interest-free credit. The subsidy is provided by the cardholder's bank, but ultimately paid for by the merchant. The close link between interchange and merchant costs means that there continues to be significant focus on interchange and its implications for the distribution of costs between merchants and consumers. For example, there have been recent recommendations from the Black Economy Taskforce and the Productivity Commission for the Reserve Bank to consider regulatory action to lower, or even ban, interchange fees. The Payments System Board will again examine the arguments for lower interchange fees when it next conducts a formal review of the card payments system. On the competition front, one area that merits close attention is the market for acquiring services. This has come into sharper focus as a result of concerns about the costs to merchants in the debit card system, where most cards allow for transactions to be processed by either of the two networks enabled on the card. The longstanding view of the Payments System Board has been that merchants should at least have the choice of sending the debit payment through the lower cost system, whether that be eftpos or the international scheme. For merchants to be able to do this though, acquirers need to offer terminals and technical systems enabled to allow least-cost routing. Some acquirers have already completed the necessary work and are attracting new merchants. Others, including the major banks, made commitments earlier in the year regarding the timetable for this work to be completed. Partly on the basis of those commitments, the Payments System Board made a decision not to regulate. Since then, I regret to say there has been slippage by some, who have cited technical problems. It is important that the banks get back on track here. A failure to deliver on commitments or to provide the payment services that the community needs will inevitably lead to calls for further regulation. Looking beyond interchange and acquiring competition, new technologies open up the prospect of new payment options developing. Recently, there has been much discussion on the role that socalled 'Big Tech' firms might eventually play. These firms have potential advantages over existing providers of payments services. In some cases, their technology and systems are more flexible, they have a greater ability to use and process information, they have well established networks which they can leverage and they are often better at interacting with their users and customers. Given this, one scenario is that these firms become significant players in the payments industry. They might be able to do this through developing new payment applications that provide a commercial return, not through charging for payment services, but by commercialising the value of the information that they obtain as a by-product of offering these services. If this scenario were to play out, it could significantly change the payments landscape, providing both merchants and consumers new payment options at low monetary cost. At the same time though it would raise a number of important issues related to data privacy, ownership and security. The probability of Big Tech firms entering the payments arena is higher if merchants and consumers feel that the existing payment systems do not offer them the services they need and/or the prices that are being charged are too high. As I noted earlier, where banks have been slow to respond, other payment applications have emerged. This scenario highlights a broader point. The way that people are charged for payments is complex and is changing: among other things, it is influenced by interchange fees, how the value of information is commercialised, and commercial pressures on banks. It is difficult to predict how things will ultimately play out, but these are issues the Payments System Board continues to keep a close eye on. To conclude, I expect the shift to electronic payments will continue. The issues of functionality, security and reliability, and cost are central to the development of the system. The Payments System Board will be keeping a close eye on these issues. While I have talked about a near cashless payments system, I want to emphasise that we don't yet envisage a world without banknotes. The RBA is committed to providing cash consistent with demand by users and to support its distribution. Our development of the Next Generation Banknote series is a clear commitment to ensuring that cash continues to have public confidence and to meet the needs of the community. The launch of the NPP this year was a big step forward for the industry and a credit to all of the staff at participating organisations who worked hard over the life of the project to bring it to fruition. As I mentioned, there are some key things that need to be done for the full benefits of the NPP to be available to end-users, but I am optimistic that these can be achieved and this new infrastructure can provide great functionality for Australia.

r190206a_BOA

australia

The Year Ahead

lowe

Thank you for the opportunity to address the National Press Club. It is an honour to have been invited. The media and the RBA have a special relationship. Most people in the community hear the RBA's messages through the media. You report on what we say, you filter it and you critique it. We also help you with your work. The RBA is a reliable source of information and analysis on issues that your audiences care about, including interest rates, housing prices and jobs. This means we have a strong mutual interest in understanding one another. I hope that today will help strengthen that understanding. This is my first public speech for 2019, so I would like to talk about the year ahead and some of the key issues that the RBA will be focusing on. I will first discuss the global economy and then turn to the Australian economy and particularly the outlook for household spending. I will finish with a few remarks on the outlook for monetary policy. At the outset, I want to emphasise that we don't have a crystal ball that allows us to see the future with certainty. I know many of you are looking for definitive answers to questions like, 'Where the cash rate be this time next year?', 'How much housing prices fall?', 'When wages growth reach 3 per cent?'. They are all good questions. The reality, though, is that the future is uncertain. None of us can say with certainty what happen. What the RBA can do, though, is highlight the issues that are likely to shape the future, explain how we are thinking about those issues, and discuss how they fit into our decision-making framework. That is what I hope to do today. I will start with the global economy, because what happens overseas has a major bearing on what happens in Australia. My main point here is that while some of the downside risks have increased, the central scenario for the world economy still looks to be supportive of growth in Australia. It is worth recalling that 2018 was a good year for the world economy. Growth in the advanced economies was above trend in the first half of the year, unemployment rates reached their lowest levels in many decades, inflation was low and financial systems were stable (Graph 1). These are positive outcomes. We should not lose sight of this. There was, though, a change in momentum in the global economy late in the year. This change was particularly evident in Europe and it was also evident in China. It has been widely reported in the media, but it is important to keep things in perspective. Some slowing in global growth was expected, given that labour markets are fairly tight and the policy tightening in the United States was aimed at achieving a more sustainable growth rate. So, I have been a little surprised at some of the reaction to the lowering of forecasts for global growth, which has been quite negative. We need to remember that the IMF's central forecast is still for the achieved, these would be reasonable outcomes and not too different from the recent past. What is of more concern, though, is the accumulation of downside risks. Many of these risks are related to political developments: the trade tensions between the United States and China; the Brexit issue; the rise of populism globally; and the reduced support from the United States for the liberal order that has supported the international system and contributed to a broad-based rise in living standards. One could add to this list the adjustments in China as the authorities rein in shadow financing. The origins of these diverse issues are complex, but there is a common economic element to some of them: that is, the extended period of little or no growth in real incomes for many people. In a number of countries, growth in real wages has been weak or negative for years. Advances in technology and greater competition as a result of globalisation also mean that many people worry about their own future and that of their children. Politicians, understandably, are responding to these concerns. Time will tell, though, whether the various responses help or not. I suspect that some of them will not. Over recent months, the accumulation of downside risks has been evident in business and consumer surveys. It was also evident in increased volatility in financial markets around the turn of the year, with declines in equity prices and an increase in credit spreads (Graph 3). Since then, though, markets have been more settled and some of the earlier decline in equity prices has been reversed. This has been partly on the back of a reassessment of the path of monetary policy in the United States, with markets no longer pricing in further increases in US interest rates. There has also been a noticeable fall in long-term government bond yields. The adjustments in financial markets over our summer sometimes generated reporting that, to me, seemed overly excitable. I lost count of how many times I read the words 'crash', 'plunge' and 'dive'. Yet there is a positive side to some of these adjustments, which gets less reported on. The risks associated with stretched valuations in some equity markets have lessened. So, too, have concerns that very low credit spreads could lead to an excessive build-up of risk. And risks in many emerging market economies have also receded, helped by the lower global interest rates and lower oil prices. So it is important to look at the whole picture. For Australia, what happens in China is especially important. Growth there has slowed. From a medium-term perspective, this has a positive side, as it mainly reflects efforts to rein in risky financial practices and stabilise debt levels. But the slowing is probably faster than the government had hoped for, with the economy feeling the effects of the trade dispute with the United States and the squeezing of finance to the private sector. The authorities have responded by easing policy in some areas, but they are walking a fine line between supporting the economy and addressing the debt problem. There is also the question of how the economy responds to the policy easing. More broadly, we cannot insulate ourselves completely from the global risks, but keeping our house in order can go a long way to assist. Our floating exchange rate and the flexibility we have on both monetary and fiscal policies provide us with a degree of insulation. So, too, does our flexible labour market. Ensuring that we have predictable and consistent economic policies, credible public institutions and a reform agenda that supports a strong economy can also help in an uncertain world. I would now like to turn to the outlook for the Australian economy. Much as is the case globally, the downside risks have increased, although we still expect the Australian economy to grow at a reasonable pace over the next couple of years. The Australian economy is benefiting from strong growth in infrastructure investment and an upswing in other areas of investment. The labour market is also strong, with many people finding jobs. This year, we will also benefit from a further boost to liquefied natural gas (LNG) exports. The lower exchange rate and a lift in some commodity prices are also assisting. Against this generally positive picture, the major domestic uncertainty is the strength of consumption and the housing market. We will be releasing a full updated set of forecasts in the Friday. Close readers of the SMP will notice that we will now be publishing forecasts for a wider set of variables than has previously been the case. We hope that this helps people understand the various forces shaping the economy. Today, I can give you a summary of the key numbers. Our central forecast is for the Australian economy to expand by around 3 per cent over 2019 and 2 3/4 per cent over 2020 (Graph 4). For 2018, the outcome is expected to be a bit below 3 per cent. This type of growth should be sufficient to see further gradual progress in lowering unemployment. These forecasts are lower than the ones we published three months ago. For 2018, the outcome is affected by the surprisingly soft GDP number in the September quarter and the ABS's downward revisions to estimates of growth earlier in the year. We are expecting a stronger GDP outcome in the December quarter, with other indicators of economic activity painting a stronger picture than suggested by the September quarter national accounts. For 2019 and 2020, the forecasts have been revised down by around 1/4 percentage point, largely reflecting a modest downgrading of the outlook for household consumption and residential construction. I will talk more about this in a moment. The outlook for the labour market remains positive. The national unemployment rate currently stands at 5 per cent, the lowest in over seven years (Graph 5). In New South Wales and Victoria, the unemployment rate is around 4 1/4 per cent. You have to go back to the early 1970s to see sustained lower rates of unemployment in these two states. The forward-looking indicators of the labour market also remain positive. The number of job vacancies is at a record high and firms' hiring intentions remain strong. Our central scenario is that growth will be sufficient to see a modest further decline in unemployment to around 4 3/4 per cent over the next couple of years. The other important element of the labour market is how fast wages are increasing. For some time, we have been expecting wages growth to pick up, but to do so gradually. The latest data are consistent with this, with a turning point now evident in the wage price index (Graph 6). Through our discussions with business we are also hearing more reports of firms finding it difficult to find workers with the necessary skills. In time, this should lead to larger wage rises. This would be a positive development. Given this outlook, we continue to expect a gradual pick-up in underlying inflation as spare capacity in the economy diminishes (Graph 7). However, the lower forecast for growth means that this pick- up is expected to occur a bit later than we'd previously thought. Underlying inflation is now expected to increase to about 2 per cent later this year and to reach 2 1/4 per cent by the end of 2020. The latest CPI data were consistent with this outlook. The headline CPI number was, however, a bit lower than we had previously expected, reflecting the decline in petrol prices that started late last year. We expect headline inflation to decline further this year as the full effect of lower petrol prices shows up in the figures. So that is the summary of the key numbers. As always, there is a range of uncertainties, many of which will be discussed in the SMP on Friday. Today, though, I would like to focus on the outlook for household spending, which is closely linked to the housing market and the prospects for growth in household income. Before I do that, I would like to touch on one related uncertainty that we have been paying attention to - that is the supply of credit. This is because a strong economy requires access to finance on reasonable terms. Over recent years there has been a needed tightening of credit standards. But the right balance needs to be struck. As lenders have sought to find that balance, we have had some concerns that the pendulum may have swung too far the other way, especially for small business. In that context, I welcome the report of the Royal Commission and the Government's response. The Commission's recommendations that bear on credit provision are balanced and sensible, and should remove some uncertainty. I also welcome the Commission's focus on: the importance of service - as opposed to sales - in the financial sector; the necessity of dealing properly with conflict of interest issues; and the importance of accountability when things go wrong. These are all issues I have spoken about on previous occasions. Addressing them is central to rebuilding the all-important trust in our financial system. But back to household consumption and the housing market. You might recall that 18 months ago, one of the most talked about issues in the country was the high and rising cost of housing. This was understandable. In some of our cities, purchasing a home had become a very difficult stretch for many people, and this had become a major social issue. Today, the talk is about prices falling in our two largest cities. We have moved almost seamlessly from worrying that prices were going up, to worrying that they are going down. There is no single reason for this change, but, rather, it is the result of a number of factors coming together. One is that housing prices simply increased to the point in Sydney and Melbourne where demand tailed off, as purchasing a home had become very expensive and less attractive as an investment. A second is that the building boom over recent times significantly increased the supply of dwellings. It took a number of years before the rate of home construction picked up in response to faster population growth, but eventually it did pick up. This explains much of the cycle. A third factor is that the demand from overseas investors softened, partly in response to the Chinese authorities making it more difficult to move money out of China. And a fourth factor is that lending standards have been tightened and credit has become more difficult to obtain. Importantly, unlike most other housing price corrections, this one has not been associated with rising unemployment or higher interest rates. Instead, mainly structural factors - relating to the underlying balance of supply and demand - in our largest cities have been at work. The question is: what effect will this change have on household spending? Here, my earlier observation about not having a crystal ball is relevant. At this point, though, what we are seeing looks to be a manageable adjustment in the housing market. It is not expected to derail economic growth. The previous trends in debt and housing prices were becoming unsustainable and some correction was appropriate. We recognise that this correction will have an effect on parts of the economy. But our economy should be able to handle this, and it will put the housing market on a more sustainable footing. There are a few considerations here. The first is that the recent housing price declines follow very large increases in prices (Graph 8). Even after the recent declines in Sydney, prices are still 75 per cent higher over the decade. In Melbourne, they are 70 per cent higher. While the price falls are no doubt difficult for some, including people who purchased in the past couple of years, there are many people sitting on very significant capital gains and there are others who now will find it easier to purchase a home. And of course, in a number of cities and much of regional Australia, things have been more stable. A second consideration is that most households do not change their consumption in response to short-term changes in their wealth. Sensibly, many people tend to take a longer-term perspective. During the recent upswing in housing prices, the strategy of borrowing against the extra equity in your home looked less sensible than it once was, especially as debt levels rose. Some home-owners also see themselves as being part of the 'bank of mum and dad'. This meant that they refrained from spending the extra equity so that they were able to help their children purchase their own property. A third and perhaps the most important consideration, is that household income growth is expected to pick up and income growth usually matters more for consumption than changes in wealth. For some years, growth in nominal aggregate household income has been unusually slow, averaging an offset to this, even though the effect may have been smaller than in the past. As a result, aggregate consumption has grown faster than income for the past few years. But a shift is now taking place. Over the next year, we are expecting a pick-up in household disposable income to provide a counterweight to the wealth effects of lower housing prices. Labour market outcomes are key to this assessment. Continued employment growth and higher wages growth should boost disposable incomes. The announced tax cuts should also help here. In our central scenario, consumption is expected to grow at around 2 3/4 per cent over the next couple of years, broadly in line with expected growth in disposable income. This is a bit lower than our earlier forecast for consumption. There are, of course, other possible outcomes. Continued low income growth, together with falling housing prices, would be an unwelcome combination and would make for a softer outlook for the economy. Some Australian households have high levels of debt, so there is a degree of uncertainty about how they would respond to this combination. So we are monitoring things closely. The adjustment in the housing market is also affecting the economy through residential construction activity and the spending that occurs when people move homes. Residential construction activity is currently around its peak level and the large pipeline of approved projects is expected to support activity for a while. Developers, though, are finding it more difficult to sell apartments off the plan, and lenders are less willing to provide finance. Sales of new detached dwellings have also slowed. The central forecast is for dwelling investment to decline by about 10 per cent over the next two and a half years. Putting all this together, our economy is going through an adjustment following the turn in the housing markets in our largest cities. It is important that we keep this in perspective though. The correction in the housing market follows an extended period of strength. It is largely due to structural supply and demand factors, and is occurring against the backdrop of a robust economy and an expected pick-up in income growth. Our financial institutions are also in a strong position to deal with the adjustment. Indeed, lending standards were strengthened as the upswing went on. From this perspective, the adjustment in the housing market is manageable for the financial system and the economy. This adjustment will also help increase the affordability of housing for many people. Even so, given the uncertainties, we are paying very close attention to how things evolve. This brings me to monetary policy. The cash rate has been held steady at 1 1/2 per cent since August 2016. This setting has helped support the economy. The Reserve Bank Board has sought to be a source of stability and confidence while our economy adjusted to the end of the mining investment boom and responded to the shifting sands of the global economy. Over the past couple of years, economic conditions have been moving in the right direction. The labour market has strengthened, and the unemployment rate has fallen and a further decline is expected. Inflation is also above its earlier trough, although it has not changed much over the past year. Our expectation has been - and continues to be - that the tighter labour market and reduced spare capacity will see underlying inflation rise further towards the midpoint of the target range. Given this, we have maintained a steady setting of monetary policy while the labour market strengthens and inflation increases. Looking forward, there are scenarios where the next move in the cash rate is up and other scenarios where it is down. Over the past year, the next-move-is-up scenarios were more likely than the next- move-is-down scenarios. Today, the probabilities appear to be more evenly balanced. We will be monitoring developments in the labour market closely. If Australians are finding jobs and their wages are rising more quickly, it is reasonable to expect that inflation will rise and that it will be appropriate to lift the cash rate at some point. On the other hand, given the uncertainties, it is possible that the economy is softer than we expect, and that income and consumption growth disappoint. In the event of a sustained increase in the unemployment rate and a lack of further progress towards the inflation objective, lower interest rates might be appropriate at some point. We have the flexibility to do this if needed. The Board will continue to assess the outlook carefully. It does not see a strong case for a near-term change in the cash rate. We are in the position of being able to maintain the current policy setting while we assess the shifts in the global economy and the strength of household spending. It has long been the Board's approach to avoid reacting to the high-frequency ebb and flow of news. Instead, we have sought to keep our eye on the medium term and put in place a setting of monetary policy that helps deliver on our objectives of full employment, an inflation rate that averages between 2 and 3 per cent, and financial stability. Thank you for listening. I look forward to answering your questions.

r190222a_BOA

australia

Opening Statement to the House of Representatives Standing Committee on Economics

lowe

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 of Australia, members of public--the few of you--and of course the media. Since the previous hearing with the Reserve Bank of Australia in August 2018, monetary policy has remained accommodative, with a cash rate of 1.5 per cent. Following the RBA's recent decision to leave interest rates unchanged, commenting on the decision to keep rates on hold, the Governor of the In relation to the inflation outlook, the governor stated: The governor, at a speech on 6 February, commented that 'today the probabilities appear to be more evenly balanced' between an increase and a decrease in rates. It is also notable that in December the deputy governor The committee will examine these issues in more detail and will ask the RBA if it remains confident that current monetary policy settings will encourage growth and inflation consistent with the target for coming years. 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 a contempt of parliament. Dr Lowe, would you like to make your opening statement before we proceed to questions? Thank you very much, Chair, and good morning to members of the committee. My colleagues and I welcome this opportunity to share our views on the Australian economy and the RBA's important public policy responsibilities. We view these hearings as an essential part of the accountability process. Two weeks ago, we released our latest forecast for the Australian economy. Our central scenario is for GDP growth of around three per cent this year and around two and three-quarters per cent in 2020. The outcome for the year just past is expected to be a bit below three per cent. These numbers are lower than the ones we were expecting at the time of the previous hearing, in August. By contrast, the labour market outcomes have been quite a lot better than we earlier expected. When we met six months ago, we were not anticipating the unemployment rate to reach five per cent until 2020, but it's already been around that level for some months, and we had further welcome confirmation of that yesterday. The number of jobs created has also exceeded our earlier expectations, and we continue to expect the unemployment rate to move lower over the next couple of years to reach four and three-quarters per cent. In terms of inflation, the recent outcomes have been a bit lower than we had been expecting. In the September quarter, the childcare cost declined substantially due to government policy changes. In the December quarter, petrol prices fell, due to global developments, and a further decline in petrol prices is expected in the March quarter. In underlying terms, inflation is above its trough of a couple of years ago, but the pick-up is more gradual than we had previously expected, and by the end of 2020 inflation is now forecast to reach 2 1/4 per cent. Putting all this together, our central scenario for this year is for growth of around three per cent, inflation of around two per cent and unemployment of around five per cent. In the broad sweep of our economic history, that's not a bad set of numbers. Indeed, in many years over the past four decades, we would have welcomed such an outcome, and it's important that we don't lose sight of that. The economy is benefiting from increased spending on infrastructure and a pick-up in private investment as capacity utilisation has tightened. The strong growth in jobs is also supporting spending, as is the sustained low level of interest rates. Globally, the central scenario also remains a reasonable one. Inflation is low, and unemployment rates in many advanced economies are the lowest in many decades. Recently, however, the focus has not been on this, but it's been on the downgrading of the forecast for global growth by the International Monetary Fund and others. What sometimes gets lost, though, is that the latest forecast is for global growth to be around average, not below average. We need to remember that growth around average at a time of low unemployment is a reasonable outcome. What is of more concern, though, is the accumulation of downside risks. There are two major areas of risk globally that the Reserve Bank Board has been keeping an especially close eye on of late. The first is what I will label political risks. Here the list includes the trade and technology tensions between China and the United States, Brexit, the rise of populism, and strains in some Western European economies. It's hard to be certain about how these various issues will play out. But it is conceivable that one or more of these political risks crystallises in a way that damages confidence and the global economy. It is of course also conceivable that political leaders respond to the mounting economic risks in a way that restores confidence. Ultimately, time will tell. In working through the various possibilities, one issue that many people have focused on is the resilience of the global economy to a severe shock, whether it's generated in the political sphere or elsewhere. In many countries, both public and private debt levels are already very high, and real interest rates are also already very low. This means that there are fewer buffers in the global system than there were once upon a time, so there is less room for manoeuvre if something goes wrong, although in a number of important dimensions the global financial system is more resilient than it used to be. The second international risk that we are monitoring carefully relates to the Chinese economy. Growth there has slowed, probably by more than the authorities had been expecting. The economy is feeling the effects of tensions with the United States and the squeezing of finance to the private sector as the authorities clamp down on non-bank financing. The authorities have responded by easing policy in a number of areas, but they are walking a very fine line between supporting the economy in the near term and addressing the medium-term debt problems. Turning now to the Australian economy: the board has recently been paying particularly close attention to the strength of household spending and to developments in the housing market. Household consumption accounts for almost 60 per cent of total spending in the Australian economy, so what happens on that front is important. Recently, determining the underlying strength of consumption has been complicated by volatility in the consumption data in the national accounts, as well as by notable revisions to the history of both consumption and income in the national accounts. On balance, though, the available data does suggest that the underlying trend in consumption growth is softer than it earlier looked to be, and this has affected the outlook for the economy. There are a couple of important considerations here. The first is the protracted period of relatively low growth in household income, and the second is the decline in housing prices in our larger cities. Since 2016, aggregate household disposable income has grown at an average rate of just two and three-quarters per cent per year. That's down from average growth of six per cent over the preceding decade. That's quite a large change. It's plausible that households have responded to this extended period of weaker income growth by progressively downgrading their spending plans. For many people, it has become harder to see the lower growth in income as just a shortterm development that they can look through, and I think they've adjusted their spending in response to that. On this front, though, we are expecting better news ahead, with growth in disposable income forecast to increase. Wages are rising more quickly in almost all industries and in all states than they were a year ago. This is good news, and we expect this gradual lift in wage growth to continue. Disposable income will also be boosted by the announced tax cuts, and this faster income growth will support household spending. From a longer-term perspective, though, the key to boosting the real income of households is lifting productivity, and I encourage you to keep examining ways to do this. Looking beyond income growth, developments in the housing market can also affect overall spending in the economy. Lower turnover means less of the spending that occurs when people move homes. Declining housing prices also make some people feel less wealthy so they spend less, although this effect doesn't look to be particularly large. Lower housing prices are also associated with less construction activity in the economy, so these are the areas that we're keeping a close watch on. We do need to keep things in perspective, though. The adjustments in the Sydney and Melbourne housing markets are occurring at a time of low unemployment, low interest rates and strong population growth. What we're witnessing is largely the working through of shifts in supply and demand for housing due to structural factors. In both markets it took a long time for supply to respond to faster population growth, so prices went up. This shouldn't have been a surprise. And now that supply has responded, some of the earlier increasing prices have been reversed. Again, this shouldn't be a surprise. I understand that these swings in housing prices are difficult for some in the community. We should, though, take some reassurance from the fact that our economy and our financial system are resilient. This adjustment in the housing market is not expected to derail our economy. It will put our housing markets on more sustainable footings, and it will allow more people to purchase their own home. So there's a positive side too. I'd now like to turn to monetary policy. The Reserve Bank Board has held the cash rate steady at 1 1/2 per cent since August 2016. This is a stimulatory setting of monetary policy and it's helped support job creation and a gradual lift in inflation. When we met with this committee six months ago, I said that if further progress on achieving our goals of full employment and returning inflation targets made, you could expect the next move in interest rates to be up rather than down. I also said that the board did not see a strong case for a new-term adjustment in the cash rate, given that the progress towards our goals was expected to be only gradual. Today, the probability of the next move is up and the probability that it is down are more evenly balanced than they were six months ago. This shift largely reflects the change in the outlook for consumption that I just spoke about. It's important to point out, though, that we are still expecting further progress towards our goals. The unemployment rate is forecast to decline further, and inflation is forecast to increase only gradually. If we do make that progress, it remains the case that higher interest rates will be appropriate at some point. But it's also possible that the economy is softer than we expect and that progress towards our goals is limited. If there were to be a sustained increase in the unemployment rate and a lack of further progress towards the inflation objective, lower interest rates might be appropriate at some point. We have the flexibility to do this if needed, and we're not on a predetermined course. The board maintains its strong focus on the medium term and is seeking to be a source of stability and confidence in the Australian economy. As was the case six months ago, the board does not see a strong case for a near-term change in the cash rate. With monetary policy already providing considerable support to the Australian economy, it is appropriate to maintain the current policy setting while we assess developments. Much will depend on what happens in our labour market. I'd now like to turn to some other issues. Some years ago, this committee held extensive hearings into the foreign bribery issues at Note Printing Australia and Securency. The legal proceedings against former employees of these companies were finally completed last November. As a result, the Supreme Court of Victoria lifted longstanding suppression orders. This allowed the RBA to disclose that in 2011 NPA and Securency entered guilty pleas to charges of conspiracy to bribe foreign officials between 1999 and 2004. We were also able to disclose that the two companies paid substantial fines and penalties, including under proceeds of crime legislation. I have sought to deal with these difficult matters as openly and transparently as possible. The corrupt and unethical behaviour that was uncovered runs counter to everything that we stand for, so it's been an incredibly difficult matter to deal with. A number of years ago we sold our half share in Securency, the manufacturer of the polymer material that the notes are printed on. Securency is now owned by a Canadian firm. NPA remains a wholly-owned subsidiary of the RBA, and it prints Australia's banknotes in Melbourne. The company has undergone a top-to-bottom overhaul of its governance arrangements and business practices. I'm confident the company is operating to the very high standards that we demand, and that it will continue to do so. On a more positive front, over recent months NPA has been printing Australia's new $20 banknote. We are today releasing the design of the new note, and it will be issued into circulation in October. It will have the same world-leading security features as the other new notes. It will also have three raised bumps along the edge to assist people who are blind or who have low vision. I have some note that are hot off the printing press, which I could share with you at the break if you would like. They are designs only, I hope--not actual notes? No, they are notes straight off the printing press. We'll have to give them back! Yes, I won't be able to give them to you, but you can look at them! These new notes will continue remarkable woman. She arrived in the colony of New South Wales in 1792 as a 15-year-old convict. Then, through hard work and determination, she rose to become one of the colony's most successful entrepreneurs. Of course, John Flynn is best known for establishing what we know today as the Royal Flying Doctor Service. This service has helped countless Australians and is now the largest aeromedical service in the world. We're really proud to be able to celebrate the entrepreneurship and the ingenuity of these two great Australians on the $20 note. The Reserve Bank also continues to work on upgrading Australia's electronic payment system. We want to see a system that is reliable, secure and efficient and that meets the needs of Australians. It's now one year since the New Payments Platform was launched. Over 2 1/2 million Australians have registered pay IDs, and the banks are progressively adding functionality to the new system. Many people are already benefiting from faster and more flexible payments. We have, however, been disappointed that some of the major banks have not met the originally agreed time lines. This delay has, regrettably, slowed the pace of innovation in the overall system, given the substantial network effects that exist in payment systems. Late last year I wrote to the CEOs of the major banks on behalf of the Payments System Board, expressing our concerns and seeking a commitment that the updated time lines be satisfied. It's important that these commitments are kept. Notwithstanding these delays, I remain confident that the NPP will provide the backbone for substantial innovation in our payment system for years to come. Thank you very much. My colleagues and I are here to answer your questions. Thank you very much, Dr Lowe. Thank you for appearing and also for bringing to a head some of the events that have occurred only in the past 24 hours. You made a series of statements on what you think about the opportunities for the Australian economy and it's strength and resilience--or not. In the past 24 hours we have seen potentially quite dramatic events, where China is now blocking thermal coal imports. Are you expecting that that would have a dramatic effect on your confidence in the Australian economy? I'm not expecting it to have a dramatic effect. I think it's important we place in context what's happening here, and that is that the backgrounder is really developments in the Chinese steel industry. The authorities have been trying to contain production of steel for environmental reasons, and they've had difficulty in doing that. One way that they can control the amount of production is to control the amount of inputs, and coking coal is an important input into steel production. So one interpretation of what's going on is that this is a way of controlling Chinese steel production. Another possible interpretation is that the Chinese coal industry is not particularly profitable at the moment and containing imports might boost the domestic prices and help the Chinese coal industry. That would be another interpretation of what's going on. It's really to do with environmental protection and the Chinese coal industries, and it's not specific to Australia. We're still not sure about-- Media reports that I'm reading online, and I accept that this is on the hop, suggest otherwise--that it is targeted towards Australian imports. I understand the point you're making, but what do you believe would then be the impact or revision you'd need to make potentially to the Australian economic forecast? My understanding is that the amount of coal that's been blocked is the equivalent of two months of exports from Australia to China. It's entirely possible that if that cannot enter the Chinese market then it can go to other markets. There are other markets in the world for Australia's coking coal. A lot of other countries are making steel, which is what they need coking coal for, and we'll find another market perhaps at a lower price. If that's all we're talking about--the blocking of a couple of months of coal imports--that's not going to derail the Australian economy. If it were to be the sign of a deterioration in the underlying political relationship between Australia and China, that would be much more concerning. I think we've still got to wait to see what the underlying issues are, because I do know the Chinese authorities who wanted to contain steel production have had trouble doing that, and they have had concerns about the profitability of the coking coal industry. I wouldn't jump to the conclusion yet that this is something directed to Australia. It may well turn out to be that it's being driven by concerns about the environment in China and the profitability of the coal industry in China. We have to wait and see. You said that the trajectory you outlined for interest rates has been rebalanced--I'm paraphrasing-- back towards it being more or less even that it could either go up or could go down, based principally off the back of household consumption. What do you see as the underlying trends that are influencing household consumption at the moment? The two that I outlined in my remarks are weak income growth, which is the primary story, and housing prices, which is the secondary story. Income growth over recent years has been sub three per cent. It used to be six per cent. When your income is not growing as fast as it used to, you have to curtail your spending. That's the primary thing that's going on. As income growth has been slow year after year, more and more of us have realised that the old days are not coming back anytime soon and we have to adjust our spending plans. This is one reason that I've been keen to see a pick up in wage growth and, more importantly, a pick up in income growth. If wage growth picks up and income growth picks up, we'll all start feeling a bit better again and we'll be prepared to spend. That's the first-order issue. The second-order issue is what's going on in the housing market. There are some wealth effects from declining housing prices, but they're relatively small. We've got to remember that in Sydney and Melbourne prices are still up 70 or 80 per cent over a decade, so most people are sitting on very substantial capital gains. People who purchased in the last year or 18 months are not, but most people are sitting on substantial capital gains, so there are still positive wealth effects coming from that. It's largely the income story which doesn't get talked about enough, because the media love talking about property prices, but year after year of weak income growth finally weighs on our spending plans, so both the pick-up in wage growth and the tax cuts will boost disposable-income growth. In the past 24 hours the CEO of Wesfarmers, Rob Scott, has raised concerns about weak consumer behaviour, and it fits not only part of a wage story but also, potentially, income availability, particularly for Australian retirees depending on policy around refundable franking credits. Do you have any comments on his remarks--that there's a potential impact should retirees see a significant reduction in their disposable income? You've got to think about this as a package of reforms if the current opposition were to become the government and enact that policy. You'd have to think about the effect of that in the context of all its policies combined. I wouldn't like to just pick out one that saw a reduction in income without some other offsets. I think he's right, though, to focus on weak household income and the effect of that on consumption. That is the firstorder issue. We need to see a pickup in income growth if consumption growth is to be at the level we want. The key to that is wages. The key to that is wages. How much would you say is the share between that and other types of income support that people might have? We have many Australians who are dependent on nonwage income as the basis for their consumption behaviour. Obviously, if their incomes are not growing quickly or they're declining, that will affect their consumption behaviour. The other potential issues that could arise could also come out of increasing consumption on pre- existing activity--for instance, an increase in the costs associated with servicing debt, depending on what happens with interest rates, at the cash rate level but also at the retail level. We also had discussions around whether we're going to have more or less competition in the marketplace associated with how retail financial products are sold, particularly around mortgage brokers. Do you have a comment on the likely impact of that on household If interest rates were to rise, that would have a negative effect on household consumption, but they'll only rise because of what we did--if household income is growing strongly, the labour market is strong and inflation is increasing. If interest rates increase because of a policy decision by the Reserve Bank, it will be in the context of stronger household income growth. That's not a particular concern. Over the last year or so, a number of banks have raised their mortgage rates by, on average, 10 to 15 basis points, and that's obviously had some effect, but what is reported less is that competition amongst the banks has picked up. The banks are offering bigger discounts. The actual rate that people are paying on average has hardly moved at all--it may be up three or four basis points. So there are the headline rates that the banks poster up quite a lot, but the banks give you discounts off the headline rates, and those discounts have increased and people have become better at switching to lower interest rate products. I encourage everyone to go to their bank and ask for a better deal than the one they have. When people do that, they often find that the bank will be prepared to give them a lower interest rate. Maybe their mortgage broker too. Yes. Despite the banks having put up their posted rates, the average rate that Australian households are paying has hardly moved at all, and that type of change really hasn't had any effect on household spending. You make the point around competition in the retail mortgage environment. Do you think that, if there were changes to the structure of how a lot of Australians access their retail mortgages, like through changes to law around how mortgage brokers can operate, it would lessen or increase competition? The royal commissioner made a number of recommendations on mortgage brokers and, broadly, I would support them. The end of trail commissions, making sure that brokers have an obligation to act in the best interests of the person that they're helping, and subjecting them to the requirements of financial advisers--they all make a lot of sense to me. Who should pay the fee? That remains an open question. I think it's worth taking time to get that right, because many of the smaller lenders in the country rely very heavily on brokers--for some of them, 80 or 90 per cent of their loans are generated through the broker. So, if the broker channel wasn't working effectively, then the smaller lenders would have trouble and there would be less competition in the market. So, as we transition to the new model, it's worth taking the time to make sure we get this right, because I wouldn't like to see the brokers undermined and not being able to provide that service to enable competition in the market. I think a shift to a 'borrower pays' model could in principle work, but it would need to be managed very carefully. It is not something that should be done quickly. Considering the uncertainty of the interest rate environment, why was it that the RBA flagged the potential for quantitative easing? Can I pass that to Guy. I think my point was that it's prudent to look at it from a risk management perspective. I think it's highly unlikely. On the basis of the forecasts that Phil described earlier and our outlook, that is not a situation we expect to find ourselves in. However, we have seen the experience of a number of countries around the world over the past decade or so, where they've reached the limits of what can be achieved through lower interest rates and they have to look at other measures. I think that, from a risk management perspective, it's prudent for us to look at what we can learn from their experience, assess the effectiveness of the sorts of things that they've done and consider how they might play out in the extremely unlikely scenario that we might find ourselves here in that position. But that is not anywhere where we expect to be. I was doing that in the context of looking back over the 10 years globally, and that has been a feature of the global environment over the past decade or so. But has the RBA previously flagged the possibility of quantitative easing as part of the discussion As I recall, I believe at this committee sometime in the past you have asked us whether we have looked at it, and I think we said yes, from memory. I may be wrong on that, but I believe this was flagged a few years back, particularly when other countries were doing this--probably nigh on eight, nine or 10 years ago. It was asked, 'Have you, the RBA, looked at it?' We made the point, which I make again now, that we are not in that circumstance and we don't expect to find ourselves in that circumstances, but we need to think, from a scenarioplanning point of view, about what we would want to think about should we find ourselves in that circumstance. At what point would the RBA consider quantitative easing in terms of lowering of interest rates? What would the interest rate have to be before the discussion about QE started? I think that's still, again, a function of the circumstance that we find ourselves in. Clearly, it would be a lower interest rate than where we are now. But we've looked at the experience that other countries have had, including those that have implemented negative interest rates, and it's partly a function of our financial system and how that's set up, which is different from those. I think it's also a question which the other countries found themselves in: as you move your interest rate down, you start to see different dynamics happening. So that's what I mean about the function of the circumstance: it will depend on what the circumstances are should we get somewhere close to that point. We are not at that point now. You've said you've flagged the potential that it could happen as part of preparing scenarios. Are there any scenarios that you have presented where it would be considered as part of a policy response by the RBA? As I said, it's a scenario where the Australian economic is a hell of a lot weaker than it is today. That's not where we are now, and it's not where we expect to be in the foreseeable future. You don't have a predetermined idea that, if interest rates were to drop to a particular number, it would then be entertained as part of the discussion? Is it just a live conversation? I think that's a good way of describing it. It's not a live conversation in the sense that it's alive now. It would be a conversation which would evolve as the circumstances change and depending on how those circumstances change. Just to be clear, we weren't flagging that we were thinking of doing this. We get asked a lot, including by this committee in the past and publicly, about what lessons we've learnt from the experience of other countries. What Guy was doing in that speech was outlining the lessons that we have drawn from the experience of other countries. I think it's appropriate we do that, and it's appropriate we share that publicly. They're important questions, as you're asking now. We thought it would be useful for transparency and public discourse to have our assessment out in the public domain. I would very much hope that we don't have to go down that route. If the economy were to slow significantly, there are multiple margins of adjustment--things that could be done. We could lower interest rates further; of course, there could be a fiscal stimulus; and the exchange rate would adjust. So all those margins of adjustment could take place before we would need to consider this, but in extremis there are scenarios where that would have to be seriously considered. But can you understand why some people--and I include myself in this camp--would be concerned, when we have the RBA governor saying, 'We--the international community as well as us--have limited policy levers should there be a downturn because of the fiscal situation as well as relatively low long-term interest rates,' that there's the socialisation of quantitative easing as a policy response? It's a possibility. There are other possibilities that I think would be useful to explore before that, including a fiscal stimulus, in this scenario where the economy is very weak. And the exchange rate would adjust, I would expect, which would help as well. The history of the last 30 years of a flexible exchange rate is that the exchange rate is the great stabiliser. In an environment where our economy was very weak I'd expect the exchange rate to depreciate, and that would help. But there are extreme scenarios where we would have to look at other monetary options if these other margins of adjustment weren't working. It's not something that we would do lightly. If you're saying it's something you wouldn't do lightly, would it be because you'd exhausted all other options or would it just be as part of a policy mix? The other margins of adjustment are fiscal policy, the exchange rate and lowering interest rates. If we'd done all those things and the economy was still very weak, we would have to look at whether other monetary tools could work. Other countries have reached the limit where they've assessed that they couldn't lower interest rates any further, and they've looked at these other options--including quantitative easing--implemented them and had some effect on the macroeconomies as a result. That--in seeing what they've done--gives us some sense as to how this may play out and the other effects it may have on the economy. I understand. I have a deep concern that we're inflating and protecting asset prices for those who are already established at the expense, largely, of young Australians who want to do things like get into the market and buy homes. That has certainly been the experience over the past decade. So when you have the RBA flagging at least a discussion or consideration of such a policy that would perpetuate that and undermine the opportunity for home ownership for young Australians-- Could I jump in. The issue of distribution comes up a lot in quantitative easing. As you note, one of the channels through which it works is asset prices. One of the other channels it works through is boosting employment, which disproportionately benefits young people. Another channel that it works through is boosting wages and incomes, which also has effects on income distribution. So I would say it's important to focus on the fact that there are a number of different channels through which this works--as does monetary policy generally, actually. The intent is to boost employment and incomes. It does have an effect on asset prices. It also has an effect on interest rates, and the effect of that depends on whether you're a borrower or a saver. The extent to which interest rates are lower as a consequence of this also benefits people who are looking to enter the market. So I think it's important to look at the fact that there at least four channels of effect here. A number of studies have looked at how that has played out in some other countries. If I can cite just one: the Bank of England have looked at how this has played out in the UK over this period. The conclusion they get to is: yes, it does have these different impacts and, yes, there is this effect on asset price, and that has an effect on one aspect of income or wealth inequality, but then you've always got to remember that the effect on employment and wages is particularly strong at the other end of income distribution. The assessment is that, looking at all these things together, there isn't much overall effect on income and wealth inequality. Whatever your distribution of wealth or income was beforehand, they don't seem to have seen it change much afterwards. It doesn't affect things much one way or the other. It has differing effects depending on where you sit in income and wealth distribution. My final question before I hand over to the deputy chair is: why is the detail around interest rate movements made public the way it is? You have your decision statement and then you have the detail following up in speeches and a monetary statement. Why is there a delay between those? Do you think it's beneficial for the market to have a delay in that information? The Reserve Bank Board meets, it finishes its meeting close to one o'clock and the statement comes out at 2.30. The philosophy there is to let the market know as quickly as possible after the decision and to let the market know the facts upon which the decision is made. We do that in a short statement--one to 1 1/2 pages. The discussion around monetary policy and the likely next move, that tends to take place through speeches and through the minutes. If we were to change the current model, it would require that statement straight after the meeting to be delayed, and longer. The judgement that we've made, for better or worse, is it's better to let people know straight after the meeting what we've decided and the facts we've used to make that decision, and then take opportunities, including speeches and minutes, to lay out in a much more detailed way the various considerations in how we are balancing those. It's certainly true we could do it in a different way, but I'm comfortable with what we're currently doing at the moment. Mr Lowe, in the recent board minutes there was a discussion about China and Could you just elaborate on that statement? Are you referring to particular indicators here? Would it be okay if I asked Luci to answer that? Yes, of course. In looking at the data for China, we had, for a long time, been expecting that GDP would slow because of structural reasons: their population is ageing; as they get richer, you generally find a slowdown as you reach the front tier of possibility for production. We've always expected that. On top of that has been the effects of some of their tightening of financial policy in their response to financial risk there. What we noticed in the run of monthly data more recently was that some of the data around investments and the data on retail spending had just been a little bit lower and had slowed further than what GDP had slowed. That sentence is simply an assessment of the whole range of official statistics, many of which did indeed slow a little bit more than the very gentle slowing that we saw in the overall GDP numbers. So some of the indicators for the industrial sector, some of the indicators for retail spending have slowed a little bit more. Both official statistics and some of the private sector or third-party statistics around China have been saying that, and it certainly conforms to the atmospherics that we're hearing from our contacts in China. Dr Lowe, the chair asked you questions about the news overnight regarding the stoppage of some coal exports at a particular port. Your comment was that it was only two months worth of exports at that particular port. Isn't that alarming in itself, that a relatively 'smaller amount', in your words, can have such a dramatic effect on the Australian dollar? I was surprised at the reaction of the Australian dollar. I think when the news came out, people were unsure about how to interpret it. Some people interpreted it as a fundamental souring of the relationship between China and Australia. If that was what was taking place, I can understand why the currency would move quite a long way. But I wouldn't jump to the conclusion that that's what is actually taking place here. As I said, it could be as a result of what the Chinese--they've been trying to contain steel production and improve the profitability of the coal industry, so it may be that there's a more benign explanation for what's happening. We need to wait and find out more. Do you think that Australia's growth model is too reliant on China and too vulnerable in that respect? I don't think our growth model is too reliant on China. A lot of exports certainly go to China, and that's been a source of tremendous wealth and prosperity for our country. The big rise in the terms of trade, the big increase in national income and the big increase in investment are all because China is growing very well and we've been incredibly well placed to take advantage of that. Many of our service industries are doing fantastically well because of China. Tourism in many parts of the country is doing very well because of Chinese tourists and Chinese students coming to study in the country. That's been to our advantage as well. We've benefited as a country tremendously. Diversification is always good. I would hope, over time, we would develop strong links with India and Indonesia. We'll benefit in the same way that we've benefited from the growth of China. A deterioration in the relation between Australia and China would be very difficult for us, I agree. Isn't the danger here the fact that China can do this--that they can just make a decision to stop an export overnight, an export that you, yourself, have said is such an important driver of growth to the Australian economy? It's certainly undesirable. Whether it's a disaster, I think we've got to wait and see. It really depends on whether it's a result of a deterioration in the underlying political relationship or something to do with the coal and steel industries. I just want to turn to the domestic scene. I've talked to quite a few economists and commentators. Since we last met, I'd say that there's been a definite shift and that, on balance, the outlook for the Australian economy is now more negative than positive. That's reflected in a number of indicators. You've mentioned consumption and others. What struck me was the statement that you made earlier on--that is, that the probability of the next move in rates being up is more evenly balanced with the probability of it being down than it was six months ago. That single statement and the change in language from the RBA point to the fact that the outlook is now more negative than positive, doesn't it? I wouldn't say it's more negative than positive. The central scenario is for growth of three per cent, inflation of two per cent and unemployment of five per cent, as I said in my introductory comments. In the broad sweep of our history, that would be a good outcome. The central scenario is a good outcome for the Australian economy--more people finding jobs, inflation low and the economy growing at least at trend and probably a bit more than trend, and eating into spare capacity. That's the central scenario, which I think is a positive one. Is it fair to say that the outlook is more negative than it was the last time we met? I would put it slightly differently. It's not as positive. It still positive-- Glass half full, glass half empty! I think we've got to keep perspective--growth above trend, low and stable inflation and low unemployment. You've got to remember that the unemployment figure yesterday, for New South Wales, was 3.9 per cent. You've got to go back to the early 1970s to see unemployment that low in New South Wales. In Victoria, the unemployment rate is 4 1/4 per cent to 4 1/2 per cent. Again, you've got to go back to the early 1970s to see unemployment rates like that. And I'm expecting unemployment to stay at those levels for quite some time. This is not a bad outcome; it's actually a good outcome. I do agree with you that some of the downside risks have increased, but the central scenario is a positive one. Even though unemployment is at that level, Australians aren't feeling positive about their lot in life at the moment. A lot of that is related to the fact that wages growth and income growth have been so low for such a protracted period of time and there are high levels of household debt. They're not feeling the love when it comes to their outlook about the economy at the moment. Is that something that you understand? I certainly understand that and I've spoken extensively about that publicly. As you pointed out, the underlying issue is the lack of income growth. Aggregate household income used to grow at six per cent. It's growing sub three. That's a big difference. If you accumulate that over three or four years, income is eight per cent, 10 per cent or 12 per cent lower than it would have been if we'd been on the old trajectory. Many people borrowed, consuming their incomes would grow at the same rate, and they haven't. They've having more difficulty. They've got less free cash, so they can't spend in a way. This is why I've put so much emphasis on the need for a pick-up in wage growth. .Our strategy here has been twofold. The first is for me to talk publicly about the benefits of stronger wage growth to try and raise wage expectations. It's not a conventional thing for the central bank governor to be saying, 'We want stronger wage growth.' So hopefully lift wage expectations--that's the first part of the strategy. The second is to keep interest rates low, stable for a long period of time, hope the labour market tightens up and wage growth picks up. I see evidence of that strategy working. The unemployment rate has come down more than we thought six months ago and wage growth is gradually picking up. Private sector wage growth is the fastest in four years. When you look at wages including bonuses it's rising, still at a fairly low rate but a faster rate than before. So I think the strategy is working. We're having to be patient--I know that's not very satisfactory for many people in the community, but I think the underlying strategy is working here. We've had a discussion in the past about the NAIRU, the non-accelerating inflation rate of unemployment. I think you've said in the past that it was five per cent. Has that view changed within the bank? Is it now in the fours? If I said it was five, I would have misspoken, because I'm so unsure what the actual number is. Normally there's quite a large ball of uncertainty. I think you said the conventional wisdom was that it was five. And the central point of that ball of uncertainty we used to think was around five; I now think it's lower than that. But the ball of uncertainty is quite large. It sits solidly in the fours. I think this country can have an unemployment rate close to 4 1/2 per cent without wage growth causing problems for inflation. I think in the past--correct me if I'm wrong here--you've said that you'd like to see wage increases with a '3' at the beginning of them nationally in terms of wage price index data. In the recent statement on monetary policy, there's a box--Box A--on minimum wage developments in advanced economies. It indicates that a lot of advanced economies have now undertaken quite high increases in their minimum wages: South Korea above 40 per cent, New Zealand above 20 per cent, Spain above 20 per cent. Australia is looking like a bit of a laggard now when it comes to minimum wage increases. Given that I think, on average, over the last few years minimum wage increases have been at the two to three per cent level in Australia, is that something that you think it's time for us as legislators to look at in terms of the objects? I know that it's done independently of government by the Fair Work Commission, but do you think it's something that we should be looking at as legislators in terms of the objects that we provide to the Fair Work Commission to look at to perhaps encourage some growth in those minimum wages? That's entirely a matter for the parliament, but I've been quite comfortable with the minimum wage adjustments over the last few years. Last year it was 3 1/2 per cent. The year before it was 3.3. In these other countries that have had very large increases in their minimum wages, it's partly because the level of their minimum wage was quite low and they've had to lift them up. The benefit of regular adjustments in our minimum wage is they haven't got too low relative to the median wage in the economy, so we haven't had to have big-step jump-ups. But I think minimum wage increases starting with a '3', even though average wage increases are 2 1/2 to three, make a lot of sense. In terms of what I would like to see, when I spoke about this before I made the point that, over time, the Reserve Bank is supposed to deliver for you average inflation of 2 1/2 per cent. I would expect labour productivity growth to at least average one per cent--I hope we can do better, but I think we should be able to manage labour productivity growth of one per cent. And if workers get their normal long-run share of that then their real wages should rise by one per cent a year. So 2 1/2 per cent for inflation plus one per cent, at least, for productivity growth would give 3 1/2 per cent wage growth. For me, that's the best steady state--3 1/2 per cent, maybe a bit faster than that, with 2 1/2 per cent inflation. Recent increases in the minimum wage have been 3 1/4 , 3 1/2 , which is broadly consistent with that, and I think that's the sensible and the right policy. In that particular analysis, graph A2 looks at the minimum wage comparable to the median wage and it indicates that, on that measure, Australia is falling. Is that something that would be a cause for alarm? No, I think the changes are fairly small. And, in the last two years, the minimum wages have risen more quickly than the median wage. I haven't got that particular graph in front of me, but minimum wages in the last two years have risen more quickly. There are a couple of years previous to that where that was not the case, but, in the last two years, minimum wages have risen more quickly, which I think, given the circumstances we find ourselves in, is a reasonable outcome. Regular increases in the minimum wage around this three or 3 1/2 per cent benchmark, I think, make sense. Underemployment is still a great cause for concern for us. Is there a level that you think underemployment needs to get to before we'll start to see a turnaround in wages growth across the It's really in the same kind of ball of uncertainty they talked about--the NAIRU. The main source of underemployment is people who are working part-time who want more hours. So, at the moment, roughly onethird of the workforce work part-time and most of these people actually want to work part-time, but, of that one- third, about one-quarter want more hours than they have at the moment and, on average, they want two extra days a week. So it would be good to see sufficient demand in the labour market to allow those people to continue to work part-time and have the hours they actually want to work. We don't have a critical number here. It would be good to see that number come down, though. I'll move to housing. We've seen some substantial falls in asset prices particularly in the Sydney and Melbourne markets over the last two years--some up to 20 per cent falls in year-on-year averages. If prices in those markets fell by another 20 per cent, what would the bank do? What we do will be governed by what happens to the outlook for inflation, unemployment and growth. You've got to put this in perspective. In the last year, we've had a 10-plus percentage point decline in Sydney house prices, yet the unemployment rate in New South Wales is 3.9 per cent, so there are other things going on that are offsetting the decline in housing prices and the effect of that on people's consumption, so we're looking at the whole economy and what's going on with output, inflation and unemployment. I don't think a further decline in housing prices in Sydney and Melbourne is going to derail the central scenario that I've talked about. There are enough other things going on, as they have over the past year, that will offset that. It's certainly possible that the confidence in the housing market is undermined and prices fall and people will become very negative, and that has a bigger effect on the economy, but that doesn't look like what's happening to me. We had, as I've spoken about a number of times, a big pick-up in population growth in New South Wales and it took the better part of a decade for the rate of home building to respond to that. Prices went up--hardly surprising--but, finally, the supply side did adjust. There were changes at local governments and by the New South Wales government, and the rate of home building at the moment is the highest that it's been in decades, so the rate of addition to the housing stock is very high. And population growth has slowed a bit, so prices are coming down. I don't see signs of fundamental disequilibrium between supply and demand now in the market. In some parts of Sydney, maybe there are a few too many apartments, but, if you look at Sydney as a whole, I don't think we've built too many dwellings. The NAB is of the view that we've got an oversupply of apartments in Sydney and Melbourne. Are you saying you have a different view? I don't think so. One of the things that's happening is, as prices come down, new households can form. The rate of household formation has been quite low when prices were very high. This is the behavioural relationship: if house prices are lower and rents are a bit lower, households form and are moving to the newly constructed housing. So that's quite plausible. I don't see signs of widespread overbuilding of dwellings in this country. APRA have changed some of the measures that they put in place some years ago around the rates of interest-only and investment loans. Do you think that, in hindsight, APRA used a sledgehammer to crack a nut and that they went too far and it went for too long? Not at all. APRA's measures, I think, had very little effect on housing price dynamics. The dynamics have been driven by population growth and inflexibility on the supply side. When prices were rising very quickly, investors were rushing into the market, because why wouldn't you? Prices were rising quickly. You could buy an asset whose price was going to go up, and interest rates were very low. So investors were rushing into the market, and that was amplifying the upswing that was being caused by the supply-demand dynamics that I talked about. APRA, with our encouragement, came to the view that that extra impulse that we were getting from investors needed to be scaled back a bit, so in 2014 the 10 per cent limit was put in place, and then in 2017 the cap on interest-only lending. Both of those things were entirely appropriate with what was going on. The decline we're seeing in house prices has very little to do with APRA's measures. They were both targeted and temporary, and that was appropriate. The decline in prices we're seeing now is the supply response that took place almost a decade too late. Governor, do you have any insight as to why supply was so slow to respond to increasing population in the Sydney and Melbourne markets? Actually you are talking about Sydney specifically. In Melbourne the supply side was a bit more flexible, but still the population growth there picked up a lot. This is not my core area of competence. I'd observe that few people forecast the pick-up in population growth. It almost came endogenously out of a strong economy. We certainly look back now and say there was a big pick-up in population growth and where did that come from? With people not knowing it was on the agenda, the supply side wasn't able to plan for the pick-up in population growth. There are longstanding problems that others have talked about with land release in Sydney and rezoning in Sydney. It takes time. I think you're gently trying to indicate that government regulation in New South Wales was the thing that most impacted supply responses. Luci, you've probably studied this more closely than I have, but I think broadly what you're saying I'd agree with. If you're looking to compare what was happening in New South Wales versus in other states, obviously differential planning regulation matters. But what I would want to put in context is, firstly, supply and demand for housing is supply and demand for a stock of housing, and most of it is already there. So however much you can build in any one year doesn't add much proportionately to the supply. If you're used to having population growth of 0.8 or one per cent and it quite rapidly goes up to 1.5 to 1.7 per cent, that's sort of saying you almost need to double the amount of construction that's happening. That takes some doing, particularly if you haven't been warned that that's going to happen. There are just inherent delays in being able to marshal that degree of expansion in your incremental supply. There is always just a stock versus flow issue. No matter what you do with rezoning and other regulation, you will always have a situation where, if you double the rate of population growth, you will, for a time, see higher housing prices. The other point I'd make there is that Sydney, relative to some other cities, is relatively constrained. I'm a Melbourne girl. I grew up back when a number of places like Lara were not easily accessible to the centre of the city. They were considered outside of Melbourne. One of the things that's happened in Melbourne is that they've discovered that they've got all this relatively flat land to the west and south-west, and that is developing quite rapidly. There has been room to expand detached housing on the fringe. There has been relatively less apartment development in Melbourne, and there are many municipalities quite close into the centre that prevent that, whereas in Sydney, it's actually quite hard to expand Sydney much further: you hit mountains, or ocean or national park. But it has been easier to put apartments all the way through the city and so you have seen a rather different supply response, but it's one that has involved more delays because you have to realise: 'Hey, there are areas where we never used to have apartments that we need to rezone, and we need to think about that. We need to think about the transport and infrastructure.' It's just not something that happens overnight. Can I put words in your mouth for a moment? What you're saying is that the federal government's rapid expansion of immigration in 2008 is most responsible for the increase in house prices that we There are a number of factors, but that is an important one. To the extent that population growth did increase, that was a reason why we were starting to hit those inherent supply constraints, some of which could have been improved with different zoning regulations. But some of them are just mountains and national parks. And so Sydney was more likely to experience that rapid population growth resulting in high housing prices because population growth moved. But sometimes population growth does fluctuate, regardless of policy. We certainly could have had different outcomes in the housing market if society had understood that population growth was going to pick up and we planned for it--if local and state governments planned for it. But we didn't really plan for this pickup in population growth. It kind of crept up on us and then we found that the housing market was very tight and we needed to build more apartments or houses, and that we hadn't had the supply side-- Didn't we go from 170,000 migrants to 400,000 migrants within a very short period of time? I don't know whether those numbers are right, but there was a big pickup in population growth. I think it's also important to remember that a lot of the fluctuation in net overseas migration is actually people arriving on student visas. And so, in some sense, it was understanding the implications of the success of our education export industry. Okay. Governor, you mentioned that there's greater discounting among providers for interest rates at the moment. Do you keep any data on that, or is that just a sense that the-- No, we do keep data on it. We have a database called the 'securitisation database', which collects data, I think, on-- Two million. Two million loans. And I think we publish data in the Statement on Monetary Policy--the average rates-- In the Financial Stability Review--the rates that people actually pay. We're currently implementing a new data collection from the banks which will give us much finer disaggregation of what people are actually paying. We plan to publish that later this year as well. That'd be good. I've thought it really important that the community understands what people are actually paying on their mortgages-- As opposed to-- because there are actually some very good deals out there. The best thing the 25 million of us can do for bank competition is to go and demand those good deals and, when banks offer them, to respond, switch and move. It turns out that when you do that you can actually do quite a lot better than what you've got. I encourage everyone who has a mortgage, if they haven't done so recently, to go and ask their bank for a better deal. And if the bank says no, go look for another bank. Or a non-bank. Or a non-bank, as Guy says! A non-bank lender-- Or a non-bank lender. So there are plenty of very good deals out there, and if we want the banks to compete then we have to respond to those good deals. What deals should we be looking at? Are there any particular-- I'm not going to go there! On switching between accounts: you mentioned that the rate of switching between accounts has picked up. Do you publish any data on that? Or do we find that in the Statement on Monetary Policy? We have data on refinancing, but I don't know whether it's refinancing-- Yes, there is the data on refinancing, which is actually published by the ABS every month. Most, but not all, of those deals are refinancing to a better deal, but that's when you switch from one bank to another. But if you stay with your existing bank and, possibly, threaten to switch and then get a better deal, that's not in that data. We see that in this database that Phil mentioned earlier--this is loan-by-loan data. In one month it has one rate and then the next month it has a lower rate, so we can keep track of that. I understand that that would give you information on discounting, but switching. That's in the refinancing-- But that could just be--I've come to the end of my term with principal-only and now I have to refinance to interest-only. But I may not change provider. The interesting thing is that if you have data that shows that people are switching between providers then that runs counter to the Hayne royal commission's finding, which was effectively that we don't have competition in the Australian financial service market; we only have the appearance of it. So, is there-- Well, I think we do have competition. The competition would be more effective if more of us switched. People are switching all the time. There are enough people who've taken the advice and-- As a humble backbencher, if I wanted to go and find and track where switching is occurring, is that information implied in other data, such as refinancing? It's implied in the refinancing data. But you agree that it might not actually be capturing switching? Perhaps you'd like to take that on notice and come back to us. Yes, I can provide you with more details of what the refinancing data actually includes and how to interpret it. That would be fantastic. The other thing is that the Hayne royal commission pointed very early on to the fact that you have a blizzard of products--I think the number 4,000 was mentioned in terms of mortgage products in the Australian financial market--and a blizzard of brands which are effectively owned by four major providers. What this is creating in the marketplace is consumers who are confused and therefore stick with what they know or understand, because venturing forth into that market just becomes too difficult. This is a psychological phenomenon that I think Mr Krugman has mentioned on several occasions. Why then would we not want to encourage mortgage brokers? I think mortgage brokers play a very important role in the system. They help the smaller lenders. They bring competition that way. But they also help each of us to work through the maze of these thousands of products. That's their job--to kind of understand the thousands and work out which are the best deals. So, mortgage brokers play a very important role in facilitating competition. So, when the Netherlands moved to a system for mortgage brokers similar to the one that the royal commission has recommended--which is that consumers pay the fees, not the provider--did that not lead to the decline in mortgage broking business and the number of brokers available in that financial market? I haven't studied it, but I have spoken to the governor of the central bank there, and he said there were some teething problems but the market has adjusted. People pay the fee and it's capitalised into the loan and they pay it off over time. The Netherlands mortgage market's more complicated, because often the mortgage is somehow tied up with your pension, so it's much more complicated than our market. I think in principle we could move to a model where the borrower pays and the fee gets capitalised and you pay it off over time. But I'd be wary of doing that too quickly. We'd need to look at it very carefully before we did that, because the brokers play such an important role in facilitating competition. So, you agree that it's a critical role in the market that we've ended up with at the moment. Yes. I'd also agree that different models of who pays can work, but you wouldn't want to change too quickly without having made sure that you understood all the implications. In the three minutes that I have left, I'm going to venture forth into a particular area that we could talk about for the next hour and a half, which is household debt. In particular, interest rate movements could be taken out of the hands of the RBA, couldn't they? Well, how would that happen? Certainly banks adjust their mortgage rates every now and then by relatively small amounts, and that tends to get unwound by competition. Let's say there was a trade war between two major economies globally and that created an exogenous event where debt markets suddenly became more expensive. That would feed through into the Australian marketplace, wouldn't it? If credit spreads rose and the spread that the banks have to pay to raise their money increased. You're at 150 basis points at the moment. You have little room to move in terms of trying to absorb some of that shock at the Australian level. We do have some room. If the credit spreads rose further and we didn't want to see mortgage rates rise, then we could lower the cash rate, and we still have room to do that. But compared to 2008, you don't have as much headroom. That's mathematically true. If we found ourselves in this situation, then, as we were talking about before, there are other margins of adjustment. It's not just monetary policy that can stabilise the economy. Fiscal policy can play a role as well, and so can the exchange rate adjustments. We shouldn't have a mindset that monetary policies are going to solve all these problems I understand. We've got fiscal policy and exchange rate adjustments as well. But what I'm interested in is your view. We have a highly indebted household sector, by some measures the most indebted in the world. If we then had an exogenous event which drove up interest rates, what would that do to consumer confidence and to spending in the economy? Higher interest rates-- As a parliament, should we be cognisant of the fact that we don't introduce policies that impact consumer spending negatively or impact housing prices negatively in the short term? My answer to that question, whenever it's asked, is yes. We want the parliament to do things that reassure households, support household income and give people confidence and businesses confidence to employ and invest in people. We always encourage the parliament to do that. We will now resume. Just for clarity, particularly for the precocious and humble member for Mackellar, the time allotted for each member of the committee is equal, except for the chair and deputy chair, who get 20 minutes. Everyone else gets 15 minutes, and therefore I hand the next 15 minutes over to Mr Keogh, the member for Burt. Thank you, Chair. Thank you, RBA team. No doubt you would have observed that there were some articles referring to an NAB outlook that said rates would stay the same for the next decade. Then we had a story this morning regarding Westpac's view that there'll be two cuts this year. It strikes me that there are three options: neither of them are right, or one of them is right. Which? I think there are a lot of different scenarios, so we have to weigh these and assess them each time the board meets, and that's what we do. I get the impression you don't necessarily agree with NAB or Westpac, from the statement that you made in your opening remarks. In which ways are they wrong? What are they putting too much emphasis on or not enough emphasis on? I don't think of it as being wrong or right. I think of this more in probabilistic terms. There's a possibility that rates will need to go up. I think it's unlikely that that would occur this year, because the inflation outlook looks so benign. But if things turn out broadly along the lines of the central scenario--the unemployment rate comes down and inflation rises, and that happens gradually--then at some point next year it may well be appropriate to increase interest rates. So that's certainly possible, but it's also possible that we end up with weaker consumption growth, wage growth doesn't pick up, the housing adjustment weighs on spending more than we think, and we need to consider lower rates. So I don't think either one is right or wrong. Both are possible. What we do every month at the Reserve Bank board is to discuss those possibilities and see how the probabilities have shifted. When we see the probabilities shift as part of our transparency, we articulate that to the public. We don't have a crystal ball, so I can't say what's right or wrong. All I can do is say how I see the probabilities of these scenarios. What do you see as the impact, or are you in any way concerned about the impact, of having two major bank economists give, at best, a status-quo-only prediction or basically a negative prediction going forward? There's no-one saying rates are going to go up and, by that, implying that the economy's about to take off. They're saying either 'two cuts this year' or 'no change for a decade'. Are you concerned about what that is then saying to the country about what might be occurring and whether that therefore has a negative impact going I don't think so. Everyone's entitled to their opinion. Yes, but it's quite different when humble backbenchers like Jason and me express an opinion, as opposed to the chief economists of two of our major banks, or when you express an opinion for us. My opinion is that the probabilities of rates going up and going down are broadly balanced, and what we'll do at every meeting is discuss those probabilities. When we change our view, I'll articulate that publicly, and everyone else is entitled to their own view. It doesn't worry me too much if some people have one view and other people have another. That's what they're paid to do. Yes, they're paid to have a view. What I am paid to do is to balance the probabilities and make a judgement in the national interest, which is what my board try to do every single month. Would it be true to say that you would be, or are, less concerned about a long-term trend developing of inflation being below or at the very bottom end of the target band than if it were to be at the top end or above the target band? I haven't had to contemplate that, inflation being at the top end. Well, not for a while. For quite a while. But there seems to be a pattern that what is developing is a trend of it being below or occasionally getting just into the band. And that's not something that I see the board expressing any concern about, whereas, historically, when we've seen it staying at the upper end or popping up above the band, that is something that immediately we hear concern expressed about. If I thought inflation was going to stay sub two per cent indefinitely, then I would be quite concerned about that, because what would happen is inflation expectations would become lower and it would be hard to get inflation up eventually. So I would be concerned if inflation was going to stay for a long, long period below two per cent. But that's not our central forecast. We see inflation gradually picking up. And, as I said before, the strategy is really around keeping interest rates low, having the labour market tighten up, wage growth pick up and inflation picking up. Broadly, that scenario is working--that strategy is working. I'd like it to work more quickly, but-- On that, and it comes back to some of the questions that were raised earlier about the NAIRU and answers you have given this committee previously, I'm going to put a proposition to you. I want to see what you think about it. The concept of the NAIRU being at around five per cent, which I know we're not so certain about now, is premised on the basis of a particular mix in the economy of full- and part-time employment and permanent employment versus casualised employment, with an overlay of a degree of job security that comes, in particular, with permanent employment. Over more recent times, we've seen not only an increase in part-time employment and in the rate of casualisation in employment but also, even for those who have nominally permanent employment, a decreased level of job security in that employment. I'm not talking about whether any of those things are good or bad, but about the change in that make up of the employment mix. Therefore, when we talk about a particular rate of unemployment it is quite a different context and concept to what might have been spoken of a decade or two ago. For that reason, the rate at which you would see inflationary pressure from a particular rate of unemployment is much lower than we've traditionally thought. I would agree with that. That's why I said before I think the country can have an unemployment rate around 4 1/2 per cent without causing wage growth that's so fast that it causes problems for inflation, largely because of the factors that you are talking about. It's a global story. Workers and firms right around the world feel like there's more competition, and they feel more uncertain about the future because of technology and competition. That affects everyone's pricing power and pricing decisions, including workers and firms. So the global system seems less inflation prone to me, because of globalisation and technology, and workers in Australia are feeling that just as they are right around the world. And you have to have the labour market to be quite tight-- much tighter than we used to think--to get people to move beyond the concerns about competition and technology. In your opening remarks you talked about the key to boosting real income being lifting productivity. You spoke a bit about labour productivity before. But we have seen some substantial jumps in corporate profitability over the last few years not flowing into that wage growth. Picking up the point you just made, do you think it's that uncertainty and the concerns about competitiveness that's meaning that even though there have clearly been increases in productivity leading to profitability, we are not seeing that reflected in wage That's certainly possible. If you look at the last five years, the rate of underlying productivity growth the economy has generated would justify faster nominal wage growth, but if you look at the past 10 years that's not the case. In the previous five years real incomes of households rose more quickly than justified by underlying productivity growth--we had the big rise in the terms of trade and the mining investment boom. So many of the community got wage rises beyond what productivity growth would have justified, because the economy was doing so well because of the resources boom. So what we've seen in the last five years is the reversal of that. When I look at that whole 10 years together, workers have basically got their normal share of productivity growth, but it's quite different over the two five-year periods. It may be we're just seeing the workings out of the resources boom, or it's also plausible that these forces of competition and technology are meaning workers aren't getting a normal share. Isn't part of that that, when you go through what we saw in Western Australia, principally in terms of a mining expansion and mining construction boom, just looking at the productivity figures, as you might, traditionally and simplistically completely masks what's going on, because it doesn't look productive because you're investing all this money for which you don't see any income for another decade or after it's finished. There's quite a tail there. You're talking about a very different understanding of productivity and the relationship to wages, because the wages come first and the income comes much later. I agree with that, and Western Australia has got its own issues continuing at the moment. But, over 10 years, productivity growth in the Australian economy has broadly matched changes in real wages. So it aligned, even though there was that disconnect? Real wages ran ahead of productivity growth. I remember giving speeches saying that we're getting improvements in our living standards even though we're not becoming more productive. Because we were becoming more productive, but it didn't come until that investment. Because we were selling our rocks for a higher price. So that meant our real wages could rise, and, once we are selling the rocks at a lower price, that gets reversed. Except we're selling a lot more of the rocks? We're selling more. In the broad sweep of history, this has worked out okay, although we have had five years when people's wages have not been rising at the rate of productivity growth, and that partly underlies the unhappiness that we're seeing in the community. To pick up on that point, effectively what you're saying is that, because the nature of that productivity is one where there's a significant up-front investment, wages go up, there's an investment in capital in expanding these mines and whatever else was going on, and then the income flows. So it's not about the price of the commodity, but there's such a much larger volume that the income went up first, the productivity then matched--which you would presume is what all those mining companies were anticipating would occur. The issue we've discussed internally is: is that 10-year adjustment now completed? Hopefully we're going to go back to a period where real wage growth matches labour productivity growth. It's a big question about whether that takes place. I certainly hope that takes place, but you can't be certain. So does the nation. You mentioned before that Western Australia has some unique issues. Your comments and other comments have talked about a correction in housing prices within Sydney and Melbourne, and that's been a key focus. What's happening in Perth? I went to Perth a couple of times last year, and, especially earlier in the year, I saw signs of things bottoming and maybe even picking up, but the housing market in Perth has deteriorated again. I noticed the rental vacancy rate is coming down, so that's good news, but prices are still declining and employment growth has stalled over the past year in Perth, after having been reasonable in the previous year. So I'm having a bit of trouble putting all the pieces together, because I know the agricultural sector has done very well. The wheat crop in Western Australia, as opposed to eastern Australia, has been at a record high, so they're benefiting from a lot of production, higher prices and a fairly low exchange rate. So the agricultural sector is good. In the resource sector, we're hearing more positive stories all the time. A number of firms we're talking to are speaking about expansion plans, more sustaining capital investment and some are even thinking about expanding production. So they've got the resource sector and the agricultural sector doing quite well, but the housing market and the labour market seem to have softened again, and I'm having trouble putting all those pieces of the puzzle together. So are we. That's why I asked the question. To pick up on the other point you made that, in Sydney and Melbourne, the declines are not having the wealth-effect impact because, over the 10 years, house prices are still so much higher, that's not the case in Perth. Are you seeing significant wealth-effect impacts in Western Australia, where people don't have that advantage? It's hard to tell because the state based data are very noisy, and, when you try and estimate these relationships, it's much harder to find them. But it's quite plausible that the protracted period of price declines in Perth is having an effect on consumption, and the labour market is part of that. I'm a bit more optimistic because of what I hear from the resource sector: the expansion plans; the sustaining capital spending seems to be kind of flowing. I think that it's reasonable to expect that that will flow back through the rest of the economy. We'll have to wait and see. You noted in your opening remarks PayID and the changes to the payments system to allow instantaneous transfers and connection of accounts to mobile phones. I was going to ask you what the uptake was. Clearly, it's not that great, and that's because banks haven't implemented it, I gather from what you've said in your opening remarks. Have there been reasons provided for why they haven't implemented it? There are always reasons. Perhaps I can ask Michele to talk about this, as she's closer to it than I am. Sure, there are always reasons, and I think the main reason that seems to be coming back is that their legacy systems are just much more complicated than they thought they were going to be. I think there's probably some truth in that, but I also think that they've had a very long time to address this issue, and they should have been, really, a bit more ahead of the game. Having said that, I would say that I think there's a good story here. Increasingly, you're seeing more volume going through the NPP. There are about half a million transactions a day that go through. I think Phil mentioned 2 1/2 million PayIDs. I think what's really interesting, in fact, is that the Department of Human Services are now using it to make urgent and disaster payments. In fact, I'm told that they have made about 1,800 NPP payments to people who've been involved in the floods and the bushfires recently. That's really positive. They can do it on weekends. The people get it pretty much instantaneously. This, I think, is really good. We've got this system now. People aren't waiting for cheques in the mail anymore. The money is there when they need it. So I think there are some good stories. There's more to go, but I think it's really positive. My final question in this round is related to an earlier issue. It goes to this competition point-- made probably more in Western Australia than, say, some other places--where, whilst homeowners might not be underwater on their mortgages, they have now slipped to a position where their LVR is such that they're finding it very difficult or in fact impossible to refinance, or at least impossible to refinance with a different bank. Are you seeing that show up in your data? Are you concerned about the competition issue, in that it's all well and good to threaten to go to another bank, but, when your LVR is 92 per cent, there's no opportunity to go to another bank? I'd agree with that, and you really have to stay with the bank you've got, because in the current environment-- It's very hard to say, 'Give me a discount on the interest rate.' It is, but most people are not in that circumstance. Some are, and they have fewer options. Yes, that's true, but most people are not in that circumstance. I think I read in a Peter Hannam piece in Fairfax over the weekend, Dr Debelle, that you're giving a speech soon on climate change. I've got a few climate change questions, so should I direct them to you? Thank you. The bank is obviously aware that Australia has signed up to agreements that include temperature limits around global warming. For warming the planet, 1 1/2 and two degrees are referred to in the Paris agreements. APRA said in a speech a couple of years ago that policymakers, regulators and companies ought to treat those limits as a lodestar, in a sense. We know that we want to limit warming to that, so what needs to be taken into account not only by companies but also by regulators? That is not just whatever government's policy might be right now but also having to factor in policy risks, changes over the next period of time--things that might have to happen in order to stay below that limit. Has the bank considered or discussed at all the IPCC report that was released late last year? It has? Yes is the short answer to that question. In that IPCC report, they make the point that we've already warmed by one degree, and they say that to stay below the limit of 1 1/2 degrees they've got a few scenarios, which they map out. All of those scenarios say that by 2030 there is going to be a rapid decline in the amount of primary energy produced from coal. The range in the scenarios is that it will reduce by between 59 per cent and 78 per cent--on average, around twothirds. Is that the bank's understanding of the IPCC report? I've read it; and that's what they say, yes. That would have significant impacts for Australia if the world, including Australia, stuck with policies that were consistent with the IPCC report because it would mean in Australia a two-thirds decline in thermal coal use and exports. Do you think it would be a good idea for the Australian government to have a plan to deal with the managed phase-out of thermal coal exports consistent with the IPCC? I'm not sure I'm qualified enough to answer that specific question. I would make a couple of points related to what you have said. Firstly, what is the nature of the adaption, both in that sector and other sectors, to what's going on? That's what we are thinking of from our perspective. We can't influence things along the lines of what you are talking about, but we can look at and try and get a sense of how other people are responding to what has happened and also what is in prospect. Around the energy side of things, one thing we have spent a fair bit of time looking at which evident and having a macro-economic impact--what I mean by that is that it is big enough that it actually shows up in the GDP numbers, in the growth numbers--is renewables investment. That is now large enough that it is actually having a material impact on the investment numbers and also on the economy as a whole. From our point of view, we can look at the scenarios which deliver the sorts of outcomes you are saying on that sector. We also have to think about what other adjustments may or may not occur, and try to aggregate them together. If we grew a hydrogen export industry, for example, that could have huge benefits for Australia. So it might be of benefit to have a plan around that. But I want to come back to the question of thermal coal. We have seen that the dollar can move significantly on what you have put as a small decision; that can have reasonably significant impacts in the short term. If, hypothetically, Australia had signed up to an agreement that said iron ore exports have to be cut by two-thirds in 10 years I imagine everyone would be saying 10 years is only a few short-term or medium-term outlook terms away so we had better have a plan to deal with that. I am a bit surprised that the bank accepts that we have signed up to agreements that say we could see a marked decline in thermal coal in just over 10 years, not a long time, but you don't think it is useful for us to start planning for that. You are the parliament. Your job is to decide those things. Let me flip it around. We, as a central bank, have to take what the policymaking framework is and fact that into our considerations-- You agreed with APRA's characterisation. APRA said it is now the role of regulators, including yourselves, to start thinking about these things. If one agrees with that-- What I am trying to say is that we are thinking about them. We have to think about these scenarios and what they mean through the somewhat narrow lens through which we look at things, which is the impact on output in the Australian economy and inflation. But, for better or worse, to some extent we have to take whatever the policy responses are, which we don't control, as a given in thinking about that. As they change--if they change--we need to factor that into our thinking as well. It's taking these sorts of scenarios, which have that sort of horizon, and mapping them back into the way we look at things in terms of the impact on the Australian output and the economy, and saying: 'Well, okay, if that's going to happen, what does that imply for the future outlook for the economy? What does that imply for what we might do? What are the other adjustments which may occur?' including, apropos the last 24 hours--if something like that happens and the exchange rate is part of the adjustment mechanism. I'm not asking for your view about what your plan should look like. I guess that the Reserve Bank has been comfortable about encouraging parliament to have a plan to increase productivity and a plan to deal with population growth. We should have plans, without diving into the political sides about which way those plans could go-- You've encouraged us to think about some of those other things. I want to know why-- The government-- you're not encouraging us to think about plans around what could be a very significant disruption to the Australian economy if it's not planned? But, as you mentioned, the government has committed to the Paris accord. Then, the IPCC report, as you noted, informs what the scenarios and prospects look like under the Paris accord, with that 1 1/2 degrees of warming and what that implies for particular interests. Given that, it would seem to me to be reasonable to assume that if we take those scenarios then you, as a parliament, should be planning around those scenarios, yes. Have you done any scenario planning around what, on average, a two-third decline in thermal coal exports by 2030, as suggested by the IPCC, might mean for the economy? That is the sort of stuff we're looking at right at the moment--including things like that. I think that report was interesting, in saying: 'Okay, this is,'--and I was going to use the words 'baked in', that's not exactly the right term to use here!--'what appears to be in prospect. Given that, these are the sorts of outcomes.' The challenge for us is mapping, as I said, and looking at the different scenarios. That's one scenario which may well be plausible. Then we need to think about, 'Over that same 10 years, what are going to be the adaptations of other parts of the economy?' It's to what extent, if at all, those will provide offsets. The reason I went back to renewables is that there is one thing that is interesting in that space, and that is the price of investing in renewables. One of the reasons why we're seeing so much of it--that increase in it at the moment--is because the price has declined dramatically, even in the past 12 months, let alone in the past five years. One of our challenges is saying that it's probably not going to be the case that everything else remains the same. So, if we take this thing that's going on in this part of the economy, and we have these other things going on in that part of the economy, our challenge is to combine them into our overall view. In the end, we're concerned about the aggregate effect on both the economy as a whole and on inflation. So that is the challenge we have in front of us. Yes, I understand. I'm particularly interested in the exports question. You said that you're doing some of that work at the moment. Is that something where you think that in the short term, or the next time you come back before the committee, the bank will be able to say, 'We've modelled some of these scenarios'? I can share some of the potential thinking around that, for sure. The challenge we're having is that a lot of the modelling there has been done in a framework which doesn't translate. Our challenge is translating to the tools that we've used, traditionally, to some extent, and trying to look at what others do. We don't have full expertise in this area, but we try to look at some of the other models that other people have built to try to help us understand that. So that's where we're devoting time and resources now, to try to get a better handle on that, for sure. Dr Ellis, did you want to jump in and say something? We've run scenarios about this before, using external scenarios about the decline in thermal coal. We have run those. If it is drawn out, then you see it in coal exports but you don't really see it in GDP to any material extent--if it's drawn out enough. So the issue is, really, the phase over which that takes place. And, as Guy mentioned, other things are coming on to adjust to that in the movement to renewables. The other comment I'd make is that, at the moment, thermal coal has come off since we last met by about 15 per cent, but it's still roughly double where it was in 2015-16. The reason why global thermal coal prices are still very high is because all of the producers got the message that one day this would fade away and that you didn't want to be investing in expanded capacity. But many of the consumers of thermal coal in the electricitygeneration industry around the world have not yet made that adaptation. We were discussing what was going on with coking coal in China, but certainly China is also looking to try to switch from coal-fired generation to both renewables and gas, and you see similar shifts both here and elsewhere. Governor, if I can just come back to this question that's been flagged before about underemployment in particular. We're talking about if and when wages pick up. It seems like we're waiting for Godot. We've had this conversation many times. You mentioned unemployment several times in your opening statement but didn't mention underemployment once. We've had previous exchanges where you've said that, if it's the case that someone who's working five hours who might want six or seven, that's one thing, but you've also referenced that people are now, on average, wanting two extra days per week. When we used to measure full employment with respect to unemployment only, employment was probably a reasonably good proxy for having a full-time job. Now it's not. It seems to me that we now need a new measure that doesn't just take into account unemployment but takes into account underemployment. It feels to me that the RBA is underplaying underemployment. You're not mentioning it when we're talking about when we're getting to full employment. So what I want to ask is: you've said maybe in the fours is what would count from the unemployment side, but what's the number with respect to underemployment that allows us to say we're at full employment? There are a couple of things. There is a pick-up in wage growth taking place. The current rate of wage growth is the highest in four years. It hasn't been a marked pick-up, but it is actually gradually picking up. I suspect that will continue. The vacancy rate at the moment, so there are a number of vacancies that firms have relative to the size of the labour force, is the highest that it's ever been in the whole history. In the business surveys, more firms than at anytime in the past decade are saying that it's hard to find workers, and businesses are also reporting that they're going to increase their hiring at quite a fast rate. So I'm expecting that the labour market will continue to tighten and this gradual pick-up in wage growth will continue, so it is happening. You're correct: I didn't mention the word 'underemployment' in my prepared remarks. That was really because I was trying to be as succinct as I possibly could. But if you look at any of our documents, you'll see a discussion of underemployment. I can assure you that at every board meeting when we talk about unemployment, we see a graph of underemployment and we talk about the issues that you and some of your colleagues were discussing earlier on. I want to assure you that we give a lot of attention to it, and particularly to these part-time workers who want more hours. Our strategy is to keep the labour market tight so that more of these people will be offered the hours they really want. Because of this question of underemployment--so many people are working part-time or in insecure work--and this general puzzlement about why wages haven't grown fast enough over the recent few years, it seems to me that perhaps neoliberalism is having its stagflation moment. There are things that are occurring that should not be, and wages are not growing, despite low levels of unemployment, precisely because their work is now so insecure--there are so many people doing part-time work. The spare capacity in the labour market is massive, and we are going to find it very, very hard to find our way out of this without some different thinking. I wouldn't go that far. The vast bulk of people who work part time want to work part time and are happy with the hours they work. I think we've got to get away from this rather old-fashioned concept that there are full-time jobs, which are good jobs, and part-time jobs, which are bad jobs. The vast bulk of people who work part time want to work part time for personal or family reasons or they're studying or something. It's only around one-quarter of those people working part time who really want more hours, and that's a legitimate issue. As I said, our strategy is to make the labour market tight enough so that they get jobs. I wouldn't agree with the proposition that wage growth isn't picking up. As I've said, we've seen it pick up here, and overseas--in the United States and in Germany now, and even in the UK--wage growth has picked up as the labour market's tightened. The frustration that I have, and that many others have, is this is taking longer than it used to. It is still working, it's just taking longer. From where we sit we've got to be patient. We're looking at the long term and I think we're getting there, it's just taking a long time. Thank you all for coming out. I'll pick up on some of those questions. You've referred to, when you use the term not a beautiful set of numbers, but a nice set of numbers-- Reasonable? 'A reasonably nice set of numbers'--five, three and-- It's in the eye of the beholder. I just want to go back to what you said, when we met this time last year, around the proposition of the labour market tightening, and whether or not there's spare capacity. I'm just interested in your view about the range of measures that you could look at--average hours worked per month et cetera, but also, coming back to what Mr Keogh was saying, not just full-time and part-time work, but also an understanding of how the labour market has shifted. You've got permanent ongoing employees and you might have full-time contract employees, that sort of distinction that gives a little bit more sophistication to the labour market picture, and perhaps helps explain why we're all a bit dumbfounded that the apparent tightening in the labour market is not producing the effects that people say it should. As you can imagine, we look at a whole range of labour market indicators. The headline one is the unemployment rate, but we pay equal attention to the underemployment rate. We pay a lot of attention to the series on vacancies, the series on job ads and there are many business surveys that ask firms if they're going to hire workers and how hard they're finding it to find people with the right skills. We look at the whole suite of labour market indicators. We also look at trends in contract employment: is employment in the gig economy rising; is the number of sole traders rising; what's the level of employment security that people have? These are all things that we monitor. Having done all that, I still think the underlying issues are perceptions of competition and uncertainty. If you feel like there's more competition, you're less likely to put your price or your wage up, and people feel like there's more competition because of globalisation and changes in technology. That makes both businesses and workers less likely to put their prices up. This is a global story. It's not something we talk about just in Australia; at every kind of international meeting I've gone to in the past five years we've discussed this same issue--that is, why it is that wage growth is slow to pick up? It's competition and uncertainty. The things that interest me about that are the three factors that you've previously outlined in relation to low wage growth: spare capacity, this anxiety about competition globalisation and bargaining conditions. It's the first and the third that are a bit more measurable. The middle one, that uncertainty or anxiety, is a state of collective consciousness or something. It just seems to me that you pick that one out, rather than--on the spare capacity side Alan Oster says that if you take underemployment and people who have just stopped looking for work then unemployment is really 13 per cent and not five per cent. And if you look at the actual circumstances in relation to bargaining conditions--enterprise agreements that are being rolled over, locking in low wage rises--these are the structural things. Why is that you pick the more nebulous 'anxiety' rather than those other structural things that we could presumably do something about? I think the change in bargaining power has had an influence. I think these other things are more important. I say that partly because this phenomenon we're talking about is a global one. It's in almost every advanced economy. When I go to Basel, as I do six times a year to have roundtable meetings with all the other governors, this is the most frequently discussed issue. And these countries have very different industrial relations systems. Probably in most of them there's been a decline in the bargaining power of labour. But my sense is that that's not the primary thing, although I'm sure it's played some role. I would say that some of those structural things are the same there-- Sorry, just one more comment--I want to repeat the point that, as the labour markets have tightened up around the world, we have seen wage rises pick up, and we're seeing that here. So the underlying forces are still working; they're just working more slowly than we're used to seeing. But in your statement you say that wage rises are happening more quickly in all states than they were this time last year, but they're not happening more quickly than you had anticipated. So that's one thing I'd be interested in a response to. The second thing is: if that's occurring, why is discretionary spending in retail diving? Why has the NAB consumer-spending-pattern survey just recorded, for quarter 4 of 2018, the worst consumer anxiety result they've ever had since they started the measure in 2013? I'm not sure which series that is, but the aggregate measures of consumer sentiment and confidence are still fractionally above average. In the period of December there was a lot of anxiety, both domestically and globally. Domestically there was a lot of discussion about falling house prices. There were some problems in Canberra as well. Share markets globally were falling, and credit spreads were rising. The IMF had come out with forecasts downgrading global growth to average. All this made for a very negative environment in December, and I think that had an effect on confidence and spending. I have to say that since the new year turned there's been a stabilisation. Equity markets are up here; they're up a long way in the United States. Even in some of the survey measures we see from overseas, they're no longer falling and some have actually picked back up. Many people were particularly anxious during that period around the turn of the year, and I'm sure that had an effect on spending. But retail spending has been falling, on a 45 degree angle, since the middle of 2017. It's certainly slow. Well, you couldn't describe it as slow. The broader measures are in the national accounts, and it's been quite hard for us to tell what's going on there, because we've had a strong quarter, a weak quarter, a strong quarter, a weak quarter. We're going to be looking very carefully at the next set of national accounts, which are out fairly soon, to see what consumption is doing. There have also been substantial revisions to the history of consumption in the national accounts. We thought consumption was growing at close to three per cent, but when the September quarter accounts came out the whole history for the last few years had been revised down. So it's hard to know exactly what's going on. From what I understand, the big risk that you identify, and the big change in the 12 months since we last met, is around those downside risks. We met this time last year, and you talked about the risk that our economy, which is heavily dependent on consumption, could find itself tipping the wrong way if consumption doesn't improve, or perhaps gets worse. The bank has moved to a position now where you say that it's sort of balanced between a cut and a rise, and all the language in your statements suggests that your concern around consumption has got worse if anything. But you just said you think that perhaps the consumption picture is not as bad as we had thought, because we've had a closer look at it. It's certainly not as positive as we thought six months or 12 months ago, and thinking about the domestic risks, that is clearly the most important one. Is there not a risk--further, I suppose, on that risk--that if the projections are that growth in the economy is sort of returning to trend, potentially, either not much above trend or trend--then we're not going to see many more jobs created, if that's the case, and therefore we don't really get much follow-through in wages and the fall in discretionary spending and that kind of consumer anxiety continues? There is a risk of that, of course. But there is also a risk that employment growth turns out once again to be stronger than we thought. Certainly since we met last time employment growth has been much stronger. We didn't expect that the unemployment rate would be five per cent until towards the end of next year, and we've been here for four or five months. As I said in response to Mr Bandt's comment, the vacancy rate is the highest it's ever been. So, when firms are asked how many jobs they've got vacant, as a share of the existing labour force that's very high. And firms are saying in the business survey that it's very, very hard to get workers, and the unemployment here in New South Wales is 3.9 per cent. Those things give you some confidence that the labour market is going to continue to be okay, and it's quite possible that employment growth again surprises on the upside. It's possible that the scenario you paint turns out as well, and it's possible that the alternative one plays out. What we're doing at the Reserve Bank is trying to assess those scenarios all the time and be as clear as we can publicly how we're viewing the balance of probabilities. Does the current record-duration interest rate plateau have any global precedence or contemporary global analogues? Oh, yes. Some central banks have held their rates much lower and longer than we have. After the financial crisis, central banks got their rates down and then just held them. Yes, held them flat. And how long was the Fed flat for? Years and years-- Near enough to 10. The Bank of Japan's about 20-something, effectively--and still counting. It's a long time for us, but globally it's not unusual to see central banks hold interest rates steady for a long period of time. And I think in the current environment the Reserve Bank board is conscious of being a source of stability and confidence, looking at the medium term, having a clear strategy and evaluating that strategy every month, and so far I think it's working. As the balance of probabilities shift we'll have to reassess, but I think so far it's been working. Is it fair to say in relation to the inflation target that you have a kind of bandwidth--and it just seems that in terms of the combination of all the numbers you were much more sanguine about it being on the low end of that spectrum than you would if it was on the high end--but in order of the various targets that you've got, the fact that inflation has been persistently at the low end is something that the bank is prepared to discount or make a low-priority concern considering the other numbers? No, I wouldn't say it's a lower-priority concern. I want to deliver for the Australian community an average inflation rate of two point something, and hopefully close to 2 1/2 per cent. I'm confident that we'll do that. But over a fairly long period of time--since we've had the inflation targeting regime--we've delivered an average rate of inflation of 2.4-something. So, we want to do that, but we're realistic enough that it's going to take time. This is kind of what happens in every other country. Inflation's come down and it's taking time to get it back up. Whether I'm more relaxed--whether it's lower or higher--I don't know. But what I have been concerned about is the labour market. And whenever the country is generating jobs and the unemployment rate's coming down, having inflation a bit low is not particularly problematic. It'd be good to see it higher, and we want to see it higher, but the most important thing is that people are getting jobs and their incomes are rising. Most people in the community don't care too much whether inflation's 2.42 per cent or--many people think it's four per cent. So I don't think too many people in the community really worry too much if inflation is a bit low. It would be good if it were 2 1/2 per cent, but they don't worry too much. What they really worry about, and what I really worry about, is if people aren't getting jobs, and on that score we're doing okay. Does the bank give some consideration to how improvement in income flows into stronger consumption across segments? Is it fair to say that, while we'd like to see wages and incomes more broadly--non-wage income--rise to underpin greater strength in consumption, there are some parts of the income spectrum where those rises are more beneficial because of the way that they flow into consumption? Yes, people on lower incomes tend to spend more of any incremental increase in their incomes than people on high incomes. So that's true, but if the labour market tightens up then wages will rise right across the spectrum and people will spend more. So do you think the box that's included around minimum wages is one of the reasons? I think that in Australia the percentage of the workforce that receives the minimum wage is comparatively small. In South Korea, I think the stat was something like 40 per cent, and here it's two per cent. But presumably one of the ways those countries are looking at their consumption issues is to ensure that it's actually lower income households that are seeing an increase in income. Yes. Of course, very sizable one-off shifts in the minimum wage can have negative employment effects. I think the evidence is that, if you do regular and modest increases in the minimum wage, the employment effects aren't negative or positive, really. So I'd be more concerned with very large step increases in minimum wages because of the employment effects. I strongly support the approach that's been adopted in Australia, of minimum wage increases around the 3 1/2 per cent mark on a regular basis. It keeps the wages of the bottom part of the labour market rising in step with or even faster than everyone else's and avoids the need for these very large one-off adjustments, which I think could in certain circumstances be disruptive. I have a final question; it's a little bit tangential. In terms of looking into our short- and medium-term future and the kinds of things that likely have an impact on Australia's overall productivity and competitiveness, has the bank done some work on or looked at the National Broadband Network and how it's being delivered as we get close to the completion of the rollout, as the single largest infrastructure project in Australia at the moment? I'm not aware that it has. If it has, it hasn't come across my desk. We have not done a particular analysis saying what would happen to the productivity of this country if we had faster internet. That has not been something that the staff have done in recent years. With the National Broadband Network, you can see it in the numbers in terms of public investment. If you look at the investment numbers and infrastructure investment, you can see it. There's a telecommunications component, and that is observable; you can sort of see that that's high at the moment. But I would note that we've also been making statements that public demand generally, and public investment in particular, has been a source of growth, as observed in the national accounts. Infrastructure spending by both state and federal governments has been quite strong, and that has been primarily transport infrastructure rather than the NBN. The NBN isn't the only game in town in terms of the high levels of public infrastructure spending that have been happening. Dr Ellis, just for clarity, can I go back to an answer you gave earlier to Mr Bandt, related to impact on GDP as a consequence of reductions in thermal coal exports. You say that over time there wouldn't be an impact. It wouldn't be a large impact. Essentially, we have done scenarios. Guy referenced that there's been some more recent work done that's all in progress, but about 18 months ago we did a couple of scenarios based on some private sector assumptions about global coal consumption and what that would mean in terms of our exports and production. It's an arithmetic thing really. If you shut down your coal industry over 30 years, in terms of impact on annual growth, you would definitely see it in coal exports and coal production but you wouldn't see a very big impact arithmetically on GDP growth. The scenario we did 18 months ago didn't look at what would happen with renewables and what that would imply. It simply said: if coal exports did this, how big is it? The answer is: it is a small fraction of GDP in a year, so it's detraction from GDP growth is arithmetically small if you do it over a long period of time, but you would see it if you did it over three years. I guess the point is that there is also a series of assumptions that have to underpin that round things that are displaced and replaced-- That's right. That particular scenario was quite a simple one. We just said: if coal exports fall to a very low number, what's the numerical impact? Yes. It was essentially a sensitivity test. But our current forecast horizon, which is based on our forecasting technology and where we can get a non-embarrassing level of accuracy--these are outside the normal scenario. I guess one of the challenges in this space is that it is almost impossible to project what will replace those types of exports over 30 years. We can take projections for renewables as an energy source and everything else, but it is highly hypothetical. Exactly. The pure numerical impact on GDP growth in any one year from running down your coal exports over a long enough period is small. That is just the simple arithmetic of it. The Reserve Bank of New Zealand has recently released a paper around capital requirements and capital ratios. My understanding is that there is also an announcement that they want significantly higher minimum capital ratios. Is it the intention of the RBA to head in a similar direction? In Australia the capital requirements are set by APRA, not by us, so it is really a matter for APRA. APRA has already had a consultation document about higher loss-absorbing capacity and requiring banks to hold more tier 2 capital. We have discussed this a lot at the Council of Financial Regulators and we think that, in the Australian circumstances, that is the right thing to do. It will make sure the Australian banks are in the top tier of safety and soundness around the world, which is appropriate, but we will do that in a way that won't distort the capital markets. APRA will be increasing the buffer that banks have but in a way that is achievable and makes sense. So you are agreeing with the APRA approach? I am. They've still got to do final consultation on the extra loss-absorbing capacity in the tier 2 instruments because they haven't taken a final decision. In many other countries, the regulators are forcing banks to issue bonds that can be converted to equity in a crisis. So this is extra loss-absorbing capacity. In Australia we've decided to get banks to issue more of these tier 2 instruments. When was the last time the RBA did an audit of Australia's gold holdings? We intend to do our next one this year. Yes, a physical audit. When was the last one? In 2013. We have 80 tonnes of gold, which has a market value of $4 billion, and it is stored for us very safely at the Bank of England. Why do we store it at the Bank of England? The gold market, as you may know, is centred in London--it has been for a few centuries. I want to tease this out. Outside of Fort Knox, literally, and a few other places, most of the world's gold holdings are in London because that's where the bulk of the transactions occur. We haven't transacted in gold for a long time now, but the bulk of the transactions occur there, and the bulk of the storage of the physical gold is there. It's actually in, basically, two or three sites, one of which is the Bank of England's and the other one JPMorgan's. In terms of ease of transaction and shifting of ownership--not that we intend to be doing that--that's why it's in London and has been so for a very long time. Just to clarify: when was the last time we did an audit of it? 2013, and the next one is due in June this year. Sorry, that's in terms of auditing by actually going in and-- Counting--one, two, three, four, five, six? Or prodding. Weighing, actually, is relevant there too. Counting only gets you so far. You're actually at least as interested in the weight as you are in the number. If you think about the assets that we hold in our reserves, we have a whole bunch of US treasuries. We audit them from a financial point of view as part of our annual accounts, and we do the same to the gold from a financial point of view. That is audited every year as part of a--not just by us. But the physical inspection-- The actual physical-- is, what, over seven years? No, six years, actually. Every six years. We were the first country that the Bank of England--you can debate this with them--allowed to audit their gold stocks, and then subsequently everyone else has joined that bandwagon, and now it's back to us again. For clarity: when the audit was done, was there any discrepancy between what we thought we held and what we actually held? It was exactly the same? Do we engage in gold leasing? Can you explain to me why? To add a rate of return to the reserves that we hold on the part of the Australian people, which flows pretty much straight through to you, the parliament. Gold, if you just leave it sitting there, unlike a treasury bond, for instance, earns no rate of return, whereas a bond does. A way of delivering a slightly larger rate of return--it's not that large at the moment, but it's positive--on those holdings of gold is to lease it for periods of time. Just for clarity: do we lease gold? We don't borrow it; we lease it. No, we own it. We lease it out? We lease it out, but we don't lease gold in. It doesn't actually move anywhere, does it? No, that's the other thing. The other point I was going to make is that-- We're the lessor. in those gold vaults, when people buy and sell gold, by and large the gold never goes anywhere. It doesn't even necessarily get moved around too much, because every time you move gold you can lose a bit of it. I mean that literally--the gold dust. How do you lose it when you move it? Little bits-- absolutely minute fragments, come off. However, the storer of the gold has the obligation to make that good to the owner of the gold, so the weight of our gold is always what we own. What I mean is that they minimise the number of times they move the gold. Understood. The next audit is next year. How much are we charged on an annual basis to store the I will have to take that question on notice. I can't remember. I do know we earned three-quarters of a million dollars last year from the leasing, and that got returned to the taxpayer. Can I come back to you on the cost for the storage? Presumably we earned more than it costs to store. That's why I'm asking. If it weren't stored at the Bank of England, we'd have to store it here in our vaults, and there'd be extra guarding. It's quite efficient to store most of the world's gold in one spot. We used to do that. Yes, but we did make the assessment, back in the day, that actually it was cost-effective to store it there, because in gold storage there are some economies of scale. There would be economies of scale. I imagine also that there are ceiling costs in moving it as well-- if we were to ship it here or anywhere else. And if we have to store it here in Martin Place or at some other location. So there'd be costs associated with that. But we can come back to you on the exact cost. Yes, I'd like that--thank you, very much. We don't have any intention to purchase more gold? No. As I said, we've got 80 tonnes-- Two thousand and three-- We've had 80 tonnes for quite a while and I don't intend to either buy or sell--just to lease. Dr Lowe, we haven't discussed the United States--in particular, the US federal budget deficit, which I understand is projected to grow to $985 billion in fiscal year 2019. That's an 18 per cent increase on the previous year. Why isn't there more alarm in the international community about that--particularly given that the US economy has been growing? One would think that it's a time to undertake some fiscal consolidation. Exactly, and I don't have an answer! I share your concern about budget deficits that are four or five per cent of GDP at a time when you have the lowest unemployment rates since the late 1960s. The projections are that the budget deficit there is going to stay at four or five per cent of GDP indefinitely, and people seem to be turning a blind eye to it. How long that will continue, I don't know. It becomes more acute, doesn't it, given that, reading a lot of commentators, the forecasts for the US are for increasing downside risks? I think the markets are factoring in one more rate rise and then looking towards rate cuts. If there is a downturn in the US and they're saddled with this massive budget deficit, it really ties their hands in terms of what they can do to stimulate their economy and avoid some of the risks. It certainly does. We saw in the financial crisis that countries which went into the crisis with a bad fiscal position actually had to tighten fiscal policy rather than stimulate. That caused their downturn to be much more pronounced. We were able to stimulate, which I think did help here. So the US is running very close to the edge, and its ability to stimulate in the next downturn through fiscal policy is becoming more constrained. This is one reason why, whenever asked about our fiscal policy in Australia, I've said it's important that we maintain discipline and have a reasonable balance in the budget, because we really need fiscal policy to be a form of insurance. The ability to spend in a downturn is really important. If we don't have that option, then these other options we were talking about before, including quantitative easing, become more likely. We're better off using fiscal policy than extreme monetary policy. But you can only do that if you've behaved yourself in the good times. My judgement is that the US is not. Is that something that the international community--and, indeed, Australia-- should be paying more attention to, to the risk associated with that for the global economy? At all the Financial Stability Board meetings I go to, people say, 'Look, if we have a downturn, in many countries there is not much flexibility--not much policy space--either on fiscal policy or monetary policy.' So people do turn their attention to it, but the political system in the United States seems to have trouble exercising budget discipline. Any discipline-- Any discipline! Yes, it's a discipline, so why don't-- That's a perfect way to sum it up-- In a simple banking world, all we can do is look at that and sigh! But I hope our Australian parliament doesn't go in the same direction. I note that the speech by Dr Debelle did say that in terms of government public debt it's sustainable until it's not. It's an interesting observation, but it also highlights the challenges that we all face around what levels of debt are appropriate. Just in terms of the labour market figures--the unemployment rates--in Australia: is there a risk that, because employment is a lagged indicator, those rates are reflecting the periods of higher GDP growth, and that those unemployment figures could tend upwards, given that you've forecast downwards growth? I've thought about that as well, because GDP growth was quite strong in the first half of 2018 and it did seem to slow in the second half. It's possible that the labour market is really reflecting what happened in the first half of 2018 and will slow. I take some comfort, though, from the job vacancies and the job ad series. As I've said, I think, twice already, the number of job vacancies is at a record high, and job ads are fairly high as well. That suggests that the current demand for labour remains strong. We hear this in our Business Liaison Program as well: firms still want to hire more workers. They're finding it harder to get them, but they want to hire them. What you say is a possibility, but I'm not particularly concerned about that at the moment. The NAB survey of business conditions is looking quite bleak. Basically, since the beginning of 2018, their survey of business conditions indicates that there have been substantial falls down to what they consider the long run average conditions now. Is that something of a concern for the bank as well? It certainly caught my attention when that series was published. You've got to remember the background of what was happening in December when the survey was taken. The share prices around the world were tanking--the US prices fell 20 per cent and we had fair decline here. There was political tension in Canberra, if I can say it diplomatically. There was a lot of discussion in the media about falling house prices and people not spending. There was a lot of negativity in December, and it's not surprising that it was reflected in the business surveys. I am hopeful that as things have stabilised as we've gone into 2019 that we won't see further falls there. Have we seen another reading of that yet? Yes. The monthly number kicked up. It didn't fully reverse. The survey was actually taken in the early weeks of January. The AIG survey had a similar pattern in that first half of January. But we do have a later version of the NAB survey, a later data point, and it did come back a little bit. We're seen this pattern globally. In December and early January, all the business surveys moved south. Now, maybe, as we're going into January and February, things have stabilised a bit and some of them are kicking back up. You see the same pattern in equity markets. In commodity markets, the prices fell, and they have risen again. The credit spreads rose, and they've have come back again. There was a bit of panic in December, but there's been stabilisation subsequently, and I hope to see that in the business surveys going forward. I want to finish on an issue that was highlighted by Jacqui Dwyer in a speech that she recently gave on 29-- It was a while ago. It was reported recently. It was on 29 July 2017. It was quite an interesting analysis of the study of economics amongst high school students in Australia. I was quite alarmed to read the decline in the number of students studying economics in Australia fell from about 40,000 enrolments in the early 1990s to around 10,000 in 2016. What was even more alarming was the fall in females that were studying economics relative to males-- as someone with a degree in economics, I happen to think economics is very, very important for our nation. Is this an alarm for the RBA? What do you think we can collectively--the government and the bank--do to arrest that decline in the study of economics? Just for clarity, I'm glad that the deputy chair of the Economics Committee thinks that economics is important. I do. We've been very concerned about it. There are multiple dimensions. As you say, the decline in the absolute numbers and the gender balance going into economics--for every young girl that studies economics there are two-plus boys who are studying. There's also the fact that economics is increasingly taught largely in the private school system rather than the state school system, so the demographics of people who are studying economics is changing in a way that I think is not helpful. What can be done about it? That's a good question. What we're trying to do is raise the issue publicly to get people discussing it. We are working with some of the state education departments to try and put economics in the curriculum. We're providing material through our website and other resources to teachers to try and make economics more useful to individuals when they are studying it and to give the teachers material to make it real-world applicable. One thing we're doing here in Sydney, New South Wales, is we're just about to send out a survey to young high school kids to find out what their attitude is to economics and why is it that they're not looking to take it up. We also send out a lot of our staff, our junior staff in particular, to schools, and not just to the economics classes. To some extent, you want to try to convince people more generally that it's worthwhile. The other thing, though, which we have noticed and we are working with the curriculum boards in the different states on, is just making the material more relevant, for want of a better term. As Phil said, we are providing online materials, which we're able to do with the resourcing we have but an individual teacher can't. We've been doing that for a couple of years now, and that's proven to be quite helpful. Jacqui's got a small team of people who are pretty much focused full time on this and trying to do something. I think there's an issue from the country as a whole. We obviously clearly have a fair amount of self-interest here that it's a market where people in the future could work for an organisation. Economists aren't the only people we recruit, but it would be good to have a stream of educated people and educated economists for us to draw from. But I do think, to some extent--echoing what you said--it is useful for the country as a whole to have people with that skill set, and we are concerned about the decline that's there. Does the Reserve Bank run a work experience program or an internship program for graduates? We have not only a school work experience program but also a summer intern program. We take 30 a year-- About that. and then we support them through their final year at university. That's good to know. We're increasingly providing resources to help teachers. Governor, I was just wondering--back to wages for a little bit--what happens if you put up wages without productivity improvements? Prices tend to go up. At the moment, the lack of productivity growth isn't the issue. As I said before, the rate of productivity growth over the last five years, just looking at that in isolation, would have justified faster wage growth. So workers over the last five years have not got their normal share of productivity growth. Over the last 10 years they have, and I think this is one reason why prices have been so low and inflation has been so low for the last five years. So looking over 10 years, productivity growth has explained wage increases? Real wage increases broadly. You've got to be careful which years you actually pick, but the broad stories over the period that encompasses the beginning of the resources boom to today is that the increase in real wages in Australia has broadly matched the increase in labour productivity, so that's good news, but it hasn't over the last five years. As I said in response to an earlier question, the issue we're grappling with now is: what are the next five years going to look like? Are we going to have another five years where there's reasonable productivity growth in the economy and workers don't get their normal share? If that's what happens, I think we're going to have problems. I certainly hope that that does not happen, but it's possible. But it may be that the last five years are the aberration. It's really then about unwinding what happened the five years before. It's a really big question for us because it affects the rate of inflation. I think it's a really big issue for society in general, because if we have another five years where workers don't get their normal share of productivity growth, we'll have all sorts of economic, social and political problems. Besides the immediate outlook for consumption, how wage growth is going to track productivity growth over the next five years is the next big issue. Productivity growth, though, in the economy is lower than it has been in the previous 20 years, isn't it? It's certainly lower than it was in the nineties. It's low, but it's reasonable. It would be better if it was stronger, but it is what it is. It is lower. But is it true that there was still the lower-hanging fruit in the nineties to deal with? There were also significant reforms by the government and the parliament. Are you referring to labour market reforms? The floating exchange rate, liberalisation, the reduction in tariffs-- I thought those were all Keating reforms, Jason. There were many reforms in the-- So the nineties were a delay from the Hawke-Keating reforms, were they? Yes, there is a large part of that-- Order! The purpose is to hear from the Reserve Bank governor, not to have some sort of fight we could otherwise have in the parliament. So we're getting reasonable productivity growth. There are things that could be done. There's been no shortage of reports giving both business and the parliament ideas of what could be done, and my observation would be that not many of those things are being done. While ever that's the case, I think productivity growth will be less than it could be. It'll be okay but less than it could be. What are some of those things? There are endless reports. The Productivity Commission has a long list of things: the provision and pricing of infrastructure, the way we educate our students, the incentives we set up through the tax and other systems through innovation, and the way we deal with science and the funding of science. The IMF, in its various reviews of Australia, talks about the tax system, the balance between income and consumption tax and, importantly, the way we tax land. So, if you really had a laser-like focus on lifting productivity growth in the country, there is no shortage of ideas that could be pursued. Not all would be politically popular, but there's no shortage of ideas. In the absence of following those ideas, I think we'll have okay but not really good productivity growth, and that means okay growth in real wages, not fantastic growth in real wages. There's very little a central bank can do about that. We have to take the underlying growth in productivity as a given and respond to that. But both the parliament and business can do things that change the growth profile for people's real incomes. Do you think some of the industrial relations settings at the moment, which are discouraging business from negotiating directly with their workforces and vice versa, are having an impact on productivity? I'm not sure. I don't think it's the first-order issue. I think the first-order issues are the pricing and provision of infrastructure, the way we accumulate human capital, the incentives we have for innovation and the tax system. They're the first-order issues. It certainly might be the case that there are things in the industrial relations system which limit the productivity of individual businesses, and if there are then there's a case for addressing them, but it's not the first-order issue. The first-order issues are the other four things I talked about. When you're talking about pricing of infrastructure, you mean road tolls, don't you? Road, rail and airports--transportation infrastructure--and even electricity. The Productivity Commission's done some very interesting work about how we price the use of our infrastructure, and it's not optimal. But most of those things sit with state governments, don't they? They may well. I'm not trying to assign responsibility here. These are the issues that have been identified. No, but it is genuinely interesting, because of course you, the Reserve Bank, are saying, 'It is what it is; we'll deal with what we've got.' You're talking to a bunch of federal parliamentarians, but many of the Productivity Commission reports to which you refer, with one or two exceptions, actually sit with state governments around the country. They do. They're a shared responsibility. The Productivity Commission report--I think it was called Shifting the dial --talked a lot about the delivery of services by the public sector, because the economy is increasingly a service-sector economy. A lot of those services are delivered by the public sector, and the Productivity Commission's judgement is that it's not as efficient as it could be and that better use of data and more efficient techniques would deliver better services. Some of those services are delivered by the federal government, and many others are delivered by the state governments. That's not quite true, though, is it? Most of Shifting the dial refers to services provided by state governments. Yes, but in a number of areas, including health and education, the federal government-- Could influence. shapes the framework, let's say. I don't want to get into a debate about where the responsibility lies. These are the issues. My general call is for both business and the political class to take those issues seriously, because if in the next 10 years we want strong growth in our real incomes then this is what we should be doing. The Harper report on competition made the point that competition policy doesn't apply--or hasn't to date--to the state government provision of services, like health, education, infrastructure et cetera, and that it should. Is that a recommendation that the RBA would endorse? Well, Ian is a board member of mine, so-- I had no idea when I asked that question! I don't know enough about the details, but I think the general principle of bringing the same focus on competition to the delivery of state government services must be right. As to the specifics, I don't know. I have great respect for Professor Harper, so if he wrote it I would tend to agree with it. Ms Bullock, with my previous questions you mentioned that DHS is now also involved with the PayID scheme so that it can make instant relief payments when there are natural-disaster-type situations, which is a very good outcome. I presume though that they can only do that if the person receiving the payment is using a bank where they can register for PayID themselves? You don't actually need a PayID to get instant payments. It's a service that's offered to people that don't want to give out their BSB and account number. I can't remember it, but fast payments can occur with just BSB and account numbers; you don't need PayIDs. How does a customer get access to making a fast payment between, say, their own accounts at two different banks? It depends on which bank you're with; that's the point we were making earlier. Some banks are a little bit ahead of others. With some banks, you need a PayID to make a fast payment. For others, you don't; you can just use your BSB and account number to make a transfer. So it depends a little bit on where the banks are with their systems. But, ultimately, when the system is completely built out you will be able to make a fast payment to any account, whether it be your own account at another bank or someone else's, using either a PayID or a BSB and account number. In order for that to work, both banks would need to be on the system? Correct. This is back to a point Phil made: the network effect is very important here. If you've only got one bank then you can't make any payments. Which banks aren't doing this? I'd rather not single out a particular bank. I would rather you do single them out. And, to be clear to all of the government-relations people at the big banks listening: I will ask you this question in a week or so. But, for the simplicity of everyone else, which of the big four are not doing this? All of the big four are now in the NPP. They're all in there. They've all come in at different speeds. When it first started a year ago, ANZ and Westpac--and this is public knowledge--were not ready to enter the New Payments Platform. They are now in there, and they're progressively bringing on all of their different customers. So they're in it, but you may not have access to it if you're a customer. Not all customers will necessarily have access to it; it depends. Some of the banks have brought on particular groups of customers first. Some business customers might have access; some others might not. It's all just a process. Our ultimate aim--and we'll get there--is: for any payment you can make using internet banking at the moment, you'll be able to make it fast. And that will be the case whether you're doing it through account number and BSB or the telephone--whether you link another number? Yes. You don't need the phone number or the email. That's a convenience and it's helpful-- You alluded to this before, but just to clarify: some banks are only going to make it available if you've created a PayID as opposed to using your BSB and account number? Some of them, in setting up their systems, have prioritised some bits over others. Some have prioritise getting it out on the PayID. Some have prioritise getting it out to particular groups of customers. Some have prioritised it on mobile apps and some on internet banking. It just depends. You see, none of them are perfect. I don't think anyone was making that assumption, Governor. Is this a situation where banks come on at an ADI level, or are there going to be differences between, say, the nominal brand bank--to pick an There are differences there. Westpac has brought on its main brand. Customers of some of their subsidiary brands are going to be brought on, but they're being brought on a bit slower. There's another point that I would like to make, though, and that is that one of the great successes early on in this has been the number of small institutions that are on. I was going to go there. Well, you'd better go there in your final question. Because there are aggregators; there are a number of institutions that offer services to small ones. And from day one we had about 60 small banks and financial institutions who were able to offer that to the customers. For my final question I was going to follow up on Mr Thistlethwaite's questions about economics education. You mentioned programs like internship and work experience opportunities and having staff go out to schools, and you were talking about the need to have diversity in economics education, so it's not just all the boys at the private schools but also girls in the public schools and everywhere else. Are we getting diversity of geography, or is it only schools located close to Sydney? Do Western Australian students also get this opportunity? In their schools, or just the opportunity to apply? You might've noticed that it takes up a third of the landmass, Mr Falinski. The University of Western Australia has been a great education university for us. Do we have an answer, or is that sufficient? Yes is the answer. It's very wide. We like short, sharp answers, particularly at this time of day. Thank you very much for coming and presenting to the Economics Committee. There have been a lot of interesting answers amongst all of the commentary, and you provided such a comprehensive outline at the start, which I suspect will give us and all of the economics writers plenty to write about. Hello to all the people--I've been reading the live tweets that have been going on as well. Thank you to the committee members and of course to the secretariat, who always do a wonderful job. Resolved that the proceedings be published.

r190306a_BOA

australia

The Housing Market and the Economy

lowe

Thank you for the invitation to address this year's AFR Business Summit. It is good to be back here again. As you would be aware, the Reserve Bank Board met yesterday and left the cash rate unchanged at 1.5 per cent. I would like to use this opportunity to highlight some of the issues we discussed at the meeting. Before I do that, though, I would like to focus on the housing market and its implications for the economy. Readers of the monetary policy minutes would have noticed that at its February meeting the Board discussed a special paper taking a deep dive into this topic. My remarks today draw from that paper. I will first focus on the current state of the housing market. Then, I will discuss the main drivers of recent movements in housing prices, before turning to the implications for the broader economy and the financial system. Australians watch housing markets intensely, perhaps more so than citizens of any other country. Over the five years to late 2017, they saw nationwide housing prices increase by almost 50 per cent (Graph 1). Since then, prices have fallen by 9 per cent, bringing them back to their level in mid 2016. Declines of this magnitude are unusual, but they are not unprecedented. In 2008 and 2010, prices fell by a similar amount, as they did on two occasions in the 1980s. In the 1980s, the rate of CPI inflation was higher than it is now, so in inflation-adjusted terms, the declines then were larger than the current one. These nationwide figures mask considerable variation across the country (Graph 2). The run-up in prices over recent years was most pronounced in Sydney and Melbourne, so it is not surprising that the declines over the past year have also been largest in these two cities. In Perth and Darwin, the housing markets have been weak for some time, affected by the swings in population and income associated with the mining boom. By contrast, the housing market in Hobart has been strong recently. In Adelaide, Brisbane, Canberra and many parts of regional Australia, conditions have been more stable. Given these contrasting experiences, it is pretty clear that there is no such thing as housing market. What we have is a series of separate, but interconnected, markets. Another important window into housing markets is provided by rental markets. Over recent times, the nationwide measure of rent inflation has been running at a bit less than 1 per cent, the lowest in three decades (Graph 3). As with housing prices, there is a lot of variation across the country. Rents have been falling for four years in Perth and are now around 20 per cent below their previous peak. By contrast, in Hobart rents have been rising at the fastest rate for some years. As is well understood, shifts in sentiment play an important role in housing markets. When prices are rising, people are attracted to the market in the hope of capital gains. At some point, though, valuations become so stretched that demand tails off and there is a shift in momentum. When prices are falling, it's the reverse. The prospect of capital losses leads buyers to stay away or to delay purchasing. At some point, though, the lower prices draw more buyers into the market. First home owners find it easier to buy a home, investors are attracted back into the market, and trade-up buyers take the opportunity to upgrade to the home they have always wanted. These shifts in sentiment and momentum are seen in most housing cycles, but their precise timing is difficult to predict. Some of these shifts in sentiment are evident in consumer surveys (Graph 4). Over recent times, the number of people reporting that an investment in real estate is the wisest place for their savings has fallen significantly. So, it is not surprising that there are fewer investors in the market. At the same time, the number of people saying it is a good time to buy a home has increased. Lower prices draw more people in and, eventually, this helps stabilise the market. So it is worth closely watching these shifts in sentiment. An obvious question to ask is what are the underlying, or structural, drivers of the large run-up in housing prices and the subsequent decline? There isn't a single answer to this question. Rather, it is a combination of factors. Before I discuss these factors, it is worth pointing out that the current adjustment is unusual. Unlike the other four episodes in which housing prices have declined in recent decades, this one was not preceded by rising mortgage rates. Nor has it been associated with a rise in the national unemployment rate. Instead, in New South Wales, where the recent decline in housing prices has been the largest, the unemployment rate has continued to trend down. It is now at levels last seen in the early 1970s. The unemployment rate has also trended lower in Victoria. So, the origins of the current correction in prices do not lie in interest rates and unemployment. Rather, they largely lie in the inflexibility of the supply side of the housing market in response to large shifts in population growth. It is useful to start with the national picture (Graph 5). Australia's population growth picked up noticeably in the mid 2000s and it took the better part of a decade for the rate of home building to respond. It took time to plan, to obtain council approvals, to arrange finance and to build the new homes. Not surprisingly, housing prices went up. Eventually, though, the supply response did take place. Over recent times, the number of dwellings in Australia has been increasing at the fastest rate in more than two decades. Again, not surprisingly, prices have responded to this extra supply. The population and supply dynamics are most evident in Western Australia and New South Wales During the mining investment boom, population growth in Western Australia increased from around 1 per cent to 3 1/2 per cent. This was a big change. The rate of home building was slow to respond. When it did finally respond, it was just at the time that population growth was slowing significantly, as workers moved back east at the end of the boom. This explains much of the cycle. In New South Wales it is a similar story, although it is not quite as stark. The recent rate of home building in New South Wales is the highest in decades. At the same time, population growth is moderating, partly due to people moving to other cities, attracted by their lower housing prices and rents. By contrast, in cities where population patterns and the rate of home building have been more stable, prices, too, have been more stable. Another demand-side factor that has influenced prices is the rise and then decline in demand by non-residents. One, albeit imperfect, way of seeing this is the number of approvals by the Foreign Investment Review Board (Graph 7). In the middle years of this decade, there was a surge in foreign investment in residential property, particularly from China. This was apparent not just in Australian cities, but also in 'international' cities in other countries. In Australia, the demand was particularly strong in Sydney and Melbourne, given the global profiles of these two cities and their large foreign student populations. More recently, this source of demand has waned, partly as a result of the increased difficulty of moving money out of China as the authorities manage capital flows. The timing of these shifts in foreign demand has broadly coincided with - and reinforced - the shifts in domestic demand. However, making a full assessment of their impact on prices is complicated by the fact that international property developers were also adding to supply in Australia at a time of very strong demand. More recently, these developers have scaled back their activity. Domestic investors have also played a significant role in this cycle. This is especially the case in New South Wales, which was the epicentre of strong investor demand (Graph 8). At the peak of the boom, approvals to investors in New South Wales accounted for half of approvals nationwide, compared with an average of just 30 per cent over the five years to 2010. More than 40 per cent of the new dwellings built in New South Wales recently have been apartments, which tend to be more attractive to investors. The strong demand from investors had its roots in the population dynamics. Low interest rates and favourable tax treatment added to the attraction of investing in an appreciating asset. The positive side to this was that the strong demand by investors helped underpin the extra construction activity needed to house the growing population. But the rigidities on the supply side, coupled with investors' desire to benefit from a rising market in a low interest rate environment, amplified the price increases. As I discussed earlier, there is an internal dynamic to housing price cycles, and this one is no exception. By 2017, the ratio of the median home price to income had reached very high levels in Sydney and Melbourne (Graph 9). Finding the deposit to purchase a home had become beyond the reach of many people, especially first home buyers if they did not have others to help them. At the same time, the combination of high prices and weak growth in rents meant that rental yields were quite low. So, naturally, momentum shifted. Given the big run-up in prices and the large increase in supply, a correction at some point was not surprising, although the precise timing is nearly impossible to predict. No discussion of housing prices is complete without touching on interest rates and the availability of finance. The low interest rates over the past decade did increase people's capacity to borrow and made it more attractive to borrow to buy an asset whose price was appreciating. But the increase in housing prices is not just about low interest rates. The variation across the different housing markets indicates that city-specific factors have played an important role. Recently, much attention has also been paid to the availability of credit. This attention has coincided with a noticeable slowing in housing credit growth, especially to investors (Graph 10). It is clear there has been a progressive tightening in lending standards over recent years. The RBA's liaison suggests that, on average, the maximum loan size offered to new borrowers has fallen by around 20 per cent since 2015. This reflects a combination of factors, including more accurate reporting of expenses, larger discounts applied to certain types of income and more comprehensive reporting of other liabilities. Even so, only around 10 per cent of people borrow the maximum they are offered. Sensibly, most people borrow less than what they are offered, so the effect of this reduction in borrowing capacity has not been particularly large. It has also been apparent through our liaison that some lenders became more cautious last year. There was a heightened concern by some loan officers about the consequences to them and their career prospects of making a loan that might not be repaid if the borrower's circumstances changed. So, lenders became more risk averse. This, along with greater verification of expenses and income, led to an increase in average loan approval times, although some lenders have invested in people and technology to address this. Our liaison suggests that application approval rates are largely unchanged. Overall, the evidence is that a tightening in credit supply has contributed to the slowdown in credit growth. The main story, though, is one of reduced demand for credit, rather than reduced supply. When housing prices are falling, investors are less likely to enter the market and to borrow. So too are owner-occupiers for a while. Consistent with this, the number of loan applicants has declined over the past year. There is also strong competition for borrowers with low credit risk, which is not something you would expect to see if it were mainly a supply story. This competition is evident in the significant discounts on interest rates on new loans compared with those on outstanding loans. Even though the slowing in credit growth is largely a demand story, we are watching credit availability closely. It is perhaps stating the obvious to say that we want lenders who are both prudent and who are prepared to take risk. As lenders recalibrated their risk controls last year, the balance may have moved too far in some cases. This meant that credit conditions tightened more than was probably required. Now, as lenders continue to seek the right balance, we need to remember that it is important that banks are prepared to take credit risk. And it's important that they have the capacity to manage that risk well. If they can't do this, then the economy will suffer. This brings me to the issue of how developments in the housing market affect the broader economy. Movements in housing prices affect the economy through multiple channels. They influence consumer spending, including through the spending that occurs when people move homes. They also influence the amount of building activity that takes place. Changes in housing prices also have an impact on access to finance by small business by affecting the value of collateral for loans. And finally, they can affect the profitability of our financial institutions. Today, I would like to focus on the effect of housing prices on household consumption. My colleagues at the RBA have examined how changes in measured housing wealth affect household spending. They estimate that a 10 per cent increase in net housing wealth raises the level of consumption by around 3/4 per cent in the short run and by 1 1/2 per cent in the longer run. They have also examined how this wealth effect differs by type of spending. They find that it is highest for spending on motor vehicles and household furnishings and that for many other types of spending the effect is not significantly different from zero (Graph 11). Part of the effect on spending on furnishings is likely to come from the fact that periods of rising housing prices are often associated with higher housing turnover, and turnover generates extra spending. Over recent years, spending by households has risen at a faster rate than household income; in other words, the saving rate has declined (Graph 12). The results that I just spoke about suggest that rising housing wealth played a role here. If so, falling housing prices, and a decline in measured household wealth, could have the opposite effect. The more important influence, though, is what is happening with household income. For many people, the main source of their wealth is their human capital; that is, their future earning capacity. As I have discussed on previous occasions, growth in household income has been quite weak for a while. It is plausible that, for a time, this didn't affect people's expectations of their future income growth; that is the value of their human capital. So they didn't change their spending plans much, despite their current income growth being weak, and the saving rate fell. However, as the period of weak income growth has persisted, it has become harder to ignore it. Expectations of future income growth have been revised down and it is likely that this is affecting spending. My conclusion here is that wealth effects are influencing consumption decisions, but they are working mainly through expectations of future income growth. Swings in housing prices and turnover in the housing market are also having an effect, but they are not the main issue. This assessment is consistent with the data on housing equity injection (Graph 13). Over recent years, households have been injecting substantial equity into housing and have not been using the higher housing prices to borrow to support their other spending. This is in contrast to the period around the turn of the century, when households were withdrawing equity. Given this assessment, developments in the labour market are particularly important. A further tightening of the labour market is expected to see a gradual increase in wages growth and faster income growth. This should provide a counterweight to the effect on spending of lower housing prices. Taking these various considerations into account, the adjustment in our housing market is manageable for the overall economy. It is unlikely to derail our economic expansion. It will also have some positive side-effects by making housing more affordable for many people. A related issue that the RBA has paid close attention to is the impact of lower housing prices on financial stability. In 2017, APRA assessed the ability of Australian banks to withstand a severe stress scenario, in which housing prices declined by 35 per cent over three years, GDP declined by 4 per cent and the unemployment rate increased to more than 10 per cent. The estimated impact on bank profitability was substantial, but importantly, bank capital remained above regulatory minimum levels. This provides reassurance that the adjustment in our housing market is not a financial stability issue. We have not experienced the very loose lending practices that were common in the United States before the housing crash there a decade ago. Nor have we seen significant overbuilding around the country. Non-performing housing loans in Australia have risen recently, but they remain low at less than 1 per cent (Graph 14). The increase is most evident in Western Australia, where the unemployment rate has risen. The national experience has been that low levels of unemployment and low interest rates allow most people to service their loans, even if weak income growth means that household finances are sometimes strained. Our estimate is that currently, less than 5 per cent of indebted owner-occupier households have negative equity, and the vast bulk of these households continue to meet their mortgage obligations. One factor that has helped here is that the share of new loans with high loan- - in which there is an incentive to make prepayments - has also helped. I would like to conclude with some words about monetary policy and highlight some of the issues we focused on at yesterday's Reserve Bank Board meeting. As you are aware, the current setting of monetary policy has been in place for some time. A cash rate of 1.5 per cent is very low historically and it is clearly stimulatory. It is supporting the creation of jobs and progress towards achieving the inflation target. Looking forward, a key issue is the labour market. Achieving full employment is an important objective in its own right. But, in addition, a strong labour market is the central ingredient in the expected pick-up in inflation. We are expecting that as the labour market tightens, wages growth will increase further. In turn, this should boost household income and spending and provide a counterweight to the fall in housing prices. The pick-up in spending is, in turn, expected to put upward pressure on inflation. Of course, it is possible that inflation could move higher for other reasons, although the likelihood of this at the moment seems low. This means that a lot depends upon the labour market. The recent data on this front have been encouraging. Employment growth has been strong, the vacancy rate is very high and firms' hiring intentions remain positive. The latest reading of the wage price index also confirmed a welcome, but gradual, pick-up in wage growth, especially in the private sector.

r190521a_BOA

australia

The Economic Outlook and Monetary Policy

lowe

Thank you for the invitation to speak to the Economic Society of Australia. It is very good to be back here in Brisbane today. I would like to begin by providing an update on recent developments in the global and Australian economies. I will then discuss how our thinking on the appropriate stance of monetary policy has evolved over recent times. Up until around the middle of last year, the global economy was growing quite briskly (Graph 1). Then, over the second half of the year, growth slowed and this lower pace continued into 2019. There are a few factors that help explain this slowing in the global economy. The first is a slowdown in the Chinese economy. The Chinese authorities have for some time been seeking to address the build-up of risks in the financial system. As part of their efforts on this front they have sought to rein in shadow banking. The effect of this has been felt across their economy and, given the size of the Chinese economy, the impact has also been felt around the world. A second factor is a marked slowdown in international trade. Over the past year, global trade has not grown at all (Graph 2). This is unusual as, historically, global trade has tended to increase at least as fast as GDP. This recent weakness partly reflects the slowing in the Chinese economy, but the increases in US and Chinese tariffs are also a factor. Not surprisingly, it has flowed through into weaker conditions in the manufacturing sector around the world and there has been a disruption to some supply chains. Business investment, too, has been affected, with firms delaying investment decisions. In the face of increased uncertainty about future trade policy, many businesses have preferred to wait for a clearer picture. A cyclical downturn in the global electronics industry has also weighed on exports and investment, particularly in some east Asian economies. A third factor contributing to the slowdown in global growth has been a series of country-specific factors, including natural disasters in Japan, a new vehicle emissions testing regime in Germany and some extreme weather events. So, these are some of the key factors that have been at work. Looking forward, the global picture looks a little brighter and it is reasonable to expect that growth will strengthen a little later in the year. The Chinese authorities have responded to the slowing in their economy with measures to support economic activity. Globally, financial conditions are very accommodative and major central banks have signalled an easier monetary policy stance than was earlier expected. It is also reasonable to expect that the drag on growth from some of the country-specific factors that I mentioned will pass in time. Consumption growth in many economies also remains robust, supported by strong employment growth and rising wages. And notably, the weakness in the manufacturing sector has not spilled over in a material way to the services sector. All this means that the global economy appears quite resilient at the moment. The big uncertainty remains trade policy. A resolution of the current disputes would help boost trade flows and reduce some of the uncertainties facing businesses. In that case, we could expect a pickup in investment too. On the other hand, a failure to resolve the disputes represents a major downside risk to the global economy. So there is a lot riding on this issue. One other feature of the global economy that I would like to draw your attention to is the coexistence of low unemployment and low inflation. Unemployment rates in many of the major economies are the lowest they have been in many decades. At the same time, inflation remains low. While wages growth has picked up, inflation rates are mostly below 2 per cent and below the central This experience is the opposite to that of the 1970s and early 1980s. During that period, many countries experienced what became known as stagflation: the coexistence of high unemployment and high inflation. Today, the picture is very different: we have low unemployment and low inflation. This is obviously a much better configuration. Understanding why this has happened is a priority for us, as we too in Australia are experiencing something similar. We are still searching for the full answers, but the fact that the experience is common across so many countries suggests that there are some global factors at work. In my view, these are partly linked to changes in technology and to globalisation. Both of these affect perceptions of competition and they both are a source of uncertainty about the future. In turn, they are affecting pricing decisions across the world. We can't be sure how long these effects will last and whether the coexistence of low inflation and low unemployment is temporary, or whether it is a new normal. Whether or not it is permanent, the coexistence of low inflation and low unemployment does appear to be highly persistent. This persistence has led to a reassessment in a number of countries of the unemployment rate that is sustainable without inflation becoming a concern. This is an important issue and one I will return to in the context of Australian monetary policy. I would first like to provide an update on the Australian economy. Just as the global economy slowed over the second half of 2018, so too did the Australian economy - we went from growing at an above-average pace in the first half of 2018 to a below-average pace As has been the case globally, we had our own country-specific factors that have temporarily weighed on economic growth, including the drought and some disruptions to resource production and exports. More fundamentally, though, the main reason for the shift in momentum in the Australian economy is a slowdown in household consumption growth. Over the second half of 2018, household consumption increased by just 3/4 per cent, which is an unusually soft outcome. The decline in housing prices is a factor here, but the more important factor is the long period of weak growth in household income (Graph 5). Over the past three years, household disposable income has increased at an average rate of just 2 3/4 per cent. This compares with an average of 6 per cent over the preceding decade. As this period of weak income growth has persisted, it has become harder for households to dismiss it as just a temporary development - as something that will pass quickly. The lower rate of income growth has also made it harder for households to pay down debt. The end result has been that many people have decided to adjust their spending plans. There was further evidence of this adjustment in the retail trade data for the March quarter. We are not expecting a quick turnaround in growth in consumer spending, but we are expecting a gradual improvement. This is largely on the basis of an expected pick-up in growth in household income, and a stabilisation of the housing market over the period ahead. We are expecting household disposable income to grow at an average rate of 4 per cent over the next couple of years, which is noticeably higher than the average of recent times. Stronger growth in income will help, but the more important factor is some tax relief. Over the past year, tax paid by households increased at a much faster rate than did income; almost 10 per cent, compared with 3 1/4 per cent - that is a big difference and it is unusual. We are not expecting it to continue for a couple of reasons. First, the tax offsets for low- and middle-income earners announced in the recent budget will boost disposable income. And second, it is likely that we will return to a more normal relationship between growth in incomes and tax paid. Our expectation is that the stronger growth in disposable income will flow through into household spending, although this will take some time. Looking beyond household spending, the outlook for the Australian economy is being supported by a number of other developments. The first is the ongoing investment in infrastructure. This investment is important. It is not only supporting demand in the economy at a time when this is needed, but it is also adding to the supply capacity of the economy and directly improving people's lives, including through a reduction in transport congestion. There is also strong growth in demand for a range of services, partly as a result of ongoing strong population growth. Another factor supporting growth is the recent lift in the terms of trade, which have continued to surprise on the upside, boosting our national income. The outlook for investment in the resources sector has also improved, due to both higher levels of sustaining capital investment and the commencement of some new projects. After five years of declining mining investment as LNG projects were completed, we are expecting an increase over the coming year (Graph 6). Non-mining business investment is also on an upward trend as firms invest in additional capacity. By contrast, investment in residential construction is likely to be a drag on the economy for the next few years. After six years of strong growth, residential construction is now declining and this is likely to continue for a while yet. In comparison with the GDP data, the labour market data over the past year have painted a stronger picture of the economy and have mostly surprised on the upside. More people have joined the labour market and job creation has been strong, with employment increasing by 2 1/2 per cent over the year, compared with growth in the working-age population of 1 3/4 per cent. The unemployment rate has also declined over the past year (Graph 7). Recently, though, some labour market indicators have softened a little: the unemployment rate ticked up to 5.2 per cent in April; the underemployment rate has also moved a little higher as there are more part-time workers who are seeking additional hours; job advertisements have declined; and hiring intentions have come off their earlier highs. At the same time, the vacancy rate remains high, monthly employment growth remains firm and hiring intentions remain above average. Taking these various indicators together, the labour market continues to be resilient, although our expectation is that employment growth will slow to be broadly in line with growth in the working-age population. The other element of the labour market that I would like to comment on is wages. As the labour market has strengthened over the past year, wages growth in the private sector has picked up. By contrast, wages growth in the public sector has been steady at around 2 1/2 per cent (Graph 8). Overall, though, wages growth remains lower than the rate that would appear consistent with inflation being comfortably within the target range. Even in New South Wales and Victoria - where the unemployment rates have averaged around 4 1/2 per cent over recent times - wages growth has been running at just 2 1/2 per cent. It would appear that some of the global factors that I mentioned earlier are working here as well. Putting these various elements together, our central scenario - as outlined in our recent is for the Australian economy to grow by 2 3/4 per cent over both 2019 and 2020 (Graph 9). As always, though, there is a range of uncertainty around this forecast. But the central outlook is for growth at around our estimate of potential growth in the Australian economy. Given this, over these two years the unemployment rate is forecast to be around 5 per cent. In 2021, the central forecast is for slightly better outcomes, partly due to a pick-up in the resources sector. It is worth pointing out that when preparing these forecasts, we used our normal technical assumption that interest rates would move broadly in line with market pricing. At the time the forecasts were prepared, market pricing implied that the cash rate was expected to decline to 1 per cent over the next year. If, instead, we had used an assumption of unchanged interest rates, the growth forecast would have been lower and the forecast for unemployment would have been higher. Turning now to inflation, the outcome for the March quarter was noticeably lower than we had expected. In year-ended terms, headline inflation was 1.3 per cent and in underlying terms it was around 1 1/2 per cent (Graph 10). Looking through the details of the CPI, there appear to be only limited inflation pressures across much of the economy. The low rates of wages growth are contributing to relatively low rates of inflation in the services sector. Rent inflation is also the lowest it has been in decades. And various government initiatives to ease cost-of-living pressures are contributing to lower increases in many administered prices. Together, these factors have led to a low rate of inflation for non-traded goods and services (Graph 11). The picture for traded goods and services inflation is a little different. Recently, there have been increases in some food prices as a result of the drought and floods. The earlier small depreciation of the exchange rate has also been passed through into the prices for some consumer durables. These developments mean that tradables prices as a group are no longer declining. Even so, inflation remains low for most traded goods and services. Looking forward, the central forecast is for underlying inflation of around 1 3/4 per cent this year, 2 per cent next year and a little higher the following year. In headline terms, inflation is expected to be noticeably higher in the June quarter, due to the recent increase in petrol prices. For 2019 as a whole, headline CPI inflation is expected to be around 2 per cent and the same the following year. This means that inflation is expected to remain around the bottom of the medium-term target range over the forecast period. I would like to turn now to monetary policy and how our thinking and communication have evolved over recent times. You might recall that through 2018 we had three main messages: (1) we were making progress towards our inflation and unemployment goals; (2) given that this progress was expected to continue, it was more likely that the next move in interest rates would be up, rather than down; and (3) given the progress towards our goals was expected to be only gradual, any move in interest rates was some time off. Earlier this year, our assessment of the balance of probabilities around the likely direction of the next move in interest rates shifted a little. At the Reserve Bank Board meeting in February, we assessed that the probabilities of an interest rate increase and a decrease had become more evenly balanced than they were through 2018. This shift reflected two developments. The first was the slowing in the Australian economy over the second half of 2018 that I just spoke about. And the second was the lower-than-expected inflation outcome for the December quarter. The main countervailing consideration was the labour market, which painted a stronger picture of the economy than the other indicators. In the face of these conflicting signals, we judged that the best approach was to hold interest rates steady while we obtained a clearer picture of the direction of the economy. It was relatively clear, though, that if the GDP data were giving the better signal - and the labour market eventually softened - lower interest rates would likely be appropriate. This was especially so in light of the ongoing low rate of inflation. This assessment was reflected in the minutes of the Board's April meeting, where we discussed a scenario in which there was a lack of progress on inflation and the unemployment rate trended higher. Following our April meeting, we received another reading on inflation, which confirmed that price pressures were subdued across the economy. Over the past year - and particularly in the past two quarters - inflation has come in lower than we expected and our inflation forecasts have been revised down. This is evident in Graph 12, which shows the forecasts a year ago, the actual outcomes and our current forecasts. In contrast to the subdued inflation outcomes, employment growth has been stronger than we expected a year ago. This can be seen in the right-hand panel. In most cases, when employment growth is stronger than expected, we expect to see an upside, not a downside, surprise on inflation. So, from this perspective, the recent experience is a little unusual. As the Board has sought to understand this experience and studied similar experiences overseas, we have been asking ourselves: what rate of unemployment is achievable in Australia without generating inflation concerns? Over recent years, the answer to this question was thought to be around 5 per cent - in other words, it was thought that an unemployment rate below 5 per cent was likely to put pressure on the supply capacity of the economy and, in turn, raise possible inflation concerns. But from today's perspective, I think we can do better than this. My judgement of the accumulating evidence is that the Australian economy can support an unemployment rate of below 5 per cent without raising inflation concerns. This would be consistent with the experience overseas, with many other advanced economies sustaining lower rates of unemployment than previously thought possible without leading to a noticeable uplift in inflation. If this judgement is correct, the question is: how does our society achieve and sustain a lower rate of unemployment? It is possible that the current policy settings are sufficient to deliver lower unemployment. The labour market has surprised on the upside over recent times, and it could do so again. While we can't rule out this possibility, the recent flow of data makes it seem less likely. In the event that the unemployment rate does not move lower with current policy settings, there are a number of options. These include: further monetary easing; additional fiscal support, including through spending on infrastructure; and structural policies that support firms expanding, investing and employing people. Relying on just one type of policy has limitations, so each of these is worth thinking about. The Reserve Bank Board recognises that monetary policy has a role to play here. Earlier today, we released the minutes of the Board's meeting two weeks ago. At that meeting, we discussed a scenario in which there was no further improvement in the labour market and the unemployment rate remained around the 5 per cent mark. In this scenario, we judged that inflation was likely to remain low relative to the target and that a decrease in the cash rate would likely be appropriate. A lower cash rate would support employment growth and bring forward the time when inflation is consistent with the target. Given this assessment, at our meeting in two weeks' time, we will consider the case for lower interest rates. Thank you for listening. I look forward to answering your questions.

r190604a_BOA

australia

Today's Reduction in the Cash Rate

lowe

On behalf of the Reserve Bank Board, I would like to warmly welcome you to this community dinner. Thank you for joining us this evening. We value this opportunity to hear firsthand from you about the challenges and opportunities you face. I would also like to take advantage of the timing of this dinner to explain today's decision on interest rates. As you would have heard already, earlier today the Reserve Bank Board decided to lower the cash rate by a quarter of a percentage point to 1 1/4 per cent. This decision comes after more than 2 1/2 years in which we have held the cash rate steady. The last change was back in August 2016. At its core, today's decision was taken to support employment growth and to provide greater confidence that inflation will be consistent with the medium-term target. I want to emphasise that the decision is not in response to a deterioration in our economic outlook since the previous update was published in early May. The economic outlook remains reasonable, with the main downside risk being the international trade disputes, which have intensified recently. The Australian economy is still expected to strengthen later this year, supported by the low level of interest rates, a pick-up in growth in household disposable income, ongoing investment in infrastructure and a brighter outlook for the resources sector. So today's decision does not reflect a weaker outlook. Rather it reflects the fact that, even with the expected pick-up in growth, the Australian economy is likely to have spare capacity for a while yet. Today's easing of monetary policy will help us make further inroads into that spare capacity. It will assist with faster progress on reducing unemployment and will help achieve more assured progress towards the inflation target. So that is our rationale. I know that many of you are likely to have questions about today's decision. I would like to take this opportunity to provide answers to some of your probable questions. I am also happy to answer your other questions after my prepared remarks. The four questions that I thought it would be useful to answer are the following: Why did the Board act today, after having held the cash rate steady for more than 2 1/2 years? Are there more interest rate reductions to come? Should today's reduction be fully passed through to mortgage rates? and What about the savers - has the Board forgotten about them? First, why move now, after holding steady for so long? The answer is the accumulation of evidence. As you would expect, the Board is constantly sifting through masses of data and seeking to understand what are often conflicting signals about the economy. As we have gone about this task over recent times, there has been a progressive accumulation of evidence in support of two conclusions. The first is that inflation pressures are subdued and they are likely to remain so. And the second and related conclusion is that there is still significant spare capacity in the Australian labour market. The most recent batch of data has provided further evidence in support of both conclusions. The March quarter CPI was low and it was below expectations, as was the previous reading on inflation. In addition, the wage data for the March quarter confirmed that wages growth remains subdued, although it has picked up from a year ago. And the recent labour market report also confirmed that strong employment growth is not making material inroads into spare capacity in the labour market. The Board judged that the accumulation of this further evidence meant that it was now appropriate to adjust monetary policy. Given the importance of these two conclusions, I would like to elaborate a little on them and explore their implications. The subdued inflation pressures reflect a number of factors. These include slow growth in wages, increased competition in retailing, the adjustment in the housing market - with rents increasing at the slowest pace in decades - and various government initiatives to reduce the cost of living pressures on households. These factors are all putting downward pressure on prices and they are likely to remain with us for some time yet. Collectively, these factors have contributed to delayed progress in returning inflation to the 2- 3 per cent target range. In underlying terms, inflation has now been below 2 per cent for three years and the latest reading was 1 1/2 per cent. Looking forward, inflation is still expected to increase, but it is unlikely to be comfortably within the 2-3 per cent range for some time yet. So the progress on returning inflation to target is more gradual than we had hoped. It is important to remember, though, that our inflation target is intentionally flexible and that the Australian economy has benefited from this flexibility over the past 25 years. The Board is aiming to ensure that Australia has an average inflation rate of between 2 and 3 per cent over time. The focus is on the average and the medium term. We have never sought to have inflation always between 2 and 3 per cent. The RBA adopted flexible inflation targeting before other central banks, and this flexibility has served us well. It has allowed the Board to set monetary policy so as best to achieve its broad objectives, with the ultimate aim of contributing to the economic prosperity and welfare of the people of Australia. It has also allowed the Board to look through temporary factors affecting inflation. This flexibility, however, is not boundless. The point of our inflation target is to provide a strong medium-term anchor that helps deliver low and stable inflation, which, in turn, is an important precondition to sustainable growth in employment and incomes. If inflation stays too low for too long, it is possible that inflation expectations move lower - that Australians come to expect sub- 2 per cent inflation on an ongoing basis. If this were to happen, it would be harder to achieve the medium-term inflation goal. So we need to guard against this possibility. Moving on to our conclusion about spare capacity in the labour market. For some years, most estimates of full employment, including our own, equated to an unemployment rate of around 5 per cent - it was thought that if unemployment went below that for too long, inflation would rise and become a problem. But, given the combination of the labour market and inflation outcomes we have seen of late, our judgement now is that we can do better than this - that we can sustain an unemployment rate of 4 point something. It is also worth noting that the supply side of the labour market is turning out to be more flexible than we had earlier expected. The recent evidence is that when jobs are there, more people join the labour force and other Australians stay in work longer. Reflecting this, the participation rate is currently at a record high, despite demographic shifts that we anticipated would reduce participation. It is also the case that people are prepared to work extra hours when there is strong demand for their labour. Together, these observations support the conclusion that there is still spare capacity in the labour market and this is likely to remain the case for a while yet. The recent data have given us more confidence in this assessment and we have responded to this. Over the past few years, one concern has been that lower interest rates could add to the medium- term risks facing the Australian economy as a result of high household debt. We need to keep a close eye on this issue, but this concern has receded recently. Lending practices have been tightened considerably and many lenders have become quite risk averse. The demand for credit has also slowed due to the changed dynamics of the housing market and slower income growth. So the risks on this front look to be less than they were previously. This brings me to the second question: are interest rates going to be reduced further? The answer here is that the Board has not yet made a decision, but it is not unreasonable to expect a lower cash rate. Our latest set of forecasts were prepared on the assumption that the cash rate would follow the path implied by market pricing, which was for the cash rate to be around 1 per cent by the end of the year. There are, of course, a range of other possible scenarios and much will depend on how the evidence evolves, especially on the labour market. If you accept the argument that a sustainably lower rate of unemployment in Australia is achievable, the question that we should all be thinking about is: how do we get there? It is possible that the current policy settings will be enough - that we just need to be patient. But it is also possible that the current policy settings will leave us short. Given this, the possibility of lower interest rates remains on the table. Monetary policy does have an important role to play and we have the capacity to play that role if needed. In saying that, I also want to recognise that monetary policy is not the only option. There are certain downsides from relying just on monetary policy and there are limitations on what, realistically, can be achieved. So, as a country, we should also be looking at other options to reduce unemployment. One option is for fiscal support, including through spending on infrastructure. This spending not only adds to demand in the economy, but it also adds to the economy's productive capacity. So it works on both the demand and supply side. Another option is structural policies that support firms expanding, investing, innovating and employing people. All three options are worth thinking about. From my perspective, the best option is the third one - structural policies that support firms expanding, investing, innovating and employing people. A strong dynamic business sector is the best way of creating jobs. Structural policies not only help with job creation, but they can also help drive the productivity growth that is the main source of improvement in our living standards. So, as a country, it is important that we keep focused on this. I will now change tack and move to the third question: should today's reduction in the cash rate be fully passed through to mortgage rates? My usual practice in answering this question has been to explain that there are a range of other factors that influence mortgage pricing, and then say 'it all depends'. There are often reasonable explanations for why the standard variable mortgage rate does not move in lock-step with the cash rate. Today, though, I would like to break with my usual practice and provide a clearer answer. And that is: Yes, this reduction in the cash rate should be fully passed through to variable mortgage rates. This answer is based on recent reductions in bank funding costs. Not only have these costs declined as a result of the change in monetary policy, but they have also declined because of movements in market-based spreads. Last year, these spreads increased and most lenders responded by increasing their standard variable rates by around 15 basis points. Over recent months, these spreads have reversed all the increase that occurred last year and returned to their 2017 levels. The result is that there has been a substantial reduction - at both the short end and the long end - in the cost of banks raising funds in wholesale markets. Average rates on retail deposits have also come down. This means that the lower cash rate should be fully passed through into standard variable mortgage rates. Full pass-through would also mean that the economy receives the full benefit of today's policy decision. That brings me to the final question: what about the savers, have we forgotten about them? I know this question is on the minds of a lot of Australians, especially older Australians. I am reminded of this daily as people write to me telling me how the already low deposit rates are affecting their income. I am expecting to receive more such letters and emails after today's decision. The Board had a thorough discussion of this issue at our meeting today. We recognise that many Australians have saved hard and rely on interest from term deposits to support their income and spending. Today's decision will reduce their income from this source and we understand why they would be disappointed with the outcome of today's meeting. At the same time as paying close attention to this issue, the Board considered what was best for the overall economy. Our judgement is that lower interest rates will help the economy as a whole. At the moment, this benefit is likely to come mainly through two channels. The first is a lower value of the exchange rate than otherwise would have been the case. The second is a boost to the disposable income of the household sector. In aggregate, the household sector pays around two dollars in interest for every dollar it receives in interest income. So, in aggregate, lower interest rates reduce the net interest payments of the household sector and so boost overall disposable income. In time, we would expect the lower exchange rate and the boost to disposable income to lead to more jobs, lower unemployment and a stronger economy. This should benefit us all, although I recognise that in the short run the effects are felt unevenly across the community. It is partly because of this unevenness that I want to repeat a point I made in answering the second question. And that is: the best approach to delivering lower unemployment and a stronger economy is through structural policies that support firms expanding, investing, innovating and employing people. These policies can have distributional effects too, but the benefits are more broadly based. So, as I said, as we ease monetary policy, it is in the country's interest that other policy options are considered too. That brings me to the end of my four questions and answers. I hope that this has helped you understand the Board's thinking and why we took the decision today. I am happy to answer other questions that you might have. Thank you for listening and for joining us this evening.

r190620a_BOA

australia

The Labour Market and Spare Capacity

lowe

I would like to thank CEDA for the invitation to address this lunch. It is a great pleasure to be back in Adelaide and to participate in another CEDA event. Those of you who follow the RBA closely would have noticed frequent references to the labour market in our recent communication. Today, I would like to explain why this is so and also discuss how we assess the amount of spare capacity in the labour market. I will then finish with some comments on monetary policy. Students of central bank history would be aware that the was passed by the Australian Parliament in 1959 - 60 years ago. In terms of monetary policy, the Parliament set three broad objectives for the Reserve Bank Board. It required the Board to set monetary policy so as to best contribute to: i. The stability of the currency ii. The maintenance of full employment iii. The economic prosperity and welfare of the people of Australia These objectives have remained unchanged since 1959. Here, in Australia, we did not follow the fashion in some other parts of the world over recent decades of setting just a single goal for the central bank - that is, inflation control. In my view it was very sensible not to follow this fashion. Our legislated objectives - having three elements - are broader than those of many other central banks. The third of our three objectives serves as a constant reminder that the ultimate objective of our policies is the collective welfare of the Australian people. From an operational perspective, though, the flexible inflation target is the centre piece of our monetary policy framework. The target - which has been agreed to with successive governments - is to deliver an average rate of inflation over time of 2-3 per cent. Our focus is on the average and on the medium term. Inflation averaging 2 point something constitutes a reasonable definition of price stability. Achieving this stability helps us with our other objectives. Low and stable inflation is a precondition to the attainment of full employment and it promotes our collective welfare. As I have said on other occasions, we are not targeting inflation because we are inflation nutters. Rather, we are doing so because delivering low and stable inflation is the most effective way for Australia's central bank to promote our collective welfare. So where does the labour market fit into all this? The answer is that it is central to all three objectives. The connection with the second objective - full employment - is obvious. The RBA is seeking to achieve the lowest rate of unemployment that can be sustained without inflation becoming an issue. In doing this, one of the questions we face is what constitutes full employment in a modern economy where work arrangements are much more flexible than they were in the past. I will return to this issue in a moment. The labour market is, of course, also central to the third objective in our mandate - our collective welfare. It is stating the obvious to say that for many Australians, having a good job at a decent rate of pay is central to their economic prosperity. Trends in the labour market also have a major bearing on inflation outcomes, so they are important for the first element of our mandate as well. Over time, there is a close link between wages growth and inflation. And a critical influence on wage outcomes is the balance between supply and demand in the labour market; or in other words how much spare capacity is there in the labour market? This question is closely linked to the one about what constitutes full employment. So, it is natural that we focus on the labour market as the Board makes its monthly decisions about interest rates. With that background I would now like to discuss how we assess the degree of spare capacity in the Australian labour market. I will do this from four perspectives: 1. The rates of unemployment and underemployment 2. The flexibility of labour supply 3. The effectiveness with which people are matched with job vacancies 4. Trends in wages growth. The conventional measure of spare capacity in the labour market is the gap between the actual unemployment rate and the unemployment rate associated with full employment. Even at full employment, some level of unemployment is to be expected as workers leave jobs and search for new ones. As my colleague Luci Ellis discussed last week, we don't directly observe the unemployment rate associated with full employment - we need to estimate it. Over recent times there has been a gradual accumulation of evidence which has led to lower estimates. While it is not possible to pin the number down exactly, the evidence is consistent with an estimate below 5 per cent, perhaps around 4 1/2 per cent. Given that the current unemployment rate is 5.2 per cent, this suggests that there is still spare capacity in our labour market. The fact that the conventional estimate of spare capacity is based on the unemployment rate reflects an implicit assumption that if you have a job you are pretty much fully employed. In decades past, this might have been a reasonable assumption. But it is not a realistic assumption in today's modern flexible labour market. As more people work part time, it has become increasingly common to be both employed and to work fewer hours than you want to work. In the 1960s, less than one in ten workers worked part time (Graph 1). Today, one in three of us works part time. Almost one in two women work part time and more than one in two younger workers work part time. A few more facts are perhaps helpful here. According to the ABS, around 3 million people work part time because they want to, not because they can't find a full-time job. Most people who are working part time do so because they are studying or have caring responsibilities, or for other personal reasons. So we should not think of part-time jobs as being jobs, and full-time jobs as being jobs. Rather, one of the success stories of the Australian labour market is that we have been able to accommodate this desire for part-time work and flexibility. Having said that, around one-quarter of people working part time are not satisfied with the hours they are offered and would like to work more hours: we can think of these people as underemployed (Graph 2). The share of part-time workers who are underemployed moves up and down from year to year, and the current share is above its average level over the past two decades. As part of the ABS's monthly survey of 50,000 people, it asks underemployed workers how many extra hours they would like to work. On average, they answer that they would like to work an extra 14 hours per week. It is interesting that this figure has trended down over the past two decades; it used to be more than 16 hours. Over the same period, the average hours worked by part-time workers has increased by around 2 hours to 17 hours per week. Taken together, these data suggest that businesses are doing a better job of providing the hours that part-time workers are seeking. This shift to part-time work means that in assessing spare capacity we need to consider measures of as well as measures of unemployment. The RBA has been doing this for some time. As part of our efforts here, we have constructed a measure of underutilisation that takes account of the part-time workers who want to work more hours. This measure adds the extra hours sought by these workers to the hours sought by those who are unemployed (Graph 3). extra hours are equivalent to around 3.3 per cent of the labour force, which, taking account of conventional unemployment, means that the underutilisation rate is 8.1 per cent. This hours-based measure is preferable to heads-based measures of underutilisation that treats an unemployed person in the same way as a part-time worker seeking a few more hours. Unlike the unemployment rate, which has trended down over the past 20 years, the underemployment rate has been relatively stable. These different patterns in unemployment and underemployment suggest that fewer inroads have been made into spare capacity in the labour market than suggested by looking at the unemployment rate alone. This is something we take into account in thinking about monetary policy. There is, though, one other perspective on the measure of underemployment that I would like to share with you. In the past, when part-time work was not as readily available, many people - mostly women - faced the choice of taking full-time paid employment or no paid employment at all. Many chose to, or had to stay outside the labour force because working was not a realistic option. From the perspective of society as a whole, this was a serious form of underutilisation - it just wasn't measured as such by the ABS. Given the trend towards part-time and more flexible jobs, people have more options than they had before and many have chosen to join, or have deferred leaving, the labour force. From the perspective of adding to the productive capacity of the nation, this is a good outcome and if there was a measure of underutilisation that took account of exclusion from the workforce, it would surely have declined. I don't want to downplay the issue of underemployment, but it is worth recognising this broader perspective, and remembering where we have come from. This naturally brings me to my second window into spare capacity in the labour market - the flexibility of labour supply. Over the past 2 1/2 years, the working-age population has increased at an annual rate of around 1 3/4 per cent. Over that same time period, employment has increased at an average rate of 2 3/4 per cent. The fact that employment has been increasing considerably faster than the workingage population has led to a reduction in the unemployment rate, but the reduction is not as large as might have been expected. The reason for this is that the supply of labour has increased in response to the stronger demand for workers. This flexibility in labour supply is evident in the substantial rise in labour force participation. The participation rate currently stands at 66 per cent, which is the highest on record (Graph 4). Reflecting this, the share of the working-age population in Australia with a job is currently around the record high it reached at the peak of the resources boom. As I discussed a few moments ago, the availability of part-time and flexible working arrangements is one reason for this. There are two groups for which the rise in participation has been particularly pronounced: women and older Australians (Graph 5). The female participation rate now stands at 61 per cent, up from 43 per cent in 1979. Australia's female participation rate is now above the OECD average, although it remains below that of a number of countries, including Canada and the Netherlands. The participation rate of older workers has also increased over recent decades as health outcomes have improved and changes have been made to retirement policies. The eligibility age for the pension was progressively raised from 60 to 65 for females and is now being gradually increased to 67 for everybody by 2023. The preservation age at which individuals can access their superannuation is also being gradually increased. These changes are contributing to higher participation by older Another source of potential labour supply is net overseas migration. Migration, including temporary skilled workers, increased sharply during the resources boom when demand for skilled labour was very strong, and has subsequently declined (Graph 6). While migrants add to both demand and supply in the economy, they can be a particularly important source of capacity for resolving pinchpoints where skill shortages exist. A related source of flexibility stems from our unique relationship with New Zealand. When labour demand is relatively strong in Australia, there tends to be an increase in the net inflow of workers from New Zealand to Australia. When conditions are relatively subdued here, the reverse occurs. During the resources boom, the inflow from across the Tasman was as large as the inflow of temporary skilled workers. The overall picture here is one of a flexible supply side of the labour market. When the demand for labour is strong, more people enter the jobs market or delay leaving. This rise in participation is a positive development. But it is one of the factors that has meant that strong demand for labour has not put much upward pressure on wages. A third perspective on spare capacity in the labour market can be gained from examining how well people looking for jobs are matched with the jobs that are available. Looking at the labour market from this perspective, things look a little tighter than suggested by the other two perspectives that I have discussed. Currently, almost 60 per cent of firms report that the availability of labour is either a minor or a major constraint on their business (Graph 7). This share is not as high as it was during the resources boom, but it is still quite high. Reports from the RBA's liaison program suggest that there are currently shortages of certain types of engineers, workers with specialised IT skills and some tradespeople associated with public infrastructure work. Businesses in regional areas are also more likely to report a greater degree of difficulty finding suitable labour. One contributing factor here is an underinvestment in staff training. In the shadow of the global financial crisis many firms cut back training to reduce costs. We are now seeing some evidence of the adverse longer-term implications of this. As the labour market tightens further, I would hope that more firms are prepared to hire workers and provide the necessary training. Another lens on job matching is the ratio of the number of unemployed people to the number of job vacancies (Graph 8). At present, there are fewer than three unemployed people for each vacancy. This compares with over 20 people for every vacancy in the early 1990s recession and five people for every vacancy in 2014. From this perspective the labour market looks reasonably tight. There is also some tentative evidence that, on average, unemployed workers are not as well matched to job vacancies as was the case in 2007, when the ratio of the two was at a similar level. One such piece of evidence is that as the unemployment rate has come down over recent years, there has been little progress on reducing very long-term unemployment, defined as those who are unemployed for more than two years (Graph 9). Addressing the causes of this chronic unemployment remains an important challenge for our community. More positively, the share of the labour force that has been unemployed between one and two years has trended down over recent times. Another lens on job matching and the overall tightness of the labour market is the rate of job mobility; that is, how often people change their jobs. Here, the evidence is interesting. Despite the frequent reports of a lack of job security and regular job switching by millennials, the average time that workers are staying with an employer is increasing. Reflecting this, the share of employed people who switch employers in a given year is the lowest it has been in a long time (Graph 10). Looking at the data by occupation, the rate of job mobility is lowest for managers and business professionals and highest for tradespeople and workers in the hospitality industry. In a tight labour market, we would expect to see either strong wages growth or frequent job changing as businesses seek out workers. But we are seeing neither at present. One possible explanation for this is the uncertainty that many people feel about the future. This uncertainty means that if you have a job you want to keep it rather than take a risk with a new employer. This might be especially so if you also have a large mortgage. So it is possible that the high level of household debt is also affecting labour market dynamics. I will now turn to the fourth perspective on labour market tightness - that is wages growth. Over the past year, wages growth has picked up as the labour market tightened. This is not surprising given the strength of demand for labour. But the pick-up has been fairly modest and is only evident in the private sector (Graph 11). Over the past year, the private-sector Wage Price Index increased by 2.4 per cent, up from 1.9 per cent in the previous year. The past two quarters have, however, seen lower wage increases than in the previous two quarters. In contrast to trends in the private sector, wages growth in the public sector has been steady at around 2 1/2 per cent, largely reflecting the wage caps across much of the public sector. It is also worth pointing out that overall wages growth in New South Wales and Victoria has been running at just 2 1/2 per cent despite the unemployment rate being 4 1/2 per cent or lower over the past year. Another perspective on wages growth is from the national accounts, which reports average earnings per hour worked (Graph 12). This measure is volatile, but the latest data painted a fairly weak picture, with average hourly earnings up by just 1 per cent over the past year. In summary, the overall picture from these various windows into the labour market is that despite the strong employment growth over recent times, there is still considerable spare capacity in the labour market. We remain short of the unemployment rate associated with full employment, there is significant underemployment and there is further potential for labour force participation to increase when the jobs are there. Consistent with all of this, wages growth remains modest and is below the rate that would ensure that inflation is comfortably within the 2 to 3 per cent range. The one caveat to this assessment is the difficulty that some firms are having finding workers with the necessary skills. This underlines the importance of workplace training. I would like to finish with a few words on monetary policy. As you are aware, the Reserve Bank Board reduced the cash rate to 1 1/4 per cent at its meeting earlier this month. This was the first adjustment in nearly three years. This decision was not in response to a deterioration in the economic outlook since the previous update was published in early May. Rather, it reflected a judgement that we could do better than the path we looked to be on. The analysis that I have shared with you today supports the conclusion that the Australian economy can sustain a higher rate of employment growth and a lower unemployment rate than previously thought likely. Most indicators suggest that there is still a fair degree of spare capacity in the economy. It is both possible and desirable to reduce that spare capacity. Doing so will see more people in jobs, reduce underemployment and boost household incomes. It will also provide greater confidence that inflation will increase to be comfortably within the medium-term target range. Monetary policy is one way of helping get us onto to a better path. The decision earlier this month will assist here. It will support the economy through its effect on the exchange rate, lowering the cost of finance and boosting disposable incomes. In turn, this will support employment growth and inflation consistent with the target. It would, however, be unrealistic to expect that lowering interest rates by 1/4 of a percentage point will materially shift the path we look to be on. The most recent data - including the GDP and labour market data - do not suggest we are making any inroads into the economy's spare capacity. Given this, the possibility of lower interest rates remains on the table. It is not unrealistic to expect a further reduction in the cash rate as the Board seeks to wind back spare capacity in the economy and deliver inflation outcomes in line with the medium-term target. It is important though to recognise that monetary policy is not the only option, and there are limitations to what can be achieved. As a country we should also be looking at other ways to get closer to full employment. One option is fiscal policy, including through spending on infrastructure. Another is structural policies that support firms expanding, investing, innovating and employing people. Both of these options need to be kept in mind as the various arms of public policy seek to maximise the economic prosperity of the people of Australia. Thank you for listening. I would be happy to answer your questions.

r190702a_BOA

australia

Remarks at Darwin Community Dinner

lowe

Good evening. A very warm welcome to this community dinner with the Reserve Bank Board and senior staff. This morning the Board held its monthly meeting here in Darwin. We were very kindly hosted at the Northern Territory Parliament building. The last time the Board met in Darwin was more than 50 years ago. I am sure that we all agree that this was too long ago. I can promise that you will be seeing more of us over the years ahead. This evening I would first like to talk a little about our history in the Northern Territory and how things have changed and then talk about today's interest rate decision. The previous Board meeting in Darwin was held on 5 June 1968. The Board met here to celebrate the opening of the RBA's new branch on Bennett Street. We operated out of this building for around 30 years, distributing banknotes and providing banking services to the Northern Territory Government. But beyond this, as many of you will know, the building on Bennett Street has played an important role in the history of Darwin. It was one of the few buildings that was virtually unscathed by the fury of Cyclone Tracy in 1974. This meant that in the aftermath of Tracy, we were able to make our banking chamber available to the police to use as their emergency coordination and communications centre. In some ways this experience symbolises the RBA itself. We build on strong foundations, we place great weight on stability and resilience, and we seek to serve the public interest. Our presence here in Darwin did all this. I am very pleased to see that the building is still serving the public interest as the location of Tourism Top End. In preparation for our meeting today, I looked back at our archives for details of the meeting in 1968, including the Minutes of that meeting, which I am glad to be releasing today. That meeting was the second last for Governor Nugget Coombs before he retired. Reading this archival material reminded me of how much the world has changed. One obvious change is in the way that monetary policy works. The main decision made by the Board at that meeting back in 1968 was that Dr Coombs to the Treasurer that he adjust the interest rates on trading bank fixed deposits and saving bank deposits by a quarter of a per cent. From today's perspective, this is remarkable on two levels. First, the RBA was just making a recommendation to the government - this was obviously before the days of central bank independence. Second, monetary policy was exercised partly through direct controls on bank deposit rates. So, it was a very different world. Today, the Board makes its decisions independently of government and we don't directly control bank interest rates for households and businesses. Another difference that struck me was the way the Board worked and its approach to risk management. In 1968, the Board was made up of nine men; no women at all. This is very different from our Board today. In 1968, the Board also took advantage of the trip to Darwin to make a oneweek tour of northern Australia, visiting Gladstone, Weipa, Gove, Kununurra, the Ord River, Dampier, Mt Tom Price and Alice Springs. Almost the entire Board travelled together on a private chartered plane. Today, our risk management guidelines wouldn't allow this. They don't allow us to travel all together and we certainly don't take private planes. And unfortunately, the demands of today's globalised world make such an extensive trip very difficult in 2019. One other area where there has been much change since the Board last met here is in the relationship between the Original people of this land and the wider Australian community. In his last months as Governor of the Reserve Bank, Nugget Coombs began work as Chair of the Council for referendum. Coombs worked tirelessly for almost three decades advocating for Indigenous rights and social justice. He was a strong advocate of land rights and encouraging pride in the identity of Indigenous Australians. He cared passionately about their welfare and the preservation of cultural values and traditions. Over the years, Nugget Coombs developed a particularly strong relationship with the people of Arnhem Land, especially with the Yolngu around Yirrkala. You might recall that they were responsible for the Yirrkala bark petitions submitted to the Australian Parliament in 1963. The Yolngu wanted to be consulted as the traditional custodians of the land before the government granted mining rights. These petitions were an important step towards the native title rights that exist today. Coombs travelled to Yirrkala many times, the first time being shortly before the Board met here in 1968. He wanted the interests of the community to be recognised and was looking for ways that its members could benefit from the new bauxite mine at Gove. Tomorrow, I will have the great honour of being able to travel to East Arnhem Land and Yirrkala just as Nugget Coombs did. I am incredibly pleased to be accompanied on this trip by Susan MoylanCoombs. Susan was born in Darwin and is part of the group known today as the Stolen Generations and was adopted by Nugget's oldest son, John, and John's wife, Jan. Susan is continuing her Grandfather's work as a tireless advocate for the welfare and prosperity of Indigenous Australians. We will be accompanied by two members of the Reserve Bank Board: Phil Gaetjens, who is also Australia. We are all greatly looking forward to the visit. We want to pay our respects to the traditional owners of the land and to learn from their wisdom. We will also unveil a plaque to Nugget Coombs, whose ashes are buried both at Yirrkala and the Australian National University in Canberra, which he helped found in 1946. I am hopeful that our visit will help keep alive the long relationship between the RBA and the people of East Arnhem Land. Turning back to today's Board meeting, we had a thorough discussion of the Northern Territory economy. We discussed the difficulties that you have faced as investment has fallen following the completion of the LNG plant. The effects of this decline in investment are evident right across the economy: in the housing market; in retail spending; in the labour market; and in public sector finances. As we reviewed these indicators, though, we were struck by the fluidity of the labour market and the population here in the Northern Territory. Despite employment falling significantly over the past year, the unemployment rate remains below the national rate. At our Board meeting we also discussed the future opportunities facing the Northern Territory economy, including in the areas of defence infrastructure, tourism, the cattle industry, and in minerals and gas. In addition, we considered the progress that has been made in addressing the sources of disadvantage for Indigenous Australians. There are many areas where Nugget Coombs would have been pleased to see the progress that has been made. But, regrettably, there are too many areas where not enough progress has been made and where the progress has been too slow. I would now like to turn to today's interest rate decision. As I am sure you are aware, this morning the Board decided to reduce the cash rate by a quarter of a percentage point to 1 per cent. This follows a similar adjustment last month. This easing of monetary policy will support jobs growth across the country and provide greater confidence that inflation will be consistent with the medium-term target of 2 to 3 per cent. Our assessment is that despite the Australian economy having performed reasonably well over recent years, there is still a fair degree of spare capacity in the economy. It is both possible and desirable to reduce that spare capacity. We should be able to achieve a lower rate of unemployment than we currently have and we should also be able to reduce underemployment. If, as a country, we can do this, we could expect a further lift in wages growth and stronger growth in household incomes. These would be good outcomes. As I hope you are aware, the Reserve Bank's monetary policy framework is centred on the inflation target, but the ultimate objective of our policies is to promote the collective economic prosperity of the people of Australia. In the Board's judgement, the easing of monetary policy last month and this month will help promote our collective welfare. At the same time, though, we recognise that the benefits are not evenly distributed across the community and that there are some downsides to monetary easing. Partly for these reasons, over recent times I have been drawing attention to the fact that, as a nation, there are options other than monetary easing for putting us on a better path. One option is fiscal support, including through spending on infrastructure. This spending adds to demand in the economy and - provided the right projects are selected - it also adds to the country's productive capacity. It is appropriate to be thinking about further investments in this area, especially with interest rates at a record low, the economy having spare capacity and some of our existing infrastructure struggling to cope with ongoing population growth. Another option is structural policies that support firms expanding, investing, innovating and employing people. A strong, dynamic, competitive business sector generates jobs. It can help deliver the productivity growth that is the main source of sustainable increases in our wages and incomes. So, as a country, we need to keep focused on this. To repeat the point, it is important that we think about the task ahead holistically. Monetary policy does have a significant role to play and our decisions are helping support the Australian economy. But, we should not rely on monetary policy alone. We will achieve better outcomes for society as a whole if the various arms of public policy are all pointing in the same direction. The two cuts in interest rates the Board has delivered recently will make an important contribution to putting us on a better path and winding back spare capacity. It is also worth drawing your attention to a few other developments. First, borrowing costs for almost all borrowers are now the lowest they have ever been. As an illustration, the Australian Government can borrow for 10 years at around 1.3 per cent, the lowest rate it has faced since Federation in 1901. It is also able to borrow for 30 years at an interest rate of less than 2 per cent. Private businesses and households also face low borrowing rates. This is not only because official interest rates are low, but because credit spreads are low too. Second, Australia's terms of trade have risen again, largely due to higher iron ore prices. Investment in the resources sector is also expected to increase over the next few years, after having declined steadily for almost seven years. To be clear, we are not expecting another major mining boom, but we are expecting a solid upswing in the resources sector, which will help the overall economy. I hope that, in time, the effects of this upswing will be felt here in the Northern Territory too. Third, the exchange rate has depreciated over the past couple of years and, on a trade-weighted basis, is at the bottom end of its range of recent times. This is helping support important parts of the economy. And fourth, we are expecting stronger growth in household disposable income over the next couple of years, partly due to the expected implementation of the low and middle income tax offset. Stronger growth in incomes should support household spending. Together, these various developments will help the Australian economy. At the same time, though, we need to watch global developments very closely. Over recent times, the uncertainty generated by the trade and technology disputes between the United States and China has made businesses in many countries nervous about investing. Many are preferring to sit on their hands, rather than commit to capital spending that is difficult and costly to reverse. The result is less international trade and a weakening trend in investment globally. If this continues for too much longer, the effects on economic growth are likely to be significant. For this reason, the risks to the global economy remain tilted to the downside. The combination of these persistent downside risks and continuing low rates of inflation has led investors around the world to expect interest rate reductions by all the world's major central banks. In Europe and Japan, official interest rates are already negative but investors are expecting the central banks to go further into negative territory. And in the United States, investors are expecting a substantial reduction in interest rates over the period ahead. This is quite a different world from the one we were facing earlier in the year. What all this means for us here in Australia is yet to be determined. We need to remember that the central scenario for both the global and Australian economies is still for reasonable growth, low unemployment and low and stable inflation. As I discussed a few moments ago, there are a number of developments that are providing support to the Australian economy. So we will be closely monitoring how things evolve over coming months. Given the circumstances, the Board is prepared to adjust interest rates again if needed to get us closer to full employment and achieve the inflation target in a way that supports the collective welfare of all Australians, including those who call the Northern Territory home. Thank you once again for joining us this evening and for listening. Historical photographs of the Reserve Bank's presence in Darwin

r190725a_BOA

australia

Inflation Targeting and Economic Welfare

lowe

It is a great pleasure to address the Anika Foundation lunch for the third time. I would like to start by winding the clock back, not by three years, but instead by 40 years. It was 40 years ago that I started studying economics in high school in Wagga Wagga. I sat the 3 unit economics exam for the Higher School Certificate (HSC) in 1979. At that time, the standard exam question was in two parts: why did Australia have both high inflation and high unemployment and what should policy do about it? I recall writing numerous essays on this troubling topic. I also recall learning about the Misery Index. For those of you whose memories don't go back that far, this index is the sum of the unemployment rate and the inflation rate. Few people talk about this index these days, but I thought it would be useful to show it to you as background (Graph 1). As you can see, things were pretty miserable in the 1970s and 1980s. Today, though, at least according to this metric, they are not too bad. The Misery Index is now as low as it has been since the late 1960s. Today, we are living in a world of low and stable inflation and low unemployment. It is useful to remind ourselves of this sometimes. So this means that today's HSC students are likely to be writing about why inflation is so low at the same time that unemployment is also low. I hope that they are also being asked to write about how public policy should respond to low inflation and its close cousins of slow growth in nominal wages and household incomes. These are important issues to be thinking about. Given this, I would like to use this opportunity to address two related questions that I am asked frequently. The first of these is why is inflation so low globally and in Australia? And the second is, is inflation targeting still appropriate in this low inflation world? I will then draw on my answers to make some remarks about monetary policy here in Australia. It is useful to start off with a couple of graphs. The first is the average rate of inflation globally (Graph 2). The picture is pretty clear. Global inflation declined over the three decades to the early 2000s and has been low and stable for some time. Low inflation has become the norm in most economies. This is evident in this next graph, which shows the share of advanced economies with a core inflation rate below 2 per cent and below 1 per cent (Graph 3). Currently, three-quarters of advanced economies have an inflation rate below 2 per cent, and one-third have an inflation rate below 1 per cent. The obvious question is why this has happened? There is no single answer. But there are three factors that, together, help explain what has happened. These are: the credibility of the current monetary frameworks; the continuing existence of spare capacity in parts of the global economy; and structural factors related to technology and globalisation. I will say a few words about each of these. First, the credibility of the monetary frameworks. One of the responses to the high inflation rates of the 1970s and 1980s was to put in place monetary frameworks with a strong focus on inflation control. In some countries, this took the form of rewriting the law to require the central bank to focus on just one thing: inflation. Many countries also adopted an inflation target, with monetary policy decisions being explained primarily in terms of inflation. This increased focus on inflation has helped cement low inflation norms in our economies. Many people understand that if inflation were to pick up too much, the central bank would respond to make sure the pick-up was only temporary. This means that workers and firms can make their decisions on the basis that the rate of overall inflation will not be too different from the target rate. This has made the system less inflation prone than it once was. The second explanation for low inflation is the continuing existence of spare capacity in parts of the global economy. The existence of spare capacity was an important factor explaining low inflation in the aftermath of the global financial crisis. And today, it remains a factor in some countries, including here in Australia. But, on the surface, it is a less convincing explanation for low inflation in countries where unemployment rates are now at multi-decade lows. Based on conventional measures of capacity utilisation, these economies are operating close to their sustainable limits. One explanation for continuing low inflation in this environment is that the current rate of aggregate demand growth is simply not fast enough to put meaningful pressure on capacity. If so, stronger demand growth would be expected to see inflation pick up. Another possibility is that the unemployment rate, by itself, no longer provides a good guide to spare capacity, partly due to the flexibility of labour supply. I will come back to this idea in the discussion of inflation outcomes in The third explanation is that globalisation and advances in technology have changed pricing dynamics. There are two main channels through which this appears to be happening. The first is by lowering the cost of production of many goods. And the second is by making markets more contestable and increasing competition. The main effect of these changes should be on the of prices, rather than on the ongoing rate of inflation. But this level effect is playing out over many years, so it appears as persistently low inflation. It is widely accepted that the entry into the global trading system of hundreds of millions of people with access to modern technology put downward pressure on the prices of manufactured goods. Reflecting this, goods prices in the advanced economies have barely increased over the past couple of decades (Graph 4). But the effects of globalisation and technology extend beyond this and into almost every corner of the economy, including the services sector. In today's globalised world, there are fewer and fewer services that can be thought of as truly non-traded. Many services can now be delivered by somebody in another country. Examples include: the preparation of architectural drawings, document design and publishing, customer service roles and these days many people in professional services work with team members located in other countries. In addition, many tasks, such as accounting and payroll, are being automated. All this has been made possible by technology and by globalisation. The new global technology platforms have also revolutionised services such as retail, media and entertainment, and transformed how we communicate and search for information and compare prices. These changes are having a material effect on pricing, with services price inflation lower than it once was. Many firms know that if they don't keep their prices down, another firm somewhere in the world might undercut them. And many workers are concerned that if the cost of employing them is too high, relative to their productivity, their employer might look overseas or consider automation. And, more broadly, better price discovery keeps the competitive pressure on firms. The end result is a pervasive feeling of more competition. And more competition normally means lower prices. So these are the three important factors that are contributing to low inflation. None of them by themselves is sufficient to explain what is happening, but together they are having a powerful effect. The current high inflation rates in Argentina and Turkey remind us that globalisation and technology, by themselves, do not drive low inflation. The monetary framework clearly matters too. Weaknesses in that framework still result in high inflation. This brings me to my second question: is inflation targeting still the appropriate monetary framework for most countries? It is understandable that people are asking this question. Given the factors that I have just discussed, some commentators have argued that central banks will find it increasingly difficult to achieve their inflation targets. Some then go on to argue that central banks should just accept this, not fight it; perhaps they should shift the goal posts, or even adopt another monetary framework. A related argument is that the very low interest rates that have accompanied the pursuit of inflation targets are pushing up asset prices in an unsustainable way and sowing the seeds for damaging problems in the future. You might, or might not, agree with these perspectives. Either way, it is reasonable to ask if we are on the right track: is inflation targeting still appropriate? Before I address this question, I would like to push back against the idea that central banks simply can't achieve their inflation targets. As we all know, some central banks have struggled to achieve their targets over a long period of time; Japan and the euro area are the obvious examples. But this is not a universal experience. Over recent times, inflation has been around target in Canada, Norway, Sweden and the United Kingdom. So the experience is mixed There is no single factor that explains this mixed experience. But countries that are operating nearer to full capacity are more likely to have inflation close to target. It also appears that if you have an extended period of very low inflation - as did Japan and the euro area - it is harder to get back to target as a deflationary mindset takes hold. It is also possible that demographics may be playing a role, although the evidence here is mixed. Overall, these varying experiences do not support the idea that it has become impossible for central banks to achieve their targets. Here in Australia, some have argued that a lower inflation target would be a good idea given the ongoing low rates of inflation; that we should adjust our formulation of 2-3 per cent, on average, over time. Lowering the target might have the short-run advantage of allowing us to say we have achieved our goal, but shifting the goalposts hardly seems a good way to build long-term credibility. Shifting the goal posts could also entrench a low inflation mindset. More broadly, over recent years the international debate has gone in the other direction: that is, to argue for a higher, not lower, inflation target. The argument is that a higher rate of inflation - and thus a higher average level of interest rates - would promote economic welfare by providing more room to lower interest rates, without running up against the lower bound. This greater flexibility for monetary policy could stabilise the economy when it was hit with a negative shock. To be clear, I am not arguing for a higher inflation target, but rather acknowledging there are arguments in both directions. This brings me back to the question: is inflation targeting still appropriate? The short answer is yes, but it is important to be clear what this means in practice. Inflation targeting can mean different things to different people. It comes in different shapes and sizes. Some versions require a central bank to focus on inflation alone and set monetary policy so that the forecast rate of inflation is equal to the target. But inflation targeting does not need to be rigid like this. In my view, an inflation targeting regime should consist of the following four elements. 1. The inflation target should establish a clear and credible medium-term nominal anchor for the economy. A high degree of uncertainty about future inflation hurts both investment and jobs. The economy works best if there is a degree of predictability. Most people can cope with some variation in the inflation rate from year to year. But dealing with uncertainty about what inflation is likely to average over the medium term is more difficult. Inflation targeting plays an important role in reducing that uncertainty by providing a strong nominal anchor. 2. The inflation target should be nested within the broader objective of welfare maximisation. It is worth remembering that inflation control is not the ultimate objective. Rather, it is a means to an end. And that end is the welfare of the society that we serve. I sometimes feel that as some central banks sought to establish their credentials as inflation fighters they over- emphasised the importance of short-run inflation outcomes. And this has been difficult to walk back from. Some central banks have been concerned that if they gave weight to other considerations, the community might doubt their commitment to inflation control. So, it became all about inflation. But central banks have a broader task than just controlling inflation in a narrow range. They play an important role in preserving macroeconomic stability and thus the steady creation of jobs. Also, their decisions affect borrowing and asset prices and thus financial stability too. Central banks have to determine how to balance these considerations when making monetary policy decisions. This means it makes sense for inflation targeting to be embedded within the broader objective of maximising the welfare of society. 3. The inflation target should have a degree of flexibility. This is not to say that the target itself should be flexible; this would diminish its usefulness in providing a medium-term anchor. Rather, some variation in inflation from year to year is acceptable and indeed unavoidable. How much variation is too much is difficult to know, but the variation should not be so large that it generates doubt about the commitment of the central bank to achieving the target over time. 4. The inflation target needs to be accompanied by a high level of accountability and transparency. If the inflation target is operated flexibly and is nested within the broader objective of welfare maximisation, the central bank has a degree of discretion. It is important that when exercising this discretion, the central bank is transparent. Problems can arise if the community doesn't understand the central bank's actions, or if they see it as acting unpredictably or inconsistently with its mandate. This means you should expect us to explain what we are doing, why we are doing it and how we are balancing the various trade-offs. So these are the four elements that I see as important to an effective inflation-targeting regime. We have all four elements in Australia. Our commitment to deliver an average inflation rate over time of 2 point something provides a strong nominal anchor. We have always viewed the inflation target in the wider context, reflecting the broad mandate for the RBA set out in the . That Act was passed 60 years ago and has stood the test of time. The RBA was also one of the earliest advocates of flexible inflation targeting - this is evident in our use of the words, 'on average, over time' when describing our target. We also place a heavy emphasis on explaining our decisions and their rationale to the community. Our overall assessment is that Australia's monetary policy framework has served the country well over the past three decades. The flexibility that has always been part of our regime has helped underpin a strong and stable economy and has helped Australia deal with some very large economic shocks. We are not inflation nutters. Rather, we are seeking to deliver low and stable inflation in a way that maximises the welfare of our society. Over the nearly 30 years we have had the inflation target, inflation has averaged 2.4 per cent, very close to the midpoint. It has, however, been below this average over recent years and I will talk about this in a few moments. Before I do so, it is important to note that we periodically review the formulation of the current target and examine alternative monetary frameworks, including at our annual conference last year. We are also monitoring closely the discussions that are taking place in the academic community and in other central banks. In my view, the evidence does not support the idea that a change to our inflation target would deliver better economic outcomes than achieved by our current flexible inflation target. Some alternative frameworks would also be more difficult to implement and/or be harder to explain to the community. But it is important that we regularly examine the arguments. I would now like to discuss recent inflation outcomes and monetary policy in Australia. Like other countries, Australia has had low inflation over recent years. Over the past four years, headline inflation has mostly been below 2 per cent, although it has been slightly above that mark on a couple of occasions (Graph 6). In underlying terms, inflation has been below the band for three years. Given this history, it is reasonable to ask why this happened and how the Reserve Bank Board has thought about it. I will first focus on the period from late 2016 to late 2018. Through most of this period, gradual progress was being made in returning inflation to target and the unemployment rate was moving lower. Inflation was on a gentle upswing and the unemployment rate was coming down more quickly that we had expected. Reflecting this, in August 2017 the two-year ahead inflation forecast was 2 1/2 per cent. Since then it has been lower than this, at 2-2 1/4 per cent. Throughout this period, the Board discussed the case for seeking a faster and more assured return of inflation to around the midpoint of the target range. It was natural to be discussing this because having inflation around the midpoint of the target range allows more scope for surprises in either direction. As you know, in the end the Board did not adjust interest rates through this period. It judged that seeking to achieve a faster return of inflation to the midpoint of the target range would have been accompanied by more rapid growth in debt, at a time when household balance sheets were already very extended. Our judgement was that, given the progress that was being made towards our goals, it was appropriate to use the flexibility in our inflation target to pursue a course that was more likely to be in the country's long-term interest. We could have generated a bit more inflation, but we would have had faster growth in household debt as well. I acknowledge that others might see this trade-off differently. But given the unemployment rate was coming down and inflation had lifted from its trough, we did not see a strong case for monetary easing. Towards the end of last year, that assessment began to shift. Inflation was turning out to be lower than we had earlier expected and our forecasts for inflation were being marked down. There are a few reasons for this, but the one I want to highlight today is the flexibility of labour supply, as this links back to my earlier discussion of the reasons for low inflation globally. When we prepared our forecasts in mid 2017, we did so on the basis that the share of the adult population participating in the labour market (the participation rate) would remain steady over the next couple of years (Graph 7). At the time, this was considered a reasonable forecast: while we expected some increase in participation from an encouraged worker effect because of solid employment growth, we thought this would be offset by the ageing of the population. Since then, things have turned out quite differently. Employment growth has been much stronger than expected and the participation rate has risen by 1 1/2 percentage points, which is a large change over a fairly short period. Put simply, the strong demand for labour has been met by more labour supply. It is useful to consider the following thought experiment. Suppose the participation rate had still risen materially, but by 3/4 per cent, rather than 1 1/2 per cent. All else constant, this would have meant the unemployment rate today would have been well below 5 per cent. This flexibility of labour supply is a positive development and has meant that strong employment growth has not tested the economy's supply capacity. More demand for workers has been met with more labour supply. This has contributed to the subdued wage outcomes over recent times, which in turn has contributed to the low inflation outcomes. The more flexible supply side means that employment growth can be stronger without fears of overheating. At the same time, the unemployment rate that would put upward pressure on inflation is also lower than it once was. As the evidence accumulated in support of these propositions, the outlook for monetary policy changed and the Board lowered the cash rate in June and July. In making these decisions the Board also recognised that the earlier concerns about the trajectory of household debt had lessened. The Board has also paid attention to the shift in the outlook for monetary policy globally. These two recent reductions in the cash rate will support demand in the Australian economy. So too will recent tax cuts, higher commodity prices, some stabilisation in the housing market, ongoing investment in infrastructure and a lift in resource sector investment. We also need to remember that the underlying foundations of the Australian economy remain strong. It remains to be seen if future growth in demand will be sufficient to put pressure on the economy's supply capacity and lift inflation in a reasonable timeframe. It is certainly possible that this is the outcome. But if demand growth is not sufficient, the Board is prepared to provide additional support by easing monetary policy further. However, as I have discussed on other occasions, other arms of public policy could also play a role in this scenario. Whether or not further monetary easing is needed, it is reasonable to expect an extended period of low interest rates. On current projections, it will be some time before inflation is comfortably back within the target range. The Board is strongly committed to making sure we get there and continuing to deliver an average rate of inflation of between 2 and 3 per cent. It is highly unlikely that we will be contemplating higher interest rates until we are confident that inflation will return to around the midpoint of the target range. Thank you for listening. I look forward to answering your questions.

r190809a_BOA

australia

Opening Statement to the House of Representatives Standing Committee on Economics

lowe

To inquire into and report on: Good morning everybody. I declare open this hearing of the House of Representatives Standing Committee on Economics and welcome representatives of the Reserve Bank of Australia here this morning, as well as members of the public and the media--and we have both. Since the RBA appeared before the committee in February 2019, during the previous parliament, there has been some activity on the monetary policy front. The RBA has eased monetary policy by 50 basis points, to one per cent, following the RBA's decision to cut the cash rate in June and July. At its meeting on Tuesday, the RBA decided to leave the cash rate unchanged at one per cent. Commenting on the decision to keep rates on hold, the However, he also noted: We acknowledge this is also a significant shift from where we were at the end of last year. The governor reported that Australia's economic growth over the first half of 2019 has been lower than earlier expected but is expected to strengthen gradually from here. He said: the governor said-- In relation to the inflation outlook, the governor said the inflation pressures 'remain subdued across much of the The governor further remarked: These and other issues will be scrutinised by the committee today; however, it is noted that many Australians question the justification of a low interest rate environment for the foreseeable future, and some of these issues have been broadcast in the public sphere by members of the committee. The committee will examine the decisions of the RBA in the context of Australia's broader macroeconomic conditions and assess the RBA's confidence in current monetary policy settings, which aim to encourage growth and keep inflation consistent with the target over the coming years. 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 of Representatives. The giving of false or misleading evidence is a serious matter and may be regarded as a contempt of parliament. Dr Lowe and other members, thank you for coming. Would you now like to make an opening statement before we proceed to questions? Good morning, everybody. Thank you for the opportunity to share our views on the Australian economy and the RBA's important public policy responsibilities. My colleagues and I strive for a very high level of transparency, and these hearings are an important part of the accountability process, so thank you for giving us this opportunity. Later this morning we'll be releasing the quarterly Statement on monetary policy , which will include our latest forecasts. What I'd like to do this morning is begin by highlighting the main points about the forecasts for output growth, the labour market and inflation, and then I'll turn to monetary policy. Our central forecast is that the Australian economy will expand by 2 1/2 per cent this year and 2 3/4 per cent over 2020. The growth forecast for this year has been revised down a little bit since we met six months ago, but the forecasts for next year are unchanged. The downward revision this year reflects weak consumption growth. It's become increasingly clear that the extended period of unusually slow growth in household incomes has been weighing on household spending, as has the adjustment in our housing market. Given this experience, the outlook for consumption continues to be the main domestic source of forecast uncertainty. Even so, looking ahead, there are signs that the economy may have reached a gentle turning point. Consistent with this, we are expecting the quarterly GDP growth outcomes to strengthen gradually after a run of disappointing numbers. This outlook is being supported by a number of developments, including lower interest rates, the recent tax cuts, the depreciation of the Australian dollar, a brighter outlook for investment in the resources sector, some stabilisation in the housing market and ongoing high levels of investment in infrastructure. It is reasonable to expect that, together, these factors will see growth in the Australian economy return to around its trend rate next year. The major uncertainty, though, continues to be the trade and technology disputes between the United States and China. These disputes pose a significant risk to the global economy. Not only are they disrupting trade flows, but they are also generating considerable uncertainty for many businesses around the world. Worryingly, this uncertainty is leading to investment plans being postponed or reconsidered. It's also now generating volatility in financial markets and has increased the prospects of monetary easing in many economies. This means that we have a lot riding on these disputes being resolved soon. Turning now to the Australian labour market, the unemployment rate, at 5.2 per cent, is a little higher than when we met six months ago, and this is despite employment growth having been stronger than we had expected. What's happened is that increased demand for labour has been met with more labour supply, especially by women and older Australians. Reflecting this, a higher share of the Australian adult population is participating in the labour market than has ever been the case before. I want to be clear: this is very good news. But one of the sideeffects of this flexibility of labour supply is that it's proving harder to generate a tighter labour market and so, in turn, it's been hard to generate a material lift in aggregate wages growth. Looking forward, while some slowing in employment growth is expected, the central scenario is for the unemployment rate to move lower to reach five per cent again in 2021. If things evolve in line with this central scenario, it's probable that we will still have some spare capacity in the labour market for a while yet, especially taking into account underemployment. This means that the upward pressure on wages growth over the next couple of years is likely to be only quite modest and less than we were earlier expecting. Caps on wages growth in public sectors right across the country are another factor contributing to subdued wage outcomes. At the aggregate level, my view is that a further pick-up in wages growth is both affordable and desirable. Turning now to inflation, the June quarter outcomes were broadly in line with our expectations, after a run of lower-than-expected numbers in earlier quarters. Over the year to June, inflation was 1.6 per cent, in both headline and underlying terms, extending the period over which inflation has been below the two to three per cent medium-term target range. The Reserve Bank board remains committed to having inflation return to this range, but it is taking longer than we earlier expected. There are a few factors that I'd highlight as contributing to the low inflation outcomes over recent times. These are, first, the slow growth in wages; second, the ongoing spare capacity in the economy; third, various government initiatives to address cost-of-living pressures on households, which have reduced some prices; and, fourth, the adjustment in the housing market, which has contributed to unusually low increases in rents and declines in the price of building a new home in some cities. Working in the other direction, though, the drought and the depreciation of the exchange rate have been pushing some prices up recently. Looking ahead, inflation is still expected to pick up, but the date at which it is expected to be back at two per cent has been pushed out again. Over 2020, inflation is forecast to be a little under two per cent and, over 2021, it's expected to be a little above two per cent. I think at this point it's appropriate to turn to monetary policy. When we met with this committee in February, I indicated that I thought the probabilities of a cash rate increase and a cash rate decrease were broadly balanced. Following that hearing, the situation continued to evolve, and the board reduced the cash rate twice--at its June and July meetings--to a new low of one per cent. A reasonable question to ask is: what changed? The answer is the accumulation of evidence that the economy could be on a better path than the one we looked to be on. The incoming data on wages, prices, GDP and unemployment all suggested that the Australian economy was some distance from running up against capacity constraints. It also suggested that the day at which inflation was comfortably back within the two to three per cent range was not getting any closer. Faced with this evidence, the board decided that it was appropriate to lower the cash rate, after having kept it unchanged for around 2 1/2 years. It judged that a lower cash rate would boost jobs and help make more assured progress towards the inflation target. In the current environment, easier monetary policy mainly works through two channels. The first is that it affects the exchange rate, which is now at the lowest level it's been for some time. The second is that it boosts aggregate household disposable income. I acknowledge that lower interest rates do hurt the finances of the many Australians who rely on interest payments, and the board has paid close attention to this issue. At the aggregate level, though, for every dollar the household sector receives in interest income, it pays well over $2 in interest to the banks and to other lenders. This means that lower interest rates do put more money in the hands of the household sector in aggregate and, at some point, this extra money gets spent, and this will help the overall economy. This is how monetary policy works. At its meeting earlier this week, the board decided to leave the cash rate unchanged at one per cent. It judged that, after having moved twice in quick succession, it was appropriate to wait and assess developments both internationally and domestically. As I mentioned earlier, there have been a number of developments that could be expected to support the Australian economy over the next couple of years. Determining with precision the combined effect of these developments is difficult. It's certainly possible that their combined effect will be greater than the sum of the individual parts. If so, growth would surprise on the upside. Of course, it's also possible that the concerning international developments and the ongoing weak growth in household incomes could see the economy underperform our central scenario. As has been the case for some time, the labour market will provide an important guide as to which path we're on. It is, nevertheless, reasonable to expect an extended period of low interest rates in Australia. This reflects what's happening both here and overseas. While we might wish it were otherwise, it is difficult to escape the fact that, if global interest rates are low, they are going to be low here in Australia too. When the global appetite to save is elevated relative to the appetite to invest--as it is right now--interest rates in all countries are affected. Our floating exchange rate does give us the ability to set our own interest rates from a cyclical perspective, but it does not insulate us from long-lasting shifts in global interest rates driven by saving/investment decisions right around the world, and that's the reality we face. In the central scenario that I've sketched today, inflation will be below the target band for some time to come and the unemployment rate will remain above the level we estimate to be consistent with full employment, and while ever that remains the case, the possibility of lower interest rates will remain on the table. The board is prepared to ease monetary policy further if there is additional accumulation of evidence that this is needed to achieve our goals of full employment and inflation consistent with the target. Time will tell here. As I have discussed on other occasions, if further stimulus to demand growth is required to get us to full employment and closer to the economy's capacity, monetary policy is not the country's only option. Monetary policy certainly can help, and it is helping, but there are certain downsides from relying too much on monetary policy alone. One option is for fiscal support, including through spending on infrastructure. Spending on infrastructure not only adds to demand in the economy right now but, done well, it can boost the economy's productivity for the future. It can also directly improve the quality of people's lives by reducing congestion and improving services. At the moment, there are some capacity constraints in parts of the infrastructure sector, but these should not prevent us from looking for further opportunities to boost the economy's productive capacity and support domestic demand, and there's no shortage of finance to do this, with interest rates today the lowest they've ever been. This week, all governments in Australia can borrow for 10 years at less than two per cent, and some can borrow at much less than this. Another option is structural policies that support firms expanding, investing, innovating and employing people. A strong, dynamic business sector is the best way of creating jobs and growing the overall economy. We will all do better if Australia is viewed as a great place to expand, invest, innovate and employ people, and a program of structural reform would help move us in this direction. It would also boost productivity growth, which over recent times has slowed noticeably. If this slowing is maintained it will become a serious issue, and as a society we'll have to make some difficult adjustments. So it's important that we think about the possibilities here, not just from a short-term perspective but also from a long-term perspective. I think this is really important. Before closing, I'd like to mention a couple of other areas of the Reserve Bank's activities. As you know, the Reserve Bank is the banker for the Australian government. As the government's banker, our systems process almost all of the government's payments and they receive almost all the government's revenue. Over recent years, we have undertaken very major investments in these systems. Two weekends ago, we finally turned off the mainframe computer on which we had been running these important banking services for the government for many, many years. Our new technology will allow us to continue providing a very high level of service to the Australian government and its agencies, and we're working with some of these agencies on innovative payment solutions. The Department of Human Services is already using our fast-payment options to get money quickly to those people who are in immediate need. The Reserve Bank is also continuing to invest heavily in the resilience of the systems that we operate that are at the core of Australia's interbank and fastpayment systems. In other payments related work, the bank is continuing to look to ways to encourage faster development of the New Payments Platform, which allows us all to move money between bank accounts in real time 24/7. We have not been satisfied with the progress to date by the major banks and we want to see a faster pace of innovation that benefits both individuals and small businesses. The bank's Payments System Board, in conjunction with the Council of Financial Regulators, is also reviewing the regulatory framework for money held in stored-value facilities and digital wallets. With so much innovation occurring in the world of digital payments, including by non-bank players, it's important that the regulatory regime in Australia is fit for purpose and appropriately balances competition and the protection of consumers. We are currently reviewing the regulatory regime in this area, and, as we complete this work, this issue may come before the parliament as we seek some changes to the arrangements. Another issue that we're working on that may come before the parliament is the strengthening of the regulatory arrangements that apply to the financial infrastructures that underpin Australia's financial markets. Finally, we will be releasing the new $20 banknote on 9 October. There are currently around 170 million individual $20 notes in circulation, so, you can imagine, this is a big logistical exercise for us and the banks. But I am confident that Australians will enjoy spending these new, high-tech, highly secure $20 banknotes. I brought along a sheet today, hot from the printing press, that I'm happy to show you later on--one of the big sheets straight from the printing press. Thank you. My colleagues and I value this opportunity, and we look forward to your questions. Thank you very much, Dr Lowe. For clarity, I presume these are the same banknotes you showed us at our February hearing? Yes, but today I have a big sheet. They are quite impressive as they come off the printing press. I'm sure we'll all enjoy the opportunity to get a photograph of that. Thank you very much for your opening statement. In your opening statement, you said: I guess my question for you then is: does this mean we are now in an environment where we're an interest rate taker, where we have very limited capacity to actually decide in comparison to decisions made by the reserve No, I wouldn't put it like that. You can think of this from two perspectives. One is a purely cyclical perspective. Because we have a floating exchange rate, that allows us to set the interest rate relative for the domestic considerations on output, employment and inflation. That's from a cyclical perspective. But there is a structural thing going on as well, and I think it is really important we understand this. At the moment, right around the world, there is an elevated desire to save and a depressed desire to invest. You see a lot of global savings because of demographic factors. There are a lot of savings in Asia. Many people borrowed too much in previous times and now they're having to repair their balance sheets, so they want to save a bit more. There is a lot of desire to save, and, right at the moment, not many firms want to invest. The reality we face is that, if a lot of people want to save and not many people want to use those savings to build new capital, savers are going to get low returns. The way the financial system works is that the central banks are the ones who set the interest rates, but we're really responding to this deep structural shift in the balance between savings and investment right around the world and there's not very much we can do about that. We can move our interest rates around this new structurally lower level, but we can't escape the fact that global interest rates are low. Could you just expand on the extent to which you think an enthusiasm to save is brought about by economic conditions versus demographic shifts? There are multiple things going on in many of the advanced economies. We have a lot of people who are ageing during the prime saving years of their lives, so they are saving a lot. We are seeing a lot of saving in Asia. The saving rates in China are particularly high. The social safety net is not very strong, so people save a lot there. We have seen governments and individuals borrow a lot in previous decades, and a time comes when you actually have to save a bit to pay back the borrowings of the past. I think that time is upon us in many countries. Also, people feel a bit nervous at the moment so they're saving more. Their income growth has slowed and they're not sure about what the future holds; that makes us all want to save a bit more. It is a global story, not just an Australian story. On the investment side, investment intentions are weak. Concerningly, they have weakened in the last six months. I think that is very clearly linked to what's going on with the trade and technology disputes between the US and China. Investment is weakening, saving is high and it's not surprising that interest rates are coming down lower. The way to get out of this is to create an environment where firms want to invest again and people feel confident about spending. Central banks are really responding to these deep structural forces in the global economy, and we are no different to other central banks in that respect. But doesn't this raise the question: to what extent does the Reserve Bank accept responsibility for any shift in consumer confidence as a consequence of lowering rates? I'm not sure that the decision to lower rates has damaged consumer confidence. It clearly has upset some people in the community, but other people see it as a positive sign because it's contributing to the turnaround in the housing market, and I think that helps people feel a bit better. So I wouldn't accept the proposition that the cuts in interest rates have damaged and hurt consumer confidence right across the country. It's a mixed story. In 2012, the RBA published a paper. This goes back to my question earlier about interest rates, particularly around demographic shifts. The paper states: A bit further down, the paper states: which is self-evident. Essentially it draws the conclusion: Obviously that will therefore have an impact, in part, on those people who depend on them for their disposable income. Firstly, has the RBA done any significant research since the 2012 paper which I'm quoting, called how has that research gone on to inform the decisions around interest rate movements? We continue to look at the distribution of income earned from interest and interest payments across the population through the various data sources that we have access to, so we have a strong continuing focus on that. But, specifically, have you modelled that shift as part of-- I'm not sure that we have done further modelling there. We monitor the shifts that are going on. With some of the relevant more recent research that we've done, while it is true that you expect that older households have more interest-bearing assets, not all of their assets are interest bearing, and you still do have a large fraction of equity and physical assets in the portfolios of older people. A relatively small share of older people have a significant fraction of their income being interest income. That's relatively unusual. The age pension and superannuation fund earnings are more important. One piece of research that I think is particularly pertinent to this is that, as the governor pointed out, the overall picture that we see of the effect of lower interest rates on household cash flows is a large positive. So, while almost every adult in Australia has some form of deposit account, most people have quite small balances. Very few people have balances that are large enough to form a significant fraction of their income. So, as the governor mentioned, the share of people who have debt and who have a positive effect on their cash flows when interest rates fall more than outweighs the effect on consumption from the people whose incomes have been reduced somewhat. But you haven't modelled that? Yes, we have. There is data that shows--firstly, there is modelling about the cash flow effect. I can't, off the top of my head, tell you all of the authors, but I know Gianni La Cava was one of them. It was Gianni La Cava and some co-authors; I would have to look it up to give you the other co-authors. So there is a recent paper on the cash flow effect. There is also some of our internal work; we look at the data, and there is more than one dataset that shows this. You can look at the HILDA dataset and some of the ABS household surveys that show you, for the people who get interest income, what fraction of income it is. There are certainly people for whom interest income is a significant fraction of their income, but in the older age group category the bulk of income comes from pensions, superannuation fund income, dividends and, increasingly, increased participation in the labour market. As the governor mentioned earlier, there has been a big increase, from a low base, in participation of older workers. The participation of men aged 65 and over has gone up 2 1/2 percentage points just in the last two years. That's a big shift. Perhaps I could offer one other perspective on it. Yes, of course. Certainly the modelling's important, and we try and track the data as best we can, but I have another perspective on this from the many people who write to me. Each day as I turn up to my office, there are some letters, and it's not uncommon for people to say to me they've worked hard all their lives, they've saved, they're frugal, they don't spend very much, they rely on interest income and they're having to cut back their spending. So I understand that it's a real issue for many people, and some of these letters go on to say that there are other people in the community who've borrowed a lot of money and they feel like they're being bailed out and the savers are having to pay for that. At the very human or individual level, I have a great deal of sympathy for the people who write to me. If I were in their situation, I would feel very similar to how they feel. So we understand that at an individual and human level. It's a very significant issue for many people, and we discuss this at the Reserve Bank board. On balance, though, our responsibility is to the national interest. Of course. And, as I said before, lower interest rates do support the overall economy, and if more people have jobs and income growth is stronger we'll all benefit, even though the distribution of those benefits is not even. I don't want to be misinterpreted in what I'm asking, because I understand that there's modelling on the cashflow effect. The RBA has itself identified that there is a shift that is occurring within society. This is not a new shift; we've been aware of it. As I said, it's a paper I'm quoting from 2012. I understand when you look at individual households and their disposable income as a share of their overall income, but there hasn't been specific modelling to assess whether there's a need to review the efficacy of reducing interest rates on disposable income in light of that demographic shift; it's only on the basis of pre-existing data. Is that correct? Yes. There has been a demographic shift and, all else equal, you do expect that that means that more of the household sector wants long interest-bearing assets and not so long equity, which is not what, for example, the typical super fund is composed of. So, with your asset allocation, as you get older it does tend to be longer fixed interest. More defensive, yes. That's true. Household deposits actually have not been growing at the same rate over the last five years as they did over the previous five years. I would have to look up the data; I don't think I've got those numbers with me. But, as part of our monthly numbers coming from the banks and other deposit takers that make up the money and credit statistics, we do get information on the split of that between household accounts and business accounts, and there hasn't been a continuing strong growth in deposits relative to income. So, all else equal, you would expect the demographic effects to have an influence, but all else is not equal. I'll come back to the example I gave earlier about participation. All else equal, given population ageing, you would expect the participation rate to have fallen by about half a percentage point over the last year. In fact, it has increased by more than a percentage point. So all else is not equal, and people are making decisions. As the governor said, we recognise that there are some people who are strongly motivated to hold interest-bearing assets. They don't want to take financial risk. They feel that deposits are a safe asset that they can put their savings in, and we appreciate that that's how some people want to allocate their assets, and therefore they're in a difficult situation, and we do appreciate that. Phil actually makes me write some of the responses, so I see these letters too. But it is important to recognise that all else is not equal, and so that demographic shift that my colleagues identified hasn't really influenced the portfolio of household wealth recently to the extent that you might have thought. One final comment on the effectiveness of the cashflow channel: we haven't got any evidence that that has fundamentally shifted. It's changed at the margin as interest-earning assets have risen, but, as to the effectiveness of the cashflow channel, there's no evidence that that's become less. But I think part of the point is: isn't all else equal, simply on the basis that one of the reasons why there may not have been an increase in the volume of savings and use of instruments like term deposits is the low I accept aspects of that point. A number of people raised questions and, at some points, criticism of the RBA, particularly for its decision, at its first board meeting after the election, to cut rates and then do it at the one immediately after that--and obviously, at the most recent meeting, it stabilised. To what extent do you believe that the election result had any influence on investment in the economy, which may have made it prudent to cut rates immediately after the election, before it had washed through, particularly in different policy scenarios? The election had zero influence on our decisions. I don't mean your decisions so much; I mean the decisions of investors. I won't say that they forced your hand, but people were looking at the different policy options available at the election, obviously, in their choice for a potential change of government; and that flowed through to investment decisions not being made, which made cutting rates an imprudent decision, rather than waiting to see through the wash-through. I don't see any short-run impact on investment from the election--other than perhaps in residential property, where there was uncertainty about what the future tax arrangements would be. That probably had an effect at the margin. But, across the broad, on business investment, I don't think the election was a major factor-- and it certainly didn't affect our interest rate decisions. You have outlined consistently that we are in a lower interest rate environment and may continue there. In a 2017 conference paper, 'Is monetary policy less effective when interest rates are persistently low?' you In an environment in which the RBA's own research questions the efficacy of lowering rates in a low-rate environment, how does the RBA continue to justify lowering rates? I wouldn't draw the conclusion that that paper says monetary policy is not very effective at low rates. It does outline some channels through which it may become less effective. There are two core channels. One is the exchange rate, and the evidence is that that is working. If we didn't have the level of interest rates that we have today--let's say they were one percentage point higher--I am confident that the exchange rate would be higher. That would be hurting our agricultural sector, our miners, our tourism sector, the education sector and the advanced manufacturing sector that we are building. So a higher exchange rate would be hurting many, many sectors across the economy. That part of the transmission channel still works as well as it has ever worked. We talked previously about the cash flow channel. As I said, there is no evidence that that has become less effective. It is certainly true that, in the current environment--at least in my view--monetary policy is less effective than it used to be. Once upon a time, when we lowered interest rates people were very quick to run off to the bank to borrow more to spend. We saw that in the level of debt relative to people's income; it grew a lot. So that was part of the transmission through which monetary policy used to work. In today's environment people don't run off to the bank to borrow more when interest rates fall; they are more likely to pay back their mortgage more quickly. So that dynamic is different. The other dynamic that is different is that, as interest rates get lower and lower, it is harder for the banks to pass it through fully to the mortgage rates because their deposit rates start to bunch up around zero, and they can't reduce those anymore. So there are those two aspects where it is not as effective as it previously was, but the exchange rate channel and the cash flow channel, which are two incredibly important channels, are as effective. So I wouldn't accept the proposition that lowering interest rates is no longer effective at stimulating the economy; it is just different than it used to be. The question then is: what are the likely conditions that would emerge which would see the RBA consider increasing interest rates? I look forward to that day because the conditions are that income growth has picked up, people are getting real increases in their wages, inflation's returning to target and we're at full employment or very close to full employment. So I look forward to that day. Full employment being the new revised 4.5 per cent rate? That would be my current best guess. As I think we talked about at this committee when we met in Sydney in February, there is a large ball of uncertainty around that estimate. But our current thinking is that we probably need to get down to an unemployment rate of 4 1/2 per cent to have wage growth consistent with the inflation target. That's the world in which we'll be raising rates. We will not be considering raising rates until we're comfortable that inflation's going to be within the target range and we're close to full employment. Dr Lowe, you will have been in your position for three years next month. Would you agree that in the time you've been governor the Reserve Bank has pretty much comprehensively failed to meet its inflation No, I wouldn't agree with the proposition that we've failed. We're facing some difficult challenges. Perhaps I can start off with the role of the inflation target, which I really see providing the north star for what we're doing. We're trying, over time, to get back to an inflation rate of two to three per cent. We want to deliver for the Australian community an average rate of inflation of two to three per cent. It's desirable and unavoidable that inflation will move around that medium-term range, and it's been below it for quite a while now. We're trying to get it back there, but we've faced difficult circumstances. But under your predecessor inflation averaged almost slap-bang in the middle of the target band, at 2 1/2 per cent. Under your governorship, almost every time the Reserve Bank board has met it has been below the lower band, yet the decision was only made relatively recently to cut rates. In retrospect, does that look to you to be a mistake? I think it's too early to tell whether we would have gotten better outcomes if we'd cut interest rates earlier. We have to let this whole cycle play out. Perhaps I can replay for you, briefly, our thinking through last year, when we did not cut interest rates. Remember, in the first half of last year the economy was growing very quickly. I think in each of the first two quarters growth was close to one per cent, the unemployment rate was coming down, we got to a five per cent unemployment rate two years earlier than we thought, employment growth was running at 2 1/2 to three per cent and the vacancy rate was the highest it had ever been. In the first half of last year, things looked like they were on track. Unemployment was coming down quickly, inflation had lifted, wage growth was picking up and we were growing at one per cent a quarter. In that environment, we thought it was reasonable that the economy would continue on that track, and we decided not to cut interest rates. During the second half of the year, things did slow. Globally they slowed, consumption was weaker, the economy was hit by some supply disruptions in the resources sector and we had this big increase in labour supply. Progressively, as that data came in, we made a revision to our outlook and we adjusted interest rates in response to that. But through most of last year, things looked pretty good. They were clearly moving in the right direction. It's turned out since then that they've slowed a bit. You say things were looking pretty good, but you were still sitting below the bottom range of the target band. We still had unemployment, according to your new estimates of the NAIRU, sitting almost a full percentage point above where it could have been. Many have asked why a decision wasn't made to cut rates at that point. During last year, the CPI in the first part of last year was at two per cent--it subsequently slowed-- employment growth was very strong, as I said, and the unemployment rate was coming down more quickly than we'd thought. In that environment, we thought the most prudent thing was to let this improvement run its course. It was more than likely we would get back to two per cent inflation and the unemployment rate would come down further. As the evidence has come in that that wasn't the path we were on, we have adjusted policy. Whether we should have adjusted it earlier or not, I think only time will tell. But it did come at a fairly significant cost, didn't it? If I take your most recent general equilibrium model--the Rees, Smith and Hall model--that would suggest that an exogenous cut of 100 basis points would lead to inflation being about 0.2 percentage points higher, growth being about 0.6 percentage points higher and unemployment--if we take a conservative Okun's law estimate--being about 0.2 per cent lower. That's 20,000 Australians who were not in work as a result of that decision. That's a pretty significant cost to the economy, if indeed it was a mistake, is it not? If it was a mistake, as I said, I think only time will tell. You have to remember that employment growth has actually been very strong. For the last three years, employment growth has averaged 2.5 per cent a year and the working age population is growing at 1.6 or 1.7 per cent. The economy has generated a huge number of extra jobs, and the employment-to-population ratio has never been higher in Australia than it is right now. One of the things that's happened, and that we're dealing with, is that the extra demand for labour has been there and the job creation has been there. A lot more people have joined the labour force. We did not predict that. As Luci has talked about, there has been a big increase in participation by older Australians and by workers. We did not predict that. The fact that labour supply has responded so quickly to increased labour demand has meant that the unemployment rate has stayed high, wage growth has stayed fairly low and inflation has stayed low. A lot of this--not all of it, but a lot of it--is coming down to the flexibility of labour supply, and we did not predict that. If I think about it from a welfare point of view, welfare is primarily determined by employment. The fact is that more people have jobs than we had anticipated and that employment growth was faster than we forecasted a year ago--and it still is, actually. I suppose you can make the case that it could have been--as Dr Lowe noted, we were unable to predict that the supply response was going to be as strong as it was. That is true. You're able to see that now with the benefit of hindsight. That is something that is difficult to predict in advance. As it has turned out, if you want look at it from a welfare point of view, we do have more people in jobs than we had anticipated 12 months or even two years ago. As you map it through to the welfare costs, that is something to take account of. With the benefit of hindsight, can you make the case that things could have been even better? That's certainly plausible. But if you're concerned about the impact on wages, then unemployment is the key variable. Our unemployment rate has sat a percentage point higher than Britain, the United States, Germany or New Zealand for quite some time. Wouldn't you agree that unemployment could be lower, and would have been lower, had you chosen to cut as housing prices fell? I certainly agree that the unemployment rate could be lower. The evidence is pretty clear that, because of labour supply flexibility, employment growth can be even stronger than we had thought. The evidence has accumulated in support of that proposition. As that evidence has accumulated, we have responded. If we'd known that labour supply was going to be as flexible as it has turned out to be, should we have cut interest rates earlier? Only time will tell there, and people have their different views on that. But we did not predict the flexibility of labour supply. Let's say that the participation rate had stayed steady, which was our forecast two years ago, and we had the type of employment growth that we had, the unemployment rate today would be well below five per cent and wage growth would be stronger. The fact that labour supply has been so flexible means that it's hard to create a tight labour market and, therefore, wage growth doesn't pick up. We have discussed this at our board. It gives us the possibility for employment growth to be stronger than we previously thought. Lower interest rates are helping that. We have responded. We can debate whether we should have responded earlier or not, but, given the circumstances and the information we faced, we thought we made the right decision at the time. One of the arguments that were being made in favour of keeping rates on hold--or, as you said in November last year, the anticipation that the next movement would be upwards--was that there was some value in so-called leaning against the wind, maintaining higher rates as a means of ensuring greater financial stability. But Trent Saunders and Peter Tulip, in new research by the bank, suggest that that policy has greater costs than benefits--indeed, that the costs are three to eight times higher than the benefits. Do you accept that that new research suggests that the bank's focus on 'leaning against the wind' was misplaced? I wouldn't describe our approach as 'leaning against the wind'. Through 2017 and the first half of 2018, as I described before, inflation was picking up. Employment was growing strongly. The unemployment rate was coming down. So things were moving quite well. The discussions we had around the board were about whether we should lower interest rates in that environment. We made the decision that it wasn't appropriate to do so. I accept that other people might have made different decisions. Part of the reason that we decided not to lower interest rates during that time, to get inflation up a bit more quickly, was the judgement that, if we did that, it would encourage more borrowing and higher housing prices, and, in an environment where there was already quite a lot of exuberance in the housing market, lower interest rates in an economy where employment growth was strong and inflation was gradually returning to the target were not in the country's long-term interests. Sorry to interrupt you; at what period are you talking about exuberance in the housing market, given that prices were falling? The period '17, into early '18. By early '18, as I described before, employment was strong and the unemployment rate was coming down. But certainly through '17 and the early part of '18 we did not think it appropriate to encourage a faster return of inflation to target if that came with more borrowing and further upward pressure on asset prices. I accept that different people might make a different judgement about that, but that was our rationale. Including two of your own researchers, who seemed to suggest that the costs of that policy were three to eight times the benefits of the policy. We encourage diversity of opinion. As you know, economists have lots of different views. That's one view. That's not my view. But we're prepared to put the paper out in the public domain. We encourage our staff to think about ideas from different perspectives. We put them in the public domain. I don't agree with everything that comes out, but I encourage people to put material out, even if it doesn't agree with the central view of the bank. I think it's worth pointing out that, on the very same day that paper was released, another paper was released that showed quite important results--that, looking at microdata rather than macrodata, you can find evidence that high debt levels actually impinge on consumption in a way that hadn't previously been found. That's effectively the opposite conclusion. So, on the same day, we published two papers that had opposite policy conclusions. I'm surprised you're walking away from Trent Saunders and Peter Tulip's findings, partly because they fall in line with a lot of the international macroeconomic research--the work by Lars Svensson in a series of papers and the Canadian work by Alexander Ueberfeldt. There have been a succession of papers that have suggested that 'leaning against the wind' has larger costs than benefits, and you were doing so in an environment in which housing prices were falling rapidly. I wouldn't accept that. In 2017 housing prices were not falling rapidly. The adjustment really started at the end of that year and in early 2018. My judgement, particularly through 2017, was that, with household income growth rising at maybe three or four per cent a year and debt rising at six or seven per cent a year, as it had been for quite some time, it was not in the country's long-term interest to get inflation up a bit more quickly if that came with continuing year after year of rapid credit growth--much more rapid than income growth--and that that carried certain longer term risks for the country. In the work that Peter Tulip and his colleagues have done, they say: 'That doesn't really matter that much. These risks coming from extra borrowing aren't really that material.' My judgement is different--that year after year of growth of debt much faster than people's income carries longer term risks, and ultimately we could be very sorry if they manifested. While the economy was doing well and inflation was broadly on the right track, it was prudent to allow that track to play out without encouraging yet further borrowing by the household sector. Once the borrowing by the household sector slowed and the track that we were on looked like it had changed we responded--this year. I accept others will make different judgements, and many of my staff do. What work has the Reserve Bank done on what unconventional monetary policy might look like as you head towards the zero lower bound? It's possible that we end up at the zero lower bound. I think it's unlikely, but it is possible. We are prepared to do unconventional things if the circumstances warranted it. Could you detail them for me? I hope we can avoid that. It's clearly prudent for us to be thinking about it, given the global forces that I talked about before. As part of our preparation or understanding of the issues, we've studied overseas experience in a great deal of detail. Perhaps I can quickly run through what's happened overseas and the lessons we've drawn from that. When we look overseas, we see some central banks have very low interest rates and some countries have negative interest rates. In Switzerland right now the interest rate is minus three-quarters of a per cent, in the euro area it's minus 40 basis points and in Japan it's minus 10. So some central banks have gone negative. That's one possibility. Another thing that central banks have done is give very explicit forward guidance that they're not going to move interest rates until some time has passed or until some certain conditions are met. So there is explicit forward guidance. We've also seen some central banks support credit creation in their economies. There's a particular case in Europe where banks didn't want to lend. The European Central Bank has provided funding to the banks that is cheaper than the market rate, on the condition that they lend. We've seen that happen. We've seen some central banks expand their balance sheets very greatly by buying government securities in the effort to try and get the risk-free yield curve down. We've seen other central banks buy other assets, mortgage backed securities and corporate bonds. The Bank of Japan has bought equities. All are expanding their balance sheet. The other thing we've seen in just a couple of cases is foreign exchange intervention. Switzerland is the best example of that. Their currency was under strong upward pressure and they put a cap on it. This is the range of things that we've seen overseas. I'm not thinking that any or all of those would be appropriate in Australia. There are some lessons, though, that we've drawn. The effectiveness of these measures depends upon the specific circumstances the country's in and the nature of its financial markets. There's not a one-size-fits-all here. Another lesson is that these measures have had clear success in dealing with dislocation and credit supply in the economy. I think Europe's the best example of that. They've also had success in lowering government bond yields, which is a risk-free rate, and therefore they've had success in lowering interest rates across the economy for private borrowers as well. A third message would be that a package of measures works best--rather than doing just one thing, doing a number of things that reinforce one another. A fourth lesson would be that clear and consistent communication is really important. We've seen some instances where the communication wasn't as clear and consistent as it could have been, and it's caused problems. The final point that I'd raise is that a full evaluation of these measures can't yet be undertaken. You can point to some successes in lowering government yields and improving the dislocation in credit markets, but we're a long way from unwinding these measures, so a full evaluation can't yet be done. How we would apply those lessons to Australia would really depend upon the particular circumstances that we're in. I think the focus would be on trying to reduce the risk-free interest rate. We could reduce the cash rate down to a very low level, and it's possible, if the circumstances warrant it, that we could take action to lower the risk-free rates further out along the term spectrum. I think some of the other things wouldn't be appropriate, but we're certainly examining experience overseas and trying to work out how that would apply in Australia in specific circumstances. Again, it's unlikely. I want to repeat that. We're not doing this because we think it's likely; we're doing it because it's prudent in the global circumstances we face. Putting aside the zero lower bound, would a policy of explicit forward guidance be wise for My perspective on this is that transparency is very important. Where's the borderline between transparency and forward guidance? I don't think it's that hard a boundary. I've tried to be very clear recently that we're expecting interest rates to stay low for a very long period of time. We haven't said 'until X date' or 'until these conditions are met', but we're trying to be transparent, so forward guidance is just another form of transparency. The Reserve Bank, unlike most other central banks around the world, doesn't publish transcripts of meetings, doesn't publish the voting record of members, doesn't hold regular press conferences after announcements and doesn't attribute views to board members in the minutes. Would you agree that the Reserve Bank of Australia's possibly one of the least transparent central banks in the world? I would reject that strongly. We release minutes after every meeting. We release the results of a meeting straight afterwards, an hour and a half afterwards. It's true we don't have voting records; the decisions are taken by consensus as the board has decided that's the way it wants to operate. I give more public speeches than most central bank governors. I always take questions from the media at least once a month, sometimes twice a month, so I'm giving public speeches and taking questions from the media. I feel like the public understand what we're doing, why we're doing it and where we're coming from. We put a huge amount of material in the public domain. You can open up any newspaper in the country on any day and you'll find multiple stories about what we've said or what I've said, so I don't accept the idea that we're not transparent at all. We go to great efforts to have people understand what we're doing, why we're doing it and what trade-offs we're making. And to be fair, we get to ask you questions as well. And just for the Reserve Bank conference, at least you know some people are reading the research papers that you're publishing. We do. My first question is about an interesting word that you added to your written transcript here, Dr Lowe, in the second last paragraph on the first page. You said: those being international disputes around trade and technology-- You then added the word 'soon'. Could I put to you that the reverse is probably the case, that these are going to be here for years or decades? If we are to build in this uncertainty, assuming that it's not going to be resolved soon-- India showed yesterday just how this can rapidly expand, if anything--how does your thinking change if we accept that we are a highly trade-dependent nation? Our trade is built mostly on large-scale commodities with very low labour ratios, I guess meaning that our trade can increase, but it won't necessarily change unemployment if we expand trade as much as a growth in our service economy, which has a direct effect on employment. Can't we just build this instability into our assumptions, and doesn't it then change your thinking? Well, perhaps. I'm a bit more optimistic than that because the lesson from history is incredibly clear: no country has made itself wealthy and prosperous through protectionism. Building walls actually makes you worse off. We know that, in the end, building tariff walls-- Could I interrupt by saying it's not about being the fastest runner; it's just being faster than the other guy. Yes. I'm hopeful that at some point that lesson from history will be sufficiently internalised so that it influences the outcomes. Maybe I'm inappropriately optimistic but I wouldn't give up hope yet, because if you're right, and these tensions don't go away, we're going to have a higher level of uncertainty for a long period of time. That's going to affect the investment climate. I talked before about how, when people don't want to invest and want to save, people get low interest rates, and that's what we're seeing, so that's problematic. If people don't want to invest, growth around the world will be lower and that will affect us here in Australia, including through wage growth and asset prices, so it's a very significant issue. One potential offset, at least in the short run, is that the Chinese may decide to stimulate their domestic economy again. When they stimulate the domestic economy, they demand more resources from Australia and prices go up, and so we may get some benefit from that. And there may also be some opportunities in agriculture. China might decide to buy some agriculture products from us rather than the US, but they're very much short-run things. If you're right and this goes on for years, investment certainly will stay for years; we'll see volatility in financial markets, capital accumulation will be slower and growth prospects for the world will be slower. So what does Australia do in those circumstances? I think we've got to make sure that our economy's incredibly flexible, which it is, and we've got to do every single thing we can do to support domestic productivity growth, because ultimately that's where improvements in our living standards are going to come from. If the global environment's not conducive to growth, then we can do things domestically that will make a difference. So I think, if you're right, that makes it even more important that we do the things to support growth domestically to make Australia a great place to invest, innovate, hire people and have businesses expand. The lesson from the GFC was that high-tech manufacturing economies really took a hit, whereas the less elastic purchases like energy keep rolling on--where there are long-term contracts in commodities, for instance. So we want to stay in that space where, potentially, even with a global downturn, there is still reasonable consumption of the stuff we're offering the world. Isn't there a slight difference there--that countries that are high-tech manufacturers are again going to bear the brunt, just like they did in the GFC? What we're seeing at the moment are the supply chains being disrupted, and that affects manufacturers, obviously. We're also seeing firms want to invest less, and a lot of international trade is in capital goods, so trading capital goods is softening. So you're right: those things are weak, and we may get some benefit in commodity prices, particularly if there is a stimulus in China. These are very much short-run things, and you couldn't say that these are actually good things. They're good in the short run, but they shouldn't give us very much solace. We may just fare better than some of the other wealthy comparators-- We may fare better than others, but we'll all fare not so well. So we shouldn't take that much comfort that we're better than the person next door when the whole neighbourhood is not doing so well, which is the prospect we face. We often compare ourselves with other rich G20 nations, but in reality, there's only just a handful of really truly trade-exposed wealthy countries. Do you find yourself looking at Canada as the best possible comparator, even though politically they're very different, when you look at the decisions the Reserve I often feel that the Bank of Canada and the Reserve Bank of Australia have a very close affinity. Many of the issues we've faced over the past decade are very similar. We've both had a resources boom, we've both had housing booms and then adjustments, we've both had strong population growth and we've both got strong relationships with Asia. So, yes, I'd agree with the proposition that the Bank of Canada and the Reserve Bank of Australia are very similar, and it's great to be able to talk with the governor there periodically. Just to finish, as government struggles with this propensity for those without work or underemployed to seek employment, there is quite a bit of political difference around this topic. There are 770,000 Newstart recipients who are getting income replacement, but only a small proportion--about 10 per cent of them--are actually taking up programs like PaTH, where an additional $200 a fortnight is paid to jobseekers if they seek out placement and work, and employers are telling us that the PaTH is not being picked up because they're not finding the right kinds of people. We really struggle with this propensity to seek employment. In a centralised, urban nation like Australia, with a mismatch between where its people are and where the job opportunities are, can you venture some possible measures that would increase the likelihood of people finding work, if the government has placed money on the table and is finding the PaTH program, if we take that as an example, is not a very effective measure? I don't know enough about the specifics of these programs to offer any particular comments. Perhaps the one thing I can say is the importance of training and skills development by employers and through the education system, because I hear a lot of stories at the moment that firms are struggling to find workers with the necessary skills, and I think in the past decade there has been underinvestment in skills development by businesses, and maybe the VET system hasn't been working as well as it could have been as well. I think this needs to be a priority not just to give people jobs right now but to build the productive capacity for the future, and I think, as a nation, businesses and probably government haven't done enough there over the past decade. I don't know whether that addresses the specific issue you were raising but I think it's really important we do more there. We'll go to Dr Aly now, and then we'll finish at 10.55 for a break. Thank you so much, Dr Lowe. In the fourth paragraph of your opening statement you talk about signs the economy is reaching a gentle turning point and the expectation that GDP growth outcomes will strengthen gradually, particularly over the next 12 months. You support this prediction via a number of developments. Among them are the lower interest rates and the recent tax cuts. I'd like to ask you to just expand on that a little bit. I'd like to ask specifically: how much of an impact have the recent tax cuts had, given that they haven't really yielded an increase in consumer spending? That's because they are being used to pay down household debt or are being saved for savings, as you mentioned earlier. Also, where is the outlook supported for GDP growth in the context of sluggish world growth, trade tensions and increased risk aversion? On the tax offset payments that are being made now, we estimate that they will boost household disposable income by roughly 0.6 or 0.7 per cent of income, and that is a sizable boost. As I said, we are the government's banker; we can see the ATO paying back the refunds now more quickly than they normally do. People are putting their tax returns in more quickly, the ATO is processing quickly and the money is now hitting people's bank accounts. I think it's too early to see signs of that in spending, because this has only really been happening over recent weeks. We'll be looking very carefully this month, next month and the following month to see if we can see signs that people are actually spending this money. Sorry to interrupt, but do you expect it to go into spending? Our estimate is, based on the payments during the GFC and international work, that people will spend around half of the money. They will use the other half to build up their savings or pay back their debt. We still get a reasonable kick to spending. It's not the full amount. If people use it to pay back their debt, that brings forward the day that they might spend. It doesn't help today, but maybe it helps tomorrow. If their balance sheet is in a better position, they might feel more comfortable to spend. It is too early to see the effects of that, but we're expecting it to be significant. If I can just wind back to last year, one of the reasons that household income growth was so slow last year was that taxes paid by households rose by 10 per cent. Gross income by households was up 3.5 or four per cent, and tax paid was up 10 per cent. Last year, working Australians paid a lot more tax to the government and that restrained household income. I don't expect that to be repeated this year, and they are getting the tax refunds paid right now. I'm expecting that this will boost spending. I hope to see it in coming months. In the context of the sluggish world growth, trade tensions and increased risk aversion, I'm just really looking at what the factors are that cancel out any kind of outlook that indicates strengthening. The depreciation of the currency helps. The Australian dollar now is the lowest it's been since the financial crisis. That helps education, tourism, manufacturing, agriculture and resources. The exchange rate, over 30 or 40 years, has actually been the great stabiliser of the Australian economy. I see that stabilisation role actually working out again now. That's important. The lower interest rates, which we talked about before, work through the cashflow channel. I think that still works. On the resources sector in Western Australia, there's a hope that the gentle turning point is soon to be evident there, if it's not already evident. For seven years in a row, resource sector investment has been declining in Australia. That has been quite a drag on Australia and in particular on Western Australia. This year, we're expecting resource sector investment to increase a little and, given what we know about future projects, to increase a reasonable amount the following year. That is quite a turnaround. Something that has been quite a drag on the economy is now going to become a stimulus. We are seeing Australia's terms of trade increase again, mainly because of iron ore but for some other reasons as well, and that generates extra domestic income. The stabilisation of the housing market, I think, is another important thing here. For some years, or for some time, the housing prices have been declining, and that has weighed on people's spending. You see it particularly in the purchase of cars and household goods. We are expecting housing turnover to pick up a bit and prices to rise a bit, and so people will spend a bit more and feel a bit happier. So, together, there are enough things there to give us some confidence that the economy's actually going to pick up, and we've got to weigh that against the global developments, and it is hard to know how to balance those. But I think there are enough domestic things to say growth will strengthen. You mention also in your opening remarks options other than monetary policy, and you talk about fiscal support. In particular, you mention infrastructure spending and investment. What other forms of fiscal support are there? Specifically, I'd like to ask about population policy and wages policy--increasing wages. Well, as I said, I would like to see stronger wage growth in the country, because it would help us get to our inflation target, as Dr Leigh talked about. So how do we get stronger wages growth in the country? At the Reserve Bank our strategy has been twofold. The first thing that I've been doing is talking publicly about the benefits of stronger wage growth and trying to lift wage expectations. For the central bank governor, it's controversial to say wage growth should be stronger, so that's got quite a lot of news, so I hope that helps lift wage expectations. And the second part of the strategy is to keep interest rates low for a long period of time to try and create a tight labour market, and a tight labour market will, in turn, turn into stronger wages growth. So they're the things that we can do. I've also drawn attention in my prepared remarks to the wage caps in public sectors. Most public sectors have wage caps to 2 1/2 --some have 1 1/2 ; I think in Western Australia it's probably even lower--and I can understand why governments are doing that, because it's important that we have budget discipline, and wages account for around 70 per cent of most state governments' budgets, so I can understand why the state governments want to do this. On the other hand, the wage caps in the public sector are cementing low wage norms across the country, because the norm is now two to 2 1/2 per cent, and partly that's coming from the decisions that are taken by the state governments. So I'm hopeful that at some point the budget positions will improve sufficiently that state governments, or even the federal government, will be able to lift their wage caps. On population policy, particularly immigration being at 1.6 per cent for permanent immigration-- but, of course, temporary immigration is much more amenable to market forces--are there any kinds of levers there in terms of creating physical support for growth? Well, in principle, you can create extra demand in the economy through fiscal expansion, not just through population growth but by lower taxes or increased spending. I'm not saying that that should be done at the moment, but it is an option. If we find ourselves in the position where aggregate demand in the economy is very weak, we're not making progress on unemployment and interest rates are very, very low, I think the fiscal option would need to be on the table. One way of doing that, as I've noted, is increased spending on infrastructure, and what I find attractive about that is that it helps demand now but it creates future supply capacity in the economy. So we've got to do that carefully, because we don't want a repeat of what happened with LNG investment, where everything got done at once and the cost of doing it blew out. So we've got to sequence infrastructure investment carefully, but I still see potential to do more of that over time and help support demand growth in the economy, increase productive capacity and make people's lives better, and we can do it at very low interest rates. So from my perspective it's, 'Tick, tick, tick, tick.' We've just got to find the right projects to do and to sequence them, and that would help demand growth in the economy. If the country as a whole comes to the conclusion that stronger demand growth is required to get unemployment down or get the economy growing at the pace we want, we face the question: how do you get stronger demand growth in Australia? And, as I said, monetary policy can play a role and is playing a role, but we do have other options as well, and at some point I'd like to see those other options explored, particularly if growth weakens from here. I don't think that's going to happen, but it's possible. I don't want to put probabilities around it. It's inherently very difficult to know. If, as Mr Laming said, these global factors go on for a long period of time it's going to be a drain on us. If they're resolved in a way that restores confidence, with low interest rates around the world and the domestic fundamental support factors that I talked about, I think we could look forward to quite good growth. But it's inherently difficult. We'll resume the hearing. Mrs Archer. Dr Lowe, you talked in your opening statement--and you've talked a little bit more--about the unexpectedness of the labour supply flexibility issue. You talked about it being particularly in the area of women and older Australians. Could you expand on that a little bit more, with some of the reasons that you see for that and whether it's something that you factor into future calculations. That's a very good question. As I said in response to Andrew's question before, the increase in labour force participation has taken us by surprise. I think there are a series of things going on. One is that older people's health is actually quite a lot better than it used to be, and so that's allowing people to stay in the workforce longer. That's a positive development. Another change we've seen is that hours of work are becoming more flexible. Part-time employment is much more available. Flexible working hours are much more common. That's allowing people to transition into retirement in a different way and stay in the labour force. Another thing that may be at work is that people are carrying debt into their 60s in a way that they once didn't. When the debt is still there, people feel like they've got to stay in the labour force longer. All these factors--the structural improvement in people's health, higher debt, more employment opportunities--are seeing participation rise. We're seeing the same factors affecting women's participation. Perhaps the slow growth in household incomes is a factor here as well. If one partner is working, and incomes are only rising at two per cent a year, when they used to rise at four, maybe the partner says, 'Well, I've got to work as well,' and, because part-time work is available and flexible hours are available, people are doing that. I think it's a good news story that a higher share of the adult population has a job today than ever before in Australian history. You didn't expect that in terms of these calculations, but you anticipate you would factor that in going forward as something that may continue? It's possible. The labour force participation of older Australians has picked up a lot, but it's not particularly high by international standards, and female participation in Australia is a bit higher than the average of the advanced economies but it's certainly not the highest, and there's quite a gap still between Australia and some countries. I think if the forces that I talked about before continue then it's reasonable to expect further structural increases in participation. It's a good news story but it does have this side effect. When there's strong demand for labour and a lot of people are getting jobs, the labour market doesn't tighten up that much, because there are more workers, which in one way is good but, in terms of generating wage pressures, it's an issue. I would agree with that. You also said: Could you expand on what you think such a program of structural reform might look like. I'm always reticent to be giving the government advice, because the government doesn't give me advice and I don't want to give the government advice either. It's very much linked to the issue of productivity. What do we do to lift productivity growth in the country? If you go back over the last 30 years, in the early nineties to the mid-2000s productivity growth in Australia averaged 2 1/4 per cent a year. That was the basis of a big pick-up in our collective living standards. Since 2005 productivity growth has averaged about 1 1/4 per cent, so a full percentage point less. And just recently there's been very little labour productivity growth at all. I think this is a serious issue for us to confront. There's no shortage of advice from people more qualified than I am. The government has commissioned endless reports, and there's a lot of other advice as well. I'd encourage anyone who is interested in this to read those reports, but I can perhaps summarise the main areas. Probably it won't surprise you that I'm starting off with infrastructure. The population has been growing rapidly. Up until quite recently we did not invest enough in transport and other infrastructure, and we're paying the cost of that now in terms of the productivity of the country--so, investing in quality infrastructure. Another issue that people focus on is the way we tax land. I don't see any economist arguing that the current way that society taxes land is appropriate. The incentives the tax system established for innovation and entrepreneurship are something to focus on--so the tax system, the balance between consumption and incomegenerating taxes. Competition policy is incredibly important because a lot of innovation comes when firms feel like they're competing with the person next door. Skills and education--we talked about those previously. The use of data by government to drive better delivery of services: the government is actually a very large employer. The Productivity Commission had a report , which talked about the possibility of a significant improvement in the delivery of health and education services provided by the government. There's no shortage of ideas across those various areas; the challenge is to work out which ideas to implement. I'm not going to provide the government advice on how to do that but these are the areas that I hope people are looking at. Thank you. I don't have any other questions. Thank you very much, Mrs Archer. I'll now go to Mr Bandt, if you're on the phone? I am. Thanks, very much, Governor, and others. If 4 1/2 per cent, give or take, is the appropriate number for what counts as full employment at the moment, what's the appropriate underemployment number? I'm not sure I know the answer to that. The underemployment rate, if you count it in terms of the number of extra hours that people want to work, is around three per cent, and that's been fairly steady for a number of years now. I would hope that, if the labour market's sufficiently strong to get the unemployment rate down to 4 1/2 per cent, underemployment would also decline. Because it's a fairly recent phenomenon, it's hard to know what the right number is there. You mentioned it in your opening remarks, and I don't think many other people have raised it in the questions since. It seems to me that that is one of the key issues. Something is happening now that is different from before. Underemployment, especially amongst young people, has in fact gone up since the GFC, and, when you ask underemployed people how many more hours they want to work, 64 per cent said they'd like 10 hours or more, so it's not just wanting an extra hour or two. Amongst young people we now have what I would say is a near-crisis point in the country that's got worse since the GFC, where nearly one in three young people either haven't got a job or haven't got enough hours of work. Shouldn't we be paying more attention to underemployment than we currently are? Because, even if we get unemployment down, aren't we still going to have this massive underemployment crisis--and a growing crisis, as you say--that isn't being fixed? As to whether we should be paying more attention to it, or not, I don't know the answer to that. But we should be paying attention to it, I agree. And I gave a speech in Adelaide about a month ago, where I talked a lot about underemployment. But it is important to keep this in perspective. Roughly a third of the labour force work part time. Back in the 1960s, I think only 10 per cent of the workforce worked part time. So there has been a very big increase in part-time work, which has allowed the rise in participation that I spoke about before. The vast bulk of part-time workers are actually happy with the hours they work; it is only around 20 or 25 per cent of people working part time who say they want more hours than they have, and, on average, those people want two days extra. So there is a group of the population who are working part time who want more hours--and a stronger labour market, I agree with you, would help fix that. Beyond that, I'm not sure what the solution is, other than just making sure the labour market is strong and there is demand for labour, and then people get the hours they want to work. Given that full employment is part of something that is your mandate and it is something that we have to consider as policymakers, and we have notional targets around that, should we also be considering a notional target around underemployment? I would like to see it lower. I don't know what the right number is. I am confident that if the unemployment rate gets down to 4 1/2 per cent we will see less underemployment. The two things move together. I think that if we can get the unemployment rate down to 4 1/2 per cent we will see less underemployment as well. On the question of public sector wages, we've got caps in place of around two per cent across the country--give or take. In some states it's a little bit higher. The federal level is two per cent. You've said those caps might be having a general depressing effect on wages generally. If public sector wages were increased by four per cent a year, the Parliamentary Budget Office estimates that that would have a gross cost of around $12 billion over four years--and you could perhaps offset that with some savings around consultancies and the like to bring it down to $9 billion. Is a four per cent increase in public sector wages out of the ballpark? I'm not going to speak on behalf of the government. Four per cent does seem like a large number. In the medium term, I think wages in Australia should be increasing at three point something. The reason I say that is that we are trying to deliver an average rate of inflation of 2 1/2 per cent. I'm hoping labour productivity growth is at least one per cent--and I'm hoping we can do better than that--but 2 1/2 plus one equals 3 1/2 . I think that's a reasonable medium-term aspiration; I think we can do better, but I think we should be able to do that. So I would like to see the system return to wage growth starting with three. We have seen that with the minimum wage increase in the last three years. I think we had 3.3, 3.5 and three. They seem reasonable outcomes. Over time, I hope the whole system, including the public sector, could see wages rising at three point something. If it were incorporated into government wages policy to allow for public sector wages growth at three point something, that would be of assistance? We are in a situation now where wage norms have drifted down to two to 2 1/2 per cent. At the Reserve Bank we talk a lot about inflation expectations lowering as a result of low inflation. But what is really important is the wage norms in the country. Most people are accepting wage increases of two to 2 1/2 per cent. And the public sector wage norm I think is to some degree influencing private sector outcomes as well--because, after all, a third of the workforce work directly or indirectly for the public sector. So I think it is an issue but, on the other side of the ledger here, it is important that state governments manage their budgets prudently. I have spoken to a number of state treasurers. They say, 'We'd like to do more here but we've got a tough budget situation.' So there is a balancing act to be completed here. But I hope that, over time, that balance could shift in a way that would allow wage increases, right across the Australian community, of three point something. One of the matters you mentioned before was around stimulating demand. Would lifting the rate of Newstart be helpful? If you're asking: 'Would an increase in Newstart lift aggregate demand?' I think the answer to that is yes, because the payments are low and they haven't been increased in real terms for a number of years. I think if people who are getting Newstart got more money they would spend it, and so aggregate demand would rise. But this is another area where a balancing act needs to be achieved. It would cost the budget money, and the judgement for the government and the parliament is: if the government's going to spend more money, is this the best way of spending it? Can I come back to a question about infrastructure spending that you referred to before. Given all of the factors that you outlined and given the specific situation that we find ourselves in at the moment, would it be better to have a small surplus and not borrow to fund infrastructure or to have a small deficit because of meeting the interest costs of borrowing for productive infrastructure? I don't see the trade-off in those terms, because there are ways that you can fund infrastructure that don't require drawing on the recurrent budget. It's important that the recurrent budget is in good shape, because having a strong recurrent budget allows you options if things turn bad. We saw that in the financial crisis. Having run disciplined fiscal policy, the country had options that it wouldn't otherwise have had. It's important that we keep disciplined fiscal policy. We can do that and still support further asset accumulation, either by the public sector or the private sector, through infrastructure. There are ways that one can do that in a budgeting sense, and we see that the New South Wales government has done it a different way. Sometimes these projects can be financed off of the recurrent budget. But it's not happening at the moment, and part of the reason is that there's a mindset that governments should not be investing public funds in these areas of what, perhaps, used to be called nationbuilding projects. It all suggests that, in many ways, neoliberalism is having its stagflation moment. Things are happening that aren't meant to be happening. The usual tools aren't working. Although interest rates aren't bringing down unemployment, extra money that people might get through tax cuts is just going to pay off debt. The government has still got its blinkers on and we're not having the spend on infrastructure that would get us out of this hole. We really need--don't we?--a rethink from government about the point of what government is for, otherwise these crises are going to continue. I'll leave whether or not we need a rethink of what government's doing up to others. I wouldn't agree with the idea that we're not spending quite a lot on infrastructure. Spending has increased a lot over recent years, particularly in New South Wales and Victoria. The federal government has a plan to spend $100 billion over the next 10 years on supporting various infrastructure projects, and the state governments are spending a lot more. We're actually spending a lot on infrastructure at the moment. The debate is: how do we keep that high level of spending and what are the opportunities, perhaps, to do a bit more, particularly if we need more aggregate demand growth? I know that the treasurers are thinking about that at both the state and federal levels. At the last hearing I had some discussion with Dr Debelle and Dr Ellis about climate change. I understand that you're in the process of updating the kind of modelling that could be done within the Reserve Bank and considering climate change impacts, the IPCC's report, the need to phase out thermal coal and so on. Is there anything further that you've done on the climate change front and the modelling on the economic impact, since your last appearance before this committee, that you can update us on? I'll hand over to Guy. Absolutely. As I think you know, we have for a while now been members of this global central banking group, the NGFS. We're working actively there. One of the things we are working directly on, along with colleagues at the Bank of England and a few other central banks--this is not directly related to what you just said but is where we're devoting our resources at the moment--is thinking about various stress scenarios and stress testing that we think both investors and financial institutions should wish to consider in their reporting on this, which most of them are now doing. That's one of the areas we've been devoting some resources or some of our thinking to over the last little while. You may have seen that the Bank of England last month, I think, put out some scenarios for the insurance industry in the UK to consider. We made some contribution to that. I hope that later this year, in a couple of months time, there'll be some work put out by the NGFS, which we are making a reasonable contribution to, which expands on that. That's one of the areas we've been focusing on and working on with fellow regulators in Australia--APRA and ASIC--and how that might be most usefully applied to the Australian financial system. That's certainly one of the areas where we've been spending a fair bit of time in this space since we last met. Are you doing any work on the impact on Australian exports--for example, agriculture and so on--if droughts get worse, as predicted by IPCC reports, considering particularly Australia's unique exposure given our industry profile? We're obviously spending a fair bit of time looking at the impact of the drought on the economy right now and the fact that it's still going on and the impact in some parts of the country, at least--although I suspect the part of the country we're in right now is welcoming the rain that it's getting, which is the first in a while. That's one thing we're considering. We have talked to a number of groups, including the National Farmers' Federation recently, about this and some of the thinking that they have. An interesting thing about Australian agriculture is that one area where we have seen a lot of productivity growth and technological progress over the last couple of hundred years really is in adapting to the changing climate. I think our agricultural sector is one of the more advanced in its adaptation to that. One of the interesting challenges around climate, as well as the direct impact, is how people respond as the situation changes. Our agricultural sector has proven to be one of the more flexible ones. So that is something that we think about. It's both: what is the direct impact but also what is the likely response and how are we likely to adjust? We can look back at how that's changed, and it has changed quite dramatically over the last 50 years as our agricultural sector has adjusted to the change which has already occurred, and we can use that as some guide as to how it might adjust in the future. So it's all going to be okay? No, that's not what I said--no, not at all. The outlook isn't fantastic on this front, but you've also got to think about how things adapt to that. That's the challenge for us: you look at the direct impact but then you've also got to think about how the different parts of the economy are going to respond as the situation changes. That is something we are still devoting time and effort to thinking about. I want to clarify a comment by Mr Bandt. He said that we are in a stagflation environment. Would that be the view of the Reserve Bank? That's not what I said, Chair. I said that neoliberalism is having its stagflation moment, where things are happening, just as Keynesianism did; we're reaching a crunch point now--that was my point. I didn't say we're in a stagflation environment. Let me ask for your reflection on that. Stagflation is what I learnt about when I first started studying economics in high school in Wagga, not that far from here--and that was high unemployment and high inflation. Today we have exactly the opposite. I gave a speech a couple of weeks ago and said that the standard exam question when I was doing the HSC was: 'Why does the country have high inflation and high unemployment, and what should government do about it?' The kids who are doing their HSC now--and I have a daughter who's doing the HSC, but unfortunately she's not studying economics--are getting asked a very different question: 'Why is inflation so low, why is unemployment so low and what should public policy do about it?' That's right. The exam question at the moment surely is, 'Why is inflation so low, interest rates so low and wages growth so low, while underemployment is growing and not enough is being spent on infrastructure?' That would be the exam question now, wouldn't it? That would be a very good question, and I'd look forward to seeing the answers. Thank you so much for taking our questions today. I'd particularly like to focus on the extended period of unusually slow growth in household incomes weighing on household spending that you mentioned in your opening statement. Obviously wages is a very key part of that. Particularly in the current environment, with the high level of underemployment and without stronger upward pressure on wage growth, what levers are available to boost employment and wage growth? As we talked about before, employment growth has actually been strong--2 1/2 per cent on average over the last three years, which, given the growth of the population, is very strong--so the issue isn't a lack of employment growth. As we said, the supply side has been very responsive. Going forward, how do we ensure that employment growth remains strong? At least conceptually, the options are fairly clear. The first set of options is monetary policy stimulus, which is what we're doing, and, if needed, we're prepared to do more. As we've discussed, our second set of options are fiscal options. And the third set of options, which are my preferred ones, are creating an environment where businesses want to expand and hire people. That's the menu, and it's up to society, through the parliament, to choose from that menu. Sorry, I probably should have phrased it differently with regard to employment growth. We have a level of unemployment that is higher than it needs to be to stimulate wage growth. On the fiscal side, what more could the government be doing to address that unemployment, particularly underemployment. I don't want to provide the government with advice on what it could be doing, but at least conceptually, if aggregate demand growth is not strong enough, fiscal stimulus could be one way of overcoming that. I'm not calling for the government necessarily to do that, but just conceptually that's what you could do. You could have monetary stimulus, fiscal stimulus, infrastructure spending and--the final one; the best one--create an environment, through structural policies, where firms want to expand. We talked briefly about the range of options there. Beyond that, I'm not sure I've got much more to say. You've mentioned caps on public sector wages. Do you feel that's an important part of slowing wage growth and household spending? Is that a lag on household spending more generally? It's part of the story. The public sector, directly and indirectly, employs roughly one-third of the labour force, and they're saying wage increases across the public sector may be averaging two per cent. That has as indirect effect on the private sector, because there's competition for workers and it reinforces the wage norm in the economy at two-point something. I know that treasuries have to balance the considerations about the benefit they'd get from stronger aggregate wage growth against needing to deliver responsible, balanced budgets. Again, that's a trade-off that our society is making through its governments, and the trade-off that they're making is to entrench low wage norms in our country. Whether it's the right trade-off, I'm not going to comment on that. No; of course. But if they made a different trade-off and wages in the public sector were rising at three per cent, then over time I think we'd see stronger aggregate demand growth in the economy. I don't think it would have much of a negative effect on employment; in fact, arguably it could be positive. I'll come to infrastructure spending in a moment; but, aside from infrastructure, what would you describe as some examples of a successful fiscal stimulus package? If you go back to the global financial crisis, the fact that Australia ran disciplined fiscal policy for many years allowed us to have one of the biggest fiscal stimuluses around the world. I know there's debate, and rightfully so, about the size of the stimulus and the particular design of the package, and there are issues there, but at the big-picture level, that fiscal stimulus did help the economy get through what was a very, very difficult period. Remember that back in late 2008 people were predicting the unemployment rate going to seven or even eight per cent. For various reasons, Australia got through the global financial crisis with the unemployment rate going close to six per cent and growth returning pretty soon afterwards. The fiscal stimulus was part of the answer there. We were only able to do that because of the good history we had. We saw some countries which had run poor fiscal policy in the past actually have to tighten fiscal policy in the middle of the global financial crisis. We didn't. So it can work. Obviously, part of that package was 'go households' and target them directly. Could you comment on the role of the social security system in stimulating household spending in the current context? I'm not sure what in particular you have in mind. We've talked about the tax offset payments that are now occurring. I think that is stimulating spending. Beyond that, I don't think there are other measures in the social security system that are having an effect at the moment. I'm not sure of other changes that are being proposed. I mean, we've discussed the possibility of Newstart, and again that's a trade-off. I think increased spending there would see greater spending in the economy, but it's a balance. A government has to decide where best to spend its scarce resources. Absolutely. Looking at the tax cuts, in terms of stimulating household spending, do you think an increase to Newstart allowance or tax relief to people on higher incomes is more effective? In the short run I think you get more stimulus from giving money to people who have a high propensity to spend that money, and that's obviously lower-income people. In the short run I think the answer to that is pretty clear. In the longer run it's more complicated because we've got to think about the incentives for work and innovation and reward. So it may be that, in the longer run, having lower tax rates on people who earn high income, either through entrepreneurship or other reasons, actually stimulates more growth in the economy so everyone can be better off. In the long run, there's not a simple answer. In the short run, though, the answer's simple. Given the situation we're in at the moment, where we're coming to record-low interest rates and no pressure on wages, do you think we should be focusing on those shorter-term objectives at the moment? No, because the central scenario for the Australian economy still remains quite reasonable. We're expecting growth to return to trend, the government's projecting a budget surplus and inflation is going to gradually rise back to two per cent. In the broad scheme of things, in our history, having inflation close to two, growth on trend and unemployment around five is not so bad. If that's how things work out, maybe we could do a bit better, but there's not an immediate call to do things to make things better. It's more an issue of the long term. What I'm increasingly concerned about is the low productivity growth, and the prospects for that to continue, because if productivity growth is low, it means real wage growth is low, the budget is going to come under greater pressure, the value of people's assets won't rise at the rate they expect and people's incomes won't rise. For me, that's the much more important challenge for us to address than trying to manipulate aggregate demand over the next little while. If the situation turns bad and the global economy has a downturn, we may need to think about measures to stimulate aggregate demand because we're falling short of the central scenario. That's a debate we might have to have. I hope we don't have to have it, but we might have to have it. The much more important issue is: how do we keep generating growth in our real wages, our real incomes and employment over the next 10 or 20 On that productivity, what policy levers do you think are available to boost productivity? I ran through my list before. I could read it out again, but it's not my core area of competence; the governments around the country have large public services to advise them on that. But I read out my list. I've read many of these reports and I think a lot of these ideas would be actually quite good. But they would all be politically contestable, and it's really up to you, the parliament, to work out how to solve those political contests. There's no shortage of good ideas out there--things that I think would make a material difference to the growth prospects of the country. It's up to the political class to work out which of those it can support. I'm not going to give you advice on how to do that, but I know there are things that could be done, and I think that's actually a much more important priority than arguing over the next six months or 12 months. Make sure that our kids have living standards materially better than ours. If productivity growth doesn't lift, then they're going to struggle to have materially better living standards than ours. I think that's a much more important issue for us to grapple with. If I could, I want to come back to the importance of infrastructure investment that you've mentioned. What types of actions, specifically, could the government be taking to support that growth further? Broadly speaking, at least in the transport area, there are two types of infrastructure investment going on. There's the big megaprojects. We see those in Sydney and, to some extent, in Melbourne. I think in the large capital cities at the moment there's probably limited scope to do another big megaproject. People tell me there are capacity constraints and the prices are rising, so we do have to be careful there. It's really a job for the state governments to plan to make sure that there's a strong pipeline of projects so that, as one winds down, they can do another one and, wherever they can, perhaps do a bit more, particularly if the economy were to weaken. The second type of infrastructure project is much smaller in scope, and there I think there is scope to do more across the country, particularly in regional areas--maintenance of rail, road and bridges and some expansion of regional infrastructure--because people tell us at the regional level there is still spare capacity. There may not be the capacity for the big megaprojects in Sydney and Melbourne, but right across the country there is the capacity to do more infrastructure spending that would make people's lives better and improve the quality of people's existence, so I encourage governments to look at the possibility of a series of smaller projects. They're not a big as building a metro in Sydney, but they can be more widely dispersed across the country, and that can help us all. What do you think would be the ideal time period to bring forward those projects, in terms of I don't know the answer to that. It really depends what happens. If we proceed along the central scenario, I would describe that as kind of okay. Do we have an aspiration to be better than okay? I'll leave that up to you. If things turn out not to be so okay, then these issues would become pressing. If the global economy were to weaken, if these trade tensions were to get worse and if the Australian economy were to underperform our central scenario, then I think these would be serious issues, because then we wouldn't be doing okay, and in that situation we should be looking to all arms of public policy to help. But, in the central scenario, things are broadly okay, aren't they? We're looking at five per cent unemployment, two per cent inflation, growth around trend and a budget balance. Now, we might like to be better in a number of those dimensions, but broadly that's okay, and if the society can make a choice to be better than okay, it-- The wage situation's not really okay though, is it? That's something we really need to address. Yes. Income growth is still weak. I think it'll pick up a bit, but it's still weak. How do we turn back and have wage growth with a '3' in front of it? I think it's stronger demand. We've been through the options there, and it's really an issue for the governments across the country and whether they want to do that or whether they can live with growth being kind of okay and wage growth being as it is. What do you think will happen if they don't? If fiscal policy isn't working in the same direction as monetary policy is at the moment, what are the implications of that? I think things will be okay. But I hope that we can lift our sights higher than things being okay, and I think, as a country, we can do that. But it does require some of these structural issues that I ran through before to be addressed, and that does require the political classes to come together to agree on and support some structural changes. That's completely out of the area of the central bank. It's really in your area. Are we happy for things to be okay or do we aspire for something better? I hope, as an Australian, we can do the latter, but, if we don't, then I think things will be okay. I hope we can aim to be better than okay too. Could you comment on the quantum of infrastructure investment that you think is required to have the desired impact? We have a very high level at the moment. I think it is important that we sustain that level. That requires the sequencing of projects, as I talked about before. At the margins, I think there are some opportunities in some areas to increase it. I talked, particularly, about regional Australia and smaller scale projects, where you are not going to put pressure on capacity constraints. If things turn down in the economy, I think we should be more ambitious and look for further opportunities. Let's hope we don't have to confront that situation, but it's one of the things on the menu. It's really going to be up to the governments, particularly the state governments around the country, to select whether they want that item from the menu or they want other ones. We all face trade-offs. Thank you. I have two unrelated questions. Maybe we could give you a rest, Dr Lowe, and ask Guy a question. The first question is just about understanding better what is probably an old chestnut that has been discussed prior to me being on the committee. It is an issue that is often raised by property investors, and it is basically about government's preference for residential property investment. It's a $2.7 trillion industry. A lot of people who are in the market have some gripe about paying more for investment home loans than residential home loans and also about being made to pay principal and interest instead of just interest only. On those two fronts, does the RBA have a view? Now that rates are getting so much lower, these differentials are relatively large compared to the actual rate, which they may not have been when rates were much higher. Are either of these two issues presenting any problems for the nation if investors feel that they have to pay more for a property loan than a homeowner? Secondly, are they being forced, in some cases, to pay P&I rather than interest-only through this period? This is actually Michele's corporate area of competency, but I will make two comments. On the principal-and-interest and interest-only loans, that was a constraint on the flow. It wasn't a ban. It was just a constraint on the flow, which was predicated--with the very high share of interest-only loans--on the concept that having a large chunk of the loans in the country not requiring any repayment of principal didn't sound like a great situation for the medium-term financial health of the country and probably put us at a point that was risky. But it was a constraint on the flow, not on the stock. In terms of the spread between owner occupiers and investors, in the end--and it is true of all interest rates--it was an assessment around wanting interest rates to reflect the relative riskiness of the proposition. Those who lend, I would hope, would have the capacity to be able to do that and set the rate appropriately. But I will give Michele the opportunity to say something. I will only add a couple of other points. Guy is right in the sense that the distinction or differentiation between the home loan rates came in when APRA put some constraints, firstly, on growth in investor loans and then, secondly, on interest-only loans. At the time, around 60 per cent of investor loans--the flow, as Guy said--were interest only. There's a reason for that. What investors were doing was utilising certain advantages in the tax system to basically bet on the capital gain. Despite those differential rates coming into play, 40 per cent of investor loans still are interest only. They are making a judgement that it is still worth their while to take out those sorts of loans. The issue of interest-only loans for owner-occupiers I think is a slightly different issue because, in principle at least, you'd hope that an owner-occupier might be wanting to get increasing equity in their home over time, and that reduces the riskiness of that loan to them because it means they are getting more equity in their home and, if prices decline a bit, they are not going to find themselves under water. So I think the differential interest rate is a sensible thing that the banks have done. They introduced it for a specific purpose. Sure, there are fewer investor loans across the board generally, but that's more related to the way the house prices have been going. I think interest-only loans are still available for investors, and a large portion of them are still taking them out. So there is still a very good case for the size of that differential remaining, as opposed to reducing the differential, given the fact that all rates are now lower than they were when this decision was made? That's ultimately a question for the banks themselves. The banks are the ones that set the interest rates. Interest-only loans are slightly more risky, so you would expect a differential. But the differential that the banks charge is ultimately a question for them, and competition between banks to lend to good risks will ultimately govern how big that differential can be. I would add that that differential has indeed, for exactly the reasons Michele just outlined, been coming down over the last couple of months. We've seen a number of the investor loans--by some of the banks, not all--being reduced by more than the owner-occupier rates recently. I want to ask you about the decision by different jurisdictions to invest in infrastructure. All states are doing it differently, and the three eastern seaboard states are a useful case in point. We look to Infrastructure Australia to do cost-benefit analyses of applications for government funded infrastructure, but it worries me that increasingly what I'm seeing in Queensland is a reduced pool of infrastructure constructors who, among a very small group, take on very large projects. We have a history of getting the economics of these projects wrong. For example, at Queen's Wharf in Queensland, we are seeing incredibly inflated wages agreed on site for a relatively small proportion of employees. They talk about the stop/go person earning in excess of $160,000 a year and the entry level cabinet-maker earning $250,000 a year. That is an increase in the wage, but is it in the public interest to see wages increased in that way? My broader question is: from your elevated position, do you start to have concerns about the way in which jurisdictions of all types are investing in social infrastructure, as opposed to economic infrastructure, which was the debate during the GFC? Even now, we are calling a lot of stuff economic infrastructure. It is the difference between investing in congestion in major cities, as we approach peak vehicle, and investment more directly in constructing industrial infrastructure that is often well away from the major cities. Is there good and bad infrastructure, as far as you see it? There is certainly good and bad infrastructure, and it is possible to waste a lot of money in this area. But it is also possible to build great assets that the country needs for its future growth. The task that the political class has is to balance those things and make sure that the governance around project selection, cost management and risk sharing between the public and private sector are all in the public interest. In front of this committee, for many years, I have been extolling the virtues of improving governance around infrastructure selection, construction and pricing. I think it is necessary for the public to have support in the process as well. If the public see money not being spent wisely, they lose support for governments building assets, which, in the end, will harm us all. I don't know the specifics of the cases you are talking about, but governance is really important. People think of infrastructure as megaprojects--the subway in Sydney or the Cross River Rail in Brisbane. These are important for our major cities, but there are a lot of infrastructure projects right across the country, in regional Australia, that also need attention. We can do those, if you have a decent governance system in place, and improve people's lives and help regional Australia. We have got to be careful that we don't say, 'Governments do this badly, so we're not going to try.' We're better off saying, 'How can governments do this really well and business, the community and government support good processes so that the public can have confidence that when governments are spending our money they're doing it wisely?' We'll all be better off if we can do that. Governor, just to take you back to one of your comments about public sector wage caps, the New South Wales government is apparently considering dropping its wage cap from 2.5 to two per cent. If it did that, what impact would that have on the New South Wales economy? My understanding is they're not going to do that. In the event that your understanding was wrong, what impact would it have on the economy? Well, it would be a move, in my view, in the wrong direction, but that's a matter for the government. It's got lots of things to balance. But I started talking out publicly about the benefits of stronger wage growth a couple of years ago when I was in a function at ANU because I was concerned then that the wage norm was maybe going to slip below two down to one point something and, if that became the wage norm in the country, there's no way that we're going to achieve 2 1/2 per cent average inflation. So I think with a wage norm of two to 2 1/2 , where we are now, I wouldn't like to see that lower, and I don't think decisions by the New South Wales government are going to move in that direction. We spoke before about transparency, and I note Kevin Warsh's 2014 study of transparency across 10 central banks, which placed the Reserve Bank second lowest on the list. I ran you through a number of transparency measures earlier, including publishing transcripts of meetings, voting records, regular press conferences after decisions and the attribution of views in the minutes. Am I to understand that the Reserve Bank has no intention of implementing any of those transparency changes, despite the fact that many of your counterpart central banks do so? On transcripts, I don't think most central banks publish transcripts. The Fed does, with kind of a long delay, but that's not the standard practice. And the Bank of England and the Bank of Japan. I've never seen these transcripts. No, the Bank of England don't. They publish attributed views; that's correct. I'm pretty sure that's right. A transcript really is kind of what we see in here, with everyone's views being recorded in detail. The Fed, I think, does that with a very long delay, doesn't it? It's five years. Five years. So we're not considering that. The minutes of the meeting are pretty comprehensive. As I read the minutes, I can see every graph that's been presented during the board presentation. So the minutes are very comprehensive. On press conferences, I've thought about that--a press conference after every meeting. The Reserve Bank of Australia board meets more frequently than the central bank boards in most other countries. The standard is now eight meetings a year or sometimes fewer than that. We meet 11 times a year. I think meeting frequently is good. So, if I did press conferences, that would be 11 press conferences a year, plus all the other regular speeches--one or two a month--and I'm a bit worried that the community would end up hearing too much from the central bank. I feel that at the moment the community hears a lot from me and the central bank, and I'm not convinced that adding to the number of public appearances would be in the country's interest. I hope people can focus on things other than monetary policy. The other one you mentioned was attribution of votes, and we have long taken a view that these decisions should be taken by consensus, and the board supports that. I support that. And, through the discussions at the board, we always reach a very high level of consensus, so I don't see anything to be gained from attributing individual views. And the board has also agreed that the governor is the spokesperson on monetary policy to try and make sure the communication lines are as clear as they can be. I suppose I would also note that the composition of our board is different--and that's a function of you, the parliament--in a way, from, I think, all of those other central banks you meet, and I think that is a consideration you at least have to think about in heading down that route. Indeed, and I was going to go directly to that issue. We've discussed a range of macroeconomic concepts: Okun's law, the Tinbergen rule, the Taylor rule and dynamic stochastic general equilibrium models. What share of your external board members would have a deep understanding of those concepts? I think it's a reasonable question as to whether some of those concepts are useful for anyone to have a deep understanding! I think there's an issue of what perspective you want a central bank policy board to bring to these discussions, right? And I think that's an interesting question to think about. I'm not saying there's a right or a wrong answer, but there is possibly more than one answer to that question. The Parliament of Australia--and I'd emphasise it's the Parliament of Australia, not our choice--has chosen to have a board which is made up of a different constellation of people to make this decision around monetary policy than other countries have chosen to do. Another thing to bear in mind in thinking about that is that, if you look at the composition of the US Fed, up until about five years ago there was a big shift towards having, for want of a better descriptor, academic economists constitute the vast majority of membership of the FOMC. If you look at that constitution today, it's actually shifted away from that, so there are fewer on the board. It's an interesting question to think about as to what gives you the best decision-making. There's not an obvious answer to that question. Do you want a diverse set of views rather than a set of views purely from a particular perspective as to what gives you the best outcome? It's really not at all obvious to me what the answer to that question is. Those arguments are well taken, Dr Debelle, but you cunningly slipped past the actual answer to the question. Sorry, what was the question? How many of your external members would have a familiarity with concepts such as Okun's law, the Taylor rule, DSGE models-- We provide information to them on a monthly basis. The information is of the sort that I think you, as a trained economist, would expect to be presented to a board making those sorts of decisions. I still feel an answer is eluding us. No. What I am saying is that they are then able to process that information. I don't think it requires a PhD economist to understand all of the concepts that you outlined. They are people who are used to dealing with complicated issues and dealing with risk management and, therefore, are able to get their heads around, and do spend the time making sure they do get their heads around those concepts and ask questions if they don't understand the stuff that's put in front of them. If the suggestion, Deputy Chair, is that there should be a skills matrix against particular theories, I'm sure they can take it on notice. I can tell you that 100 per cent understand the concept of NAIRU. We've had extensive discussions about that, about capacity constraints and potential output--I can tell you that 100 per cent understand that. They 100 per cent understand the Phillips curve and the link between inflation and unemployment. Probably greater than the economics profession. They may not fully understand how to interpret econometric equations and stochastic equilibrium models, but there is a high level of understanding. I'd pick up on one other point that Guy made, which I think is really important. From my perspective, much of the time we're dealing with decision-making under uncertainty. The world is inherently uncertain, as we've talked about today, and the job that we have is more than just a technical job; it's how to make the best decisions under uncertainty. What I've noticed over time is that people from business and other backgrounds typically have very good skills at making decisions under uncertainty. The frame of reference they bring is sometimes different from the technical perspective, and a board, which is what the Reserve Bank board has, which marries those things together works very effectively. I do not have any concerns at all about the competency of my board. I think they bring great perspective and they're very good at making decisions under uncertainty and considering trade-offs, because that's what we have to do. Over recent years a number of other central banks have chosen noncitizens to head the bank: Stan to head the Bank of Israel; Mark Carney to head the Bank of England. Increasingly, it looks as though there's more like a global labour market for central bankers. Supposing that a future Australian government were to go down that path, what changes would that necessitate within the way in which the Reserve Bank is internally None, I don't think. It would be a matter for the government whether they wanted to appoint the next governor as a non-Australian. I'm sure if they did that he or she would manage the bank as he or she saw fit. I can't speculate on what changes the next governor might make, and I don't think the nationality is particularly important from that perspective. So the prospect of an external appointment wouldn't change in any way the way in which you manage the institution? It very much depends upon the individual, doesn't it? You can imagine some external people wanting to do something very differently and others kind of continuing. I don't think the nationality of the person is important in terms of what changes they might make. It's entirely a matter for the government whom they appoint as the governor and the board members of the Reserve Bank. I don't want to speculate on what might or might not happen in the future. Finally, New Zealand unexpectedly cut rates by half a percentage point this week. Did you get a heads-up about the decision? What does it mean for your thinking now about monetary policy in Australia? We did not get a heads-up on that decision. Central banks, most of the time, do not give a heads-up to other central banks. This information is incredibly tightly held. It's very market sensitive. So we don't whisper in advance to one another what we're going to do. Does it have any immediate implications for us? No. Our exchange rate came down in response to the cut in New Zealand, but they are responding to the same forces that we're responding to. At the global level, the elevated desire to save rather than to invest is seeing interest rates low, and everyone is having to respond to that. They meet less frequently than us, so they chose to do it in one step. As I said before, we meet very frequently, which I think is good. We were able to do it in a couple of steps. We'll continue to look at the outlook to see whether we need to do more. It has no immediate implications for us at all. Governor, you said before--and I just want to clarify that I'm getting this right--that you thought that it was prudent to model or project scenarios where you have zero rates or look at unconventional policy like quantitative easing. Is that a fair assessment? I think, given the world we're in, it is prudent to look at these things. As I said, it's unlikely, but it is possible. The world's uncertain, and there are scenarios where we might decide that this is warranted. If that's the case, it's prudent for us to have done the work in advance to see what we would do. It's really contingency planning. We're thinking about what we might do. I understand. You've just talked about looking at what you would do in those scenarios. What would a scenario look like where you decided to take zero rates, since you've just acknowledged that you are preparing for it? You would appreciate it's difficult to speculate about this, but, if, globally, all central banks go to zero, then we would have to consider that as well. At the moment, every major central bank in the world is expected to cut interest rates over the next six months. The ECB has been at minus 40 basis points for years, and the market is expecting it to go to minus 60. The Bank of Japan has been at minus 10 for three years, and the market is expecting a decline there. There is the People's Bank of China, the Bank of Canada, the Bank of England. If they all cut interest rates, and they keep cutting--let's hope that doesn't happen, but it's possible--then we would need to think about what we would do in that scenario. We would probably need to move lower. That's one scenario. Have you looked at any time frames around that? No, I haven't. We've got market pricing for what other central banks are going to do, but the market pricing can move quite a lot quickly. I hope this doesn't happen. I hope all central banks don't end up going down towards zero. It is a possibility. I think it's a small possibility, but it is possible, and it's prudent for us to think about what we'd do in that case. I think the other scenario would be if growth in the Australian economy fell considerably short of our central scenario. We think the economy is going to pick up from here, but-- If growth failed to pick up, and the unemployment rate started rising noticeably, then all arms of public policy would need to address how to combat that. Lower interest rates, in that scenario, would be an option, as I hope fiscal measures would be as well, from both the state and the federal governments--and a package of structural reform as well. So, if the economy isn't doing very well and the unemployment rate's rising, we'll all need to look at how to support jobs growth, and lower interest rates, and, in extremis, unconventional policy measures would need to be on the table. When you say 'unconventional policy measures', let's go to QE, which is: what is the scenario that you have mapped out that would raise the possibility of going down that path? I think I can only repeat what I said before: if all interest around the central banks is going to zero-- Right. It's in that circumstance and condition. and if the economy underperforms materially our central scenario, growth is very weak--it stays in the one per cent range for a longer period of time--the unemployment rate starts rising, wages growth doesn't pick up and inflation's falling short, then we'll need to look at all monetary options, fiscal options and structural options. It's not like we're saying, 'We would do this if growth got to one per cent.' In broad terms, if the economy significantly underperforms the central forecast, then these options are going to need to be on the table. Is it possible to have QE decoupled from a zero-rate environment? It depends. If we're talking about QE as being the central bank purchasing government securities-- which I think in the Australian context is the most likely form it would take--in principle, we could do that at any level of interest rate and principal. Of course. I think it's reasonable to expect that we wouldn't do it at the current level of interest rate, or even a bit below the current level of interest rate. We'd need to be very close to zero to do that. We've got scope to lower interest rates at least a couple more times, using conventional monetary policy. Beyond that, I think we would have to draw upon the lessons that I talked about before and formulate a package that we thought was in the best interests of the country. In that world, I'd hope we were getting some fiscal support as well and support through the other mechanisms that I talked about. In talking about this, I want to make it clear that this is quite a long way from the central scenario. I think it's unlikely; it is possible, and it's prudent for us to be prepared. I want to return to the paper that was raised before by the deputy chair around housing modelling, the paper by Saunders and Tulip, which found: Is the expectation of the RBA that, if we continue to drop interest rates, you'll see a proportional increase in house It's certainly possible, because one of the ways that monetary policy works is by pushing up asset prices. That's how it works, and it's no surprise to me that equity markets around the world are very high at the moment, at a time when central banks are expected to cut interest rates--and the same mechanism works on all asset prices. I think the housing market is more complicated. I think the piece of work that Peter Tulip did was very good. I don't agree with all its particular conclusions, but, in the same spirit we talked about before, we encourage our staff to look at things from different perspectives, and we think it's important they go in the public domain. The paper is right, though, in saying that lower interest rates have pushed up housing prices. I think that's pretty clear. In my own view, there are other things that are probably more important over the past decade, and they go to population growth and the slow response to that on the supply side. I think we talked about this last time--that population growth picked up in Australia quite a lot and it took almost a decade for the rate of growth of the supply to respond to that. I'm just raising this in the context of the next phase in the housing market, because what we're seeing at the moment is quite strong population growth, which I think is good, but the additions to supply of the housing stock are slowing right down. New development is slowing down, and one of the issues we're going to keep a very close eye on over the next little while is what the supply of housing is doing. If developers cannot get finance, the supply of housing will slow a lot and we will be sowing the seeds for the next upswing. It's coming from this intersection, again, of strong population growth and the supply side that takes a long time to respond. I'm just a bit confused, because there have been differing opinions between the contribution to interest rates and its contribution towards rising house prices. I almost feel like there was an inconsistency where you agreed with the Tulip paper but then said you actually think there are other factors at the same time. I draw it in the context that there's another paper the RBA did in 2019-- and going back to some of the earlier questions asked about consumer behaviour. It said: If we agree that the RBA is cutting rates and it is inflating the house prices, which can then have a proportionate relationship to the amount of debt, yet someone in the RBA believes that's going to have a proportionate negative impact on disposable income--I just wonder what your reflection is on that analysis. Perhaps I can just say that, in an institution with a couple of hundred economists, you're going to get lots of different views on issues. My general approach here is not to suppress those views; it's to let people--I encourage people-- We put material out which is going to be contradictory, but we also-- I don't think the data points are necessarily contradictory. I'm asking for your reflections on this. I probably have a couple of reflections. I think low interest rates do have a significant effect on housing prices. We saw this particularly in the early 1990s and up to the early 2000s when with lower interest rates we became a low-inflation country, and financial liberalisation meant people could borrow a lot more and that got capitalised into housing prices. So, that's very clear. The recent lowering of interest rates, I think, has pushed up house prices a bit as well. The other factor, and in my view the more important factor, is the supply and demand dynamics in the housing market over recent times. You asked about the effect of lower interest rates on people's borrowing. I do think that lower interest rates increase people's incentive to borrow and, in the end, they will have higher mortgage debt. That was one reason why we did not pursue an aggressive return of inflation to target 18 months ago--because I was worried that lower interest rates would just encourage people to borrow more and, in the end, that would be unhelpful. In the current environment, I'm not particularly worried that the lower interest rates will cause people to race to the bank and borrow more and increase their leverage. I say that for two reasons. The first is that people have already borrowed a lot, and so the same borrowing psychology no longer exists. Their income growth isn't what it used to be. People are coming to the gradual realisation of that, so their appetite to borrow is diminished. They're more likely to want to pay down debts. I don't think the lower interest rates are going to see people run off to the bank and borrow. The other thing is that the supply of credit is still pretty restricted. The banks are being much tougher. Borrowing capacity for many borrowers, because of various changes, is down 10 or 15 per cent, so people can't borrow as much from the banks. And I'm sure you've all heard from your constituents how hard it is to get a loan from a bank at the moment and all the box ticking and form filling they have to do. The banks are not really in expansion mode for mortgage credit, and the borrowers don't want to borrow a lot more. At the moment, I'm not worried that we'll see a borrowing binge because of lower interest rates but we do need to keep an eye on that. If the economy does pick up, people are feeling good again, wage growth starts picking up and there are lower interest rates, they may decide now is the time to borrow again, particularly if housing prices are rising because the supply side's responding slowly. So, we need to keep an eye on it but today I'm not particularly worried about it. Governor, I refer to the statement of monetary policy that's just been released. Could you please go through which of the key forecasts were downgraded for 2019-20. Can I ask Luci to answer that, because she has all the facts and figures at her fingertips. So have I. I've got the printout. But what I can tell you, even before I shuffle to the right bit of paper, is that our wages growth forecast has been pushed out a little. We've been talking about this all morning, but a couple of things have influenced that. Mostly it's history--the fact that unemployment is starting from a point 0.2 percentage points higher than what we had three months ago and the fact that growth has been a little bit slower than what we had expected. So that influences the starting point, and also we've been quite influenced by our liaison program, which has noted that a lot more firms are now expecting wages growth to be the same as last year rather than having a few more being a little bit above. So wages growth profile has definitely been pushed out, so that's effectively lowering. Consequently, the inflation forecast has been lowered a bit, and the unemployment forecast is effectively starting from a higher point, although it has a very similar shape. So, as we talk about in the SMP, the near-term risks are to the downside and things are looking a big soggier to the downside in the near term because of this lower starting point or this weaker starting point. But one of the things we did end up doing is that the growth forecasts in the subsequent years are actually a bit stronger, so we get back to three or a little above in Just to be clear: in the SMP, the forecasts that have been downgraded are wages growth, economic growth, GDP growth and consumption growth. Consumption growth has been downgraded across the whole profile. GDP growth has been downgraded in the near term, for 2019, but it's been upgraded for 2021. Then it talks about the cash rate going down to 0.75 and then possibly to 0.5 in 2020. In light of the fact that previously, Governor, you've effectively called on the government to do more to support growth through fiscal means and the limitations of monetary policy in doing some of the heavy lifting here, how effective are these projected reductions in the cash rate going to be? Can I just clarify something: I have not called on the government to do fiscal expansion. It would be inappropriate for me to do that. I don't advise the government. What I've sought to do is lay out some options. Yes, additional fiscal support. It's up to the government to choose from the options. People ask me about what the options are, and I lay them out, and people can ignore that if they want to. You asked how effective lower interest rates would be. Coming back to what we talked about before, I'm confident that the lower interest rates affect the exchange rate and that helps many, many sectors of the economy, and I'm also confident that it will boost the net cash flow of the household sector. As I said before, people spend the extra money. So I'm confident those effects will work. But we do need to be realistic here. If the global economy does take a turn for the worse, it's going to be very hard for the Australian economy to do well, so we have a lot riding on that working out well. We can play our part at the central bank, and we're doing as much as we think is responsible, but we could face difficult circumstances if the international environment goes south, and there's very little the central banks can do about that. Another perspective of what's going on is that there's quite a large political shock going on around the world. We see this in the US and China. We've got Brexit. They've got problems in Italy, and at the moment there are increased tensions between Japan and South Korea. So all these international political tensions are weakening the global outlook, and it's very hard for central banks to completely offset that. The markets will look for us to offset that, but the reality is that, if we're getting this political shock globally that reduces growth prospects, central banks can't offset that completely for the community. So we have a lot riding on these political shocks dissipating. Would you say that we could withstand those shocks if we had some fiscal support and not just the monetary levers? It's hard to answer that, because you've really got to think about the specific scenarios. If the global economy has a very bad downturn, I'd expect our exchange rate to depreciate. That's the great stabiliser, so that would be a first-order thing that would help. We could ease monetary policy further, including some of the unconventional things we talked about before. In that environment, I would expect and hope for some fiscal support as well, but I'm not going to lay out what the specific circumstances are or what that support would look like. But, if the economy is not doing well and the global economy is not doing well, we need all arms of public policy to support the Australian economy. But that's not a call for the government to do more now. I understand. I just want to be clear about that. Governor, taking into account the forecasts just released in the Statement on monetary policy , you expect inflation to remain below target until mid-2021, which would mean five years of missing the target. How many more years of undershooting would be required before the Reserve Bank stopped attributing that undershooting to one-off forecasting mistakes? It's a good question. I don't characterise this as missing the target, because the target is very much the average inflation rate over time, and I accept that, the longer this period of sub-two per cent inflation goes on, the average is drifting down. I'm hoping that we can get back there. We're doing what we can, reasonably, to get back there. But we are fighting some very large global forces and some structural shifts in the Australian economy. We're committed to getting it back there. We're doing what we think is responsible to get it back there. I accept it's not as quick as many people would like, but we're doing what we think is responsible here. We have discussed already today the enthusiasm to have higher wages and wage growth for the economy. What effect do you believe that continuing to increase the super guarantee to 12 per cent will have on workers' disposable income? I don't have any comment on that. I haven't studied it carefully enough, so I would rather avoid commenting, if you don't mind. All right. I'll take that as what it is. We've also had a weak currency, and the lowest level in a decade this week, which should in theory be of benefit to the economy, at least in terms of inward investment. Has there been any evidence in recent years of foreign firms shifting their operations to Australia to take advantage of the weaker currency? I can give you one clear example. I'm not sure if I would quite characterise it as working exactly the way you talked about. Part of it is that it affects the competitiveness of Australian firms on global markets, and there are plenty of good examples around that. The drugs and pharmaceuticals industry is one clear example. With high-end manufacturing in Australia--a thing which I think is underappreciated--there has been very strong growth in exports over the past couple of years. That's going in the opposite direction to the question you are actually asking, but the effect of the exchange rate is very evident in that industry, in particular, where there has been very strong growth. That's something which has benefited this country rather than firms coming in. I suppose that has been one clear benefit to the country as a whole from the exchange rate. That said, the recent decline in the exchange rate is only recent. Going back three or four years now, we had a reasonable decline from the very high levels we had at the height of the resources investment boom. We have again seen a direct impact, I think, of the lower exchange rate there on both the tourism and education sectors in Australia. There are other things going on too, but they have been a direct beneficiary from that. So I suppose I'd answer your question slightly the other way around and just say: you can see the clear impact on parts of the Australian economy of the lower exchange rate. We've talked about wage growth. Going back, and just to prove that we're all doing our research, as part of the RBA's Low Wage Growth conference, the paper 'Wage Growth Distribution and Decline among Individuals: 2001-2017' highlighted the largest determinant 'by worker characteristic is age and education'. It's a paper by Kalb and Meekes. Governor, in light of the fact that you've delivered a number of speeches looking at demographic shifts, particularly around the fact that Australia has, by comparison, one of the lower average ages in population of countries, certainly developed countries, around the world, to what extent do you think that is being reflected in the data that we're seeing, which seems to suggest there is not much wage growth? That we're a fairly young country. I don't know; I haven't thought enough about whether that's a significant contributor. Luci, I don't know whether you've thought about that particular-- Has there been any modelling done by the RBA? Can you clarify the paper you're referring to? Okay; yes. This was a paper that obviously, like the other-- It didn't originate from within the RBA? Yes, like the other paper from the 2017 conference that you referred to earlier, this was not an RBA paper. Guyonne presented this paper. One of the things we found, as part of that conference, was there had been a range of things that people proposed as explanations for low wage growth that can't be evidenced in the data. Part of the discussion that happened at the end of that conference was that there were a lot of suspects for the murder, but a number of them ended up being cleared. It is actually very hard to say the change in the distribution or the composition of the population doesn't seem to have been driving that, that you can see it in other factors. I chaired that session. It was a good piece of work. I have a question around inflation targeting. The University of Chicago Press's Randall Kroszner recently told inflation targeting frameworks are based on 'faith', and the former Bank of India governor Raghuram Rajan said the QE--which is something the Bank of New Zealand has canvassed this week and we've discussed already--had little evidence to back it. He said: from the inflation target. Do you have a view on that? Yes, I have a strong view. I think it's wrong. Remember the experience of Australia in the 1980s? We had high and variable inflation. I lived through it as a child, but yes. In the 1990s, inflation came down. Since 1990, inflation has averaged 2.4 per cent. I accept it's a bit lower than that at the moment, but inflation expectations are very well anchored. Inflation has been low and stable. Why is that? It's the monetary policy regime, partly. So, inflation targeting has provided a very strong nominal anchor for our economy. I hope Australians understand that inflation in Australia over long periods of time will average two point something--notwithstanding the recent undershooting, which I think you need to put into its historical context--and that that understanding affects people's behaviour in a constructive way. There may be other points they were making that I would agree with, but I think the idea that inflation targeting hasn't worked is fundamentally wrong. It doesn't mean it can't be adjusted here and there, but having a flexible inflation target centred around an average inflation rate of two point something has served Australia incredibly well. We're now at the conclusion of today's hearing. You've survived another one. Thank you very much to all of those from the Reserve Bank who have presented before us today.

r190924a_BOA

australia

An Economic Update

lowe

I would like to thank the Armidale Business Chamber for the invitation to speak this evening. I grew up in regional New South Wales - in Cootamundra and Wagga Wagga - so it is a treat for me to have been invited to speak in another great regional city. Thank you. Tonight, I would like to provide you with an economic update. I will focus first on the global situation and then talk about the Australian economy. And finally, I will make some remarks about monetary policy. The main message on the global economy is that while it is still growing reasonably well, the risks are increasingly tilted to the downside. The main source of these downside risks are geopolitical developments in many parts of the world. These developments are creating considerable uncertainty and this uncertainty is causing businesses to reconsider their spending plans. This is making the international environment more challenging for us. On the Australian economy, there are two main messages. The first is that after having been through a soft patch, a gentle turning point has been reached. While we are not expecting a return to strong economic growth in the near term, we are expecting growth to pick up. Against this backdrop, the main source of domestic uncertainty continues to be the strength of household spending. The second message is a longer-term one. And that is the fundamental factors underpinning the longer-term outlook for the Australian economy remain strong. One of the ongoing challenges we face as a country is to capitalise on those strong fundamentals. forecasts for the next few years (Graph 1). Looking at this graph, one might ask why the concern: global growth has been stable and reasonable over recent times and the IMF is forecasting this to continue over the next couple of years. If this forecast were to come to pass, that would make for 12 years of solid growth. Looking at labour markets, one might also ask why the concern. Unemployment rates in most advanced economies are the lowest they have been in many decades, and businesses are finding it more difficult to fill jobs (Graph 2). These tighter labour markets are finally translating into stronger wages growth, with wages now increasing at close to the rates seen before the financial crisis in some countries. With inflation remaining low, this pick-up in wage growth is translating into real wage increases and strong growth in household spending. So why the concern? The answer is the increased downside risks generated by various geopolitical developments. The most prominent of these are the trade and technology disputes between the United States and China. Others include: the Brexit issue, developments in the Middle East, the problems in Hong Kong and the tensions between Japan and South Korea. The US-China disputes, in particular, are having a disruptive effect on international trade flows. Over the past year there has been no growth at all in international trade, despite the global economy growing at a reasonable rate (Graph 3). This weakness on the trade front is flowing through to factory output, with growth in industrial production slowing considerably. More broadly, though, the geopolitical concerns are creating considerable uncertainty about the future. This can be seen in measures of economic policy uncertainty constructed from news stories in leading media around the world (Graph 4). In the face of this uncertainty, it is not surprising that many businesses are preferring to wait before committing to significant investments; they are inclined to sit on their hands for a while and see how things play out. This is evident in the surveys of business investment intentions, which have fallen considerably (Graph 5). The effect is also evident in June quarter GDP figures, with GDP declining in Germany, the United Kingdom and Singapore. A particular concern is that if this uncertainty continues, businesses might decide not only to defer investment, but to also defer hiring. Of course, it is also possible that some of these uncertainties will be resolved. If this were to happen, the global economy could grow quite strongly as firms caught up on their capital spending in an environment of easy financial conditions. Notwithstanding this possibility, as the downside risks have come more clearly into focus, there has been a marked shift in the outlook for monetary policy globally. Almost all major central banks are expected to ease monetary policy over the year ahead, with the United States Federal Reserve and the European Central Bank having already moved in this direction (Graph 6). Given that inflation is low - and forecast to remain low - investors are also expecting central banks to maintain very accommodative settings of monetary policy for years to come. This expectation has had a major effect on long-term bond yields around the world. In Europe and Japan, investors are paying governments to hold their money for them interest rate of 0.5 per cent. For the world as a whole, around a quarter of the total stock of government bonds on issue has negative yields. And where yields are in positive territory, they are at very low levels and in many cases at the lowest on record. All this is making for a challenging international environment. I would now like to move to the Australian economy. Over recent times, our economy has been going through a soft patch. Over the year to June, GDP grew by just 1.4 per cent, which is the slowest year-ended growth for some years (Graph 8). We did not expect this slowdown, so it has come as a bit of a surprise. It is important, though, that we keep things in perspective. The economic expansion in Australia has now been running for 28 years. That is quite an achievement. Over such a long expansion, there are going to be ebbs and flows in growth. There are also going to be periods where growth is stronger than expected - as it was in the first half of 2018 - and other periods, like now, where growth is weaker than expected. With the benefit of hindsight, there are a few factors that help explain the slowing in the Australian economy over the past year. One is the international developments that I spoke about earlier. While Australia has been less directly affected by the US-China trade disputes than have many other countries, there is an indirect effect through slower global growth and increased global uncertainty. A second and more important factor is weak consumption growth. Over the past year, there has been no growth at all in consumption per person, which is an unusual outcome at a time when employment is growing strongly (Graph 9). An important part of the explanation here is that household disposable income has been increasing only slowly for an extended period, reflecting both subdued wage increases and strong growth in taxes paid. The persistence of slow growth in household income has led many people to reassess how fast their incomes will increase in the future. As they have done this, they have also reassessed their spending, particularly on discretionary items, which has been quite weak over recent times (Graph 10). Not surprisingly, spending on household essentials has been much less affected. Another part of the explanation for weak growth in household spending is the adjustment in the housing market. As housing prices have fallen, there has been a marked decline in housing turnover, with the turnover rate having declined to the lowest level in more than 20 years (Graph 11). With fewer of us moving homes, spending on new furniture and household appliances has been quite soft. So too has expenditure on moving costs and real estate fees. More broadly, the correction in the housing market has also affected the economy through its impact on residential construction activity. A third factor contributing to the slower growth has been the drought. Across the Murray-Darling Basin, including here in the Northern Tablelands, farmers have faced extremely dry conditions. Indeed, as indicated in this graph, in some areas conditions have been the driest on record (Graph 12). Reflecting this, farm output in Australia has fallen for the past two years and there has been a sharp drop in farm income as farmers have had to cope with the increased costs for obtaining feed and water. These difficult conditions have contributed to the weakness in overall household incomes and consumption, and the effects are particularly felt in regional communities. The drought has also put upward pressure on food prices over the past year, particularly for bread, milk and meat. We are all hoping that the drought breaks soon. Even after accounting for these three factors - the slowdown overseas, weak growth in household disposable incomes and the drought - part of the slowing in the Australian economy remains unexplained. This is especially so taking into account the labour market data, which continue to paint a stronger picture of the economy than the GDP data. Over recent times, employment growth has been stronger than was expected. Over the past year, the number of people with a job increased by 2 1/2 per cent (Graph 13). Reconciling this with GDP growth of just 1 1/2 per cent remains a challenge, because, normally, output growth exceeds employment growth, rather than falls short. We are seeking to understand what is going on here. It is possible that it is just measurement noise, but we can't yet rule out something more structural. The other striking feature of the labour market over recent times has been a large increase in labour supply. In particular, there has been a material lift in the labour force participation by women and by older Australians (Graph 14). As a result, the increase in labour supply has more than outstripped the increase in labour demand. Reflecting this and despite the strong employment growth, the unemployment rate has moved higher since the start of the year to 5 1/4 per cent. This increase in labour supply is a positive development, but it does mean that it is proving quite difficult to generate a tight labour market with the flow-on consequence that wage increases remain subdued. Over the past year, the Wage Price Index increased by just 2.3 per cent (Graph 15). This is a pick-up from the rates of recent years, but the lift in wages growth looks to have stalled recently. Another relevant factor here is the ongoing caps on wage increases in the public sector. Low wages growth is one of the factors contributing to low inflation outcomes. Over the year to June, inflation was 1.6 per cent, in both headline and underlying terms (Graph 16). Another contributing factor is the adjustment in the housing market, with rents increasing at the slowest rate in decades and declines being recorded in the price of building a new home in some cities (Graph 17). Another factor is various government initiatives to address cost-of-living pressures, with these initiatives pushing down inflation in administered prices. The price rises for utilities are also much lower than over recent years. Working in the other direction, the drought and the depreciation of the exchange rate have been pushing up retail prices over the past year. Looking forward, there are some signs that, after a soft patch, the economy has reached a gentle turning point. This is evident in the fact that GDP growth over the first half of this year was stronger than it was over the second half of last year (Graph 8). We are expecting a further modest pick-up in the quarters ahead. This outlook is supported by a number of developments, including lower interest rates, the recent tax cuts, the depreciation of the Australian dollar, ongoing spending on infrastructure, the stabilisation of the housing markets in some cities and a brighter outlook for the resources sector. It is reasonable to expect that, together, these factors will see growth in the Australian economy return to around its trend rate next year, although there are some obvious risks to this outlook. One factor that should help is an expected pick-up in household disposable income. Many households are currently receiving larger tax refunds due to the low and middle income tax offset. These payments will boost aggregate household income by 0.6 per cent this year. Past experience suggests that around half of these tax refunds will be spent over coming quarters. Household disposable income is also being boosted by lower interest rates, although the effect is uneven across the community, with lower rates reducing the income of those households who rely on interest income. Household spending should also be supported by an increase in housing turnover. Working in the other direction, though, is a further contraction in residential construction activity. Another positive element is likely to come from the resources sector. Mining investment is expected to increase over the next year, after having declined for six years as the LNG investment boom wound down (Graph 18). Mining companies are increasing their investment not only to sustain their current production levels but, in some cases, to expand capacity as well. There has also been a pick-up in exploration activity. To be clear, we are not predicting a return to boom-time conditions in the resources sector. But we are predicting better times for the sector ahead. Business investment elsewhere in the economy is also expected to move higher. Earlier I discussed how uncertainty globally is affecting the outlook for investment in many countries. Fortunately, we don't see the same spike in the measure of policy uncertainty in Australia that I showed in the earlier graph for the world economy. There has, however, been some softening in measures of business conditions - from well above average to around average. The investment outlook is being supported by a solid pipeline of infrastructure projects. This ongoing investment in infrastructure is not only supporting demand in the economy at a time when this is needed, but it is also adding to the supply capacity of the economy and directly improving people's lives, including through providing better services and reducing transport congestion. Together, it is reasonable to expect that these various factors will see annual growth pick up from here. Apart from the international uncertainties, the main source of uncertainty around this outlook continues to be the strength of household spending. It remains the case that a sustained pick-up in household spending will require faster growth in household incomes than we have seen over recent times. As we grapple with these issues, it is important that we do not lose sight of the fact that the Australian economy has strong fundamentals. Australia is fortunate in having enviable endowments of natural resources, both in terms of minerals and agricultural land. We have a reputation as a highly reliable supplier and a producer of high-quality clean food. We also have close links with the rapidly growing countries of Asia. Three of the four most populous countries in the world - China, India and Indonesia - are in our neighbourhood. And our ties with these countries are strengthened by the many people from there who live, work and study in Australia. Our demographics are also reasonably favourable. Our population is aging less quickly than that of many other advanced economies. The population is also growing relatively rapidly for an advanced economy - 1.7 per cent a year, compared with 0.6 per cent in the United States and declining populations in some countries in north Asia and Europe. Immigration has been a strong contributor to this: almost half of us were born overseas or have at least one parent who was born overseas. While we have struggled to meet the infrastructure needs that come with this growing population, it does bring a dynamism that is not easily matched in countries with declining populations. We also have a highly talented, flexible and adaptive workforce. We have strong public institutions, a well-established macroeconomic framework, and the rule of law is respected. There is also a demonstrated record of responsible fiscal policy and low public debt. And, finally we benefit from having both a flexible exchange rate and a flexible labour market. So, our fundamentals are strong. The challenge we face is to fully capitalise on these fundamentals. If we can do this then I am confident that we can, once again, experience strong growth in real incomes in I would like to finish with some remarks about monetary policy. As you would be aware, the Reserve Bank Board lowered the cash rate in June and July to a new low of 1 per cent. Financial markets are pricing in further reductions in the cash rate over the next year. Our decisions - and the expectations of investors about the future - reflect both international and domestic factors. On the international front, as I discussed earlier, interest rates around the world are low and they are moving lower. There are many reasons for this, but the central reason is that the global appetite to save is elevated relative to the global appetite to use those savings to invest in new productive capital. When lots of people want to save and there is not much demand for those savings, savers earn low returns. We live in an interconnected world, which means that we cannot completely insulate ourselves from long-lasting shifts in global interest rates. Our floating exchange rate gives us a degree of monetary independence, but we can't ignore structural shifts in global interest rates. If we did seek to ignore these shifts, our exchange rate would appreciate, which, in the current environment, would be unhelpful in terms of achieving both the inflation target and full employment. As I have spoken about on other occasions, the key to more normal interest rates globally is addressing the factors that are leading to a depressed appetite to invest relative to the appetite to save. Whether or not this will happen, time will tell. But as a small open economy, we have to take the world and global interest rates as we find them. On the domestic front, there has been an accumulation of evidence over recent times that the economy can sustain lower rates of unemployment and underemployment than previously thought likely. The flexibility of labour supply also means that strong rates of employment growth can be sustained without inflation becoming a problem. These are both positive developments. Inflation has been below the 2-3 per cent medium-term target range for some time now for the reasons that I spoke about earlier. Looking ahead, inflation is expected to pick up, but to remain below the midpoint of the target range for some time to come. The decisions to ease monetary policy in June and July were taken to help make more assured progress towards full employment and the inflation target. Further monetary easing may well be required. While we are at a gentle turning point and expect growth to pick up, the strength and durability of this pick-up remains to be seen. Regardless of the short-term outlook for monetary policy, the point about the solution to low global rates is relevant here in Australia too. We will all be better off if businesses have the confidence to expand, invest, innovate and hire people. Given Australia's strong fundamentals, this is not out of our reach, but it does require constant effort. At our Board meeting next week, we will again take stock of the evidence. It is nevertheless likely that an extended period of low interest rates will be required in Australia to make progress in reducing unemployment and achieving more assured progress towards the inflation target. The Board is prepared to ease monetary policy further if needed to support sustainable growth in the economy, make further progress towards full employment, and achieve the inflation target over time. Thank you for listening. I look forward to answering your questions.

r191001a_BOA

australia

Remarks at Reserve Bank Board Dinner

lowe

Good evening. On behalf of the Reserve Bank Board I would like to thank you for joining us at this community dinner. The Board held its monthly meeting here in Melbourne today. This was the first meeting that we have held in our new offices on Collins Street after last year selling our building on the corner of Collins and Exhibition Streets. So even if we are in a different location, it is really good to be back in Melbourne. As you are probably aware, at our meeting today, the Board decided to cut the cash rate by a quarter of one per cent to 0.75 per cent. This decision followed a detailed assessment of both global and domestic developments. Globally, the main issue at the moment is the uncertainty generated by a series of geopolitical events, particularly the US-China disputes over trade and technology. Understandably, this uncertainty is causing many firms around the world to sit and wait before proceeding with costly investment decisions. At the same time, many businesses are having to deal with disruptions to their supply chains. The result of all this is that after a period of reasonable growth in the global economy, the risks are clearly to the downside. Central banks are responding to these downside risks by lowering interest rates. With inflation low - and expected to remain low - they are seeking to take out some insurance against the possibility of a noticeable slowdown in economic growth. From a longer-term perspective though, central banks have for some time been responding to fundamental shifts in the global appetite to save and invest. The underlying explanation for low interest rates globally is that the global appetite to save is high relative to the global appetite to invest. Like many things in economics it comes down to supply and demand. When the global supply of savings is high relative to the global demand for funding to invest in new capital, the price of savings - or the global interest rate - is going to be low. There are certainly other factors at play as well, but savings and investment decisions are at the heart of the issue. This means that the key to a return to more normal interest rates globally is addressing the factors that are leading to the low appetite to invest, relative to the appetite to save. This is mainly a task for governments and businesses, not for central banks. Whether or not this will happen, only time will tell. But as a central bank in a small open economy we have to take the world as we find it. While we might wish it were otherwise, we can't ignore these global trends and their impact on our economy. So, the Board is watching these global developments. Domestically, the Board today discussed how the Australian economy appears to have reached a gentle turning point. The economy has been through a soft patch recently, but we are expecting a return to around trend growth over the next year. There are a number of factors that are supporting this outlook. These include the low level of interest rates, the recent tax cuts, ongoing spending on infrastructure, signs of stabilisation in some established housing markets, and a brighter outlook for the resources sector. Together, these factors provide a reasonable basis for expecting that the economy will remain on an improving trend from here. The Board has also been paying close attention to the labour market. Over recent years, employment growth has consistently surprised on the upside, which is good news. At the same time, the strong demand for workers has been met with strong growth in the supply of available workers, with the participation rate now at a record high. Partly as a result of this flexibility on the supply side, unemployment is a little higher than it was at the beginning of the year, and there has not been much upward pressure on wages. In turn, this has contributed to the extended run of inflation outcomes below the medium-term target range. In considering these developments today, the Board decided that it was appropriate to ease monetary policy further. We are seeking to make more assured progress towards both full employment and the inflation target. We still expect to make progress on both fronts, but that progress is slower than we would like. Today's decision will help. In reaching that decision, the Board recognises that the impact of monetary policy on the economy has changed over time, and that there can be some undesirable side effects from low interest rates. The many people who write to me saying how low interest rates are hurting their finances serve as a constant reminder of this. But, importantly, the Board also recognises that monetary policy still works. It works to support employment, jobs and income growth across the economy. Today's decision, together with our decisions in June and July, will assist on each of these fronts. In doing so, these decisions will promote the collective economic welfare of the Australian people, which we need to remember is the ultimate goal of monetary policy. Even so, my earlier point about the solution to low interest rates globally is relevant here in Australia too. We will all be better off if businesses have the confidence to expand, invest, innovate and hire people. Given Australia's strong longer-term fundamentals this should not be out of our reach, but it does require constant effort. One part of this effort could be a renewed focus on structural measures to lift the nation's productivity performance. At our meeting today, as well as considering monetary policy, the Board had its six-monthly deep dive into financial stability issues. On Friday, the Bank will be releasing the results of this in our . Ahead of that, I would highlight three issues we discussed. The first is that internationally, there seems to be a disconnect between the uncertainty that investors feel about the economic situation and the compensation that they require for holding risk. Normally when people feel uncertain about the future, they want to be compensated for taking on risk. At the moment though, despite the uncertainty, credit spreads are low and asset prices are generally high. At our meeting today we talked about the possibility that a shock somewhere in the global system could cause a recalibration, leading to a disruptive repricing of risk. The second issue is that the resilience of Australia's financial system has steadily improved over recent times. The core capital ratios of our banks are now well within the top quartile of banks around the world. Our banks are well placed to withstand a wide range of shocks and their position will be further strengthened as they meet requirements to increase their loss absorbing capacity further over the next few years. Lending standards have also been strengthened, although in some areas the pendulum may have swung a bit too far. It is important that our financial institutions support small businesses in particular. Lenders should not be so scared of making a loan that goes bad that they don't provide the credit that the economy needs. One other risk area that we are paying close attention to is cyber and technology risks. Banks' systems have become more complex and digital platforms are now key to banking. We need to make sure that these systems are safe and resilient. The third issue is that while the Australian household sector has a high level of debt, it has also built up substantial buffers. All up, the balances in mortgage offset accounts and redraw facilities amount to 16 per cent of outstanding housing debt. This is equivalent to around 2 1/2 years of required mortgage payments at current interest rates. It is important to recognise though that this figure masks a lot of variation across households. We estimate that around a quarter of households with a mortgage have either no buffer or a very small one. Loan arrears remain low, although they have risen over recent years. Also, we estimate that for almost 4 per cent of borrowers their current loan balance exceeds the value of their property. Over half of these borrowers are in Western Australia where there has been a large and persistent decline in housing prices. So this is an area that bears watching. On a completely different matter, I would like to draw your attention to the fact that we will be releasing the new $20 note next week, on 9 October. This note is printed here in Melbourne, at our printing works in Craigieburn. I have brought along a few notes tonight hot off the presses for you to have a look at. I sometimes get asked why the Reserve Bank is replacing the existing series of banknotes, especially when more of us are moving to electronic payments. People also wonder with contactless payments now so ubiquitous, do we still need banknotes? Given these questions, it might surprise you then to know that the demand for banknotes in Australia is still strong. The stock of banknotes on issue, relative to the size of the economy, is close to the highest it has been in 50 years. It is possible that low interest rates are part of the story here. All up, there are 14 $100 notes on issue for every Australian, 30 $50s, and 7 $20s. That makes for around $3000 worth of banknotes on issue for every Australian. I, for one, don't have anywhere near that amount. At the RBA, we have recently undertaken some work to understand the whereabouts of all these banknotes. It is hard to know exactly, but we estimate that around a quarter are used to make legitimate day-to-day transactions within Australia. It also appears that between half and three- quarters are held as a store of value in safes, under beds and at the back of cupboards, both here in Australia and elsewhere around the world. We estimate that a further 4 to 8 per cent are used in the shadow economy, either to hide transactions from the tax office or to undertake illegal transactions. Finally, it appears that between 5 and 10 per cent of banknotes are either simply lost, maybe at the beach, or destroyed, perhaps in a natural disaster. So, as best we can tell, that is where all the banknotes are. One indicator of the decline in the use of banknotes for day-to-day transactions is the fact that the value of cash withdrawals through ATMs has fallen by a quarter over the past decade. Australians have clearly embraced the convenience of contactless payments. We are also increasingly embracing payments through Australia's fast 24/7 payment system, the New Payments Platform. If you have not already got your PayID to use the simple addressing feature of this new system, I encourage you to get one. If your bank is not offering this new fast payment service to you, I encourage you to ask them why. And if you are not happy with the answer, give some thought to switching banks. Before finishing I would like to return to the question of why we have been issuing a new series of banknotes. The main answer is to keep ahead of the counterfeiters. We have long had one of the safest and most secure currencies in the world. The level of counterfeiting in Australia is low and declining, with around 15 counterfeits detected per million banknotes in circulation in recent times. This compares with rates above 50 for some other major currencies. But the counterfeiters don't stand still and we need to stay ahead. So we have added new high-tech security features to the new banknotes so that they remain safe, secure and reliable. For those of you who still use banknotes for your spending, it would be good to see a bit more use and spending out there. Finally, I would like to thank you again for joining us this evening. We are looking forward to hearing directly from you about how things are going here in Victoria.

r191029a_BOA

australia

Some Echoes of Melville

lowe

Thank you for the invitation to deliver this year's Sir Leslie Melville lecture. When Ian Macfarlane delivered the inaugural lecture in this series in 2002, he said: 'any objective assessment of achievements would place Sir Leslie among the most distinguished Australians of the past century'. It is a great privilege for me to be able to honour those achievements today. Leslie Galfreid Melville had a long and close association with the Reserve Bank of Australia. He was a member of the Reserve Bank Board for most of the time between 1960 and 1975. And before joining the Board, he played a critical role in the debates that shaped the mandate given to the Reserve Bank in 1959. It is six decades now since that mandate was passed by Parliament. It has more than stood the test of time. From this perspective alone, we have a lot to thank Leslie Melville for. In today's lecture I would like to discuss two issues that Melville had strong opinions on. The first is the appropriate objectives of the central bank. And the second is his view regarding the impossibility of zero interest rates. Both of these issues have echoes in today's discussions of monetary policy. Over recent decades there has been much discussion in the academic and policy communities as to whether a central bank should have a single mandate - price stability - or a dual mandate - price stability and full employment. In practice, we see examples of both around the world. Here in Australia though, the Reserve Bank of Australia has neither a single nor a dual mandate - we have a triple mandate. Under the legislation passed in 1959, it is the duty of the Reserve Bank Board to ensure that its policies are directed to the greatest advantage of the people of Australia so as to best contribute to: 1. the stability of the currency of Australia; 2. the maintenance of full employment in Australia; and 3. the economic prosperity and welfare of the people of Australia. This triple mandate was taken from earlier legislation, passed in 1945, that set the objectives for the central banking division of the Commonwealth Bank. It had its origins in a post-World War II Australia, when ensuring economic stability and high levels of employment were very much top of mind. Establishing such a broad mandate for the central bank ran against the conventional wisdom of the time, which was that central banking was about just currency and banking. Indeed, in his book on the history of the Reserve Bank, Boris Schedvin was moved to write: 'This bold declaration of responsibility was a landmark in the history of central banking.' It was a landmark in the sense that the Australian Parliament recognised that central banking was not only about money and finance, but it was also about jobs and the welfare of our society. As the current governor of the Reserve Bank of Australia, I very much share this perspective. Ultimately, central banking is not only about finance and money; rather, it is about enhancing the economic welfare of the people we serve, primarily through achieving price and financial stability and maximum sustainable employment. Melville had an important hand in setting this direction. His contribution goes back to at least 1936, when he made a lengthy submission to the Royal Commission on the Monetary and Banking Systems in Australia. The first sentence of that submission reads: 'The ultimate purpose of monetary policy is to enable the economic system to achieve the optimum use of available resources as far as this is possible'. It was then 23 years later that this idea - in different words - found expression in the . It is worth recalling that Melville had less success in his quest for full employment to be incorporated into the charters of global economic institutions that were set up after World War II, including the International Monetary Fund. This was not for want of trying - at all the major international economic conferences at the end of the war, he was a strong advocate for what became known as the 'Full Employment Approach'. But back to the world of central banking. Since the early 1990s, the conventional wisdom has been that the best contribution a central bank can make to full employment and economic welfare is to maintain low and stable inflation. This is because by keeping inflation under control and within a narrow range, the central bank can reduce uncertainty and economic distortions and, in so doing, provide a stable foundation for people to make decisions about savings and investment. In turn, this provides the basis for reaching the maximum level of employment that is achievable given the choices that society makes about things such as the social safety net, the nature of employment arrangements, and training and education. After the high inflation 1970s and 1980s, many central banks adopted an inflation target as the means to deliver the sought-after low and stable inflation. Central banking in many parts of the world became all about inflation control, and adopting an inflation target became the way of delivering that control. As part of this shift, central banks also changed their communication to focus very much on inflation outcomes. Accountability mechanisms were also developed to make sure that the central bank kept its focus squarely on inflation. This approach made a lot of sense and it worked. Inflation rates have been lower and more stable. Central banks have established strong anti-inflation credentials and expectations of high inflation have been wrung out of the system. Core inflation in the advanced economies has been consistently around 1-2 per cent for the past 20 years (Graph 1). And measures of inflation expectations suggest that inflation is expected to remain low for many years to come. Despite this success, things have not exactly worked out as hoped, and recent experience is causing some rethinking of aspects of the conventional wisdom. I would draw your attention to two aspects of that experience. The first is that low and stable inflation is not a sufficient condition for financial stability and thus ultimately full employment. Indeed, it is possible that, in some circumstances, a low and stable inflation environment provides fertile ground for the emergence of some financial stability risks. As we have seen too often, the crystallisation of these risks can have very large welfare consequences, with people losing their jobs, their incomes and their savings. So just achieving low and stable inflation is not enough to maximise economic welfare. The second aspect that I would like to draw your attention to is that there is more uncertainty than there was previously about what is required to deliver short-run inflation control. This partly reflects some powerful worldwide forces - including technology and increased competition from globalisation - that are affecting inflation dynamics almost everywhere. So it is more difficult to manage inflation tightly than it once was. In my view, the Australian approach to inflation targeting together with our broad mandate are better suited to this changing world than are more rigid arrangements. In Australia, since the early 1990s we have had a flexible inflation target. Our target is to achieve an average rate of inflation, over time, of between 2 and 3 per cent. This means that there is an acceptable degree of variation in inflation from year to year, and we have been prepared to use this flexibility. Our focus is very much on the medium term - hence 'on average' and 'over time'. The Board is seeking to provide a strong nominal anchor that people can rely on when making their decisions. Most people in our society can cope with small variations in inflation from year to year, but medium-term uncertainty is much harder to deal with. Importantly, we have always seen the inflation target as nested within the broader objective of welfare maximisation. This means that the question the Reserve Bank Board asks itself when making interest rate decisions is how those decisions can best contribute to the welfare of the Australian people. In particular, we are seeking to achieve the maximum sustainable rate of employment consistent with inflation being at target. And we are seeking to do this in a way that limits the build-up of financial imbalances that can be the source of instability down the track. In doing this, we can make a material contribution to the welfare of the society we serve. I acknowledge there is an element of judgement and discretion in this approach. Certainly, there is more judgement involved than in an approach to monetary policy that mechanically sets interest rates so that forecast inflation is at the target in two years' time. My view is that our more flexible system has served Australia well and can more easily accommodate the changes taking place in the economic system than can other approaches. More generally, I also see longer-term benefits in terms of the standing of central banks in the community if they explain their decisions in terms of jobs and incomes, not just short-run variations in inflation rates. That's not to say inflation control is unimportant - because it clearly is important. Rather, we need to remember that it is a means to an end, and that end is welfare maximisation. I suspect that this is a sentiment that Melville would have agreed with. I want to emphasise that the discretion we have and our broad mandate to promote the economic welfare of the Australian people do not constitute a licence for the Reserve Bank Board to pursue or advocate economic policies outside our area. Our focus is on inflation control, the labour market, the payments system and financial stability. Dealing with these matters is our contribution to our collective welfare. I also want to emphasise that the flexibility of our inflation target and our broad mandate - and the discretion it allows - requires a high level of transparency and accountability from us. When we make decisions, there is always an element of judgement and we have to wrestle with difficult trade-offs, where reasonable people can come to different judgements. This means you should expect us to explain our decisions clearly. You should also expect us to explain the various trade- offs we face and how we are balancing them. And as these trade-offs become more complicated in today's world of very low interest rates, you should expect us to be as clear as we can be about how we are viewing these trade-offs and how they are affecting our decisions. That brings me to my second topic, and that is the very low interest rates around the world. Reading through Melville's writings, it is pretty clear that he would have been perplexed about the current state of affairs, in particular the prevalence of zero and negative interest rates. Writing in the in 1938, Melville said 'Zero interest is a limiting, but unattainable, value analogous to infinity.' He went on to argue that 'the notion that a zero rate of interest is possible assumes that there is a practicable limit to the amount of useful material which can be profitably employed by society'. To reinforce this point, he went on to write that at zero interest: 'Roads would be levelled and straightened regardless of cost. In some places mountains would be dug away and valleys filled to provide residential and agricultural land. Deserts would be watered, beaches would be built in places accessible to cities and provided with artificial sea and sunlight.' I found it surprising to read this - not just because of the obvious engineering challenges - but because in other writings, Melville was very sceptical about public works and public debt. Understandably, he wanted public money to be spent wisely. So this was quite a contrast. But it reflected his strong view that zero interest rates were an impossibility, because at zero interest rates, people would just borrow, invest and consume and satisfy all their wants. So as I said, he would be perplexed at the current state of affairs. As things currently stand, the entire Swiss government nominal bond yield curve is in negative negative territory. The Swiss government, for example, can borrow for 30 years at an interest rate of -0.2 per cent. If it were to issue a zero coupon security at this yield, it would mean that the buyer would give the Swiss government 106 Swiss Francs today and receive back just 100 Swiss Francs in 30 years' time, with no other payments between now and then. That is remarkable. There have certainly been other periods when real bond yields were negative, but such widespread negative nominal yields is unprecedented. It is not just governments that can borrow at negative yields. Over recent times, private companies including Coca-Cola, Orange and Siemens have issued unsecured bonds with zero coupons and negative yields. It has also become common for European banks to issue covered bonds with negative yields. And in Denmark, at least one bank has offered residential mortgages at a negative rate of interest: -0.5 per cent, although after fees the effective interest rate is just in positive territory. All up, there are now US$14 trillion of bonds trading at negative yields around the world (Graph 3). And around a quarter of all government bonds globally are now trading at negative yields. Back in 1938, Melville would have struggled to understand this. And, today in 2019, many people also wonder how things could have come to this. In a moment, I will offer some explanations. Before I do so, though, it is worth pointing out than even back in 1938, Melville's views about zero interest rates were contested. Following Melville's article, Brian Reddaway and Richard Downing published a conflicting view in the with arguments that still have resonance today. They pointed out that even with zero interest rates, there is a limit to borrowing by both individuals and governments. This is because, even if the interest rate is zero, the principal does need to be repaid. And this means that projects undertaken with borrowed money still need to generate a return that is sufficient to repay that principal and also compensate for risk. I suspect that some of Melville's engineering ideas wouldn't have met this test. So how then do we explain these low interest rates around the world? Like many questions in economics, a reasonable place to start is supply and demand. Over recent times, the global supply of savings has been high relative to the demand to use those savings to invest in new productive capital. As a result, the return to savers, especially those who save in low-risk assets, is low. The question is then: why is the global appetite to save high relative to the appetite to use those savings to invest in new productive capital? Let me start with savings, and I will focus on three issues. These are: demographic trends; the integration of Asia into the global economy; and the legacy of high levels of borrowing in the past. First, demographics. Globally, some very large shifts are taking place. In particular, the population in many countries is aging rapidly and life expectancy is continuing to increase (Graph 4). After increasing for many decades, the share of the global population that is aged between 15 and 64 is now declining and this is expected to continue. The United Nations estimates that average life expectancy has increased from just 55 years in 1970 to over 70 years now, and this trend too is expected to continue. While retirement ages have also increased as people live longer, retirement ages have not increased to the same extent as life expectancy, so people are having to plan for more years in retirement, and have been saving more to finance this. A second important factor influencing global saving outcomes is the rise of Asia. Asian countries now account for around one-third of global GDP, up from just 10 per cent in the early 1980s (Graph 5). People in Asia tend, on average, to save a fairly high share of their incomes. This partly reflects the less extensive social safety nets and the nature of the financial systems. As incomes have risen in Asia, average savings rates in the region have fallen a little in recent years, but they remain higher than in most other parts of the world. A third factor affecting savings outcomes in many economies is the high level of borrowing in previous years (Graph 6). While the experience differs across countries, at the global level, the stock of debt outstanding relative to GDP has steadily increased for the past 50 years, and is now around a record high. The big shift has been in private debt, particularly in the advanced economies, but public debt has also trended higher over recent decades, after declining following One probable consequence of high levels of debt is that people are more careful with their spending and are less inclined to take on yet more debt. This is especially so when income growth has disappointed, as it has over recent times. In a number of countries, both government and households feel constrained by their previous decisions to borrow and are seeking to put their balance sheets on a sounder footing. One way they can do this is by spending less and saving more. So these are some of the factors that are influencing global saving outcomes. I would now like to turn to the investment side of the equation. This is important as you might recall that Melville argued that at zero interest rates there would be an almost unlimited number of things to invest in. Today's reality, though, is somewhat different. Here again I will point to three inter-related factors. The first is the high level of uncertainty. The second is slower population growth. And the third is some pessimism about future productivity growth. It is well understood that there has been a high level of global economic policy uncertainty over recent times. This is evident in measures of policy uncertainty calculated from news stories in leading media around the world (Graph 7). The sources of this uncertainty are well known. The long list includes the trade and technology disputes between China and the United States, the Brexit issue, the ongoing tensions in the Middle East, the problems in Hong Kong and the tension between Japan and South Korea. Not surprisingly, these events are making businesses nervous and they are responding by putting off investment decisions. Many would prefer to wait until some of the uncertainties are resolved before proceeding. As important as these current geopolitical tensions are, they are not the full story. Businesses face a range of other significant uncertainties, including from the rapid pace of technology change, increased competition as a result of globalisation and ongoing changes to regulatory arrangements. It is probable that the uncertainties generated by these structural changes are interacting and being amplified by the geopolitical issues. In this context, it is worth noting that despite the marked decline in global interest rates (and some decline in the cost of equity), average hurdle rates of return for new investments in many countries have not changed much (Graph 8). It seems that there is a global norm for hurdle rates somewhere around the 13 to 14 per cent mark and it is hard to shift this norm, even at record low interest rates. There are a couple of possible explanations for this. The first is that the reduction in the cost of borrowing has been offset by a rise in the required risk premium due to the uncertainties that I spoke about. If this were so, the hurdle rate would be unchanged, with lower interest rates just compensating for the riskier environment. The second possibility is that some firms have been slow to adjust to the new reality of low interest rates. We hear reports that a hurdle rate of return of 13 to 14 per cent has been hard- wired into the corporate culture in some companies. Changing this hard-wiring is difficult and time consuming. However, from our liaison with Australian companies, we do know that some companies have lowered their hurdle rates and this is opening up new opportunities for them. It would be good to hear more such reports. My view is that there is an element of truth to both explanations: risk premiums have gone up and, in some cases, hurdle rates of return are too sticky. A second explanation for lower levels of investment is a slower rate of population growth, especially in the advanced economies (Graph 9). In the late 1960s, population growth in the advanced economies was running at 1.2 per cent. Since then, population growth has steadily declined, and is now running at just 0.4 per cent. A number of countries in north Asia and in Europe have declining populations and other countries are forecast to join that group before too long. Slower population growth means there is less need to add to the capital stock to accommodate more people. Less home and other building is required, and there is less need to invest in infrastructure to meet the needs of a growing population. While there are some specific areas where more investment might be needed, the overall effect of lower population growth is to reduce investment. A third explanation for lower investment demand is that people are less optimistic about future economic growth. The slower population growth is part of the story here, but it is not the full story: there is less optimism about future productivity growth as well. One way of seeing this shift is in estimates of advanced economy potential growth (Graph 10). In the mid 1980s, estimates of potential growth were clustered around 3 per cent. They are now clustered around half of this. Similarly, there has been a downward shift in estimates of potential growth in Asia, especially in China and South Korea. With economies expected to grow less quickly than in the past, there is less incentive to invest. So these are some of the main factors influencing saving and investment globally and that help to explain low global interest rates. But this is not the full story. Central banks are also playing a role. While our regular explanations for interest rate decisions typically don't reference the broader structural factors that I have just discussed, these structural factors have had a powerful influence on the setting of interest rates over recent times. In addition, central banks have responded to the cyclical position by lowering interest rates and also by buying large quantities of government and long-term securities (Graph 11). Before the financial crisis, the central banks held only around 5 per cent of government securities on issue. Today, they hold nearly 30 per cent. In Japan, the Bank of Japan holds almost 50 per cent of government securities on issue, with these holdings equivalent to 80 per cent of Japanese GDP. Another significant purchaser of government securities over recent times has been pension funds, particularly in Europe. As prudential regulation has been strengthened, the funds have purchased additional long-dated assets to maturity match their long-dated pension liabilities. One way of seeing the effect of these various purchases is the term premium (Graph 12). Normally, when an investor purchases a 10-year security, a risk premium is earned over and above the return that is expected from rolling a short-term investment for 10 years. This premium, which historically has averaged around 1 1/2 per cent, is now negative at around minus 1 per cent. This is directly related to purchases of government securities by central banks and others. So this is part of the story too. Taking into account all these factors, the key to a return to more normal interest rates globally is to improve the investment climate. While Melville turned out to be wrong about zero interest rates, he was right in another sense. At low interest rates, many investments that didn't make sense at higher interest rates should now make sense. This is especially so for investments with long-term payoffs, because future returns no longer need to be discounted as highly. This means that low interest rates give us the opportunity to lengthen our horizons and think about projects with really long-term payoffs. There are two central elements in improving the investment climate. The first is the reduction in some of the geopolitical and other concerns that have led to higher risk premiums being required. The second is structural measures that give people greater confidence about future economic growth, so that they are prepared to expand, invest and innovate. Both elements are largely beyond the control of central banks. They are a matter for government and for business. So this is the environment in which the Reserve Bank Board is setting interest rates. We can't ignore these global trends in savings and investment and the responses of other central banks. If we did seek to ignore these trends, the exchange rate would most likely appreciate. In the current environment, this would be unhelpful for both jobs growth and for achieving the inflation target. It is important to point out, though, that while we need to take account of these global trends, there is no automatic mechanical link between what is happening elsewhere and our own monetary policy. At each meeting of the Reserve Bank Board we are asking ourselves what is best for the Australian economy and for the welfare of the Australian people. Over the course of this year we have lowered interest rates three times to a record low of 3/4 per cent. We are confident that these reductions are helping the Australian economy and supporting the gentle turning point in economic growth. In doing so, low interest rates are supporting jobs and overall income growth. At the same time, though, we recognise that monetary policy is not working in exactly the same way that it used to. We also recognise that low interest rates hurt the finances of many people, particularly those relying on interest income. So there is a balancing act here. The Board is prepared to ease monetary policy further if needed. Having said that, it is extraordinarily unlikely that we will see negative interest rates in Australia. It is likely though that we will require an extended period of low interest rates to reach full employment and for inflation to be consistent with the target. As is the case internationally, the focus needs to be on an improvement in the investment environment, so that investors are prepared to take Melville's cue and use low funding costs to build new productive assets. Not only would this help assist with a return to more normal interest rates, but it would be good for our collective welfare too. Thank you for listening. I look forward to answering your questions.

r191126a_BOA

australia

Unconventional Monetary Policy: Some Lessons From Overseas

lowe

Thank you for the invitation to address this year's Annual Dinner of the Australian Business Economists. This is the fifth time I have had the privilege of joining you. Thank you for having me back. One recurring theme of my talks over the years has been the likelihood that interest rates will remain low for an extended period - certainly, much lower, on average, than before the global financial crisis. This theme remains highly relevant today. As I discussed in the Sir Leslie Melville lecture at the ANU a month ago, low interest rates are not a temporary phenomenon. Rather, they are likely to be with us for some time and are the result of some powerful global factors that are affecting interest rates everywhere. Given this assessment, it is not surprising that there is a lot of discussion internationally about the use of so-called 'unconventional' monetary policies. People are rightly asking: if interest rates are going to stay low and be constrained by a lower bound, what other monetary policy options are I have been part of these international discussions through chairing the Committee on the Global The report reviews the experience with the use of unconventional policy tools and discusses how these tools can be used by central banks to achieve their objectives. If you are interested in these issues and have not looked at the report, I encourage you to do so. This evening I would like to summarise some key observations of the report and then explore how those observations might be applied to Australia. The report discusses four unconventional policy tools. The term 'unconventional' monetary policy has now become the conventional shorthand for a wide range of policies, although I am not sure it is the best terminology. I say this because most of these tools have always been in the toolkit of central banks and have been used in one way or another in the past. What has been unconventional over recent times is the these tools have been used. The first of the four tools discussed in the report is negative policy rates. This is one tool that is truly unconventional. Prior to the financial crisis, it was widely thought that zero was the lower bound for the policy interest rate - so it was common to talk about the 'ZLB', or the zero lower bound. It was thought that if interest rates went below zero, people would hold their savings in banknotes rather than be charged by their bank to deposit their money. But zero has not turned out to be the constraint that it was once thought to be. So we now talk about the ELB - the effective lower bound - not the ZLB. While countries with negative interest rates have seen some shift to banknotes, it has been on a limited scale only. This reflects the use of bank deposits for making transactions and the fact that most banks in countries with negative interest rates have set a floor of zero on retail deposit rates. These banks have judged that it doesn't make sense, either commercially or politically, to charge households and small businesses negative interest rates on their deposits. It is worth pointing out that negative policy interest rates have largely been a European phenomenon. Policy interest rates have been negative in the euro area, Denmark, Sweden and country outside of Europe that has had negative policy interest rates is Japan, but even there it is only a very small share of bank reserves at the Bank of Japan that earns a negative rate, at minus 0.1 per cent. The second unconventional policy discussed in the report is the extended use of central bank liquidity operations. In response to the financial crisis, many central banks made significant changes to their normal market operations to deal with strains in financial markets that were impairing the supply of credit to the economy. While the specifics differ across countries, the changes to market operations included: expanding the range of collateral accepted; providing much larger amounts of liquidity; extending the maturity of liquidity operations; increasing the range of eligible counterparties; and providing funding to banks at below the cost that was then prevailing in highly stressed markets, sometimes on the condition that the banks provide credit to businesses and households. This graph shows the size of the extended liquidity operations of the major central banks (Graph 2). The biggest operations were during the crisis period of 2008 and 2009, with significant liquidity support also being provided in 2011 and 2012 to support bank lending during the European sovereign debt crisis. It is worth recalling that during these periods of stress, banks had become very nervous about their access to liquidity. This, in turn, made them nervous about lending to others, making the possibility of a severe credit crunch very real. By providing financial institutions with greater confidence about their own access to liquidity, central banks were able to support the supply of credit to the economy. The CGFS report recognises that there were some side-effects of doing this, but the strong conclusion of the report is that these measures eased liquidity strains in highly stressed bank funding markets and helped restore monetary transmission channels to the broader economy. The third policy tool discussed in the report is the outright purchase of assets from the private sector, paying for those assets by creating central bank reserves - also known as quantitative easing or QE. These asset purchases were on an unprecedented scale and led to very large expansions of central bank balance sheets (Graph 3). Before the financial crisis, the major central banks owned securities equivalent to around 5 per cent of GDP. In recent years, this has risen to nearly 30 per cent. This is a very large change. As part of their QE programs, central banks bought a wide range of assets, but the main asset purchased was government securities. Central banks now hold nearly 30 per cent of government securities on issue, which is equivalent to around 20 per cent of GDP. The largest purchases have been made by the Bank of Japan, which holds almost 50 per cent of Japanese government bonds on issue. In the United States, the Federal Reserve also bought large quantities of agency securities backed by the US government. Elsewhere, central banks bought private securities such as covered bank bonds, corporate bonds and commercial paper. And the Bank of Japan bought equities via exchange traded funds (ETFs) and real estate investment trusts. The precise motivations for these asset purchase programs varied across countries, but a common motivation was to lower risk-free interest rates out along the term spectrum, well beyond the short-term policy rate. Buying government bonds was seen as reinforcing policy rate cuts and/or acting as a substitute for further reductions in the policy rate once it was at its lower bound. The expectation was that lower risk-free rates would flow through to most interest rates in the economy, boost asset prices and push down the exchange rate. A related motivation for buying government securities was to reinforce market expectations that policy rates were going to stay low for a long time. This 'signalling channel' added to the downward pressure on long-term bond yields. Another motivation in some countries was addressing problems in specific markets. In the United States, for example, the Federal Reserve purchased government-backed agency securities to support mortgage markets. And the Bank of England purchased commercial paper to ease highly stressed conditions in corporate credit markets. Finally, the expansion of the central bank's balance sheet through money creation should, in theory, have stimulatory effects through the so-called 'portfolio balance channel'. The idea here is that as the central bank purchases securities with bank reserves, investors seek to rebalance their portfolios, and in so doing push up other asset prices and lower risk premiums for borrowers. It is difficult, though, to isolate this effect from the other channels I just spoke about. The fourth policy response was forward guidance. This took two forms: calendar based and state based. Under calendar-based guidance, the central bank makes an explicit commitment not to increase interest rates until a certain point in time. Under state-based guidance, the central bank says it will not increase rates until specific economic conditions are met. We have seen examples of both in practice. Some central banks also have provided forward guidance regarding their asset purchase programs. A primary motivation of forward guidance is to reinforce the central bank's commitment to low interest rates. A related motivation is to provide greater clarity about the central bank's reaction function and strategy in unusual times. The experience has mainly been positive, with the guidance helping to reduce uncertainty. There are, however, some examples where a change in guidance caused market volatility. The 'taper tantrum' in the United States in 2013 is an example of this. Before I discuss the relevance of all this to Australia, I would like to make three broad observations, drawing on the report as well as my own reading of the evidence. The first is that there is strong evidence that the various liquidity support measures and targeted interventions in stressed markets were successful in calming things down and supporting the economy. When markets broke down and became dysfunctional, the actions of central banks helped stabilise the situation and helped avoid a damaging gridlock in the financial system. They also helped contain risk premiums in highly stressed markets. It is also worth pointing out that many of the measures to support liquidity were successfully unwound once the job was done - so they proved to be temporary, rather than a permanent intervention. The CGFS report also documents the positive effects of some of the other unconventional measures. In general, though, I find this evidence less compelling. These various measures certainly pushed down long-term yields and provided monetary stimulus in the depths of the crisis when it was needed. But these extraordinary measures have continued way past the crisis period. In some countries, asset purchases have yet to be unwound and it remains unclear when, and even if, this will happen. So a full evaluation is not yet possible. This brings me to my second general observation. And that is that there have been some sideeffects of the various unconventional measures. I will touch on a few of these that the CGFS report discusses. The first is that the extensive use of unconventional monetary tools can change the incentives of others in the system, perhaps in an unhelpful way. It is possible that the willingness of a central bank to provide liquidity reduces the incentive for financial institutions to hold their own adequate buffers, making episodes of stress more likely in the future. It is also possible that the willingness of a central bank to use its full range of policy instruments might create an inaction bias by other policymakers, either the prudential regulators or the fiscal authorities. If this were the case, it could lead to an over-reliance on monetary policy. A second side-effect is the impact on bank lending and the efficient allocation of resources. Persistently low or negative interest rates and a flattening of the yield curve can damage bank profitability, leading to less capacity to lend. In some countries, there are concerns that low interest rates allow less-productive (zombie) firms to survive. There are also financial stability risks that can come from low interest rates boosting asset prices (and perhaps borrowing) at a time of weak economic growth. A third side-effect is a possible blurring of the lines between monetary and fiscal policy. If the central bank is buying large amounts of government debt at zero interest rates, this could be seen as money-financed government spending. In some circumstances, this could damage the credibility of a country's institutional arrangements and create political tensions. Political tensions can also arise if the central bank's asset purchases are seen to disproportionality benefit banks and wealthy people, at the expense of the person in the street. This perception has arisen in some countries despite the strong evidence that the various monetary measures supported both jobs and income growth and thereby helped the entire community. These are all side-effects we need to take seriously. The third general observation is that experience suggests that a package of measures works best, with clear communication that enhances credibility. Exactly what that package looks like varies from country to country and depends upon the specific circumstances. But clear communication from the central bank about its objectives and its approach is always important. The report also notes that there may be better solutions than monetary policy to solving the problems of the day. It reminds us that when there are problems on the supply-side of the economy, the use of structural and fiscal policies will sometimes be the better approach. We need to remember that monetary policy cannot drive longer-term growth, but that there are other arms of public policy than can sustainably promote both investment and growth. I would now like to turn to what this all implies for us in Australia. I will make five sets of observations. The first is that the Reserve Bank has long had flexible market operations that allow us to ensure adequate liquidity in Australian financial markets. We have used this flexibility in the past, particularly during the global financial crisis, and we are prepared to use it again in periods of stress if necessary. At the moment, though, Australia's financial markets are operating normally and our financial institutions are able to access funding on reasonable terms. In any given currency, the Australian banks can raise funds at the same price as other similarly rated financial institutions around the world, and markets are not stressed. So there is no need to change our normal market operations to do anything unconventional here. Having said that, if markets were to become dysfunctional, you can be reassured by the fact that we have both the capacity and willingness to respond. But this is not the situation we are currently in. Things are operating normally. The second observation is that negative interest rates in Australia are extraordinarily unlikely. We are not in the same situation that has been faced in Europe and Japan. Our growth prospects are stronger, our banking system is in much better shape, our demographic profile is better and we have not had a period of deflation. So we are in a much stronger position. More broadly, though, having examined the international evidence, it is not clear that the experience with negative interest rates has been a success. While negative rates have put downward pressure on exchange rates and long-term bond yields, they have come with other effects too. It has become increasingly apparent that negative rates create strains in parts of the banking system that can impair the ability of some banks to provide credit. Negative interest rates also create problems for pension funds that need to fund long-term liabilities. In addition, there is evidence that they can encourage households to save more and spend less, especially when people are concerned about the possibility of lower income in retirement. A move to negative interest rates can also damage confidence in the general economic outlook and make people more cautious. Given these considerations, it is not surprising that some analysts now talk about the 'reversal interest rate' - that is, the interest rate at which lower rates become contractionary, rather than expansionary. While we take the possibility of a reversal rate seriously, I am confident that here, in Australia, we are still a fair way from it. Conventional monetary policy is still working in Australia and we see the evidence of this in the exchange rate, in asset prices and in the boost to aggregate household disposable income. My third observation is that we have no appetite to undertake outright purchases of private sector assets as part of a QE program. There are two reasons for this. The first is that there is no sign of dysfunction in our capital markets that would warrant the Reserve Bank stepping in. The second is that the purchase of private assets by the central bank, financed through money creation, represents a significant intervention by a public sector entity into private markets. It comes with a whole range of complicated governance issues and would insert the Reserve Bank very directly into decisions about resource allocation in the economy. While there are some scenarios where such intervention might be considered, those scenarios are not on our radar screen. My fourth point is that - and it is important to emphasise the word - the Reserve Bank were to undertake a program of quantitative easing, we would purchase government bonds, and we would do so in the secondary market. An important advantage in buying government bonds over other assets is that the risk-free interest rate affects all asset prices and interest rates in the economy. So it gets into all the corners of the financial system, unlike interventions in just one specific private asset market. If we were to move in this direction, it would be with the intention of lowering risk-free interest rates along the yield curve. As with the international experience, this would work through two channels. The first is the direct price impact of buying government bonds, which lowers their yields. And the second is through market expectations or a signalling effect, with the bond purchases reinforcing the credibility of the Reserve Bank's commitment to keep the cash rate low for an extended period. Currently, the government bond yield curve sits around 20 basis points above the overnight indexed swaps (OIS) curve, which represents the market's average expectation of the future monetary policy rate (Graph 4). Purchasing government securities could compress this differential and could also flatten the OIS curve through the expectations effect I just mentioned. A lower term premium would lower borrowing costs for both governments and private borrowers, and would bring the benefits that come with that. An exchange rate effect could also be expected. Our current thinking is that QE becomes an option to be considered at a cash rate of 0.25 per cent, but not before that. At a cash rate of 0.25 per cent, the interest rate paid on surplus balances at the Reserve Bank would already be at zero given the corridor system we operate. So from that perspective, we would, at that point, be dealing with zero interest rates. My fifth, and final, point is that the threshold for undertaking QE in Australia has not been reached, and I don't expect it to be reached in the near future. In my view, there is not a smooth continuum running from interest rate reductions to quantitative easing. It is a bigger step to engage in money-financed asset purchases by the central bank than it is to cut interest rates. There are, however, circumstances where QE could help. The international experience is that in stressed market conditions, the central bank can help stabilise the situation by buying government securities. That experience also suggests that QE does put additional downward pressure on both interest rates and the exchange rate. In considering the case for QE, we would need to balance these positive effects with possible side-effects. We would also need to consider the effects on market functioning. We are conscious that government securities play a crucial role as collateral in some of our financial markets. Given the limited supply of government debt on issue, the Reserve Bank and APRA have already had to put in place special liquidity arrangements for the banking system. We are also conscious that the Australian government's fiscal position means that the gross stock of government debt is projected to decline relative to the size of the economy over the years ahead. These considerations are not impediments to undertaking QE, but we would need to take them into account. It is a reasonable question to ask what might be the threshold to undertake QE in Australia. It is difficult to be precise, but QE would be considered if there were an accumulation of evidence that, over the medium term, we were unlikely to achieve our objectives. In particular, if we were moving away from, rather than towards, our goals for both full employment and inflation, the purchase of government securities would be on the agenda of the Board. In this world, I would hope other public policy options were also on the country's agenda. At the moment, though, we are expecting progress towards our goals over the next couple of years and the cash rate is still above the level at which we would consider buying government securities. So QE is not on our agenda at this point in time. It is important to remember that the economy is benefiting from the already low level of interest rates, recent tax cuts, ongoing spending on infrastructure, the upswing in housing prices in some markets and a brighter outlook for the resources sector. Given the significant reductions in interest rates over the past six months and the long and variable lags, the Board has seen it as appropriate to hold the cash rate steady as it assesses the growth momentum both here and elsewhere around the world. The Board is also committed to maintaining interest rates at low levels until it is confident that inflation is sustainably within the 2 to 3 per cent target range. The central scenario for the Australian economy remains for economic growth to pick up from here, to reach around 3 per cent in 2021. This pick-up in growth should see a reduction in the unemployment rate and a lift in inflation. So we are expecting things to be moving in the right direction, although only gradually. The Board continues to discuss what role it can play in ensuring that this progress takes place and how it might be accelerated. It recognises the benefits that would come from faster progress, but it also recognises the limitations of monetary policy and the importance of keeping a medium- term perspective squarely focused on maximising the economic welfare of the people of Australia. There may come a point where QE could help promote our collective welfare, but we are not at that point and I don't expect us to get there. Thank you for listening. I look forward to answering your questions.

r191210a_BOA

australia

A Payments System for the Digital Economy

lowe

Thank you for the invitation to address this year's Australian Payments Network Summit. This summit has become an important fixture on the Australian payments calendar and this is the third time I have had the privilege of joining you. A recurring theme across these summits has been the need to improve customer outcomes. I am very pleased to see that this focus has been continued at this year's summit. The focus on customer outcomes aligns very closely with the focus of the Payments System Board. The Board wants to see a payments system that is innovative, dynamic, secure, competitive, and that serves the needs of all Increasingly, this means that the payments system needs to support Australia's digital economy. With the digital economy being an important key to Australia's future economic prosperity, we need a payments system that is fit for purpose. We will only fully capitalise on the fantastic opportunities out there if we have a payments system that works for the digital economy. The positive news is that we have made some substantial progress in this direction over recent years and in some areas, Australia's payments system is world class. However, in the fast-moving world of payments, things don't stand still and there are some important areas we need to work on. In my remarks today, I would like to do three things. The first is to talk about some of the progress that has been made over recent years. The second is to highlight a few areas where we would like to see more progress, particularly around payments and the digital economy. And third, I will highlight some of the questions we will explore in next year's review of retail payments regulation in Australia. Over recent years there have been significant changes in the way that we make payments. We now have greater choice than ever before and payments are faster and more flexible than they used to be. The launch of the New Payments Platform - the NPP - in early 2018 has been an important part of this journey. This new payments infrastructure allows consumers and businesses to make real-time, 24/7 payments with richer data and simple addressing using PayIDs. After the NPP was launched, it got off to a slow start, but it is now hitting its stride. Monthly transaction values and volumes have both tripled over the past year (Graph 1). In November, the platform processed an average of 1.1 million payments each day, worth about $1.1 billion. The rate of take-up of fast retail payments in Australia is a little quicker than that in most other countries that I expect that we will see a further pickup in usage once the CBA has delivered on core NPP functionality for all its customers. The slow implementation has been disappointing and we expect the required functionality to be available soon. There are now 86 entities connected to the NPP, including 74 that are indirectly connected via a direct NPP participant. There are at least six non-ADI fintechs that are using the NPP's capabilities to innovate and provide new services to customers. All up, approximately 66 million Australian bank accounts are now able to make and receive NPP payments. Use of the PayID service has also been growing, with around 3.8 million PayIDs having been registered to date. If you have not already got a PayID, I encourage you to get one. I also encourage you to ask for other people's PayIDs when making payments, as an alternative to asking for their BSB and account number. It is much easier and faster. One specific example of where the NPP is bringing direct benefits to people is its use by the Australian Government, supported by the banking arm of the RBA, to make emergency payments. During the current bushfires, the government has been able to use the NPP to make immediate payments to people at a time when they are most in need, whether that be on the weekend or after their bank has shut for the night. One other area of the payments system where we have seen significant change is the take-up of 'tap-and-go' payments. Around 80 per cent of point-of-sale transactions are now 'tap-and-go', which is a much higher share than in most other countries. This growth has been made possible by the acquirers rolling out new technology in their terminals and by the willingness of Australians to try something different. There has also been rapid take-up of mobile payments, including through wearable devices. Progress has also been made on improving the safety of electronic payments, particularly in relation to fraud in card-not-present transactions. The rate of fraud is still too high, but it has come down recently (Graph 3). I would like to acknowledge the work that AusPayNet has done here to develop a new framework to tackle fraud. This framework strengthens the authentication requirements for certain types of transactions, including through the use of multi-factor authentication. This will help reduce card-not-present fraud and support the continued growth in online commerce. As our electronic payments system continues to improve, we are seeing a further shift away from cash and cheques. The RBA recently undertook the latest wave of our three-yearly consumer payments survey. We are still processing the results, but ahead of publishing them early next year, I thought I would show you the latest estimate on the use of cash (Graph 4). As expected, there has been a further trend decline in the use of cash, with cash now accounting for just around a quarter of day-to-day transactions, and most of these are for small-value payments. Given the other innovations that I just spoke about, I expect that this trend will continue. The progress across these various fronts means that there is a positive story to be told about innovation in Australia's payments system. At the same time, though, there are still some significant gaps and areas in our payments system that need addressing and where progress would support the digital economy in Australia. I would like to talk about four of these. The first of these is further industry work to realise the full potential of the NPP, including its data- rich capabilities. The NPP infrastructure can help make electronic invoicing commonplace and help invoices be paid on time. It can also support significant improvement in business processes, as more data moves with the payment. Real-time settlement and posting of funds also enables some types of delivery-versus- payment, so that the seller can confirm receipt of funds and be confident in delivering goods or services to the buyer. The layered architecture of the system was designed to promote competition and innovation in the development of new overlay services. Notwithstanding this, one of the consequences of the slower- than-promised rollout of the NPP by some of the major banks is that there has been less effort than expected on developing innovative functionality. Payment systems are networks, and participants need to know that others will be ready to receive payments and use the network. Some banks have been reluctant to commit time and funding to support the development of new functionality given that others have been slow to roll out their 'day 1' functionality. The slow rollout has also reduced the incentive for fintechs and others to develop new ideas. So we have not yet benefited from the full network effects. The Payments System Board considered this issue as part of its industry consultation on NPP access and functionality, conducted with the ACCC earlier this year. As part of that review we recommended that NPPA - the industry-owned company formed to establish and operate the NPP - publish a roadmap and timeline for the additional functionality that it has agreed to develop. The inaugural roadmap was published in October and NPPA also introduced a 'mandatory compliance framework'. Under this compliance framework, NPPA can designate core capabilities that NPP participants must support within a specified period of time, with penalties for non-compliance. This is a welcome development. One important element of the roadmap is the development of a 'mandated payments service' to support recurring and 'debit-like' payments. This new service will allow account-holders to establish and manage standing authorisations (or consents) for payments to be initiated from their account by third parties. This will provide convenience, transparency and security for recurring or subscriptiontype payments and a range of other payments. Another element of the roadmap that has the potential to promote the digital economy is the development of NPP message standards for payroll, tax, superannuation and e-invoicing payments. The standards will define the specific data elements that must be included with these payment types, which will support automation and straight-through processing. We would expect financial institutions to be competing with each other to enable their customers to make and receive these data-rich payments. Less positively, there is still uncertainty about the future of the two remaining services that were expected to be part of the initial suite of Osko overlay services. These are the 'request-to-pay' and 'payment with document' services. We understand there are still challenges in securing committed project funding and priority from NPP participants to move ahead, even though BPAY has indicated it is ready to complete the rollout. The RBA strongly supports the development of these additional NPP capabilities, which are likely to deliver significant value for businesses and the broader community. A second area where the Payments System Board would like to see further progress is the provision of portable digital identity services that allow Australians to securely prove who they are in the digital environment. Today, our digital identity system is fragmented and siloed, which has resulted in a proliferation of identity credentials and passwords. This gives rise to security vulnerabilities and creates significant inconvenience and inefficiencies, which can undermine development of the digital economy. These generate compliance risks and other costs for financial institutions, so it is strongly in their interests to make progress here. It is fair to say that a number of other countries are well ahead of us in this area. The Australian Payments Council has recognised the importance of this issue and has developed the identity services will be used to access online government services. The challenge now is to build on these frameworks and develop a strong digital identity ecosystem in Australia with competing but interoperable digital identity services. The rollout of open banking and the consumer data right should bring additional competition among financial services providers, and digital identity is likely to reduce the scope for identity fraud, while providing convenient authentication, as part of an open banking regime. A strong digital identity system would also open up new areas of digital commerce and help reduce online payments fraud. It will also help build trust in a wide range of online interactions. Building this trust is increasingly important as people spend more of their time and money online. So we would like to see some concrete solutions developed and adopted here. A third area where we would like to see more progress is on reducing the cost of cross-border payments. For many people, the costs here are still too high and the payments are still too hard to make. It is important that we address this. It is an issue not just for Australians, but for our neighbours as well. I recently chaired a meeting of the Governors from the South Pacific central banks, where I heard first-hand about the problems caused by the high cost of cross-border payments. Analysis by the World Bank indicates that the price of sending money from Australia has been consistently higher than the average price across the G20 countries (Graph 5). And a recent ACCC inquiry found that prices for cross-border retail payment services are opaque. Customers are not always aware of how the 'retail' exchange rate they are being quoted compares with the wholesale exchange rate they see on the news, or of the final amount that will be received in foreign currency. There are also sometimes add-on fees. As part of the RBA's monitoring of the marketplace, our staff recently conducted a form of online shadow shopping exercise, exploring the pricing of international money transfer services by both banks and some of the new non-bank digital money transfer operators (MTOs). This exercise showed that there is a very wide range of prices across providers and highlighted the importance of shopping around. The main results are summarised in this graph (Graph 6). In nearly every case, the major banks are more expensive than the digital MTOs. For the major banks, the average mark-up over the wholesale exchange rate is around 5 1/2 per cent, versus about 1 per cent for the digital MTOs. The graph illustrates why the cost of cross-border payments is such an issue for the South Pacific countries. These costs are noticeably higher than for payments to most other countries. This is a particular problem as many people in the South Pacific rely on receiving remittances from family and friends in Australia and New Zealand. In many cases, low-income people are paying very high fees and it is important that we address this where we can. As is evident from the graph, most digital MTOs do not service the smaller South Pacific economies, which limits customers' choice of providers. In part, the high costs - and slow speed - of international money transfers is the result of inefficiencies in the traditional correspondent banking process. It is understandable why some large tech firms operating across borders see an opportunity here. Where people are being served poorly by existing arrangements, new solutions are likely to emerge with new technologies. This represents a challenge to the traditional financial institutions to offer better service at a lower cost to their customers, while still meeting their AML/CTF requirements. Central banks have a role to play here too, and there is an increased focus globally on what we can do to reduce the cost of cross-border payments. One example of this is the promotion of standardised and richer payment messaging globally through the adoption of the ISO20022 standard. The RBA is also working closely with the Reserve Bank of New Zealand, AUSTRAC and other South Pacific central banks to develop a regional framework to address the Know-YourCustomer concerns that have limited competition and kept prices high. A fourth area where we would like to see more progress is improving the operational resilience of the electronic payments system. Disruptions to retail payments hurt both consumers and businesses. Given that many people now carry little or no cash, the reliability of electronic payment services has become critical to the smooth functioning of our economy. We understand that, given the complexity of IT systems, some level of payments incidents and outages to services is inevitable. But it is apparent from the data we have that the frequency and duration of retail payments outages have risen sharply in recent years. In response, the RBA has begun working with APRA and the industry to enhance the data on retail payment service outages and to introduce a suitable disclosure framework for these data. These measures will provide greater transparency around the reliability of services and allow institutions to better benchmark their operational performance. The third and final issue I would like to touch on is the Payments System Board's review of retail payments regulation next year. The review is intended to be wide-ranging and to cover all aspects of the retail payments landscape, not just the RBA's existing cards regulation. As the first step in the process, we released an Issues Paper a couple of weeks ago and have asked for submissions by 31 January. There will also be opportunities to meet with RBA staff conducting the review. The review will cover a lot of ground, including hopefully some of the issues that I just mentioned. There are, though, a few other questions I would like to highlight. The first is what can be done to reduce further the cost of electronic payments? Both the Productivity Commission and the Black Economy Taskforce have called for us to examine this question. It is understandable why. As we move to a predominantly electronic world, the cost of electronic payments becomes a bigger issue. The Payments System Board's regulation of interchange fees and the surcharging framework, as well as its efforts to promote competition and encourage least-cost routing, have all helped lower payment costs. At issue is how we make further progress: what combination of regulation and market forces will best deliver this? Relevant questions here include: whether interchange fees should be lowered further; how best to ensure that merchants can choose the payment rails that give them the best value for money; and whether restrictions relating to no-surcharge rules should be applied to other arrangements, including the buy-now-pay-later schemes. A second issue is what is the future of the cheque system? Cheque use in Australia has been in sharp decline for some time. Over the past year, the number of cheques written has fallen by another 19 per cent and the value of cheques written has fallen by more than 30 per cent, as the real estate industry has continued to shift to electronic property settlements (Graph 7). At some point it will be appropriate to wind up the cheque system, and that point is getting closer. Before this happens, though, it is important that alternative payment methods are available for those who rely on cheques. Using the NPP infrastructure for new payment solutions is likely to help here. Third, is there a case for some rationalisation of Australia's three domestically focused payment schemes, namely BPAY, eftpos and NPPA? A number of industry participants have indicated to us that they face significant and sometimes conflicting investment demands from the three different entities. This raises the question of whether some consolidation or some form of coordination of investment priorities might be in the public interest. Fourth, and finally, what are the implications for the regulatory framework of technology changes, new entrants and new business models? The world of payments is moving quickly, with new technologies and new players offering solutions to longstanding problems. At the same time, expectations regarding security, resilience, functionality and privacy are continually rising. Meeting these expectations can be challenging, but doing so is critical to building and maintaining the trust that lies at the heart of effective payment systems. The entry of non-financial firms into the payments market also raises new regulatory issues. As part of the review, it would be good to hear how the regulatory system can best encourage a dynamic and innovative payments system in Australia that fully serves the needs of its customers. So these are some of the many issues on our agenda. We are looking forward to receiving your input. For now, thank you for listening and I am happy to answer your questions. Thank you.

r200205a_BOA

australia

The Year Ahead

lowe

Thank you for inviting me back to address the National Press Club. It is an honour to be here again. At this lunch a year ago, I spoke about the year ahead. I would like to do the same again today. Twelve months ago, I reminded you that we do not have a crystal ball that can be used to see the future with certainty. Since then, some things have turned out as expected, but there have been plenty of surprises as well. No doubt, the same will be true this year. Today, though, I would like to talk about the Reserve Bank's central scenario for the global and Australian economies and some of the factors that we will be watching over the year ahead. I would also like to touch on monetary policy. The central scenario for the global economy over the next couple of years remains reasonable and growth is expected to be a little stronger than it was in 2019. The IMF estimates that the global economy expanded by 2.9 per cent last year and in its latest published forecasts is predicting economic growth to lift to 3.3 per cent this year and 3.4 per cent in 2021 (Graph 1). Looking back, though, global growth in 2019 was not as strong as we had expected. This was largely because the trade and technology disputes between the United States and China and the Brexit debate had a sobering effect on investment around the world. The trade disputes also led to some reconfiguration of global supply chains and resulted in very soft conditions in the manufacturing sector and a contraction in international trade. Some of these dark clouds that were hanging over the global economy last year have lightened a little recently. With the progress on the trade and Brexit issues, there have been some signs that the downswing in manufacturing activity and international trade is coming to an end (Graph 2). The down cycle in the global semiconductor industry also looks to be running its course. These are encouraging developments and provide a reasonable basis to expect that this year will be better than last year. Having said that, it remains possible that the expected pick-up in growth is derailed by a re-escalation of the trade and technology disputes. Another, more recent source of uncertainty is the outbreak of the coronavirus, which I will discuss shortly. One other unexpected development over the past year was the easing of monetary policy by most central banks. This easing was in response to both the disappointing growth outcomes in some countries and the continuing accumulation of evidence of low and stable inflation. This evidence suggests that the previous relationship between the unemployment rate and inflation has changed. Many countries have unemployment at the lowest level in decades - in the United States it is the lowest since 1969, and in the United Kingdom it is the lowest since 1974 (Graph 3). Yet inflation remains subdued. The reasons for this change are complicated. But my view is that it largely reflects some structural changes related to technology and globalisation, which together have increased competition and uncertainty about the future. With our economies seemingly less inflation prone than they once were, it is now possible to sustain lower rates of unemployment than previously thought to be the case. This is a good thing. Partly as a result of this shift, investors have a high degree of confidence that interest rates will stay low for a long time. This assessment is reinforced by the fact that the global desire to save is high relative to the desire to invest in new capital. When a lot of people want to save and there is weak demand by businesses to use those savings, the return to savers - that is the interest rate - is going to be low. This means that we find ourselves in a world of low unemployment, low inflation and low interest rates. I expect that we are going to remain here for quite some time given the structural factors at work, although it does remain possible that a re-acceleration of growth in economies with little spare capacity could see inflation re-emerge. One consequence of interest rates being lower for longer is that asset prices have increased as investors discount future returns by less. The most obvious example of this is global equity prices, which have recorded strong gains over recent times (Graph 4). Some investors are also taking on more risk as they search for higher returns in a low interest rate world. Both higher asset prices and a willingness to take more risk can be good for the global economy, especially if they lead to more investment, not just more borrowing. We do, though, need to remember that it is possible to have too much of a good thing. So this is also an issue that international bodies, including the Financial Stability Board, are keeping a close eye on. I would now like to turn to the Australian economy. We will be releasing an updated full set of forecasts on Friday in the . Ahead of that I can provide you with the main numbers and highlight some of the issues shaping the outlook. Our central forecast is for the Australian economy to expand by 2 3/4 per cent over 2020 and 3 per cent the following year (Graph 5). These growth rates are a little above our current estimate of medium-term growth in Australia, so some inroad into spare capacity should be made. These growth rates are also higher than the outcomes for 2018 and 2019. As I have been saying for some time, we are passing through a gentle turning point for the better. There are a number of factors contributing to this outlook. The expected pick-up in world growth should help us, the resources sector is in expansion mode again and we are expecting consumer spending to pick up. The outlook is also being supported by ongoing high levels of investment in infrastructure and the likelihood that the downswing in residential construction will come to an end later this year. Further increases in resource exports and continuing solid growth in public demand will also help. In terms of the labour market, we are expecting the unemployment rate to remain around its current level for a while yet, before declining below 5 per cent late next year as growth picks up (Graph 6). One consideration here is the outlook for labour force participation. Over the past couple of years we have seen a very large lift in participation, especially by women and older Australians. This is a positive development but it has meant that very strong employment growth has not resulted in a lower unemployment rate: strong demand for labour has been met with strong supply of labour. In terms of inflation, we continue to expect a gradual increase, with underlying inflation expected to approach 2 per cent over the next couple of years (Graph 7). The recent inflation data were in line with our expectations and show contrasting trends with higher prices for groceries and continued subdued outcomes for housing, especially rents and utilities. With that broad overview I would like to focus on three issues: 1. the ongoing adjustment in household balance sheets 2. the bushfires, the drought and the coronavirus outbreak 3. the importance of continuing to invest in our future. Looking back at last year, economic growth was weaker than we had expected. The global slowdown is part of the story, but the most important factor is a domestic one, and that is subdued consumer spending as households adjusted to slow wages growth and falling housing prices. The downswing in residential construction was also a factor. Over 2019, household consumption looks to have increased by only around 1 per cent (Graph 8). Given that Australia's population is growing at 1.5 per cent a year, this represents a decline in per capita terms. This is a highly unusual outcome in an economy that has recorded the type of strong jobs growth that we have experienced in Australia. For some time now, households had been gradually adjusting their spending to the slower trend rate of income growth. This adjustment accelerated last year in response to falling housing prices. Faced with the reality of slow growth in wages and falling housing prices, many households scaled back their spending to put their finances and their balance sheets on a sounder footing and the effects have been felt across the economy. On the wages front, Australians have been getting used to increases of 2 point something (Graph 9). This is a noticeable step down from the 3-4 per cent range we experienced previously and we are forecasting the current rate of wages growth to continue for the next couple of years. As this period of low wages growth has run on, many people have adjusted down their expectations of how fast their own income will grow in future. At the same time, households have been dealing with another adjustment - that is in housing prices. Between late 2017 and mid last year, nationwide housing prices fell by 8 per cent, and in Sydney and Melbourne housing prices fell an average of 13 per cent (Graph 10). The speed and extent of this decline came as a shock to many people, although it did follow an earlier very large run-up in prices. It reminded us all that housing prices can, and do, fall substantially. For some people the salutary effect of that reminder has been amplified by lower wage increases and high levels of debt. As part of the Reserve Bank's efforts to understand how households are adjusting we have been looking carefully at the data on mortgage repayments and I would like to share these updated data with you. This graph shows housing loan repayments as a share of outstanding credit, broken down into interest payments and repayments of principal, including through higher balances in offset There are three points that I would draw your attention to. The first is that as monetary policy has been eased since late 2011, interest payments as a share of credit have come down (top panel). This has freed up income to be spent on other purposes. The second is that the rate of repayment of principal (bottom panel) has moved up and down over time. These fluctuations partly reflect trends in the housing market. In particular, the increase in repayments around 2014 and 2015 was associated with strong growth in offset accounts and coincided with a period of high turnover in the housing market and strong growth in loan refinancing. And the third point is that over the second half of 2019, principal payments have increased, more than offsetting the decline in interest payments. Households have made larger voluntary repayments and they have also maintained higher balances in their offset accounts. Partly, this has been made possible by the higher tax refunds for low- and middle-income earners which have boosted disposable income. It is entirely understandable that households faced with low growth of wages and falling housing prices sought to repay their debts a bit faster. I am going to speak about monetary policy shortly, but ahead of that I would like to address one point that I hear frequently: that the Reserve Bank's decision to cut interest rates last year dented consumer confidence and that this is what lies behind the weak consumption growth. I certainly understand that having interest rates at very low levels has unsettled some people. But I don't accept the idea that this is what is driving weak consumption. There is something deeper going on. While the Reserve Bank's decisions reminded people of what is going on, Australians were already adjusting their spending to the reality of a combination of subdued wages growth, the fall in housing prices and high debt levels. Consumer confidence and monetary policy were both responding to this reality. My judgement is that if the Reserve Bank had not eased monetary policy last year, this adjustment by households would have been harder, the balance sheet repair would have been more difficult, and the economy would have been weaker. The lower interest rates have assisted with both sides of the balance sheet. They have allowed people to pay down their liabilities more easily, and they have also boosted asset prices. So they are helping, not hampering, the process of balance sheet adjustment. In doing so, they are also bringing forward the day when households feel comfortable to lift their spending again. As I said when discussing the global situation, we need to remember that it is possible to have too much of a good thing. We are aware of the risk of low interest rates encouraging too much borrowing and driving excessive asset valuations. So we will continue to watch borrowing, in particular, very carefully. The main point here, though, is that we expect consumption growth to strengthen as households become more comfortable with their balance sheet positions. Assisting with this, disposable income is expected to grow more strongly over the next couple of years than it has over the past couple of years. Housing prices are also now rising, not falling, and a pick-up in residential construction activity is in prospect. The unemployment rate is also expected to decline, which should give people the confidence to spend. So it is reasonable to expect that things improve from here, although it is hard to be precise about how much longer this period of balance sheet adjustment will continue. Other issues that we have examined carefully in putting together the forecasts are the devastating bushfires over the summer and the drought. On behalf of the Reserve Bank Board and staff I would like to extend our thoughts to all those who have been affected, especially to those who have so tragically lost loved ones. I would also like to extend our deep gratitude to all those who have worked so tirelessly to control the fires. The economic impact of the fires in the areas affected is very large. There have been very significant disruptions to normal activity in these areas and there has been large-scale destruction of homes, farms and businesses as well as public infrastructure. In assessing the impact of this on the Australian economy as a whole we have taken into account that there will be a material rebuilding effort and that government grants and insurance payments will assist many people. On this basis, our assessment is that GDP growth for 2020 as a whole will be largely unaffected. There is, however, likely to be a noticeable effect across the December quarter last year and the current quarter. While it is still difficult to be precise, we estimate that the effects of the bushfires will reduce GDP growth by around 0.2 percentage points across the two quarters. We are also continuing to assess the effects of the drought on the economy. Farm output declined by 16 per cent between 2017 and 2019, and farm exports fell by 13 per cent. A further decline of around 10 per cent in farm output is expected in 2020, representing a drag on GDP growth of around a quarter of a percentage point. This is a stark reminder that the economic effects of these climate events are material. A new uncertainty affecting the outlook is the outbreak of the coronavirus. It is too early to tell what the overall impact will be, but the SARS outbreak in 2003 may provide a guide. On that occasion, there was a sharp slowing in output growth in China for a few months, before a sharp bounce-back as the outbreak was controlled and economic stimulus measures were introduced. Today, China is a larger part of the global economy and it is more closely integrated, including with Australia, so the international spillovers could be larger than they were back in 2003. Much will depend on the success of the various efforts to control the virus so we are monitoring developments closely. The third issue I would like to discuss is the importance of continuing to invest in our future. Australia's economic fundamentals remain very strong and they provide a solid foundation for us to be optimistic about our future. The strong fundamentals include: world class endowments of natural resources; a highly skilled and innovative workforce; an established and predictable regulatory system; sound public finances; a diverse and growing population; and being well placed to benefit from the strong growth in Asia, not just in China, but also in the populous countries of Indonesia and India. So we have a lot to feel fortunate about. We enjoy a set of fundamentals and a standard of living that few other countries enjoy. It's important that we do not lose sight of this. Strong fundamentals, though, can take us only so far. If we are to turn these fundamentals into strong and consistent growth, we need to keep investing in our future. The level of investment spending, relative to the size of the economy, has trended lower over recent years, although there has been some increase in public investment (Graph 12). We have also experienced a troubling decline in productivity growth. While the reasons for this are complex, it is hard to escape the conclusion that higher levels of investment spending would promote productivity growth and our collective living standards. The list of areas where further investment would improve our future prospects is well known. It includes investments in infrastructure, in human capital, in energy production and distribution, in new data technologies, and in measures to deal with climate change and its effects. Businesses, as well as governments across Australia are addressing these areas and it is important that they remain focused on them. Both public and business sector balance sheets are in good shape and so are strong enough to take advantage of these investment opportunities. As I have said on other occasions, low interest rates should make it easier for both the public and business sectors to contemplate long-term investments, given that future returns don't need to be discounted as much. They also mean that financing costs are lower. With interest rates at record lows and likely to remain low for quite some time there are plenty of opportunities here. I would like to finish by returning to monetary policy. At its meeting yesterday, the Reserve Bank Board decided that, given the current outlook, the best course was to hold the cash rate steady at 0.75 per cent. The recent inflation and unemployment data were both in line with our expectations and show things moving in the right direction, although only very gradually. Over the next couple of years we expect further progress to be made towards full employment and the inflation target, although that progress is likely to remain quite slow. The gradual nature of this progress reflects some significant structural shifts in the global economy related to technology and globalisation and, as I discussed earlier, a period of adjustment in household finances in Australia. Monetary policy has already responded to this and is providing considerable support to the Australian economy. Given the outlook I have outlined today, the Board has, however, continued to discuss the merits of further monetary stimulus in an effort to speed the pace of progress and to make it more assured. On balance, though, the Board has decided to hold the cash rate steady, recognising the significant monetary stimulus already in place and the long and variable lags associated with monetary policy. This decision also reflects a judgement about the benefits from a further reduction in interest rates against some of the costs and risks associated with very low interest rates. It certainly remains the case that a further reduction in interest rates would help with the balance sheet adjustment by households with existing debt, which should help bring forward the day that consumption strengthens. It would also have a further effect on the exchange rate, which would boost demand for our exports and therefore support jobs growth. On the other side of the equation though, there are risks in having interest rates at very low levels. Internationally, there are increased concerns about the effect of very low interest rates on resource allocation and their effect on the confidence of some people. Lower interest rates could also encourage more borrowing by households eager to buy residential property at a time when there is already a strong upswing in housing prices in place. If that occurs, this could increase the risk of problems down the track. So there is a balance to be struck here. The Board recognises that the nature of this balance can change over time and that it depends very much upon the state of the economy. So it is continually looking at both sides of the equation. If the unemployment rate were to be trending in the wrong direction and there was no further progress being made towards the inflation target, the balance of arguments would change. In those circumstances, the Board would see a stronger case for further monetary easing. We will continue to monitor developments carefully, including in the labour market, as we seek to strike the right balance in the interests of the community as a whole. Thank you for listening and I look forward to your questions.

r200207a_BOA

australia

Opening Statement to the House of Representatives Standing Committee on Economics

lowe

Good morning Chair and members of the Committee. These hearings are a central part of the accountability process for the Reserve Bank of Australia. As usual, my colleagues and I will do our best to answer your questions and to explain how we are discharging our important responsibilities on behalf of the Australian community. Later this morning we will be releasing a full set of updated forecasts in our quarterly Statement on Monetary Policy. Ahead of that I would like to highlight the main numbers and some of the factors that are influencing the outlook. I will then turn to monetary policy and finish with some remarks about the RBA's payments system responsibilities. When we met six months ago, I said that there were signs that the Australian economy may have reached a gentle turning point. The data that we have received since then are consistent with this. Our central forecast is that economic growth in Australia will pick up from an average rate of 2 per cent over the past couple of years to 2 3/4 per cent this year and 3 per cent over 2021. This expected pick-up in growth is supported by accommodative monetary policy, a new expansion phase in the resources sector, stronger consumer spending and a recovery in dwelling investment later this year. High levels of spending on infrastructure and strong growth in public demand are also helping the economy. The outlook is also supported by an expected modest lift in global growth. The global economy has clearly suffered over the past year from the uncertainty and interruption to international trade caused by the US-China trade and technology disputes. More recently, though, there have been signs of stabilisation, especially in the manufacturing sector. Consistent with this, in its latest public forecasts the International Monetary Fund has predicted global growth will be stronger this year and next than it was last year. Notwithstanding this, there are still some significant areas of uncertainty. One of these is the possibility of a re-escalation of the US-China disputes. The 'phase one' deal has alleviated some of the earlier uncertainties, but it has not eliminated them. There are also a number of other trade disputes that are simmering elsewhere around the world. And more recently, the outbreak of the coronavirus represents a new source of uncertainty. It is too early to tell what the impact will be, but the SARS outbreak in 2003 may provide a guide. On that occasion, there was a sharp slowing in output growth in China for a few months, before a sharp bounce back as the outbreak was controlled and economic stimulus measures were introduced. Today, China is a larger part of the global economy and it is more closely integrated, including with Australia, so the international spillovers could be larger than they were back in 2003. Much will depend on the success of the various efforts to control the virus so we are watching developments carefully. In terms of the domestic issues, perhaps the most significant one at the moment is that household spending has been very soft. For some time now, households had been gradually adjusting their spending to the slower trend rate of income growth. This adjustment accelerated last year in response to falling housing prices. Faced with the reality of slow growth in wages and falling housing prices, many households scaled back their spending and adjusted their finances. Looking forward, we expect this adjustment in household finances to continue for a while yet, but for consumption to pick up gradually. As households become more comfortable with their finances they should have the confidence to spend. Continued growth in employment, stronger growth in disposable income than in recent years and the recent increases in housing prices will also help here, as will an upswing in residential construction. So we are expecting stronger growth in consumption over the course of this year, although there is some uncertainty about how long this period of balance sheet adjustment will continue. The other significant domestic issues are the bushfires and the drought. The fires have had a devastating personal and economic impact on the areas affected. In addition to the tragic loss of life, many people have lost their homes and there has been extensive damage to farms, businesses and public infrastructure. Our current estimate is that over the December and March quarters, the fires will have reduced Australian GDP growth by around 0.2 percentage points. The rebuilding effort is expected to broadly offset that effect over the rest of this year. The drought is also continuing to act as a drag on the economy and is expected to reduce GDP growth by a quarter of a percentage point this year. Turning now to the labour market, we are expecting the unemployment rate to hold steady for a while at around its current level of just over 5 per cent before declining to a little below 5 per cent as economic growth picks up. Employment growth slowed a little towards the end of last year, but most of the forward-looking indicators - including job vacancies - suggest reasonable employment growth over the months ahead. In terms of wages, we are expecting a continuation of the current pace of increase. Wage increases of 2 point something have become common across much of the country and we do not see this changing in the near term. The recent inflation data were in line with our expectations, with CPI inflation running at 1.8 per cent. Within the overall CPI there are contrasting trends. The prices of many food items are rising more quickly than they have for some time, largely because of the drought. In contrast, housing-related costs remain subdued, with rents increasing at the slowest rate on record and electricity prices falling in most places. Looking forward, we are expecting inflation to pick up to 2 per cent over the next couple of years. I would now like to turn to monetary policy. Since the previous hearing, the Reserve Bank Board has cut the cash rate by a further 1/4 of a per cent, bringing the total reduction last year to 3/4 percentage point. Since last October, including at our meeting earlier this week, the Board has maintained the cash rate unchanged at 0.75 per cent. I understand that some people in our community have concerns about interest rates being at very low levels and that low interest rates makes it more difficult for people relying on interest income. I would like to assure these people that we did not take those decisions lightly. Rather, we have been responding to two major developments. First, the low interest rates globally. And second, a period of balance sheet adjustment by Australian households. As we have discussed at previous hearings, world interest rates have moved lower over the past decade. This is mainly because of structural factors related to ageing of the population, productivity growth, slower population growth and high rates of saving in Asia. Since we live in an interconnected world, we cannot ignore this shift in world interest rates. On the domestic front, as I discussed earlier, households have been responding to the period of low wages growth and a fall in housing prices. This has resulted in a period of low consumption growth and below-average economic growth. If interest rates had not been reduced last year this adjustment in household finances would have been more difficult and the overall economy would have suffered. The lower interest rates have made it easier for people to manage their debts and, on the other side of the balance sheet, they have boosted asset values. In doing so, they are bringing forward the day when households feel sufficiently comfortable to increase their spending again. The easing of monetary policy is also supporting a turnaround in housing investment and has also had an effect on the exchange rate, which boosts demand for our exports. So, it is working. Looking forward, we are expecting progress to be made towards the inflation target and full employment, but that progress is expected to be only gradual and there are uncertainties. Given the only gradual nature of the progress, the Board has been discussing the case for a further easing of monetary policy in an effort to speed the pace of progress and to make it more assured. In considering this case, we have taken account of the fact that interest rates have already been reduced to a low level and there are long and variable lags in the transmission of monetary policy. The Board also recognises that a balance needs to be struck between the benefits of lower interest rates and the risks associated with having interest rates at very low levels. Internationally, there are increasing concerns about the effect of very low interest rates on resource allocation in the economy and their effect on the confidence of some people. Lower interest rates could also encourage more borrowing by households eager to buy residential property at a time when housing debt is already quite high and there is already a strong upswing in housing prices in place. If so, this could increase the risk of problems down the track. After considering this balance, the Board decided to maintain the cash rate unchanged. We recognise, though, that the nature of this balance between benefits and risks can change over time and it is dependent upon the state of the economy. If the unemployment rate were to be moving materially in the wrong direction and there was no further progress being made towards the inflation target, the balance of arguments would tilt towards a further easing of monetary policy. So we are continuing to watch the labour market carefully, as we seek to strike the right balance in the interests of the community as a whole. While on the topic of interest rates, I would like to draw your attention to some new analysis of lending rates that will be included in today's Statement on Monetary Policy and updated each month on the RBA website. In particular, the newly published data show that households that took out their mortgage four or five years ago are paying noticeably higher interest rates than those who took out their mortgage more recently. This reflects the fact that the discounts offered to lenders' standard variable rates have risen over recent years and these discounts tend to be fixed for the life of the loan - what might have once seemed a big discount might not be so big now. As I have said a number of times recently, if you took your loan out a while ago it is worth shopping around and checking in with your lender to see if it can now give you a bigger discount. New data being published by the RBA and ASIC should help with this shopping around. On a different matter, you might recall that at our previous hearing we had a discussion about quantitative easing (QE). Shortly after that I gave a public speech on the issue. Given the Committee's previous interest in the topic I thought it would be useful to summarise the main points for you. The first is that negative interest rates in Australia are extraordinary unlikely. This is not a direction we need to go in. The second point is that Australia's financial markets are currently operating normally so there is no need for any special liquidity operations. If liquidity pressures did emerge in our markets, though, we have the capacity and the tools to respond. We have done this in the past, and would do so again to support the smooth operation of Australia's financial markets. The third point is that the threshold for undertaking QE - that is, the RBA purchasing assets through balance sheet expansion - has not been reached in Australia and I do not expect it to be reached. So, it is not on our agenda at the moment. The fourth point is that we would consider QE only if there were an accumulation of evidence that, over the medium term, we were unlikely to achieve our objectives of full employment and the inflation target. As I have said on other occasions - including before this Committee - in the event that the country did find itself in that position, I would hope that policy options other than monetary policy were also on the country's agenda. The fifth and final point is that QE would be considered only at a cash rate of 0.25 per cent. Our focus would be on purchasing government securities to put downward pressure on longer-term interest rates. We have no appetite to purchase private sector assets as part of any QE program. Doing so would represent a major intervention by the RBA into resource allocation in our economy and come with a whole host of governance issues. So this is not a direction we are inclined to go in. Finally, I would like to highlight a few payments matters. Australia's new fast payments system is continuing to grow, with most of the major banks now close to offering the agreed initial functionality. The RBA - as banker to the Australian Government - has been using this new system recently to get money immediately into the bank accounts of people affected by the bush fires. More generally, most people in Australia are now able to move money between bank accounts in a matter of seconds. The Payments System Board is hoping to see banks, fintechs and others use this new infrastructure to develop innovative payment solutions that help individuals and small businesses. Another priority for the Payments System Board over the year ahead is to complete its periodic review of payments regulation in Australia. We are currently reviewing the initial submissions to this review and it is clear that the world of payments is moving quickly, partly driven by new technologies. One of the issues that the Council of Financial Regulators has already raised with government is the regulatory arrangements for so-called stored value facilities, which could include digital payment 'coins'. The Council is seeking some changes to current regulatory arrangements that would provide stronger protections for consumers as well as creating a simpler regulatory system that encourages innovation. Another issue on which the Council of Financial Regulators will provide advice to government this year is the resolution arrangements that apply to Australia's systematically important financial infrastructures, including central counterparties and securities settlement facilities. We need to make sure that our arrangements for dealing with problems in these critical parts of Australia's financial infrastructure are strong and that they meet international standards. This will likely require some changes in current legislation. Thank you. My colleagues and I are here to answer your questions.

r200319a_BOA

australia

Responding to the Economic and Financial Impact of COVID-19

lowe

Good afternoon. The Reserve Bank Board met yesterday and decided on a comprehensive package to help support jobs, incomes and businesses as the Australian economy deals with the coronavirus. I would like to use this opportunity to explain this package and to answer your questions. We are clearly living in extraordinary and challenging times. The coronavirus is first and foremost a very major public health problem. But it has also become a major economic problem, which is having deep ramifications for financial systems around the world. The closure of borders and social distancing measures are affecting us all and they are changing the way we live. Understandably, our communities and our financial markets are both having trouble dealing with a rapidly unfolding situation that they have not seen before. As our country manages this difficult situation, it is important that we do not lose sight of the fact that we will come through this. At some point, the virus will be contained and our economy and our financial markets will recover. Undeniably, what we are facing today is a very serious situation, but it is something that is temporary. As we deal with it as best we can, we also need to look to the other side when things will recover. When we do get to that other side, all those fundamentals that have made Australia such a successful and prosperous country will still be there. We need to remember that. To help us get to the other side, though, we need a bridge. Without that bridge, there will be more damage, some of which will be permanent, to the economy and to people's lives. Building that bridge requires a concerted team effort, with us all pulling together in the country's interest. On the economic front, there is very close policy coordination between the Australian all in close contact with one another and are working constructively together and we will continue to do so. This coordination is evident in the various policy statements today. Governments across Australia are playing their important role in building that bridge to the recovery, with the various fiscal initiatives from the Australian and state governments providing very welcome support. Rightly, the focus is on supporting businesses and households who will suffer a major hit to their incomes. It is increasingly clear that further help will be required on this front and the Australian Government has indicated that additional policy measures will be announced shortly. Australian public finances are in good shape and the country's history of prudent fiscal management gives us the capacity to respond now. The banks too have an important role to play in building that bridge to the recovery by supporting their customers. Without this support, it will be harder for us all to get to the other side in reasonable shape. Australia has a strong financial system, which is well placed to provide the needed support to businesses and households. The system has strong capital and liquidity positions and our financial institutions have invested heavily in resilience. As APRA confirmed this afternoon in a public statement, the current large buffers of capital and liquidity are able to be used to support ongoing lending to the economy. The financial regulators have also confirmed that they are examining how the timing of various regulatory initiatives might be adjusted to allow financial institutions to concentrate on their businesses and work with their customers. APRA and ASIC both stand ready to assist institutions work through regulatory issues arising from the virus. The Council of Financial Regulators is meeting again tomorrow and will also meet with the largest lenders to discuss how they can support their customers and whether there are any regulatory impediments in the way. The Reserve Bank itself is also playing a role in building that bridge to the recovery. I will now turn to that. Our major focus is to support jobs, incomes and businesses, so that when the health crisis recedes the country is well placed to recover strongly. Supporting small business over coming months is a particular priority. Prior to today's announcement, we had already taken several steps over recent days to support the Australian economy. Over the past week or so we have been injecting substantial extra liquidity into the financial system through our daily market operations. As part of this effort, we will be conducting one-month and three-month repo operations each day. We will also conduct repo operations of six-month maturity or longer at least weekly, as long as market conditions warrant. As a result of these liquidity operations, Exchange Settlement balances have increased from around $2.5 billion a month ago to over $20 billion today. The Reserve Bank also stands ready to purchase Australian government bonds in the secondary market to support its smooth functioning. The government bond market is a key market for the Australian financial system, because government bonds provide the pricing benchmark for many financial assets. Our approach here is similar in concept to our longstanding approach to the foreign exchange market, where we have been prepared to support smooth market functioning when liquidity conditions are highly stressed. We now stand ready to do the same in the bond market and we are working in close cooperation on this with the Australian Office of Financial Management In addition to these previously announced measures, today's package has four elements. They are: a reduction in the cash rate to 0.25 per cent; a target of 0.25 per cent for the yield on 3-year government bonds; a term funding facility to support credit to businesses, particularly small and medium-sized businesses; and an adjustment to the interest rate on accounts that financial institutions hold at the RBA. I will discuss each of these in turn. This brings the cumulative decline over the past year to 1 1/4 percentage points. This is a substantial easing of monetary policy, which is boosting the cash flow of businesses and the household sector as a whole. It is also helping our trade-exposed industries through the exchange rate channel. At the same time, though, low interest rates do have negative consequences for some people, especially those relying on interest income. The Reserve Bank Board has discussed these consequences extensively, but the evidence is that lower interest rates do benefit the community as a whole, although I acknowledge that the effects are uneven. With this decision today, the policy rates set by the Reserve Bank of Australia, the United States per cent. Each of us are using all the scope we have with interest rates to support our economies through a very challenging period. At its meeting yesterday, the Board also agreed that we would not increase the cash rate from its current level until progress was made towards full employment and that we were confident that inflation will be sustainably within the 2-3 per cent range. This means that we are likely to be at this level of interest rates for an extended period. Before the coronavirus hit, we were expecting to make progress towards full employment and the inflation target, although that progress was expected to be only very gradual. Recent events have obviously changed the situation and we are now likely to remain short of those objectives for somewhat longer. I am not able to provide you with an updated set of economic forecasts. The situation is just too fluid. But we are expecting a major hit to economic activity and incomes in Australia that will last for a number of months. We are also expecting significant job losses. The scale of these losses will depend on the ability of businesses to keep workers on during this difficult period. We saw during the global financial crisis how flexibility in working arrangements limited job losses and this benefited the entire community. I hope the same is true in the months ahead. It is also important to repeat that we are expecting a recovery once the virus is contained. The timing and strength of that recovery will depend in part upon how successful we are, as a nation, in building that bridge to the other side. When that recovery does come, it will be supported by the low level of interest rates. We will maintain the current setting of interest rates until a strong recovery is in place and the achievement of our objectives is clearly in sight. Over recent decades, the Reserve Bank's practice has been to target the cash rate, which forms the anchor point for the risk-free term structure. We are now extending and complementing this by also targeting a risk-free interest rate further out along the yield curve. have set this target at around 0.25 per cent, the same as the cash rate. Over recent weeks, the yield on 3-year AGS has averaged 0.45 per cent, so this represents a material reduction. We have chosen the three-year horizon as it influences funding rates across much of the Australian economy and is an important rate in financial markets. It is also consistent with the Board's expectation that the cash rate will remain at its current level for some years, but not forever. To achieve this yield target, we will be conducting regular auctions in the bond market. We published some technical details earlier today and we will keep the market informed of our operations. Our first auction will be tomorrow. As part of this program, our intention is to purchase bonds of different maturities given the high level of substitutability between bonds. We are also prepared to buy semigovernment securities to achieve the target and to help facilitate the smooth functioning of Australia's bond market. I want to make it clear that our purchases will be in the secondary market and we will not be purchasing bonds directly from the Government. I would also like to emphasise that we are not seeking to have the three-year yield identically at 25 basis points each and every day. There will be some natural variation, and it does not make sense to counter that. It may also take some time for yields to fall from their current level to 25 basis points. I understand why many people will view this as quantitative easing - or QE. This is because there is a quantitative aspect to what we are doing - achieving this target will involve the Reserve Bank buying bonds and an expansion of our balance sheet. But our emphasis is not on the quantities - we are not setting objectives for the quantity and timing of bonds that we will buy, as some other central banks have done. How much we need to purchase, and when we need to enter the market, will depend upon market conditions and prices. Rather than quantities or the size of our balance sheet, our focus is very much on the price of money and credit. Our objective here is to provide support for low funding costs across the entire economy. By lowering this important benchmark interest rate, we will add to the downward pressure on borrowing costs for financial institutions, households and businesses. We are prepared to transact in whatever quantities are necessary to achieve this objective. We expect to maintain the target for three-year yields until progress is being made towards our goals of full employment and the inflation target. Our expectation, though, is that the yield target will be removed before the cash rate is increased. The scheme has two broad objectives. The first is to lower funding costs for the entire banking system so that the cost of credit to households and businesses is low. In this regard, it will complement the target for the three-year yield on AGS. The second objective is to provide an incentive for lenders to support credit to businesses, especially small and medium-sized businesses. This is a priority area for us. Many small businesses are going to find the coming months very difficult as their sales dry up and they support their staff. Assisting small businesses through this period will help us make that bridge to the other side when the recovery takes place. If Australia has lost lots of otherwise viable businesses through this period, making that recovery will be harder and we will all pay the price for that. So it is important that we address this. Under this new facility, authorised deposit-taking institutions (ADIs) in total will have access to at least $90 billion in funding. ADIs will be able to borrow from the Reserve Bank an amount equivalent to 3 per cent of their existing outstanding credit to Australian businesses and households. ADIs will be able to draw on these funds up until the end of September this year. Lenders will also be able to borrow additional funds from the Reserve Bank if they increase credit to business this year. For every extra dollar lent to large business, lenders will have access to an additional dollar of funding from the Reserve Bank. For every extra dollar of loans to small and medium-sized businesses they will have access to an additional five dollars. These funds can be drawn upon up until the end of March next year. There is no extra borrowing allowance for additional housing loans. The funding from the Reserve Bank will be for three years at a fixed interest rate of 0.25 per cent, which is substantially below lenders' current funding costs. Institutions accessing this scheme will need to provide the usual collateral to the Reserve Bank, with haircuts applying. The first drawings under this facility will be possible no later than four weeks from today. This scheme is similar to that introduced by the Bank of England. Unlike the Bank of England's scheme, though, the interest rate is fixed for the term of the funding. This is consistent with our view that the cash rate is likely to stay at its current level for some time. Another difference with the Bank of England's scheme is that we have not included a higher interest rate if credit contracts. While a decline in credit would be undesirable, including a penalty may act as a disincentive for institutions to take part in the scheme. We are encouraging all ADIs to use the term funding facility to help support their customers. I welcome APRA's confirmation this afternoon that it also supports ADIs using this scheme. I also welcome the Australian Government's announcement that it will support the markets for assetbacked securities through the AOFM. This support is important as it will help non-bank financial institutions and small lenders to continue to provide credit to Australian households and businesses. Under our longstanding framework, the RBA operates a corridor system around the cash rate. Under that system, the balances that banks hold with the RBA overnight in Exchange Settlement accounts earn an interest rate 25 basis points below the cash rate. And on the other side of the corridor, in the event that a bank needed to borrow from the RBA overnight, it would be charged 25 basis points above the cash rate. Under this arrangement and with the cash rate now at 25 basis points, the interest rate on Exchange Settlement balances would have been zero. We have decided to increase this to 10 basis points. We are not making any change to the arrangements for the top of the corridor. This adjustment to the corridor reflects the fact that there will be a significant increase in the balances held in Exchange Settlement accounts due to the combined effect of the Bank's enhanced liquidity operations, bond purchases and term funding program. Maintaining a zero interest rate on these balances would increase the costs to the banking system. In the current environment, this would be unhelpful. The increase in settlement balances is also expected to change the way that the cash market operates. In other countries, where there have been large increases in balances at the central bank, the cash rate equivalent has drifted below the target and transaction volumes in the cash market have declined. It is likely that we will see the same outcome in Australia. The Reserve Bank will continue to monitor the cash market closely and is prepared to adjust arrangements if the situation requires. So these are the four measures announced earlier this afternoon. Together, they represent a comprehensive package to lower funding costs in Australia and support the supply of credit. Complementary initiatives by APRA and the AOFM are also working towards those same objectives. The term funding scheme and the three-year yield target are both significant policy developments that would not have been under consideration in normal times. They both carry financial and other risks for the Reserve Bank and they both represent significant interventions by the Bank in Australia's financial markets. The Reserve Bank Board did not take these decisions lightly. But in the context of extraordinary times and consistent with our broad mandate to promote the economic welfare of the people of Australia, we are seeking to play our full role in building that bridge to the time when the recovery takes place. By doing all that we can to lower funding costs in Australia and support the supply of credit to business, we will help our economy and financial system get through this difficult period. Thank you for listening and I am here to answer your questions.

r200421a_BOA

australia

An Economic and Financial Update

lowe

Good afternoon and thank you for joining us today. When I spoke a few weeks ago, I talked about the importance of building a bridge to the recovery and helping as many people and businesses as possible get across that bridge. Over the past month, the scale of that national bridge-building task has grown in size - as our efforts to contain the virus have stepped up, that bridge has had to be bigger, longer and stronger. As a country, we have been up to this task. While we still face some difficult days ahead, Australians can take some reassurance from the fact that all arms of public policy are pulling in the same direction. We are all working to support the Australian economy through what is a very challenging period and to make sure we are well placed to recover. Today, I would like to provide some details about the economic outlook and an update on the implementation of the Reserve Bank's recent policy package. Economic forecasting is difficult at the best of times. It is even harder at times like this when we are experiencing a once in a lifetime event. Given this, I don't think it makes sense at the moment to focus on forecasts to the nearest decimal point, as we often do. Instead, I would like to focus on two broad issues: the immediate outlook for the economy the nature and speed of the recovery. The next few months are going to be difficult ones for the Australian economy. One very obvious consequence of the efforts needed to contain the virus is that many normal activities are restricted or not permitted. This means that, for as long as these restrictions are in place, we don't have the jobs and incomes that come from these activities. On top of this, there is a high level of uncertainty about the future, which means that many households and businesses are holding back their spending and investment. The result of both the restrictions and the uncertainty is that over the first half of 2020 we are likely to experience the biggest contraction in national output and income that we have witnessed since the 1930s. Putting precise numbers on the magnitude of this contraction is difficult, but our current thinking is along the following lines: National output is likely to fall by around 10 per cent over the first half of 2020, with most of this decline taking place in the June quarter. Total hours worked in Australia are likely to decline by around 20 per cent over the first half of this year. The unemployment rate is likely to be around 10 per cent by June, although I am hopeful that it might be lower than this if businesses are able to retain their employees on lower hours. The unemployment rate would have been much higher than this without the government's JobKeeper wage subsidy. These are all very large numbers and ones that were inconceivable just a few months ago. They speak to the immense challenge faced by our society to contain the virus. In terms of inflation, we are also expecting a significant decline in the June quarter. The large fall in oil prices, combined with the introduction of free childcare and the deferral or reduction in some price increases mean that it is quite likely that year-ended headline inflation will turn negative in June. If so, this would be the first time since the early 1960s that the price level has fallen over a full year. In underlying terms, however, inflation is expected to remain positive. As the economic data roll in over coming months, they will present a very sobering picture of the state of our economy. There will be many reports of record declines in economic activity. As Australians digest this economic news, I would ask that we keep in mind that this period will pass, and that a bridge has been built to get us to the other side. With the help of that bridge, we will recover and the economy will grow strongly again. That bridge has been partly built with the help of Australia's strong balance sheets - in particular, the strong balance sheets of our governments, our private banks and of the Reserve Bank. Australia's long record of responsible fiscal policy has allowed the government to use its balance sheet to help smooth out the income shock and to offer protection to those most affected. In doing so, it is making a major difference. The strong balance sheets of our banks are also helping. By offering payment deferrals and concessional terms, our banks are rightly acting as shock absorbers and helping the country through this difficult period. And as I will speak about in a few minutes, the Reserve Bank itself is using its balance sheet to keep funding costs low and credit available to both businesses and households. Without these strong balance sheets, we would have been in a more difficult position. I would now like to turn to the speed and nature of the recovery. We can be confident that our economy will bounce back and that we will see it recover. We need to remember that once the virus is satisfactorily contained, all those factors that have made Australia such a successful and prosperous country will still be there. Inevitably, the timing and pace of this recovery depend upon how long we need to restrict our economic activities, which in turn depends on how effectively we contain the virus. So it is difficult to be precise and it makes sense to think in terms of scenarios. Consistent with this, the Bank will discuss some possible scenarios in the in a few weeks' time. One plausible scenario is that the various restrictions begin to be progressively lessened as we get closer to the middle of the year, and are mostly removed by late in the year, except perhaps the restrictions on international travel. Under this scenario we could expect the economy to begin its bounce-back in the September quarter and for that bounce-back to strengthen from there. If this is how things play out, the economy could be expected to grow very strongly next year, with GDP growth of perhaps 6-7 per cent, after a fall of around 6 per cent this year. There is though quite a lot of uncertainty around the numbers, with the exact profile of the recovery depending not only upon when the restrictions are lifted but also on the resolution of the uncertainty that people feel about the future. It is harder to make forecasts about the unemployment rate given the uncertainty about how many employees will remain attached to their firm and whether people who are stood down will be looking for employment and thus be counted as unemployed. But it is likely that the unemployment rate will remain above 6 per cent over the next couple of years. With many firms delaying or cancelling wage increases, year-ended wage growth is expected to decline to below 2 per cent, before gradually picking up again. In underlying terms, inflation is expected to remain below 2 per cent over the next couple of years. Of course, there are other scenarios as well. On the optimistic side, the restrictions could be lifted more quickly, with the virus being contained. In that case, a stronger recovery could be expected, particularly in light of the very large monetary and fiscal support that is in place. On the other hand, if the restrictions stay in place longer, or they have to be reimposed, the recovery will be delayed and interrupted. In that case, the loss of incomes and jobs would be even more pronounced. Whatever the timing of the recovery, when it does come, we should not be expecting that we will return quickly to business as usual. Rather, the twin health and economic emergencies that we are experiencing now will cast a shadow over our economy for some time to come. It is highly probable that the severe shocks we are now experiencing will change the mindsets of some people and businesses. Even after the restrictions are lifted, it is likely that some of the precautionary behaviour will persist. And in the months ahead, we are likely to lose some businesses, despite best efforts, and some of these businesses will not reopen. There will also be a higher level of debt and some households might revaluate the risks of having highly leveraged balance sheets. It is also probable that there will be structural changes in the economy. We are all learning to work, shop and travel differently. Some of these changes will probably stay with us, requiring a rethinking of business models. So the crisis will have reverberations through our economy for some time to come. The best way of dealing with these reverberations is to reinvigorate the country's growth and productivity agenda. As we look forward to the recovery, there is an opportunity to build on the cooperative spirit that is now serving us so well to push forward with reforms that would move us out of the shadows cast by the crisis. A strong focus on making Australia a great place for businesses to expand, invest, innovate and hire people is the best way of extending the recovery into a new period of strong and sustainable growth and rising living standards for all Australians. I would now like to change tack and turn to the Reserve Bank's policy response. To recap, that response has had five elements: i. a reduction in the cash rate to 25 basis points with forward guidance that the cash rate will not be increased until we are making sustainable progress towards our goals for full employment and inflation ii. the introduction of a target for the yield on 3-year Australian government bonds of 25 basis points, and a preparedness to buy government bonds in whatever quantities are needed to achieve that target iii. the introduction of a Term Funding Facility, under which authorised deposit-taking institutions (ADIs) have access to funding from the Reserve Bank for three years at 25 basis points, with additional funding available if ADIs increase lending to business, especially small and medium-sized businesses iv. using our daily open market operations to make sure that there is plenty of liquidity in the financial system and using our bond purchases to promote the smooth functioning of the market for government securities v. modifying the interest rate corridor system so that balances held in Exchange Settlement Accounts at the Reserve Bank earn 10 basis points, rather than zero. This is a comprehensive package and is an important part of that national effort to build the bridge to the recovery that I spoke about earlier. It was designed to keep funding costs low across the economy and ensure credit is available to businesses and households. Following the announcement of the package, the yield on 3-year government bonds has declined and is now around the target level of 25 basis points, after having been around 50 basis points immediately prior to our announcement. Liquidity in the Australian government bond market has also improved substantially and this important market is working much better. Bid-ask spreads are still a little wider than they were a couple of months ago, but they have narrowed substantially recently. To date, the Reserve Bank has bought around $47 billion of government bonds. We have bought bonds along the yield curve and bonds issued by the Australian government and by the states and territories. We have done this through daily auctions in the secondary market. The initial daily purchases were quite large - $4 and $5 billion a day. In those first days we were keen to underline our commitment to the target and we were also seeking to relieve some of the very severe dislocation in the government bond market at the time. As conditions in the market have improved and the 3-year yield has settled around 25 basis points, we have scaled back our daily bond purchases - over recent days, the purchases have averaged around $750 million. We will scale up these purchases again if needed and we will buy bonds in whatever quantity is required to achieve our goals. With conditions more settled at the moment, our plan for the immediate future is to schedule any bond auctions we conduct for three days each week - Mondays, Wednesdays and Thursdays. That does not mean that we will necessarily purchase bonds on each of these days. Whether or not we do so will depend upon the yield on 3-year government bonds and on market functioning. It is likely, though, that for the foreseeable future we will be purchasing semi-government securities weekly. As is the case now, we will announce our intentions at 11.15 am. If conditions warrant it, we will return to daily bond purchases. I would like to restate that we are buying bonds in the secondary market and we are not buying bonds directly from the government. One of the underlying principles of Australia's institutional arrangements is the separation of monetary and fiscal policy - that is, the central bank does not finance the government, instead the government finances itself in the market. This principle has served the country well and I am confident that the Australian federal, state and territory governments will continue to be able to finance themselves in the market, as they should. While we are not directly financing the government, our bond purchases are affecting the market price that the government pays to raise debt. Our policies are also affecting the price that the private sector pays to raise debt. In this way, our actions are affecting funding costs right across the economy as they should in the exceptional circumstances that we face. But our actions should not be confused with the Reserve Bank financing the government. Another element of the recent package was the Term Funding Facility. Around $3 billion of the initial allowance of $90 billion has already been drawn under this facility, with around 35 institutions participating so far. The knowledge that ADIs have access to this scheme over coming months has reduced any concerns there might have been about possible future liquidity strains. In doing so, this scheme has supported confidence that Australia's ADIs will be able to access the liquidity needed to support their customers. It has also contributed to the low cost of borrowing new funds at fixed interest rates for businesses and households. The drawings under this facility, combined with the bond purchases and the Reserve Bank's open market operations, have resulted in the balances held in Exchange Settlement Accounts increasing substantially. At the beginning of March these balance stood at around $2 1/2 billion. Today, they stand at $83 billion. On the other side of the Reserve Bank's balance sheet, there are increased holdings of government bonds, purchased both outright and under repurchase agreements in our daily open market operations. The very large increase in the balances in Exchange Settlement Accounts has affected the operation of the cash market. The number of transactions in this market has declined as fewer institutions need to borrow settlement balances each day. The cash rate has also drifted below 25 basis points and today is at 15 basis points. Both of these changes are consistent with experience in other countries and have not come as a surprise to us. The increase in liquidity in the financial system has also resulted in the spread between the bank bill swap rate (BBSW) and the overnight indexed swap rate (OIS) falling significantly. At the threemonth horizon this spread is now around zero, which has further reduced funding costs for both the banking system and for the non-bank lenders. The increased liquidity in the system also means that the Bank's daily open market operations are now on a smaller scale and we have adjusted the frequency of the longer-term operations. We will continue to adjust these operations as required to support the liquidity of the system. So that is where we are four weeks after the announcement of our policy package. This package, combined with the government's fiscal policies and the work of the banks and many businesses, is building that strong bridge that I have spoken about. Our monetary response is keeping funding costs low across the economy and credit available. The fiscal response is providing significant support to both jobs and incomes. Businesses are also helping their employees by keeping them on where they can and the banks are supporting their customers with more flexible terms. Together, these efforts are helping the Australian economy through a difficult period and positioning us well for the recovery. Thank you very much for listening. I am here to answer your questions.

r200521a_BOA

australia

Remarks to FINSIA Forum

lowe

I would like to thank FINSIA for putting this event together. Thank you also for your work in raising professional standards in Australia's financial sector. This work is helping restore trust in our financial institutions, as is the effort by the institutions themselves to support the national effort to overcome As the chair of the Council of Financial Regulators, I would like to begin with a few remarks about the recent work of the Council. I will then say a few words about the economic outlook. and the RBA. It serves as a clearing house for ideas and a forum for the discussion of issues affecting the stability of the Australian financial system. While it does not have formal powers, it has established a strong cooperative culture that has helped Australia's financial regulators work closely together. When things were moving very quickly through much of March and April, the Council met frequently, holding conference calls at least weekly, with the Australian Treasurer joining some of these calls. And at the staff level, our agencies were meeting daily. Recently, we have also been having calls with our counterparts in New Zealand under the umbrella of the Trans-Tasman Council on Banking In the difficult days of mid March, the Council made a number of public statements focused on four key points. I would like to run through these again. The first is that the Australian financial system is resilient and is well placed to deal with COVID-19. In particular, the system has large capital and liquidity buffers and it has made substantial investments in operational resilience. The system is in this strong position partly because over the past decade APRA has worked with financial institutions to boost their capital and to reduce their liquidity risks. Australia's financial institutions are also profitable and they have had low levels of problem loans. The second point is that the capital and liquidity buffers that exist are available to be drawn upon if required to support the economy. I would like to reinforce this point today. If there was ever a time to allow these buffers to be used, now is that time. We should not expect to see capital buffers be maintained during a once-in-a-century shock. These buffers have been built up to be utilised in events such as this, and some reduction in capital ratios is entirely appropriate as lenders support their customers through this difficult period. The third and related point that the Council wanted to emphasise is that it is important that lenders continue to support the flow of credit to the economy. The Council is committed to assisting this process. The Reserve Bank, through its package of policy measures, is doing what it can to keep funding costs low and credit available. The Government has granted a six-month exemption from responsible lending obligations when lenders provide credit to existing customers who run a small business. Consistent with this, ASIC has been encouraging lenders to work closely with their customers to provide short-term assistance and support their longer-term viability. And APRA has announced temporary changes to its expectations regarding bank capital ratios. The fourth and final point made by the Council is that the regulatory agencies have been conscious of the need to adjust the timing of their regulatory initiatives where possible to allow financial institutions to focus on serving their customers. In the case of the RBA, we have put on hold the Review of Retail Payments Regulation, which we started last year. While we are continuing to do work in the background, the review will not be completed until next year. So these have been the four key messages. I am sure my colleagues will expand on some of these during this webinar. I would now like to turn to the economy. We are living through the biggest and the most sudden economic contraction since the 1930s. Unlike previous contractions, this one is not being caused by a financial event or by macroeconomic policies. Rather, it is the result of society's efforts to contain a pandemic. Last week we had a stark reminder of the very human cost of these efforts, with almost 600,000 jobs lost in April and more than 750,000 Australians on zero hours. All up, total hours worked in Australia fell by an unprecedented 9 per cent in April. The labour market data that post- date April's Labour Force Survey suggest a further decline in hours worked in May, although the decline does not look to be as large as it was in April. If this is an accurate gauge, it is possible that the total decline in hours worked will be less than earlier feared as firms make use of the JobKeeper wage subsidy. Just as the nature of this economic contraction is different, so too has been the fiscal and monetary policy response. This response has been built around the idea that we need to build a bridge to the point when the virus is contained and the capacity of our health system has been scaled up so that it can cope. This has been the right approach and it has involved coordinated and unprecedented monetary and fiscal measures. The banks, too, have been part of building this bridge through their repayment deferrals and their provision of credit lines to businesses. Yet, despite all these efforts, the future remains unusually uncertain. So much so that in the Reserve Bank's latest we took the unusual step of providing upside and downside scenarios as well as a baseline scenario. One obvious source of uncertainty is the pace at which the various restrictions are eased. The faster that the restrictions can be lifted safely, the sooner and stronger the economic bounce-back will be and the less economic scarring will take place. But this is not the only source of uncertainty. Another source of uncertainty is the level of confidence that people have about their future, both in terms of their health and their own finances. It is interesting that the initial evidence is that countries that have had fewer restrictions are also experiencing very large contractions in economic activity. This suggests that voluntary decisions that people have made in response to the uncertainty about their health and their finances is also playing a major role. In the face of this uncertainty, people have been reluctant to go out and spend and businesses have been reluctant to invest. This points to a critical issue for us here in Australia: that is, restoring people's confidence on two fronts. The first is the confidence that we can go about our lives and remain healthy. And the second is the confidence that we will have jobs and incomes and the economy will grow strongly again. On the economic front, the Reserve Bank's package of policy measures announced in mid March will help. That package was designed to keep funding costs low and credit available. It included cutting the cash rate to 25 basis points, targeting a yield of 25 basis points for 3-year Australian Government bonds and making a Term Funding Facility available to the banks to support credit to businesses, especially small and medium-sized businesses. The early evidence is that these measures are working as expected. Banks have reduced their lending rates to record lows, with interest rates for small business declining the most. The yield on 3-year bonds has settled at the target and the government bond markets in Australia are working well again. To date, the RBA has bought around $50 billion of government bonds. We have scaled back our purchases recently as conditions have continued to improve, and over the past week we have not purchased any bonds. We remain prepared to scale up these purchases again if necessary to achieve the yield curve target and to assist smooth market functioning. There is, though, a limit to what can be achieved with monetary policy. Fiscal support through this difficult period has also been crucial and will continue to be over the months ahead. So too will be a reinvigorated economic reform agenda that gives the community the confidence that once the virus has passed, we can move quickly out of the economic shadow it is casting. As I have said on other occasions, there is no shortage of reports filled with ideas of how to do this and how to make Australia a great place for businesses to expand, invest, innovate and hire people. If we can take up some of these ideas, we can once again experience strong and sustainable growth. Australia's financial institutions also have an important role in helping us get there. They are helping us to build the bridge to the point when the virus is contained and our economy recovers. As part of this effort, it is both understandable and desirable that lenders draw on the buffers that were built up in better times. It is in the banks' own interest and in the interest of the broader Australian community that banks support their customers now and also support them in the recovery phase when credit will be needed so that businesses can once again expand. Thank you.

r200528a_BOA

australia

Opening Statement to the Senate Select Committee on COVID-19

lowe

Good morning and thank you for the invitation to appear before this Committee. The past three months have been extraordinary ones in the life of our nation and there has been an unprecedented policy response. On the economic front, there has been very close coordination between monetary and fiscal policy, as there should be at times like this. As part of the RBA's contribution to dealing with the pandemic, we announced a comprehensive package in mid March. The goal is to support the economy by keeping funding costs low and credit available, especially to small and medium-sized businesses. As banker to the Australian Government, the RBA has also processed the many billions of dollars in government assistance to households and businesses. We have also made sure that the payments system is working well and that banknote supply is maintained. And we have done this with around 90 per cent of our staff working from home. The evidence so far is that our mid-March package is working as expected and it is helping build the necessary bridge to the recovery. The shape and timing of that recovery depends not only on when restrictions are lifted, but also on the confidence that Australians have about their own health and their finances. With the national health outcomes better than earlier feared, it is possible that the economic downturn will not be severe as earlier thought. Much depends on how quickly confidence can be restored. But even as the recovery gets under way, there will still be a shadow cast by the pandemic. As a country, we will need to turn our minds as to how to move out of this shadow. A reform agenda that makes Australia a great place for businesses to expand, invest, innovate and hire people would certainly help. For its part, the RBA will maintain its expansionary settings until progress is being made towards full employment and we are confident that inflation will be sustainably within the 2-3 per cent target band. I look forward to answering your questions.

r200721a_BOA

australia

COVID-19, the Labour Market and Public Sector Balance Sheets

lowe

I would like to thank you for your support of the Anika Foundation. The pandemic that we are all living through is traumatic for our entire community. Young people are no exception, with many anxious about their future job prospects and suffering from a loss of social connectivity. This means that the work of the Foundation is as important as ever. Thank you for your support. In this year's Anika Foundation talk, I would like to discuss two topics. The first is the impact of the pandemic on Australia's labour market. And the second is the important role that public sector balance sheets are playing in softening the economic downturn and in building the bridge to the recovery. I wanted to start with the labour market because for many people, the economic costs of the pandemic really hit home when they, or somebody they know, lost their job or their hours were cut. In April and May, employment fell by around 870,000 people and a further 760,000 people had zero hours of work, although they still had a job. Many other Australians had their hours cut, with young people bearing a lot of the burden (Graph 1). All up, total hours worked in Australia fell by 10 per cent in just a few weeks. As staggering as this fall is, it is smaller than we earlier feared. In early May, we were expecting a decline of almost 20 per cent in total hours worked. It is also a smaller than the decline we have seen in many other countries. In Canada, for example, hours fell by 28 per cent and in the United States they fell by 19 per cent. Fortunately, we have now turned the corner. In June, hours worked increased by 4 per cent and the number of employed people rose by 210,000. Notwithstanding this turnaround, the path ahead is expected to be bumpy and there are some major cross-currents in the labour market at the moment. On the positive side of the ledger, many firms that were heavily affected by the shutdowns are now rehiring and lifting hours as the restrictions are eased in most of the country. This is most clearly evident in the retail, hospitality and arts & recreation sectors (Graph 2). Some other firms have also hired large numbers of people as they respond to the increase in demand as a result of the pandemic. The supermarkets are a good example of this. example of that in the figures for June, released last week, when despite employment increasing by a record 210,000 people, the unemployment rate also rose to 7.4 per cent, a 21-year high (Graph 3). Looking forward, one of the keys to returning to a strong labour market is restoring confidence. This starts with people being confident about their own health and the public health response. The global evidence is that without this, people are reluctant to resume their normal activities and firms are reluctant to hire and invest. The other element is people being confident about their own finances and jobs, and businesses being confident about future demand. Addressing the health issues will help here, but so too will the policy response on the economic front. This brings me to the second issue that I wanted to talk about: the important role that is being played by public sector balance sheets in softening the economic downturn and in providing the best platform for the economy to recover. I will first talk about use of the RBA's balance sheet and then about the government's balance sheet. In mid March, the RBA announced a comprehensive monetary policy package to keep funding costs low and the supply of credit available, especially to small and medium-sized businesses. As part of this package, we have used our balance sheet: to make sure the financial system has plenty of liquidity to address dislocations in the government bond markets to provide low-cost funding to the banking system, so that lenders can support the provision of credit to their customers to reduce funding costs across the whole economy by having a target of around 25 basis points for three-year Australian Government bond yields. Reflecting these various measures, the Reserve Bank's balance sheet has increased from around $180 billon prior to the pandemic to around $280 billion today and further increases are expected To date, around $25 billion has been advanced under the funding scheme for the banking system, with 66 ADIs having used the facility (Graph 5). We expect further drawings to be made over coming months, with the total amount available currently standing at $150 billion. This facility is working as expected and is contributing to the plentiful supply of liquidity in the Australian financial system. The three-year yield target is also working well. In the weeks immediately after the announcement of the target, the Bank used its balance sheet to purchase $50 billion of government bonds, to support the yield target and address market dysfunction. Since late April we have scaled back purchases significantly and have not needed to purchase any bonds for some time (Graph 6). The target is viewed as credible by market participants, not least because it is consistent with the outlook for the cash rate over the next three years. There is also a broad understanding that the RBA is prepared to use its balance sheet in whatever quantity is needed to maintain the target. Government bond markets are also again operating normally, after the signs of dysfunction in bond markets around the world in March and April. I would now like to address one idea for the use of the central bank's balance sheet that I sometimes hear - that is, we should use it to create money to finance the government. A variant on this idea is that the central bank should just deposit money in every bank account in the country - this is sometimes known as 'helicopter money' because, before we had an electronic payments system the idea was that banknotes could simply be dropped by helicopter. For some, this idea is seen as a way of avoiding financing constraints - it is seen as holding out the offer of a free lunch of sorts. The central bank, unlike any other institution, is able to create money and the resource cost of creating that money is negligible. So the argument goes, if the government needs money to stimulate the economy, the central bank should simply create it in the public interest. The reality, though, is there is no free lunch. The tab always has to be paid and it is paid out of taxes and government revenues in one form or another. I would like to explain why. I will start with some central bank accounting. When a central bank creates money to finance government spending it does so by crediting the government's deposit account with it. These extra deposits represent a liability of the central bank. And on the asset side of the balance sheet, the central bank might have an IOU from the government to be paid in the future. Now suppose that the additional government spending is successful in stimulating the economy and this starts to push inflation up. At some point, interest rates would need to be increased to avoid inflation rising too far. If this lift in interest rates did not occur, inflation would rise, perhaps to a very high level. In this case, it would be through the inflation tax that the community pays for the extra government spending. So there is no free lunch - the spending is just paid for in a different way. Now instead suppose that interest rates are increased to avoid high inflation successfully. Even then, there is still no free lunch. How the tab is paid though depends on the nature of the arrangements that are in place. One possibility would be for the government to pay back the IOU along with any accumulated interest at some point down the track. This repayment would need to be funded by future taxes. If instead the IOU was not interest-bearing and was not repaid, the central bank would start accumulating losses as the interest rate it paid on its deposit liabilities increased and there was no offsetting income. This would lead to a decline in dividends to the government and possibly a future recapitalisation of the central bank. Both have to be funded through tax revenue. Another possibility would be to increase the general level of interest rates to deal with inflation, but to maintain the low interest rate on deposit balances held at the central bank. This approach would limit losses at the central bank even if the IOU was not interest bearing. But it would effectively amount to a tax on the banking system, as it is the banks that would hold these low-interest balances once the government has spent the money. In this case, it is this tax that would help finance the extra spending. The message here is that somebody always pays. It certainly is possible for the central bank to change when and how the spending is paid for, but it is not possible to put aside the government's budget constraint permanently. Where countries have, in the past, sought to put aside this constraint the result has been high inflation. Notwithstanding this historical experience, some prominent mainstream economists, including Stanley Fischer, a former governor of the Bank of Israel and Vice Chair of the US Federal Reserve, have recently argued that central bank financing of government spending may be appropriate in some circumstances. In particular, they have focused on the situation in which: i. conventional monetary policy options have been exhausted ii. the central bank is falling short of its goals, and crucially iii. public debt is high and the government cannot borrow in financial markets on reasonable terms. They argue that under these particular circumstances, central bank financing may be welfare enhancing, provided that there are strong safeguards to avoid the inflation problem. The main safeguard proposed is that the amount of monetary financing and the conditions under which it is provided, are determined solely by the independent central bank, not by the government. It is envisaged that the central bank provides finance up until the point that its goals for inflation and perhaps unemployment are met. Importantly, the government would continue to determine how the financing is spent. This idea has attracted a lot of attention recently, although many commentators have pointed out that there are likely to be very significant challenges in maintaining this type of safeguard over time. It is worth repeating that this proposal is only relevant to the situation where high government debt constrains the ability of the government to provide necessary fiscal stimulus financed through the normal channels. Clearly, it is not relevant to the situation we face in Australia. So I want to make it very clear that monetary financing of fiscal policy is not an option under consideration in Australia, nor does it need to be. The Australian Government is able to finance itself in the bond market, and it can do so on very favourable terms. There is strong demand for government debt and the Australian government can borrow for five years at just 0.4 per cent and for ten years at just 0.9 per cent (Graph 7). These are the lowest borrowing costs since Federation. While monetary financing is not an option in Australia, the Reserve Bank Board continues to review overseas experience with other monetary options. We had another discussion on this at our meeting two weeks ago. Central banks around the world have all moved in the same general direction, but they have configured their monetary support packages differently. Using international experience as a guide, it would have been possible to configure the existing elements of the RBA package differently. For example, the various interest rates currently at 25 basis points could have been set lower, at say 10 basis points. It would also have been possible to introduce a program of government bond purchases beyond that required to achieve the 3-year yield target. Different parameters could have also been chosen for the Term Funding Facility. After discussing these possibilities, the Board concluded that that there was no need to adjust our package of measures in the current environment. The Board has, however, not ruled out future changes to the configuration of this package if developments in Australia and overseas warrant doing so. At our meeting, we also reviewed some alternative monetary policy options. One of these is negative interest rates. There has been no change to the Board's view that negative interest rates in Australia are extraordinarily unlikely. Our reading of the international evidence is that the main potential benefit from negative rates is downward pressure on the exchange rate. But negative interest rates come with costs too. They can cause stresses in the financial system that are unhelpful for the supply of credit. They can also encourage people to save more, rather than spend more, so they can be counter-productive from that perspective too. So this is not a direction we need to head in. Another monetary option that has been used elsewhere is to intervene in the foreign exchange market. The evidence here is that when the exchange rate is broadly in line with its economic fundamentals, as the Australian dollar is currently, this approach has limited effectiveness. It can also involve substantial financial risks to the public balance sheet and complicate international relationships. So this too is not a direction we need to head in. The conclusion of our discussions at the July Board meeting was that the best course of action is to maintain the mid-March package and to continue to monitor the effects of the pandemic on the economy. The Board has not ruled out future changes to this package, though it recognises that, in the current environment, there are limitations to what more can be achieved through monetary policy. Given these limitations, and the outlook for the labour market, there is an important ongoing role for fiscal policy and use of the government's balance sheet. I would now like to turn to this issue. Over recent decades, the conventional wisdom has been that the government's balance sheet has a limited role in managing economic fluctuations, with the main focus instead being on structural and intergenerational issues. The global financial crisis, and now the pandemic, have caused some rethinking here. What we have seen over recent times is the government balance sheet being used to smooth out large shocks to private sector incomes. By smoothing things out, the government is helping people right now and also limiting the longer-term damage to the economy. Looking forward, we should have confidence that the pandemic will pass, either because of scientific breakthroughs or we become better at managing the effects of the virus. Until it does pass, our incomes will be temporarily lower and it makes sense to smooth this out through fiscal support. At the same time, we need to recognise that the task is complicated by the fact there is still considerable uncertainty about how long this period of weak income will last. The longer it lasts and the more uncertain things are, the harder it is to smooth out. At some point in the future, attention will rightly return to addressing the ratio of public debt to GDP, as low levels of public debt do give us the capacity to use the public balance sheet to smooth out future shocks to private income. When the time does come to address the build-up of debt, the best way to do this will be through economic growth. Given that we are borrowing against future income, we will be better placed if that future income is strong. I have spoken on previous occasions about some of the options here and the need for Australia to be a great place for businesses to expand, invest, innovate and hire people. It is important that as a country we focus on this, not only to deal with our current challenges but also our future ones. I want to conclude by reminding you that the foundations of the Australian economy are strong and that at some point the pandemic will pass. We have handled the health crisis better than many other countries and our economy is also faring better than many others. Public balance sheets in Australia are also in a strong position and they have been used to deliver unprecedented monetary and fiscal support to the Australian economy. These measures are helping to provide an important bridge to the days when the recovery is well entrenched and we are making renewed progress towards full employment. Thank you for listening and I am happy to answer your questions.

r200814a_BOA

australia

Opening Statement to the House of Representatives Standing Committee on Economics

lowe

Much has changed in the world since we last met in February. We have experienced a global pandemic, the biggest peacetime contraction in the Australian economy in nearly a hundred years and extraordinary monetary and fiscal policy measures. This all means that many of the challenges we face today were hardly imaginable just six months ago. Economic forecasting is very difficult at a time like this, but the RBA released its regular economic update last Friday in the . I will begin by highlighting some of the main points from this update and then turn to the policy response. We do not yet have the GDP data for the June quarter, but it will show the biggest economic contraction in many decades, likely to be around 7 per cent. If there is any good news to be found here, it is that this decline is not as large as initially feared. Similarly, while the labour market outcomes have been poor, they have not been as bad as expected. Hours worked were initially expected to fall by a staggering 20 per cent over the first half of this year. The actual fall has been around half of this, largely due to Australia's initial success in containing the virus and the earlierthan-expected easing of some restrictions. Looking forward, there is a high degree of uncertainty about the outlook and our economic recovery depends upon how successful we are in containing the virus. In our baseline scenario, we are expecting the Australian economy to contract by around 6 per cent this year, and then grow by 5 per cent next year and 4 per cent in 2022. It is possible that we will do better than this if there is near-term success in containing the virus or there are medical breakthroughs. On the other hand, if we were to see further setbacks in containing the virus, the recovery would be delayed even further. Given this uncertain outlook, we should be prepared for a recovery that is uneven and bumpy. The recovery is also likely to be more drawn out than was initially expected despite the downturn being less severe than expected. There are a few factors at work here. The most obvious is the outbreak in Victoria. At a personal level this is very distressing, and on behalf of the staff of the RBA I extend best wishes to everybody in Victoria. And on the economic front, we expect the outbreak will reduce GDP growth in the September quarter by at least 2 percentage points. This will broadly offset the recovery that has been taking place in most other parts of the country. As a result, we are now not expecting a lift in economic growth until the December quarter. Another consideration is the growing impact of an extended period of weak aggregate demand. In the initial phase of the pandemic some firms were able to keep going because they had a pipeline of work to keep them busy - the construction industry is a good example. But with new contracts having been scarce over recent months, this pipeline is being emptied for many firms and they are having to scale back. Critical to reversing this is stronger growth in aggregate demand. A third consideration is that people's attitudes to spending are changing because of the pandemic. It is probable that households and businesses will remain more cautious and that this will affect consumption and investment. How long this change might last is hard to tell, but we are unlikely to see a quick return to the previous patterns. Given these considerations, our baseline forecast is that the unemployment rate continues to increase, reaching around 10 per cent later this year. Unemployment would have been substantially higher if it were not for the JobKeeper and other income support programs. And, if we take into account people who are on zero hours, the true unemployment rate is higher than the published measure. We are expecting the published unemployment rate to decline gradually from 10 per cent, but to still be around 7 per cent in a few years' time. As I will come back to later, addressing this should be high on our list of national priorities. In all three scenarios published in our latest update, inflation is likely to be very low. Inflation fell into negative territory in the June quarter for the first time since the early 1960s. While grocery prices and prices of some other items rose, this was more than offset by the decline in oil prices and governments' decisions to make child care (and some pre-school) free. We are expecting inflation to return to positive territory in the current quarter, but to average between only 1 and 1 1/2 per cent over the next few years. Wage growth is also expected to be low, averaging 1 1/2 per cent over the next two years. I would now like to turn to the economic policy response. As the pandemic evolved in the early days of March, it became clear that a very significant monetary and fiscal response would be required. By virtue of my role as Governor of the RBA, I have been able to see first-hand how this support has been put in place. What struck me from the outset was the very strong sense of common mission from our political leaders, our regulators, our banks and the RBA itself. That common mission was to support the Australian economy through this difficult period. The level of cooperation and coordination was extraordinary and there was a real 'Team Australia' mindset. In my view, this reflects positively on both Australia's political system and our institutions. From the outset, there was a strong sense that we needed to build a bridge to the other side, when the virus is contained. As things have turned out, that bridge has had to be longer and stronger than we might have hoped would be necessary. Even so, it has been the right strategy. At some point the virus will be contained and those foundations that have made Australia such a prosperous country will still be there. We will be better placed to build on those foundations if we have limited the damage to the fabric of our economy and our society while we are battling the pandemic. In terms of the RBA's own response, that began with a cut in the cash rate at our regular meeting on March. The Reserve Bank Board then held an extraordinary meeting just two weeks later, where it decided on a comprehensive package that included: a further reduction in the cash rate to 25 basis points the introduction of a target on three-year Australian Government bonds of 25 basis points a Term Funding Facility for the banking system under which funds can be provided for three years at 25 basis points the continued use of our open market operations to make sure that the financial system has a high level of liquidity the modification of the interest rate corridor system, with the rate paid on Exchange Settlement balances set at 10 basis points, rather than zero. This package is designed to keep funding costs low across the economy and support the provision of credit, especially to small and medium-sized businesses. To support these businesses, the Term Funding Facility provides banks with an additional five dollars of low-cost funding for every extra dollar of credit extended to them. Many other central banks have announced similar packages, although the Bank of Japan is the only other central bank with a yield target; in their case, it is a target for 10-year yields. In announcing our yield target, the Bank indicated that we are prepared to buy bonds in the secondary market in whatever quantity was needed to achieve the target. To date, overall bond purchases have totalled around $55 billion, with most of these bonds bought in March and April. These purchases have had the desired effect, lowering yields and they eased the market dislocation at the time. In the past week or so, we have again purchased bonds, buying around $6 billion. We have done this following a few weeks in which the yield on three-year bonds had been trading consistently a little above 25 basis points. The yield is now closer to 25 basis points and we are committed to maintaining the target. In taking the decision in March to target the three-year yield, the Board considered the possibility of instead undertaking a regular program of bond purchases - say buying a set dollar amount of bonds each week - as a number of other central banks have done. We chose the yield target for a couple of reasons. The first is that it is a more direct way of achieving our objective of low funding costs. A bond purchasing program would have also lowered bond yields, but it would have done this indirectly, and there would have been challenges in calibrating the required size of these purchases. Directly targeting a longer-term risk-free interest rate is also a natural extension of our target for the cash rate, which is the risk-free interest rate at the very start of the yield curve. The second reason is that this target reinforces the forward guidance regarding the cash rate. The Board has clearly indicated that it will not increase the cash rate until progress is being made towards full employment and it is confident that inflation will be sustainably within the 2-3 per cent target range. Given the outlook I discussed earlier, these conditions are not likely to be met for at least three years. So it is highly likely that the cash rate will be at this level for some years and having a target for three-year yields of 25 basis points reinforces this message. So that is our rationale. We have not ruled out a separate bond buying program, or other adjustments to the mid-March package. But for the time being, the Board's view is that the best course of action is to continue with the current package. The Board recognises that in the unique circumstances in which the country finds itself, the solutions to the challenges we face lie in areas other than monetary policy. Having said that, the mid-March package is providing material help now and it will continue to do so. Interest rates are lower than they have ever been before and the financial system is flush with liquidity. Also helping is the fact that the Australian financial system is in good shape. We went into the pandemic with strong balance sheets and high levels of capital in the Australian banking system. This means that our financial institutions are well placed to provide the credit that the economy will need. One monetary policy option that has been the subject of public discussion over recent months is the possibility of the RBA creating money to directly finance government spending. For some, this offers the possibility of a 'free lunch'. The reality, though, is that there is no free lunch. There is no magic pudding. There is no way of putting aside the government's budget constraint permanently. As I spoke about in a talk last month, it is certainly possible for a central bank to use monetary financing to affect when and how government spending is paid for. Depending upon how things are managed, it can be paid for through the inflation tax, by implicit taxes on the banking system and/or higher general taxes in the future. But it does have to be paid for at some point. I want to make it clear that monetary financing of the budget is not on the agenda in Australia. The separation of monetary policy and fiscal financing is part of Australia's strong institutional framework and has served the country well. The Australian Government and the states and territories have ready access to the capital markets and they can borrow at historically low rates of interest. At a more practical level, I would like to mention a couple of other areas where the RBA has been providing assistance with Australia's COVID-19 response. The first is as transactional banker for the Australian Government. Over recent months the RBA's banking systems have been used to make record numbers of payments, processing the Government's income support to households and businesses. We have done this with around 90 per cent of our staff working from home and it has been a great effort by the RBA's banking and payments teams. The second is meeting the increased demand for banknotes. While COVID-19 has accelerated the shift to electronic payments, there has, paradoxically, also been record demand for banknotes. Some people seem to be wanting to keep some extra money at home. The result has been that the stock of banknotes on issue has increased from $83 billion in February to $94 billion today. We have met this extra demand despite our main storage vault being located in one of the coronavirus hotspots in I would like to close with some general comments about the economic policy response to the pandemic. While monetary policy has played an important role, it has been fiscal policy that has provided much of the support to the Australian economy. This is quite a change from how things have worked over recent decades and it is being accompanied by a significant increase in public borrowing as governments work to limit the hit to people's incomes. This shift in fiscal policy is quite a shock for a country that has got used to low budget deficits and low levels of public debt. In that context, it is worth pointing out that: By borrowing today to support the economy we are avoiding an even bigger loss of output and jobs that would damage our economy and society for years to come, which would put ongoing strain on the budget. Australia's public finances are in strong shape and public debt here is much lower than in most other countries. The overall national balance sheet is also in a strong position after decades of good economic performance. Government's financing costs have never been lower, with interest rates being the lowest since Federation. This all means that the expected increase in public debt is entirely manageable and is affordable. It is the right thing to do to borrow today to help people, keep them in jobs and boost public investment at a time when private investment is very weak. There will always be debates about the precise nature of programs and about how much support should be provided, but the general strategy that we have is the right one. Looking forward, an important priority will be to boost jobs. Based on the forecast I discussed earlier, high unemployment is likely to be with us for some time, which should be a concern for us all. The Reserve Bank will do what it can with its policy instruments to support the journey back to full employment. Beyond that, government policies that support people's incomes, that add to aggregate demand through direct government spending and that make it easier for firms to hire people all have important roles to play. We need to make sure that Australia is a great place for businesses to expand, invest, innovate and employ people. Thank you. My colleagues and I are here to answer your questions.

r201015a_BOA

australia

The Recovery from a Very Uneven Recession

lowe

It is a great pleasure to be able to join you today. It is especially good to be able to join you in person, rather than over the internet. This is the first time since February that I have been able to speak to a room of people. I hope this is another sign that the worst is behind us and that a recovery is under way. Today, I would like to talk about that recovery and four interrelated factors that will shape it. These are: (i) how successful we are in containing the virus; (ii) how effectively we deal with the shadow of the very uneven recession; (iii) how willing people and businesses are to draw on their accumulated financial buffers; and (iv) economic policy, including monetary policy. As we all know, the past seven months have been very difficult ones in the life of our nation. They are months that we will always remember. Our lives have been affected in ways that were barely imaginable at the start of the year. The economic policy response has also been on a scale that was barely imaginable back in January. At a high level, that response has had two parts. The first has been to build a bridge to the day that the pandemic is contained and to get as many people and businesses across that bridge as possible. And the second part has been to construct the road to the recovery as the economy opens up. This has been the right strategy. It has involved the government, the RBA, the regulators and the banks working closely together in the national interest. Thanks to this effort and the progress on the health front, a recovery is now under way and we can look forward to this continuing. This is good news, but the shape and nature of that recovery remains highly uncertain. Much depends upon how as a society we can live with the virus and the success of the scientists in terms of a vaccine, anti-viral treatments and rapid testing. There has been positive news on these fronts recently and we hope for more positive news, but success is not yet assured. So the single most important influence on the recovery is how successful we are in containing the virus. I would now like to turn to a second factor that will shape the recovery - that is the shadow cast by the very uneven nature of the recession that we have been living through. All recessions are uneven, but this one has been especially so. The government has wisely sought to even things out, but inevitably we are left with outcomes that are very uneven across the country. This unevenness is especially evident in the labour market, so this is where I would like to focus. This first graph shows the fall in employment that occurred between February and May for different age groups, and the recovery through to August (Graph 1). The picture is pretty clear. The job losses have been largest for young people, with around 500,000 people under 35 losing their jobs in the early stages of the pandemic, and around 300,000 still out of work in August. This heavy burden partly reflects the uneven way the pandemic has affected different industries (Graph 2). The hospitality industry - in which many young people and women work - has been worst affected, with almost 300,000 job losses between February and May. There has been an encouraging recovery of late, and for this to be sustained our economy will need to open up further. In contrast, a number of other areas - including the finance industry, the public sector and mining - have been much less affected. One consequence of these developments is that people who work in lower-paid occupations have, on average, been the hardest hit. This is evident in Graph 3, which shows that the decline in employment has been largest for occupations with the lowest hourly earnings, while employment has actually increased for occupations with the highest hourly earnings. The difference in experience is striking. The uneven effect of the pandemic is also evident in small businesses being harder hit, on average, than large businesses. As at mid September, the number of people on the payrolls of firms with at least 200 employees was down just 1 per cent on the level of mid March (Graph 4). In contrast, payrolls are down 7 per cent on average for firms with between 20 and 200 employees, with a similar decline for firms with fewer than 20 employees. This divergence in experience is also evident in the retail spending data (Graph 5). Spending at large firms is up considerably, but spending at small firms has only just returned to its level before the pandemic. Many retailers selling items such as home office equipment, electronics and groceries have done relatively well, but cinemas and many restaurants have had a very difficult time. So the experience has been very uneven. The pandemic has also hit our states and territories quite differently. In the first couple of months, all jurisdictions were affected broadly in the same way, with the number of payroll jobs falling between 7 and 9 per cent everywhere (Graph 6). Since then, labour market conditions have diverged very significantly. The recovery has been strongest in Western Australia - so much so that in our business liaison we are hearing reports of some labour shortages. Consistent with the labour market data, retail spending, consumer confidence and house building have also picked up by more in Western Australia than elsewhere. At the other end of the distribution is Victoria, where the second wave has meant that the earlier recovery in jobs has been reversed, with the number of jobs there still down by 8 per cent from that in March. Retail spending in Victoria in August was also 11 per cent lower than at the start of the year - in contrast, spending in the rest of the country was up by 13 per cent. This uneven experience by age, industry, firm size and region will shape the recovery. Some parts of the country and some industries face very real challenges. At the same time, others now have new opportunities. The way business is done is also changing and it is possible that people and firms living through a pandemic become more risk averse, affecting their appetite to spend and invest. This all means that we are likely to see a period of heightened structural change in our economy. As a consequence of this and the recession we will see a pick-up in the number of business failures and households facing financial stress. How well we support those who are most affected while at the same time capitalising on the new opportunities will shape the recovery over the next few years. I would now like to move to the third factor that will shape the recovery: that is how willing people and businesses are to draw on their accumulated financial buffers to spend and invest over the months ahead. One of the many unique features of this recession is that it has been associated with a big increase in household saving. Normally in a recession, income falls and many people draw on their savings to get through the hard times. But in the June quarter, when fears about the pandemic were at their peak, the household saving rate surged to 20 per cent, the highest in almost 50 years (Graph 7). There are two factors at work here. The first is that Australians were more cautious and had fewer opportunities to spend, given that many services were simply unable to be offered. As these opportunities disappeared, households did adjust their spending patterns, spending more on electronics and exercise equipment and online. But this substitution was not enough to offset the very large drop in spending on services and there was a record decline in consumption in the June quarter. The second factor was the large boost to incomes from the various government support programs. Social assistance benefits, including the JobSeeker payment, increased by nearly $15 billion in the June quarter. In addition, businesses received more than $30 billion in JobKeeper payments to support the wages of their staff. These payments are equivalent to around 15 per cent of total household disposable income in a typical quarter. Many households have used this extra income and their increased savings to put their balance sheets on a firmer footing. Some of the money withdrawn from superannuation funds under the early release scheme - which is now equivalent to about an additional 10 per cent of quarterly household disposable income - has also been used to pay down debt and strengthen cash buffers. The impact of this can be seen in some of the banking data. Over recent months, there have been record rates of repayment on personal credit cards and other forms of personal debt (Graph 8). Interest-bearing credit card balances have fallen by 22 per cent since March and are now at their lowest level in around 15 years. For many people with a mortgage, much of the extra savings and some of the superannuation withdrawals have been used to increase their balances in their offset accounts, with offset balances up 10 per cent since March. Other people have simply paid down principal directly. Combined, all forms of mortgage payments - including the additional balances in offset accounts - reached a record high over recent months, despite repayments being deferred on around 8 per cent of housing The question that all this raises is: what are people going to do with this extra saving and improved debt situation? In aggregate, household income is likely to decline in the December quarter as the unemployment rate increases and government support becomes more targeted. In normal times, a decline in income would be expected to affect consumption, but these are not normal times. It is entirely possible that as restrictions ease, people will choose to draw on their accumulated buffers to sustain and increase their spending. Many businesses face a similar choice to households. Many have boosted their cash buffers over the past six months and face a decision about what to do with these: sit on these buffers in case something goes wrong, or use them for investment and expansion? The better outcome for the economy is for households and businesses to keep spending and investing. The key to this is confidence in the health situation and the future state of the economy. If people are nervous about the health situation or their job prospects, they are likely to sit on their savings. On the other hand, if they are confident that the virus can be contained and that they will have a job, they will be more willing to spend. This means that there are large payoffs to be had from ensuring public confidence in the capacity of the health system to respond. From this perspective alone, there are likely to be large returns from public investments in first-class testing, contact tracing and quarantine arrangements. These are essential, not only to open up our economy successfully but to also build the confidence that is required for people to spend and invest. Economic policy also has a critical role to play in reducing uncertainty about the future. So I would now like to turn to this issue. The policy response to the pandemic has been central to getting the Australian economy through the past six months in better shape than the economies of many other countries. In previous downturns, it was monetary policy that played the leading role, but this time it has been fiscal policy that has taken the lead. This switch is entirely appropriate given the pandemic and the low interest rate world that we are living in. The fiscal response has been crucial in helping build that bridge to the recovery that I spoke about earlier. The income support provided by the government has: assisted many people get through this difficult period; kept many businesses afloat; and reduced some of the unevenness of the pandemic. Fiscal policy has been supported in this effort by monetary policy and by the actions of the banks and the financial regulators. The recent Budget provided welcome further support to the economy. The various measures will provide ongoing support to disposable incomes and help boost aggregate demand. Policies of a structural nature will also help build the road to the recovery. I expect that this will help reinforce what I hope to be improving confidence on the health front. This fiscal support necessarily involves increased borrowing. For a country that became used to low budget deficits and low levels of public debt, this is quite a change. But it is a change that is entirely manageable and affordable and it is the right thing to do in the national interest. Debt across all levels of government in Australia, relative to the size of our economy, is much lower than in many other countries and it is likely to remain so (Graph 10). The national balance sheet is in a strong position and is able to provide the support that is now required. The Australian Government can borrow at the lowest rates ever and the demand from investors for government bonds remains very strong. The states and territories can also borrow at record low rates and have an important role to play in the national fiscal response. No doubt, there will be a point in the future when attention will need to return to the task of rebuilding our fiscal buffers to deal with the next downturn. This task will be easier when the additional government spending is temporary in nature. In any case, the best way to rebuild these buffers is through economic growth. This means that structural reforms that drive that growth need to remain on our national agenda. I would now like to turn to monetary policy, which has played an important supporting role. The package of measures announced in March - including the target for the yield on 3-year Australian Government bonds - has led to record low funding and borrowing costs, which have eased the burden of the pandemic for many people. The RBA's open market operations and the Term Funding Facility have both contributed to a plentiful supply of liquidity in the Australian financial system and this is supporting the supply of credit to households and businesses. This supply of credit will be important in the recovery phase. These measures to support the Australian economy have resulted in a very large increase in the RBA's balance sheet (Graph 11). Between 2016 and early this year, our balance sheet averaged around $170 billion. It is now almost double this at over $300 billion. At its September meeting, the Reserve Bank Board decided to expand the Term Funding Facility to provide authorised deposit-taking institutions (ADIs) with additional low-cost funding equivalent of 2 per cent of their total lending. The timing of this decision coincided with the approach of the deadline for final drawings under the initial allocations under this facility. As ADIs draw on the expanded facility there will be a further significant expansion of our balance sheet. This expanded facility should be seen as a further easing of monetary policy, although in a different way than in the past. At its most recent meeting, the Board continued to consider the case for additional monetary easing to support jobs and the overall economy. As part of this discussion we also considered the nature of our forward guidance regarding the cash rate. Before turning to the broader policy question, I would like to discuss how the Board's thinking on forward guidance has evolved. The Board agreed that it made sense for me to talk about this today, where more context can be provided, rather than make a change in the statement directly after the meeting. Over recent months, our communication has stated that the Board will 'not increase the cash rate target until progress is being made towards full employment and it is confident that inflation will be sustainably within the 2-3 per cent target band'. It might seem strange to some that we are even talking about the day that interest rates increase, given that it is a long way off. But expectations about future interest rates affect people's decisions and asset pricing, so we seek to be as transparent as we reasonably can. In terms of inflation, our forward guidance has been forward looking - we have focused on the outlook for inflation, not just current inflation. This was a sensible approach when the inflation dynamics were relatively stable and well understood. In today's world, things are much less certain. So we will now be putting a greater weight on actual, not forecast, inflation in our decision-making. In terms of unemployment, we want to see more than just 'progress towards full employment'. The Board views addressing the high rate of unemployment as an important national priority. Consistent with our mandate, we want to do what we can do, with the tools we have, to ensure that people have jobs. We want to see a return to labour market conditions that are consistent with inflation being sustainably within the 2 to 3 per cent target range. The Board will not be increasing the cash rate until actual inflation is sustainably within the target range. It is not enough for inflation to be forecast to be in the target range. While inflation can move up and down for a range of temporary reasons, achieving inflation consistent with the target is likely to require a return to a tight labour market. On our current outlook for the economy - which we will update in early November - this is still some years away. So we do not expect to be increasing the cash rate for at least three years. Turning to the broader policy question, we have been considering what more we can do to support jobs, incomes and businesses in Australia to help build that important road to the recovery. The options have been laid out in previous speeches by the Deputy Governor and myself and I don't plan to elaborate on these again today. While the Board has not yet made any decisions, I thought it might be useful to close today by highlighting three of the many issues we are working through. The first is how much traction any further monetary easing might get in terms of better economic outcomes. When the pandemic was at its worst and there were severe restrictions on activity we judged that there was little to be gained from further monetary easing. The solutions to the problems the country faced lay elsewhere. As the economy opens up, though, it is reasonable to expect that further monetary easing would get more traction than was the case earlier. A second issue is the possible effect of further monetary easing on financial stability and longer-term macroeconomic stability. This is an issue that we have paid close attention to in the past when we were considering reducing interest rates in a relatively robust economic environment. It remains an important issue today, but the considerations have changed somewhat. To the extent that an easing of monetary policy helps people get jobs it will help private sector balance sheets and lessen the number of problem loans. In so doing, it can reduce financial stability risks. This benefit needs to be weighed against any additional risks as people take more investment risk in the search for yield. We also need to take into account the effect of low interest rates on people who rely on interest income. A third issue is what is happening internationally with monetary policy. Australia is a mid-sized open economy in an interconnected world, so what happens abroad has an impact here on both our exchange rate and our yield curve. In the past, the interest differentials provided a reasonable gauge to the relative stance of monetary policy across countries. Today, things are not so straightforward, with monetary policy also working through balance sheet expansion. As I noted earlier, our balance sheet has increased considerably since March, but larger increases have occurred in other countries. We are considering the implications of this as we work through our own options. So these are three of the complex issues we have been considering at our recent Board meetings. The Board will continue to review these and other issues at our upcoming meetings. We are committed to do what we reasonably can, with the tools we have, to support the recovery of the Australian economy. Thank you for listening. I look forward to your questions.

r201103a_BOA

australia

Today's Monetary Policy Decision

lowe

Good afternoon. The Reserve Bank Board met this morning. It decided on a package of further measures to support the Australian economy as it recovers from COVID-19. Given the significance of this package, I wanted to explain in person what we are doing and why we are doing it and to answer your questions. At its core, today's decision reflects the Reserve Bank's commitment to do what we reasonably can, with the tools that we have, to support the recovery of the Australian economy. The Board views addressing the high rate of unemployment as a national priority and it wants to do what it can to support job creation. Importantly, today's decision complements government efforts to support the Australian economy and to lower unemployment. When the virus first arrived on our shores, economic policy quickly turned to building a bridge to the recovery. This was the right strategy and this bridge has made a major difference to people's lives, helping many people and businesses get through a very difficult period. This bridge was constructed through close co-operation by governments across Australia, the Reserve Bank, the financial regulators and Australia's financial institutions. For the Reserve Bank's part, we have kept borrowing costs low and the financial system very liquid and supported the supply of credit to the economy. This broad economic policy response and Australia's progress on the health front have meant that the Australian economy is in a better shape than many others. While Australians have experienced a severe recession, it has not been as bad as was earlier expected or experienced in many other countries. In light of this experience, we have recently updated our economic outlook, with the full details to be published on Friday. These updated forecasts will contain an upgrade to the near-term economic outlook, although there are a number of factors weighing on the medium-term outlook, including lower population growth. On balance, both the recent household spending and employment data have been a little stronger than we were expecting. It now appears probable that GDP increased solidly in the September quarter despite the lockdown in Victoria. And growth over the year to June 2021 is expected to be close to 6 per cent compared with an expectation of 4 per cent growth when we reviewed our forecasts three months ago. The fiscal support, including through the Budget, has played an important role here. The unemployment rate is also now expected to peak at a lower rate than previously - at a little below 8 per cent, rather than the 10 per cent expected three months ago. This upgrade to the near-term outlook is clearly welcome news. At the same time though, we need to recognise that the pandemic has inflicted significant damage on our economy. It will take time to repair that damage and it is highly likely that the recovery will be uneven and drawn out. In particular, we face the prospect of a long period of higher unemployment and underemployment than we have become used to. In the RBA's central scenario, job creation is slow over coming months and the unemployment rate is still around 6 per cent at the end of 2022. One consequence of this is that wages growth and inflation are both likely to stay very low. In each of the next two years, we are expecting annual wages growth of less than 2 per cent. And inflation, in underlying terms, is expected to be just 1 per cent next year and 1 1/2 per cent in 2022. Given this outlook, the Board judged that it is appropriate to take further steps today to support the economy. Unemployment is a major economic and social problem that damages the fabric of our society. So, it is important that it is addressed. The Board recognises that, in the context of the pandemic, the responsibility for job creation falls mainly on the shoulders of business and government. But the Reserve Bank can, and will, make a contribution too. Today's policy package does that and it builds on the contributions from our policy measures earlier in the year. Today's package has three elements. These are: first, a reduction in the cash rate target, the three-year yield target and the interest rate on new drawings under the Term Funding Facility to 10 basis points, from the current 25 basis points. second, a reduction in the interest rate on Exchange Settlement balances to zero from the current 10 basis points. and third, the introduction of a program of government bond purchases. In particular, we are intending to buy $100 billion of government bonds over the next six months, purchasing bonds issued by the Australian Government as well as by the states and territories. Together, these three elements represent a significant package. The lower interest rates and our plan to buy $100 billion of government bonds over the next six months will help people get jobs and support the recovery of the Australian economy. The package combines the price-based target at the shorter part of the yield curve that has been in place since March with a quantity target at the longer part of the yield curve. In doing so, it will lower the whole structure of interest rates in Australia. This lower structure of interest rates will work to support the economy through the normal transmission mechanisms, including lower borrowing costs, a lower exchange rate than otherwise and higher asset prices. To be clear, the inflation target remains the cornerstone of Australia's monetary framework. Even so, the priority over the next couple of years is jobs, with inflation risks remaining low. The RBA has a broad legislative mandate for price stability, full employment and the economic welfare of the Australian people. Today's decision reflects that broad mandate. The Board expects that this new lower level of interest rates will be in place for an extended period. The Board will not increase the cash rate until actual inflation is sustainably within the target range. It is not enough for inflation to be forecast to be in the target range. For inflation to be sustainably within the target range, wage growth will have to be materially higher than it is currently. This will require a lower rate of unemployment and a return to a tight labour market. On the current outlook, it will take some years to get there. Given this, the Board is not expecting to increase the cash rate for at least three years. It remains the case that prior to any increase in the cash rate target, the Board intends to remove the three-year yield target. I would now like to provide some further details of the bond purchase program. At the start, it is important to point out that all purchases will be made in the secondary market through an open auction process. The RBA will not be buying bonds directly from governments. We plan to hold auctions three times a week: on Mondays, Wednesdays and Thursdays, with the first auction being on this Thursday. and on Wednesdays we plan to purchase bonds issued by the states and territories (semis). We will focus on buying bonds with maturities of around five to 10 years, but may also buy bonds outside this range, depending upon market conditions. To assist with the smooth running of the auctions, we plan to buy AGS with five to seven-year maturities on Mondays and AGS with seven to 10-year maturities on Thursdays. For semis, we plan to alternate weekly between the five to seven and seven to 10-year securities, subject to market conditions. We will be purchasing fixed-rate nominal bonds only, as these are the benchmark fixed-income securities in Australia and they underpin the pricing of many other assets. Inflation-indexed bonds are not part of the program. The initial auctions for AGS will be for around $2 billion and the initial auctions for semis will be around $1 billion. This means that we expect to purchase around $5 billion per week. We will closely monitor the impact of our purchases on market functioning and are prepared to adjust the size and timing of the auctions if necessary. If the size of these initial auctions is maintained, 80 per cent of the bonds purchased would be AGS and 20 per cent would be semis. In allocating our bond purchases across the various states and territories we will be guided by the stock of debt outstanding and relative market pricing. These bond purchases mean that the RBA is now conducting quantitative easing, or QE, similar to that of many other central banks. I want to point out, though, that there has already been a very substantial increase in the size of our balance sheet as a result of our earlier measures. Once these additional bond purchases are completed mid next year, our balance sheet would have nearly tripled since the beginning of 2020, provided that the funds currently available under the Term Funding Facility are drawn upon. I also want to point out that this bond purchase program is separate from any bond purchases that we undertake to support the three-year yield target. We remain committed to buying bonds in whatever quantity is needed to support that target. Any bonds purchased in support of the three- year yield target will be separate from the $100 billion. I would now like to address four specific questions that I know some people would have. I will then answer questions more broadly. These four specific questions are: 1. Why make this change now? 2. Is the RBA now financing the government? 3. Why have a price and a quantity target? 4. With interest rates so low, is the RBA now out of fire power? This is an understandable question, especially given that we are easing monetary policy further today at the same time as we are upgrading the near-term outlook for the economy. Apart from the general case for further monetary easing that I have already spoken about, there are a couple of other factors that have influenced the timing. The first is that over recent months we have learnt more about the pandemic and its economic impact. As the months have passed, it has become increasingly apparent that there will be longlasting effects, including high unemployment. While the outlook does remain uncertain, we do have a somewhat clearer picture of the future state of the labour market. A sharp bounce-back in jobs is unlikely and it will take time to return to where we were before the pandemic. We have responded to this clearer picture today. The second factor is that monetary easing is likely to get more traction today than it would have when widespread restrictions were in place. In earlier months, the usual transmission mechanisms were not working as normal and the challenges facing the country were best addressed by other policy tools. However, as restrictions are eased and people have more opportunities to spend, our judgement is that further monetary easing now provides additional support to other policies, including the fiscal initiatives and the RBA's earlier monetary policy package. In reaching today's decision, the Board also considered the effects on medium-term financial and macro stability as well as the impact on savers. The Board recognises that low rates can encourage some additional risk-taking, as investors search for yield. It also recognises that low deposit rates can create difficulties for some people. These issues will need to be closely watched over the months ahead. But the Board judged that the bigger risk at the moment was the threat to our economy and to balance sheets from an extended period of high unemployment. Today's decision will lessen that risk. The answer is a simple no. Today's decision does not change the long-standing separation of monetary policy and fiscal financing in Australia. The RBA is not financing government spending. I want to highlight the important distinction between providing finance and affecting the cost of that finance. The RBA is not providing finance to the government, but our actions are lowering the cost of government finance. I should point that our actions are also lowering the cost of finance for all other borrowers in Australia, whether they are a household buying a home or a business wanting to expand. This lower cost of finance for everybody is supporting the recovery from the pandemic. It is important to point out that the bonds purchased by the RBA will have to be repaid by the government at maturity. They will have to be repaid in exactly the same way as would occur if the bonds were held by others. The same is true for the ongoing coupon payments on the bonds. The fact that the RBA is holding some bonds makes no difference to the financial obligations of the government, other than through a lower cost of finance. The Australian Government and the states and territories continue to fund themselves in the market, as they should. Raising funds in the market is an important discipline and movements in market prices can contain valuable information. Recent bond auctions have been heavily oversubscribed, even though the size of these auctions has been a record high. There is strong demand by domestic and global investors for bonds issued by the Australian Government and by the states and territories. I expect that this will remain the case. As part of the RBA's March package, we announced a price target for the yield on the three-year Australian Government bond, rather than a quantity of bonds to purchase. We viewed the yield target as the more direct way of achieving our objective of low funding costs. The target also reinforced our forward guidance regarding the cash rate. Given that we expected the cash rate to remain low for some years, we judged it appropriate to target a three-year yield and stand behind that target with our balance sheet. These arguments for a yield target remain valid and so we are continuing with the three-year yield target. We considered targeting a longer yield - say five years - but decided against this. This was on the basis that the yield target is most effective when it is consistent with our forward guidance on the cash rate. As I said earlier, we expect the cash rate to be at its current level for at least three years. Beyond that, we have less confidence. I certainly hope that the economy will be sufficiently strong sometime over the next five years to warrant an increase in the cash rate. So three years, not five years, is the appropriate maturity for the yield target. Today's decision supplements this price target with a quantity target further out along the yield curve. This quantity target is similar to the approach adopted by many other central banks, which have responded to the pandemic with government bond buying programs. The evidence is that these programs have lowered government bond yields in other countries. One result of this is that Australia has had higher long-term bond yields than elsewhere, even though the setting of the short-term policy rate is similar across countries. These higher bond yields have added to the attractiveness of Australian dollar assets and this has put some upward pressure on the exchange rate. There has also been an accumulation of evidence that central bank balance sheet expansion has a stimulatory effect beyond that resulting from lower bond yields. When the central bank buys assets, investors in the private sector adjust their portfolios, buying different assets with the proceeds of their bond sales. This portfolio rebalancing can affect the price of other assets and international capital flows, as well as the exchange rate. Given these considerations, the Board judged it was now appropriate to combine the three-year yield target with QE further out along the yield curve. The short answer here again is no. The Reserve Bank is not out of firepower. We have additional monetary policy options and we are prepared to use them if the circumstances require. In terms of interest rates, I think we have gone as far as it makes sense to do so in the current environment. There has been no change to the Board's view that there is little to be gained from lowering the policy rate into negative territory. While a negative rate might lead to a helpful depreciation of the Australian dollar, it could impair the supply of credit to the economy and lead some people to save more, rather than spend more. Given this assessment, the Board continues to view a negative policy rate in Australia as extraordinarily unlikely. But monetary policy is now about more than just short-term interest rates - we have returned to a world in which quantities matter too. In this world, it is certainly possible for us to increase the size of our bond purchases. Given this, we will continue to closely monitor the economic situation and the impact of our purchases on market functioning. If we need to do more, we can and we will. The RBA also has a range of tools to support the proper functioning of markets and address market dysfunction were that to occur. These tools include further liquidity provision, asset purchases and transactions in the foreign exchange market. So it would be incorrect to conclude that we are out of firepower. That brings me to the end of the four questions I posed. I am now happy to answer any other questions that you might have. Thank you.

r201116a_BOA

australia

COVID, Our Changing Economy and Monetary Policy

lowe

Thank you very much for the invitation to speak at CEDA's annual dinner. After so many webinars and Zoom meetings, it is great to be able to be here in person. 2020 has been a year like no other and one we will never forget - a global pandemic, the closure of our borders, the biggest economic downturn in nearly a century, a very large budget deficit, interest rates down to zero and QE by the RBA. None of this was expected at the start of this year. Unfortunately, it guarantees that 2020 will be a year that is talked about for decades to come. Yet through these difficult times, the underlying strengths of the Australian economy and people have been on display. Our economy has performed better than many others in challenging circumstances. We have had more success in containing the virus than many other countries. Australia's public institutions have worked effectively and constructively together. Our public sector balance sheets are strong and have been used to good effect to cushion the shock. Our financial institutions have also helped people and businesses manage their mortgages and their debts. And Australians across the country have reacted sensibly and worked together to contain the virus. So, even though we have had our challenges and setbacks, we do have a lot to be thankful for. Notwithstanding this, a year like the one we are living through will inevitably leave some marks on our economy and on economic policy, including on monetary policy. Tonight I would like to talk about some of these. In terms of the economy, I am going to touch on five areas where the pandemic is leaving a mark. The first is that it has brought an end to Australia's nearly three decade-long run without a recession. This was an impressive record and it is one that will not easily be broken by us or by others. We are now, though, having to adjust to a new reality. The level of output in Australia fell by a record 7 per cent in the June quarter and over 2020, we are expecting GDP to decline by around 4 per cent (Graph 1). In the RBA's central scenario, we are expecting growth of 5 per cent next year and 4 per cent over 2022. These are fast growth rates, but because of the size of the fall in the first half of this year it will take until the end of 2021 for us to reach the level of output at the end of last year. This downturn has taken a heavy toll on our labour market. Hours worked in Australia fell 10 per cent between March and May and the unemployment rate has risen to 6.9 per cent, with underemployment even higher. We are expecting the unemployment rate to rise further over coming months to a little below 8 per cent. In our central scenario, we expect it then to start gradually declining, but still be a little above 6 per cent at the end of 2022 (Graph 2). One consequence of this higher unemployment is that wage and price pressures are likely to remain subdued. In each of the next two years, we are expecting annual wages growth of less than 2 per cent. And inflation, in underlying terms, is expected to be just 1 per cent next year and It is certainly possible that the economy will do better than this baseline scenario. The recent data have been better than expected and the easing of restrictions has lifted spirits. Further good news on a vaccine and rapid testing would also help. There is a lot of stimulus in the system, balance sheets are generally in good shape and governments are providing substantial incentives for firms to invest and employ people. So if we do get further good news on the health front, we could have a rapid rebound. At the same time, it is still possible that we experience further outbreaks. And the hoped-for medical advances may be delayed and could face production and distribution challenges slowing their rollout. This means that there are downside scenarios too. So there is still considerable uncertainty about the outlook. It does, though, seem highly probable that one of the marks the pandemic will leave is an extended period of higher unemployment than we have become used to. Addressing this is an important national priority. A second area where the pandemic has left a mark is the sharp decline in population growth. Over the past two decades, Australia's population grew at an average annual rate of 1 1/2 per cent (Graph 3). But in 2020/21, it is expected to increase by just 0.2 per cent. This will be the slowest rate of increase since 1916, when many Australians left our shores to fight in the First World War. The fast population growth of recent decades has been a major factor shaping our economy. It has underpinned our relatively fast growth in GDP compared with other advanced economies. It also slowed the ageing of the population, given that the new arrivals have been fairly young. The large number of students coming to Australia has also boosted our education sector. And the effects of fast population growth have also been felt in our housing market and in pressure on some of our infrastructure. So the effects have been widespread. Looking to the future, it remains hard to predict when the borders will open again and when they do, what the rate of new arrivals will be. If population growth is to be noticeably slower in a post-COVID world, the trajectory for our economy will look different too. A third area where the pandemic is having a marked effect is on our property market. It is a complex picture here, with the market simultaneously adjusting to: a recession; lower population growth; record low interest rates; substantial government incentives to support residential construction; and changes to the way that people work, shop and live. So there are a lot of moving pieces at present and the effects are very uneven across different types of property and across the country. The effects of the pandemic are most obvious in the market for retail properties in our CBDs, where vacancy rates have increased sharply (Graph 4). Not surprisingly, rents and the capital values of these properties have both fallen. There has also been an impact on the CBD office market, as people work from home. The national office vacancy rate has increased sharply this year and further increases are expected (Graph 5). But even here, there is considerable variation across our cities, with the biggest increase in CBD office vacancies in Sydney and Melbourne. In contrast, the markets for industrial property have been stronger, with increased demand for warehousing and distribution facilities as people increasingly shop online. The residential market is also a mixed picture. Our biggest cities have been more affected than others by the slowdown in population growth. They have also been more directly affected by the virus. As a result, prices in Sydney and Melbourne have fallen over recent months, while they have risen in most other cities. It is also noteworthy that in some states, the markets in our regional towns and cities have been stronger than those in the capital cities. For example, while prices have fallen in Sydney they have increased in regional NSW (Graph 6). Many regional centres have been less affected by the virus and some are experiencing increased demand as people work remotely and look for property outside the big cities. Within the capital cities, the markets for houses and apartments are also performing quite differently. In most cities - especially Sydney and Melbourne - rents for apartments are falling, while rents for houses are generally rising (Graph 7). The apartment markets are more affected by the lower population growth and fewer foreign students and by young adults staying at home with their parents. There has also been an increase in demand for houses as people work from home. As I said, it is a complex picture and the full effects of the pandemic will take time to be evident in our property market. To date, the demand from investors in residential property has been subdued, but it is possible that low interest rates will change this. This is one of the many areas that we will be watching carefully in the period ahead. The fourth area where the pandemic is likely to leave a mark is on our attitude to risk. While it is not possible to be definitive here, I expect that for a time, people will be more cautious in their borrowing and spending decisions. As we all know, 2020 has been a sobering year. Given this, it is probable that some people will want bigger buffers in future in case things go wrong. They might also be less inclined to lever up and be more cautious in taking on debt. At the same time, though, it is important that we guard against becoming too risk averse. Over the past decade or so, there have been signs that our economy was becoming less dynamic. An increase in risk aversion would reinforce this trend. We all know that businesses need to take risks to innovate and grow. I understand that in an uncertain world, it can be hard to take on risk and there can be a natural tendency to avoid new risks. But, if businesses are to seize the opportunities that are out there to grow and to increase Australia's productive capital base, some degree of risk-taking is necessary. Another area we will be watching carefully is how people adjust their portfolios as they search for yield in a low interest rate environment. Some people will no doubt move out along the risk spectrum. As they do so, the additional investment risks will need to be understood and managed. A fifth area where the pandemic is leaving a mark is in the digitalisation of our economy. In some areas, progress that otherwise would have taken years has been made in a matter of months. The combination of necessity, new technologies and the easing of regulations has made a real difference. Digitalisation is not only helping Australians deal with the pandemic, but it will also boost productivity and can help drive future economic growth. Examples of this include the uptake of telehealth and the availability of electronic prescriptions. Companies can also now hold AGMs virtually and more legal documents can be executed electronically. Many people are also benefiting from not having to travel as much for work and for meetings. For some, the time that they would otherwise have spent sitting in cars or on public transport and planes can now be used for more productive or rewarding activities. There has also been very rapid growth in online retailing, with many people shopping online for the first time (Graph 8). Reflecting this, online retail sales have increased by 80 per cent since the start of the year. The shift to doing things differently is also evident in the payments data, where there has been a marked increase in the use of electronic forms of payment. One side effect of this is that the use of banknotes for transactions has declined considerably, with the value of cash withdrawals falling by This acceleration in the shift to a more digital economy is prompting firms to innovate and to find new ways of doing things. They are having to compete to come up with new products and new ways of delivering them. This innovation and competition will have a positive payoff for our economy. It will take time to realise the full benefits, but as businesses are re-engineered to become more digital we will all see the benefits in terms of higher productivity. On that positive note, I would now like to turn to economic policy, where there have been major changes too. On the fiscal front, fiscal policy has taken on a greater role in macroeconomic stabilisation than was the case prior to the pandemic. This is entirely appropriate and reflects both the size and nature of the shock that we have experienced and the limits on monetary policy in a low interest rate world. This change has been accompanied by a shift in the government's broader fiscal strategy. The first stage of the revised strategy is to support the economy and jobs and promote economic growth until the recovery is assured. This focus will remain in place until the unemployment rate is comfortably below 6 per cent. This is a form of forward guidance familiar to central banks. In the longer run, the strategy will shift to stabilising and reducing debt as a share of GDP. Doing this will provide greater flexibility to respond to future shocks, wherever they come from. The key here is to ensure a strongly growing economy, so we need to focus on the reforms and innovations that will deliver this. There have also been changes on the monetary policy front. I would like to highlight four. The first is the nature of the RBA's own forward guidance. In the past, our forward guidance about interest rates was forward looking - we have focused on the outlook, or forecast, for inflation. This was a sensible approach when the inflation dynamics were stable and predictable. But the combination of globalisation and technology and now the pandemic have changed these dynamics. Labour markets are working differently than they used to and wage and inflation dynamics have changed. This has made relying on forecasts more difficult. Given this, we have now moved to place much more weight on actual outcomes, rather than forecast outcomes, in our decision-making and in our forward guidance. As an example of this, in our communication after the most recent Board meeting we said 'the Board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market.' This forward guidance is in contrast to the earlier approach, which emphasised our expectation of future inflation. A second and related change has been a shift in the relative weight given to jobs and inflation in our communication. The mandate of the Reserve Bank of Australia was established by Parliament back in 1959 and the central elements have remained unchanged since then. Our mandate is to promote price stability, full employment and the economic welfare of the Australian people. This mandate is broader than that given to most other central banks, with Australia not swinging with the fashion over recent decades to adopt a singular focus on inflation. My view is that this broader mandate has served the country well and that it is especially relevant in today's world. In particular, the challenge facing Australia over the next few years is much more likely to be the creation of jobs, rather than controlling inflation pressures. So that is our focus too. The Board wants to do what it can, with the tools that it has, to support the national effort to reduce unemployment. This does not mean that we are backing away from the inflation target. As Australia's central bank, we will continue to provide a strong nominal anchor through the 2 to 3 per cent medium-term flexible inflation target. We remain committed to achieving this target. The best way to do this is through reducing the spare capacity that currently exists in the economy. And this starts with getting people back into jobs. If this can be done we will get closer to both full employment and the inflation target and enhance the economic welfare of the Australian people. The third change to monetary policy is a strengthening in the gravitational pull of low global interest rates. A decade ago, world real interest rates fell sharply in the aftermath of the global financial crisis. Around the world, people wanted to save more and invest less. The inevitable result was that the return to savers fell. Given that Australia is part of the interconnected global financial system, we felt the effects of this here too. Even so, our interest rates did not fall as far as they did elsewhere due the combination of the resources boom, our relatively strong economy and higher levels of investment in Australia. This year, the pandemic has brought another major shock, with investment intentions falling further. As a result, global interest rates and the return to savers have also declined. The gravitational pull of this on our own interest rates has been very strong. The RBA has responded to this, with the policy rate now essentially zero in Australia, as it is in many other countries. If we had sought to ignore this gravitational pull, there would have been obvious implications for our exchange rate and our economy. If our interest rates were higher than in the major countries there would be stronger inflows into Australian dollar assets and this would put upward pressure on our exchange rate. In turn, this would make it harder to make the needed progress on jobs. Over the medium term, I do expect to see a time when Australia's strong economic conditions once again justify higher interest rates. But today, during a global pandemic when a lot of people have lost their jobs and many businesses are struggling, is not the time for that. The fourth and final change on the monetary front is the return to a world in which quantities, not just prices, matter. Over recent decades, monetary policy has been about the price of money, or the short-term interest rate. Little attention was paid to the quantity of money. This has now changed, with the RBA now undertaking QE, or quantitative easing, as many other central banks are also doing. Quantities and prices are obviously connected, so QE works partly through affecting the price of money, including long-term risk-free interest rates. But there are other effects too. When the central bank increases the quantity of money and buys assets, liquidity in the financial system is increased and investors in the private sector need to purchase other assets with the proceeds of the bonds they sell to the central bank. These portfolio adjustments can affect the price of other assets and international capital flows, as well as the exchange rate. We are still learning about how strong and durable these transmission mechanisms are, and we will learn more over coming months as we implement our own $100 billion QE program. To conclude, 2020 has been a year of great change and disruption. We are all talking about issues that few of us even contemplated at the start of the year. Australia is managing well in these challenging circumstances and I expect it to continue to do so. The pandemic has been difficult for many people and businesses, but we are now on the road to recovery. As we travel along that road we will see some changes in our economy and there will be new opportunities as well. As we make that journey, economic policy will also continue to adjust to our changing circumstances. Thank you for listening. I look forward to your questions.

r201202a_BOA

australia

Opening Statement to the House of Representatives Standing Committee on Economics

lowe

We welcome the opportunity for this additional hearing of the House Economics Committee. A lot has happened since the previous hearing, including further significant policy measures by the RBA. This morning, I would like to explain why we took these additional measures and how they will help the recovery. To provide some context, I will begin with a summary of recent economic developments and the economic outlook. This year has been an extremely difficult one for many people and businesses. But we have now turned the corner and a recovery is underway. Since we last met, the economic news has, on balance, been better than we were expecting. Over recent months, the number of people with a job has risen significantly and the peak in the unemployment rate is now likely to be between 7 and 8 per cent, rather than close to 10 per cent. Retail spending has also continued to increase, with consumers adjusting their spending patterns to the realities of a COVID-19 world. Business and consumer confidence has also lifted and housing markets have generally proved resilient. Given these developments, we are now expecting GDP growth to be solidly positive in both the September and December quarters. And then, next year, our central scenario is for the economy to grow by 5 per cent and then 4 per cent over 2022. These figures, though, cannot hide the reality that the recovery will be uneven and bumpy and that it will be drawn out. Some parts of the economy are doing quite well, but others are in considerable difficulty. And even with the overall economy now growing solidly, it will not be until the end of 2021 that we again reach the level of output recorded at the end of 2019. The effects of this loss of output and income are all too obvious in the labour market. The unemployment rate currently stands at 7 per cent and we are expecting it to be still above 6 per cent in two years' time. Underemployment is higher still, with many people working on reduced hours. One consequence of higher unemployment is that wage and price pressures are likely to remain subdued. In each of the next 2 years, we are expecting annual wages growth of less than 2 per cent. And inflation, in underlying terms, is expected to be just 1 per cent next year and 1 1/2 per cent in It is certainly possible that the economy will do better than our central scenario. This scenario does not envisage a vaccine being widely available to most Australians until late next year at the earliest. It also assumes that significant restrictions on international travel are still in place at the end of Recent medical breakthroughs give us some hope that things will work out better than this. If so, confidence would lift and there would be a further easing of restrictions. The result would be an upside surprise to growth and jobs, especially given the significant policy stimulus that is already in place, the generally strong balance sheets and the substantial government incentives for businesses to employ people and invest. But it is also possible that things could go the other way. Europe provides a salutary reminder of this. It was just 3 months ago that many commentators were remarking on the robust bounce-back in Europe. Now, the European economy is expected to contract again in the December quarter as countries struggle to contain the virus. Similarly, in the United States the outlook is clouded by the sharp increase in case numbers there. Fortunately, here in Australia, we look to be on a different path, but there is no guarantee that we will remain so. This inevitably means that there is still a high degree of uncertainty about the outlook. What has become clearer, though, as time has passed is that Australia is likely to experience a run of years with unemployment too high and wage increases and inflation too low, leaving us short of our goals. In the current environment, addressing the high rate of unemployment is a priority for the Reserve Bank Board. We are intent on doing what we can, with the tools that we have, to help here. This brings me to our recent monetary policy decisions. Since the previous hearing in August, significant policy announcements were made following the Board's meetings in September, October and November. We made no further changes at our meeting yesterday. In September, the Board increased the size of the Term Funding Facility and allowed authorised deposit-taking institutions (ADIs) more time to draw on this facility. Institutions can now access funds up to the equivalent of 5 per cent of their total loans, with additional funds available if an ADI increases its lending to businesses, especially small and medium-sized businesses. In October, we changed the nature of our forward guidance about the cash rate. The focus is now on actual outcomes for inflation and unemployment, rather than forecast outcomes. This shift reflects the changing price dynamics in our economy due to globalisation and technology, and now the pandemic. The Board will now want to see evidence that inflation is consistent with the target before it increases the cash rate. It is not enough for inflation to be forecast to be consistent with the target. In November, we announced another major policy package, including: reductions in the cash rate target, the 3-year Australian Government bond yield target and the interest rate on new drawings under the Term Funding Facility to 0.1 per cent a reduction in the interest rate on Exchange Settlement balances at the RBA to zero the introduction of a quantitative bond purchase program, under which the RBA will buy $100 billion of government bonds over the next 6 months. As part of this program we are buying bonds issued by the Australian Government and the states and territories. These decisions, together with those made by the Board earlier in the year, will support the recovery of the Australian economy. They will keep funding costs low for households, businesses and governments. They are also complementary to the significant fiscal stimulus by the Australian Government and the states and territories. This fiscal stimulus has played a critical role in helping the economy through the pandemic and it has preserved hundreds of thousands of jobs. For our part, the RBA's recent measures will support the economy through a number of channels. Lower borrowing costs free up cash flow for both households and businesses, some of which will be spent. Lower interest rates also support asset prices, which boost balance sheets and consumption and investment. And a lower structure of interest rates leads to a lower value of the Australian dollar than would otherwise be the case. The end result is a stronger economy and more jobs. The decision to implement a bond buying program as part of the November policy package followed a careful review of the international experience. When we met last time, I said that my judgement was that a price-based target (i.e., a yield target) was preferable to a quantity-based target. That remains my view, but it doesn't need to be an either/or choice and we can't ignore what is happening overseas. As other central banks have bought government bonds under quantitative easing programs they pushed down the yields on those bonds. In turn, this put downward pressure on the value of their currencies. As a result, here in Australia we found ourselves in the position of having relatively high longer-term bond yields compared with other countries, despite the short-term policy rate being similar across countries. These relatively high bond yields were putting unhelpful upward pressure on the value of our own currency. Given monetary policy developments overseas and the strong gravitational pull of very low global interest rates, the Board judged that it was now appropriate to combine the 3-year yield target with a quantity target for bond purchases. This judgement was reinforced by the outlook for unemployment and inflation that I discussed earlier. As the Deputy Governor outlined in a speech last week, the movement in market prices in response to this package was broadly as we expected. The Board will continue to review the details of this package at our future meetings. We are prepared to do more, if that is required. Having said that, we are still of the view that a negative policy interest rate in Australia is extraordinarily unlikely, with any benefits being outweighed by the costs. The Board recognises that its decisions have an uneven effect across the community. How any given Australian is affected depends very much on their own financial situation. As we have discussed at previous hearings, people who rely on interest as a significant source of income find this a difficult time. People with more diversified sources of income and assets, including a home, tend to be in a better position. And those people who benefit most from monetary stimulus are those who get a job or retain a job because of this stimulus. The benefits here are wider, though, than just those to the individual. When more people who want jobs have one, the whole community benefits too. This is not just in terms of stronger household income growth but in an improvement in a wide range of social indicators as well. In making its decisions, the Reserve Bank Board is looking at this whole picture. Consistent with the mandate given to it by Parliament, the Board is seeking to maximise the collective welfare of the Australian people. As we do this, we are also paying close attention to asset prices and trends in household debt. At previous hearings we have discussed the effect of low interest rates on housing prices, the incentive to borrow, and medium-term economic and financial stability. These remain issues that we are continuing to monitor. But in the current environment, the bigger stability risk is a protracted period of high unemployment, rather than excess borrowing. When people don't have jobs, their spending is curtailed and they have difficulty servicing their debts. It is also worth noting that over the past 6 months, many households have improved their finances and paid down debt. It is possible that this attitude to debt will change again, but it is also possible that people will continue to take a more cautious approach to borrowing than they did before the pandemic. So this is something to keep an eye on. But for the time being, the priority is employment. This brings me to the end of my prepared remarks. Guy and I look forward to answering your questions. Thank you.

r201207a_BOA

australia

Innovation and Regulation in the Australian Payments System

lowe

Thank you for the invitation to join you today. It is very good to see the tradition of AusPayNet's annual summit continue, even if it is taking a different form this year. As we all know, the world of payments has become an area of excitement: it brings together two things that people have a fascination with - money and technology. The pace of change is rapid and the payments landscape is complex and evolving quickly. New technologies are creating new ways of moving money around and new business models are emerging. There are also new players, including the big techs and the fintechs. And blockchain and distributed-ledger technologies are opening up new possibilities. This innovation is raising many issues for both the payments industry and for regulators. This morning I would like to discuss some of these issues and their implications for the regulatory framework. I will then discuss some of the Payments System Board's preliminary views from its The Payments System Board has a long standing interest in promoting innovation in the Australian payments system. Those of you who have followed our work over the years will recall that back in June 2012 the Board released a report titled 'Strategic Review of Innovation in the Payments In promoting innovation we have employed a mix of strategies. We have used a combination of: i. suasion and pressure on industry participants to do better ii. regulation to promote competition and access iii. using our position to help overcome coordination problems, which can act as a barrier to innovation in a network with many participants iv. helping the industry establish benchmarks that can be aspired to collectively. I will leave it to others to judge the success of this mix of strategies. But from my vantage point, Australians enjoy an efficient and dynamic payments system. There are still gaps that need addressing, but by global standards we have done pretty well. Australians were early and rapid adopters of tap-and-go payments and increasingly are using digital wallets. We have a very good fast payments system, which after a slow start, is seeing continuing strong volume growth. And there is a roadmap for the development of new payment capabilities using this fast payments infrastructure. I would though like to draw your attention to two areas where we would like to see more progress. The first is the move to electronic invoicing and the ability to link e-invoices to payments as a way to improve the efficiency of business processes. The second is improvements to the speed, cost and transparency of cross-border retail payments and international money transfers. We are looking forward to progress on both fronts. Against the backdrop of this generally positive picture, the Payments System Board recognises that the structure of payment systems is changing. In some cases it is now better to think of a payments ecosystem, rather than a payments system. In this ecosystem, the payment chains can be longer and there are more entities involved and new technologies used. This more complex and dynamic environment is opening up new opportunities for innovation as well as new competition issues to consider. One of the factors driving innovation is the increasing interest of technology-focused businesses in payments. These businesses include the fintechs and the large multinational technology companies, often known as the 'big techs'. They are a source of innovation and are playing a role in the development of digital wallets. These wallets are being used more frequently and I expect this trend has a long way to go. Another trend is the increasing use of payments within an app. Big techs are playing important roles on both fronts. This influence of the big techs is perhaps most evident in China, with Ant Group (owners of Alipay) and Tencent (WeChat Pay) having developed new payments infrastructure that has led to fundamental changes in how retail payments are made in China. In Australia and many other countries, Google, Apple, Facebook and Amazon are increasingly incorporating payments functionality into their service offerings. Mobile wallets such as Apple Pay and Google Pay are the most prominent examples of this in Australia. In some other countries the big techs are also offering person-to-person transfers and consumer credit products. Facebook also announced its Libra project. The Apple Pay and Google Pay wallets illustrate some of the new and complex issues that are arising. These wallets are clearly valued by consumers and they will reduce industry-wide fraud costs through the use of biometric authentication (e.g. fingerprint or facial recognition). The tokenisation of the customer's card number is also a step forward. So these wallets are a good innovation. At the same time, though, they are raising new competition issues. One of these relates to the restriction that Apple, unlike Google, places on access to the near-field communication (NFC) technology on its devices. Many argue that this restriction limits the ability of other wallet providers to compete on these devices and that this could increase costs. This issue has recently attracted the attention of policymakers in several countries. For example, in 2019 the German parliament passed a law requiring device manufacturers to provide third parties with access to technologies (such as NFC) that support payments services. And the European Commission announced in June that it would commence a formal antitrust investigation into Apple's restriction of third-party NFC access on the iOS platform and in September announced that it will also consider legislation on third-party access. This issue has also been raised in submissions to our review of payments system regulation, and we are watching developments in Europe and elsewhere closely. Another issue being raised by these wallets is the value of information and data, and again we observe Google and Apple taking different approaches. Google states that it may collect information on transactions made using Google Pay, which can be used as part of providing or marketing other Google services to users. In contrast, Apple states that it does not collect transaction information that can be tied back to an individual Apple Pay user. There are also different approaches to charging transaction fees. Apple charges a fee to issuers when a transaction is made with the Apple Wallet but a similar fee is not charged by Google when transactions are made with Google Pay. It is certainly possible that these different approaches to the use of data on the one hand and access and fees on the other are linked. So there are issues to consider here too. Beyond the issues raised by digital wallets, there are other competition issues raised by the involvement of the big tech companies in payments. These companies are mostly platform businesses that facilitate interactions between different types of users of their platform. They have very large user bases, benefiting from strong network effects that can make it hard for competitors. Data analysis is part of their DNA and they have become increasingly effective at commercialising the value of data they collect and analyse. Providing additional services, such as payments, also reduces the need for users to 'leave' the platform. So there are complex issues to be worked through here. One of these is the terms of access to the platform and whether the platform requires that payments be processed by the platform's own payment system. One specific issue that is raised by both digital wallets and the big techs is the nature of the protections that apply to any funds held within any new payment systems, and outside the formal banking sector. For confidence in the system and for the protection of individuals and businesses it is important that strong arrangements are in place. In this regard, I welcome the Government's announcement that it will accept the Council of Financial Regulators' proposed reforms of regulatory arrangements for so-called stored-value facilities. Under the proposals, APRA and ASIC will be the primary regulators, with requirements tailored to the nature of the facility. It would be possible, for example, to 'designate' a provider of a stored-value facility as being subject to APRA prudential supervision on the basis of financial safety considerations. This could become relevant if the technology companies were to launch new payment and other products that held significant customer funds. Internationally, this and related issues came to prominence following Facebook's announcement that it was developing a global stablecoin (originally called Libra, but recently rebranded as Diem). Since the original announcement, the Libra Association (now the Diem Association) has also announced plans to launch some single-currency stablecoins intended for use in consumer digital wallets. In April, the Association applied to FINMA (the Swiss financial regulator) for a payment system licence. This initiative has raised concerns from governments and regulators in many jurisdictions regarding a wide range of issues including consumer protection, financial stability, money laundering and privacy. The Swiss authorities have established a regulatory college to coordinate with other countries. The RBA is participating in this college on behalf of Australia's Council of Financial Regulators. FINMA has indicated that Diem will be subject to the principle of 'same risks, same rules' - that is, if Diem poses bank-like risks it will be subject to bank-like regulatory requirements. It remains to be seen how this and other similar initiatives progress. As I said at the outset, the world of payments is becoming more complex and raising new issues for industry participants and regulators to deal with. This means that it is timely to consider how the payments system should be regulated and the Payments System Board welcomes the Government's review of the regulatory architecture. The legislation governing the Reserve Bank's regulatory responsibilities was put in place over 20 years ago. This legislation gives the Bank specific powers in relation to payment systems and participants in those systems. While the powers are quite broad, in practice the Bank has the ability to regulate only a fairly limited range of entities. As I mentioned earlier, these regulatory powers have been used in conjunction with our ability to persuade and to help solve coordination problems in networks. As part of the Government's review it is worth considering what the right balance is here and whether the regulatory arrangements could be modified to better address the complexities of our modern payments ecosystem. At the same time that we have been considering these broad issues, the Payments System Board has been conducting its periodic Review of Retail Payments Regulation in Australia. This review was temporarily put on hold during the pandemic but has now restarted. I would like to use this opportunity to provide you with a sense of our thinking on three important issues: 1. interchange fee regulation 2. dual-network debit cards and least-cost routing 3. 'buy now, pay later' (BNPL) no-surcharge rules. I want to stress that we have not yet reached any final conclusions and the Bank's staff will be meeting with industry participants over the next few months to discuss these and other issues. If, at the conclusion of the review, we are to make changes to the standards it is our intention to consult on these by mid 2021. The Board's view is that interchange fees should generally be as low as possible, especially in mature payments systems. While these fees might arguably play a role in establishing new payment methods, once a payment system is well established these fees increase the cost of payments for merchants and they can distort payment choices. So the direction of change in these fees over the medium term should be down, and not up. Having said that, at the current point in time the Board does not see a strong case for a significant revision of the interchange framework in Australia. The current interchange standards have been in effect for only 3 1/2 years and submissions to the review did not point to strong arguments for major changes. The standards appear to be working well and frequent regulatory change can carry costs. It is also relevant that the average level of interchange rates in Australia is quite low by international standards, particularly the 8 cents benchmark for debit card payments. Credit card interchange fees are also lower than in most countries. One exception is the lower credit card interchange fees in Europe. The Board is watching the European experience closely and expects that, over time, a stronger case will emerge for lower credit card interchange fees in Australia. There is one aspect of the interchange regulations where the Board is considering a change as part of the review - that is the cap on the fees that can be applied to any particular category within a scheme's schedule of debit card interchange fees. Currently a 20 basis point cap applies when a fee is expressed in percentage terms and a cap of 15 cents applies when the fee is expressed in terms of cents. The Board sees a case to lower this 15 cents cap. This case has emerged as there has been an increasing tendency for interchange fees on transactions to be set at the 15 cents cap, particularly on transactions that are less at risk of being routed to another scheme. At the same time, the international schemes are setting much lower strategic rates for some merchants, particularly larger ones, in response to least-cost routing. This is resulting in large differences in interchange fees being paid on similar transactions, with unreasonably high interchange fees on some low-value transactions, especially at smaller merchants. For example, a 15 cent interchange fee on a $5 transaction is equivalent to an interchange rate of 300 basis points, which is far higher than would apply to that transaction if a credit card had been used. Over the coming months, Bank staff will be seeking further information from the industry on this issue as the Board considers a lower cap. The second issue is dual-network debit cards and least-cost routing. The Board has long held the position that merchants should have the freedom and the capability to route debit card transactions through the lower-cost network. The Government and a wide range of stakeholders have a similar view. It is understandable why: this choice promotes competition and helps keep downward pressure on the cost of goods and services for consumers. Over recent years, the Board has discussed the right balance between regulation and suasion to achieve this outcome. Its judgement has been that the best approach was for the industry itself to support least-cost routing, pushed along by pressure from the RBA. While progress has been slower than we would have liked, the slow progress by the major banks did create competitive openings for other players, which led to some innovation. The major banks now also all offer least-cost routing, with some making it the default offering for small and medium-sized businesses. So there has been significant progress. The Board is not convinced that a better outcome would have been achieved through regulation. The concept of least-cost routing is most applicable when a physical card is used and where that card has two networks on it. One recent trend that we have observed is that some issuers have sought to move away from dual-network debit cards to issue single-network cards, with no eftpos functionality. This may be partly in response to financial incentives from the international schemes and possibly the additional costs to issuers from supporting two networks on a card. Notwithstanding this trend, the Board's view is that it is in the public interest for dual-network cards to continue and to be the main form of debit card issued in Australia. It is also important that acquirers and other payment providers offer or support least-cost routing and that the schemes do not act in a way that inappropriately discourages merchants from adopting least-cost routing. The Board is again considering the best balance between regulation and suasion to achieve these outcomes. Consistent with its earlier approach, its preference is for the industry to deliver these outcomes without regulation. To help achieve this, the Board is considering setting out some formal expectations in this area. If these expectations are not met, the Board would then consider regulation. To be clear, the Board sees a strong case for all larger issuers of debit cards to issue cards with two networks on them. At the same time, it recognises that there can be additional costs of supporting two networks, which can make it harder for new entrants and small institutions to be competitive. So it may not be appropriate to expect very small issuers to issue such cards. Over the months ahead, the Bank will be consulting with small authorised deposit-taking institutions and the schemes to get a clearer picture of the costs and their implications for determining any regulatory expectations. The Board also expects that in the point-of-sale or 'device-present' environment all acquirers should provide merchants with the ability to implement least-cost routing for contactless transactions, possibly on an 'opt-out' basis. In the online or 'device-not-present' environment, it is not yet clear how least-cost routing should operate and what expectations on its provision might be appropriate. In this environment, there is scope for consumers to make more active choices, there are various technical challenges to leastcost routing and there can be more providers in the payments chain. So the idea of how least-cost routing might apply in the online world will be explored by the Bank's staff over coming months. The third issue that I'd like to cover is the no-surcharge rules of buy now, pay later providers. The Board's long standing view is that the right of merchants to apply a surcharge promotes payments system competition and keeps downward pressure on payments costs for businesses. This is especially so when merchants consider that it is near essential to take a particular payment method for them to be competitive. The Board also recognises that it is possible that no-surcharge rules can play a role in the development of new payment methods. While new payment methods can be developed without them, these rules can, under some circumstances, make it easier to build up a network and thereby promote innovation and entry. The Board's preliminary view is that the BNPL operators in Australia have not yet reached the point where it is clear that the costs arising from the no-surcharge rule outweigh the potential benefits in terms of innovation. So consistent with its philosophy of only regulating when it is clear that doing so is in the public interest, the Board is unlikely to conclude that the BNPL operators should be required to remove their no-surcharge rules right now. Even the largest BNPL providers still account for a small proportion of total consumer payments in Australia, notwithstanding their rapid growth. New business models are also emerging, including some that facilitate payments using virtual cards issued under the designated card schemes that are subject to the existing surcharging framework. In addition, the increasing array of BNPL providers is resulting in competitive pressure that could put downward pressure on merchant costs. The Board expects that over time a public policy case is likely to emerge for the removal of the nosurcharge rules in at least some BNPL arrangements. Some of the BNPL operators are growing rapidly and becoming widely adopted by merchants, particularly in certain sectors. As part of the Bank's ongoing consideration of this issue, Bank staff will be discussing with industry participants possible criteria or thresholds for determining when no-surcharge rules should no longer be allowed. If the point is reached where the Board's view is that the public interest would be served by the removal of a no-surcharge rule, the Board's preference would be to reach a voluntary agreement with the relevant provider. This would be similar to the approach adopted with American Express and PayPal. In the event that this were not possible, the Bank would discuss with the Australian Government the best way to address the issue. More broadly, as I discussed above, the current Treasury review of the regulatory architecture provides an opportunity to look holistically at this issue and whether the existing legislation and regulatory provisions could be amended to better reflect our modern and dynamic payments ecosystems. So that is a quick review of some of the issues that the Payments System Board and the RBA staff have been focusing on recently. It is clear that payments is an increasingly exciting area and that significant innovation is occurring. This presents opportunities to deliver improved services to end users of the payments system as well as raising new questions for policymakers. The Bank very much appreciates the ongoing engagement we have with the industry as we jointly work towards better outcomes for the Australian community. Thank you.

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australia

The Year Ahead

lowe

Thank you for the invitation to address the National Press Club. This is the third time I have had the privilege of doing so, but it is the first time here in Canberra. The world has changed tremendously since my previous address in February last year: a pandemic, the biggest contraction in output in generations, the closure of our borders, a very large fiscal stimulus, near zero interest rates and quantitative easing. All that in just a year and none of it was predicted. It was therefore with some trepidation that I titled my remarks today, 'The Year Ahead'. I did so, though, because at the start of a new year, I thought it important to explain how we are thinking about the Australian economy and monetary policy over the year ahead. Before I do this, I would like to offer 3 observations on the year we have just been through. The first is that Australians respond well in a crisis. The second is that the economic downturn was not as deep as was initially feared and the bounce-back has been earlier and stronger than we were expecting. And the third is that as we start 2021, there is still quite a way to go before we reach our goals of full employment and inflation consistent with the target. I would like to elaborate on each of these observations as they are relevant to the future. First, our national response. As a community, we have pulled together in the common good and been prepared to do what has been necessary to contain the virus. Our public administration and health systems have worked well in the public interest. Governments responded quickly to the pandemic and decisive fiscal and monetary policy responses have helped many people. Our banks also worked with their customers to help them meet their obligations. Because of these collective efforts Australia is in a much better place than most other countries. This is true for both the economy and the health situation. My second observation is that despite the pandemic having very significant economic costs, the downturn was not as deep as we had feared and the recovery has started earlier and has been stronger than we were expecting. Employment growth has been strong, as have retail sales and new house building. Across many indicators, including GDP, the outcomes have been better than our central forecasts and often better than our upside scenarios as well. As an illustration, in August our central forecast was that the unemployment rate would end 2020 at close to 10 per cent and still be above 7 per cent at the end of 2022 (Graph 1). In our upside scenario, the unemployment rate was expected to end 2020 a little lower than 10 per cent, but still be around 7 per cent later this year. Thankfully, the actual outcome for the unemployment rate has been much better than this, with the peak now looking to be behind us and the unemployment rate ending 2020 at It is reasonable to ask: what explains these better-than-expected outcomes? There are 3 factors that I would like to point to. The first is the success that Australia has had in containing the virus. That success has meant that the restrictions on activity have been less disruptive than we feared. It has allowed more of us to get back to work sooner and it has reduced some of the economic scarring from the pandemic. As is increasingly clear from experience both here and overseas, the health of the population and the health of the economy are inextricably linked. The second factor is the very significant fiscal policy support in Australia, which as measured by the change in the aggregate budget position is almost 15 per cent of GDP (Graph 2). Most of this support has been delivered by the Australian Government, but the states and territories have also played a role too. This support has been more substantial than was assumed in August and has made a real difference. It has provided a welcome boost to incomes and jobs and helped front load the recovery by creating incentives for people to bring forward spending. There has also been a positive interaction with the better health outcomes, which have allowed the policy support to gain more traction than would otherwise have been the case. The third factor is that Australians adapted and innovated. When the virus first came to our shores, many people hunkered down, but as the days wore on, households and businesses adjusted and changed what they do and how they do it. This resilience has helped keep the economy going and kept people in jobs. Many firms changed their business models, moved online, used new technologies and reconfigured their supply lines. Households adjusted too, with spending patterns changing very significantly. Some of the spending that would normally have been done on travel and entertainment has been redirected to other areas, including electrical goods, homewares and home renovations. Online spending also surged, increasing by 70 per cent over the past year (Graph 3). These changes in our spending patterns have been challenging for many businesses, but the ability and willingness of Australians to keep spending has helped the overall economy. My third observation is that despite the positive economic news over recent months, we still have quite a way to go. There is still very substantial spare capacity in the Australian economy. The unemployment rate is higher today than it has been for almost 2 decades and many people can't get the hours of work they want. And in terms of output, we remain well behind where we thought we would be when I spoke here they are likely to show that the level of GDP is 4 per cent lower than where we thought it would be a year ago. This is a big gap. On the nominal side of the economy, there is also a fair way to go. In underlying terms, inflation is running at 1 1/4 per cent, well below the medium-term target of 2-3 per cent. And wage growth is the lowest in decades, with the Wage Price Index increasing by just 1.4 per cent over the past year (Graph 5). Given the spare capacity that currently exists, these low rates of inflation and wage increases are likely to be with us for some time. This brings me to the year ahead. In my view, we can draw some comfort from the year just passed. Our ability to pull together and the earlier-than-expected bounce-back are both positive developments and provide a basis for confidence about the future. Yet even so, the path ahead is likely to be bumpy and uneven and it will be some time before we are back to full employment and have inflation back to the target. As was the case in 2020, much depends upon the path of the pandemic. The development of vaccines in record time is clearly good news. It has reduced one of the big uncertainties and could provide the foundation for a vigorous and sustainable recovery in the global economy. But this outcome is not assured - the global rollout of the vaccines faces challenges and there are a range of other uncertainties about the global economy, including trade tensions. We hope for the best here, but we also need to be prepared for further setbacks in what remains a highly uncertain world. The RBA will be releasing a full set of updated economic forecasts on Friday. Today, I can provide the key numbers. In preparing these forecasts we have assumed a rollout of the vaccines in Australia in line with current government guidance and that international travel remains highly restricted for the rest of this year. Our central scenario is for the upswing in the Australian economy to continue, with above-trend growth over the next couple of years (Graph 6). GDP is expected to increase by 3 1/2 per cent over both this year and 2022. Given the recovery we have seen so far, we are expecting the level of GDP to return to its end-2019 level by the middle of this year, which is 6 to 12 months earlier than we previously expected. Notwithstanding this recovery, we are not expecting the level of GDP to return to its previous trend over our forecast period. This is largely because of lower population growth. When we prepared the forecasts a year ago, we were expecting the population to grow by 1.6 per cent per year over 2020 and 2021. This slower population growth has a direct effect on the size of our economy and means that we will not get back to the previous trend any time soon. In per capita terms, we expect more, but not all, of the lost ground to be made up. In the labour market, we are expecting the rate of unemployment to continue to decline. In the central scenario, it is expected to reach 6 per cent by the end of this year and around 5 1/4 per cent by mid 2023 (Graph 8). Job vacancies, job ads and business hiring intentions are at high levels, which suggests continuing solid employment growth over the next few months. Beyond that, some slowing in employment growth is expected when the JobKeeper program comes to an end in March. Given this outlook, wages growth and inflation are forecast to remain subdued. In the central scenario, wages growth is forecast to pick up from its current low rate, but to do so only very gradually and still be below 2 per cent at the end of next year. Consistent with this, and the ongoing spare capacity in the economy, inflation in underlying terms is also forecast to stay below 2 per cent over the next couple of years: the central forecast for 2021 is 1 1/4 per cent and for 2022 it is 1 1/2 per cent (Graph 9). In headline terms, inflation is expected to spike to around 3 per cent in the June quarter, largely reflecting swings in the prices of child care and some other administered prices, but then to return to below 2 per cent by the end of this year. So that is the broad outline of the central scenario. We will also be publishing downside and upside scenarios, as we did last year. The downside scenario is one in which there is a combination of further sporadic domestic outbreaks, a delay in the rollout of vaccines and a worsening global outlook. The upside involves further good news on the health front, with a strong pick-up in consumer and business confidence propelling a stronger self-sustaining recovery, especially given the large amount of monetary and fiscal stimulus that is in place. In the downside scenario, further progress in reducing unemployment is delayed and there is a little pick-up wage growth and inflation from current levels. In the upside scenario, the unemployment rate falls faster to be a bit below 5 per cent in the second half of next year. I would like to highlight 2 specific issues that have a bearing on the forecasts. The first is how households respond over coming months to the tapering of the fiscal and other support measures. Unusually for an economic downturn, growth in household income has been quite strong, largely reflecting the support provided by fiscal policy (Graph 10). Much of this extra income has been saved, with the household saving rate surging to 22 per cent in the June quarter. This largely reflects the limited spending opportunities during the lockdowns, but it is also a response to the uncertainty that people felt about the future. These extra savings have strengthened household balance sheets and mean that many people now have bigger financial buffers than they had previously. The question is what comes next. Over the next 6 months, aggregate household income is expected to decline as the pandemic support payments unwind. Normally, when income falls, so too does consumption. But we are not in normal times. The extra savings over the past 6 months and the bigger financial buffers can support future spending - people will have more freedom to spend as restrictions are eased and be more willing to spend as uncertainty recedes. So we are expecting the recovery in consumer spending to continue. But there are risks to the forecasts in both directions here. On the downside, further bad news on the health front could see additional restrictions on activity and a renewed desire to save. And on the upside, positive news on health and jobs could see people seek to catch up on spending and run down their extra saving buffers quickly. So we are watching this area carefully. One other important factor bearing on household spending is the housing market. When I spoke here last year I discussed how falling housing prices was one of the factors that had contributed to sluggish growth in 2019. The dynamics in the housing market now look to be in a different phase, with prices rising across most of the country recently (Graph 11). It remains to be seen how long this will continue, but sustainable increases in asset prices support household balance sheets and encourage spending through positive wealth effects. Higher housing prices can also encourage additional residential construction. But as housing prices rise again, we will be monitoring lending standards closely. We would be concerned if there were to be a deterioration in these standards, but there are few signs of this at the moment. The second specific issue I want to highlight is the outlook for investment. Prior to the pandemic, there were concerns about the protracted period of low levels of non-mining business investment (Graph 12). Not surprisingly, when the pandemic hit, investment fell further. Faced with a more uncertain environment and a drop in demand, many firms deferred investment plans and sought to de-risk their balance sheets. Spending on non-residential construction has been particularly affected. On a more positive note, there has been a welcome offsetting pick-up in public investment, which is playing a strong counter cyclical role. We are yet to see the same signs of a recovery in private investment that we have witnessed in household spending. Investment is nonetheless expected to pick up as uncertainty recedes and demand increases. An increase in private business investment is not only needed to support the economic recovery but also to build the productive capital stock that is needed for our future. So this too is an issue we are watching carefully. I would now like to turn to monetary policy. At our meeting yesterday, the Reserve Bank Board reviewed the monetary policy measures announced last year and the outlook for the year ahead. I would like to share the conclusions of this review with you. The first conclusion is that last year's monetary policy package is working broadly as expected and is supporting the economy. Together, the bond purchases, the Term Funding Facility, the 3-year yield target and the record low cash rate have kept funding costs low for all borrowers and helped ensure that the banking system is able to provide the credit that is needed for the recovery. They have also resulted in a lower value of the Australian dollar than otherwise. Combined, the various measures have resulted in the RBA's balance sheet increasing from around $180 billion to $330 billion and a further The second conclusion is that very significant monetary support will need to be maintained for some time to come. It is going to be some years before the goals for inflation and unemployment are achieved. So it is premature to be considering withdrawal of the monetary stimulus. The third conclusion is that we will continue to purchase bonds issued by the Australian Government and the states and territories at the completion of the current $100 billion program in mid April. In reaching this conclusion, the Board considered 3 factors: 1. the effectiveness of the bond purchases; 2. the decisions of other central banks; and 3. most importantly, the outlook for inflation and jobs. With 3 months experience now, it is clear that the bond purchase program has helped to lower interest rates and has meant that the Australian dollar is lower than it otherwise would have been. So, it has worked. Australia's government bond markets also continue to function well and the available evidence is that further purchases would not be a source of market dysfunction. In terms of other central banks, most have recently announced extensions of their bond purchase programs, many running until at least the end of this year. Given this, if we were to cease bond purchases in April, it is likely that there would be unwelcome upward pressure on the exchange rate. And, third, in terms of the most important consideration - the outlooks for inflation and jobs - we remain well short of our goals, as I have already discussed. Given these considerations and the fact that the cash rate is at its effective lower bound, the Board decided to purchase an additional $100 billion of government bonds at the completion of the current program in mid April. These additional purchases will be at the rate of $5 billion a week, which is unchanged from the current program. They will ensure a continuation of the RBA's monetary support for the Australian economy. The fourth conclusion is that the Term Funding Facility will be maintained as it is. Banks are able to draw on the facility up until end June, which means they will have the benefit of low-cost funding out to mid 2024. The Board would consider extending this facility if there were a marked deterioration in funding and credit conditions in the Australian financial system. At the moment, there are no signs of this. Fifth, the 3-year yield target for Australian Government bonds will be maintained. This target has helped anchor the Australian yield curve and reinforced our forward guidance regarding the cash rate. Later in the year, the Board will need to consider whether to shift the focus of the yield target from the April 2024 bond to November 2024 bond. In considering this issue the Board will be giving close attention to the flow of economic data and the outlooks for inflation and jobs. It has made no decision yet. The final conclusion is that the cash rate will be maintained at 10 basis points for as long as is necessary (Graph 14). The Board has no appetite to go into negative territory and has done as much as it reasonably can with interest rates. Before increasing the cash rate, the Board wants to see inflation sustainably within the 2 to 3 per cent target range. Meeting this condition will require a tighter labour market and stronger wages growth than we are currently forecasting. It is difficult to determine exactly when this condition might be met but, based on the outlook I have discussed today, we do not expect it to be before 2024, and it is possible that it will be later than this. So the message is: interest rates are going to be low for quite a while yet. The Reserve Bank is committed to provide the support the economy needs as its recovers from the pandemic. On that note, I wish you all the best for the year ahead. Thank you for listening and I look forward to answering your questions.

r210205a_BOA

australia

Opening Statement to the House of Representatives Standing Committee on Economics

lowe

Members of the Committee My colleagues and I welcome this opportunity to once again appear before this Committee. Given the special hearing that was held in December, I thought it would be most useful to focus my introductory remarks on our updated economic outlook and the conclusions of the Reserve Bank Board meeting earlier this week. In terms of the economic outlook, I will start with the global economy, where there has been both negative and positive news recently. On the negative side, renewed outbreaks of the virus late last year have interrupted the economic recoveries in many countries. In Europe, GDP declined again in the December quarter and the growth momentum has slowed in the United States. This has been another reminder that a strong and durable economic recovery requires the virus to be contained. On the positive side, I would like to point to 2 factors. The first is there has been a strong rebound in global trade in goods - as people have switched from consuming services to goods, production and international trade in goods has picked up. This, together with the continuing strong recovery of the Chinese economy, has boosted many commodity prices and Australia's terms of trade. The more important piece of positive news is the development of vaccines. These vaccines hold out the prospect of restrictions being eased and many activities returning close to their pre-pandemic normal. The result is a more positive outlook for the global economy and a lessening of some of the downside risks. Even so, it is prudent to be prepared for further setbacks - the rollout of vaccines faces challenges and there are also other more conventional risks to the global economy. Since we last met, the outlook for the Australian economy has also improved. The downturn in Australia was not as deep as we had feared and the recovery started earlier and has been stronger than we were expecting. The outcomes for GDP and the labour market have been at least as good as the upside scenarios we published last year. Employment growth, retail sales and new house building have all been strong and measures of consumer and business confidence have also improved. These outcomes reflect a combination of factors including: our success on the health front; the very significant fiscal and monetary support that has been provided; and the resilience of Australians, who have adapted and innovated and got on with their lives. The result is that Australia has done better than most other countries on both the health and economic fronts. There are few places in the world you would rather be. This does not disguise the fact that we still have a fair way to go. Despite the welcome progress made in reducing unemployment, the unemployment rate is still higher today than it has been for almost 2 decades and many people can't get the hours of work they want. And the level of output is still around 4 per cent below where we thought it would be when this Committee met in February last year. This is a big gap and represents a lot of lost output and national income. On the wages and prices front, we also have a fair way to go to get back to the outcomes we are seeking. Wage growth is the lowest in decades and inflation continues to run below our mediumterm target of 2-3 per cent. The RBA is committed to making further progress in reducing unemployment and having inflation return to the target range. We recognise that this progress is likely to be gradual. It is also dependent on the path of the pandemic, as well as on the structural and global factors that we have discussed at previous hearings. In terms of the pandemic, the Reserve Bank continues to examine the economic consequences of a range of scenarios. Our central scenario is for the upswing in the Australian economy to continue, with above-trend growth over the next couple of years. GDP is expected to increase by 3 1/2 per cent over both this year and 2022. Taking into account the recovery so far, we are expecting the level of GDP to return to its end-2019 level by the middle of this year, which is 6 to 12 months earlier than we previously expected. In our central scenario, the unemployment rate continues to decline to reach 6 per cent by the end of this year and around 5 1/4 per cent by mid 2023. When the JobKeeper program finishes at the end of March, we expect some additional job losses. But, over time, these are expected to be offset by the jobs created by the ongoing economic recovery. Job vacancies, job ads and business hiring intentions have all rebounded sharply, which suggests continuing solid employment growth over the next few months. Wages growth and inflation are both forecast to remain subdued. Wages growth is expected to pick up from its current low rate, but to do so only very gradually and still be below 2 per cent at the end of next year. Inflation in underlying terms is also forecast to stay below 2 per cent over the next couple of years: the central forecast for 2021 is 1 1/4 per cent and for 2022 it is 1 1/2 per cent. In addition to this central scenario, we will again be publishing downside and upside scenarios in the Statement on Monetary Policy later this morning. In the downside scenario, there is little further progress in reducing unemployment this year and wages growth and inflation remain around current levels. In contrast, in the upside scenario, the unemployment rate falls faster to be a bit below 5 per cent in the second half of next year and underlying inflation is at 2 per cent in mid 2023. Time will tell whether we can continue to track close to the upside. One issue that we are paying close attention to is how households respond to the tapering of the fiscal and other support measures. The fiscal response has supported people's incomes has boosted household savings, with the result that household balance sheets have strengthened noticeably. We are expecting these stronger balance sheets to support spending, but there are uncertainties in both directions here. A related issue that we are watching closely is the housing market. There are many moving parts here at present: record low interest rates; a shift in preferences towards houses and regional locations; large government incentives for first home buyers; the slowest population growth in a century; very high rates of house building; and a decline in apartment rents in Sydney and Melbourne. In the face of all these moving parts, the housing market has been more resilient than expected and this has been helpful in terms of the overall economy. The past year would have been even more complicated if there had been large and widespread falls in housing prices. Housing prices are now rising across most of the country. Even so, the national housing price index is only around the level reached 4 years ago. As we have previously discussed at these hearings, the RBA does not - and should not - target housing prices. Instead our focus is on the lending that is used to purchase housing. We want to see lending standards remain strong. At present, there are few signs of a deterioration in these standards. If that were to change, you could expect that we would be discussing possible responses at the Council of Financial Regulators, as we did a few years ago. I will now turn to monetary policy. Given that our meeting earlier this week was the first for a new year, the Board took stock of last year's monetary policy measures and discussed the outlook for the year ahead. I would like to highlight 6 points from those discussions. The first point is one that we covered at the Committee hearing in December - that is, the RBA's monetary policy package is working broadly as expected and it is helping to support jobs. Together, the bond purchases, the Term Funding Facility, the 3-year bond yield target and the record low cash rate have kept funding costs low for all borrowers and helped ensure that the banking system is able to provide the credit that is needed for the recovery. These measures have also resulted in a lower value of the Australian dollar than otherwise. While the Australian dollar has appreciated in recent months due to both a weaker US dollar and higher commodity prices, a larger appreciation would have occurred in the absence of the RBA's measures. The second point is that very significant monetary support will need to be maintained in Australia for some time to come. It will still be some years before inflation is sustainably consistent with the target and full employment is achieved. It is therefore important that monetary support is maintained. The day will come when it is appropriate to be providing less support, but today is not that day. The third point is that as part of the RBA's ongoing monetary support, we will continue to purchase bonds issued by the Australian Government and the states and territories at the completion of the current $100 billion program in mid April. In considering this issue, the Board took account of 3 factors: the effectiveness of the bond purchases to date; the decisions of other central banks; and, most importantly, the outlook for inflation and jobs. In terms of effectiveness, the bond purchases have helped to lower interest rates and meant that the Australian dollar is lower than it otherwise would have been. It is difficult to be precise, but we estimate that our bond purchases have lowered yields on longer-term Australian Government bonds by around 30 basis points. They have also contributed to lower spreads on the bonds issued by the states and territories and added to liquidity in the Australian financial system. Australia's government bond markets also continue to function well. In terms of what other central banks are doing, many have recently announced extensions of their bond purchase programs. This is relevant to us, because we live in an interconnected world. If we were to cease bond purchases in April, it is likely that there would be unwelcome upward pressure on the exchange rate. This would further delay the already slow progress on jobs and inflation. Given these considerations - and with the cash rate at its effective lower bound - the Board judged that it was in the national interest for the Bank to continue with its bond purchases. After the current program finishes in mid April, the Bank will buy a further $100 billion of government bonds at the same rate as currently of $5 billion a week. These purchases will continue to be in the secondary market through transparent auctions. The RBA does not, and will not, directly finance governments. The bonds we own will have to be repaid in the same way as if they were owned by others. We are lowering the cost of finance for governments - as we are for all borrowers - but we are not providing direct finance. There remains a strong separation between monetary and fiscal policy. The fourth point from the Board's review this week is that the Term Funding Facility will be maintained as it is. Banks can draw on the facility up until the end of June, which means that they will have the benefit of low-cost funding for 3 years. We expect that this benefit will continue to support the supply of credit and lower the cost of credit for this period. The Bank would consider extending this facility if there were a marked deterioration in funding and credit conditions in the Australian financial system. At present, there are no signs of this. The fifth point is that the 3-year yield target for Australian Government bonds will be maintained. This target has helped anchor the Australian yield curve and has helped reinforce our forward guidance regarding the cash rate. Later in the year, the Board will need to consider whether to shift the focus of the yield target from the April 2024 bond to the November 2024 bond. In considering this issue, the Board will be giving close attention to the flow of economic data and the outlook for inflation and jobs. It has made no decision yet. The sixth and final point is that the cash rate will be maintained at 10 basis points for as long as is necessary. The Board has no appetite to go into negative territory and has done as much as it reasonably can with interest rates. Before increasing the cash rate, the Board wants to see inflation sustainably within the 2 to 3 per cent target range. Meeting this condition will require a tighter labour market and stronger wages growth than we are currently forecasting. It is difficult to determine exactly when this condition might be met, but, based on the outlook I have discussed today, we do not expect it to be before 2024, and it is possible that it will be later than this. So interest rates are going to be low for quite a while yet. On that note, I will close and my colleagues and I are here to answer your questions.

r210310a_BOA

australia

The Recovery, Investment and Monetary Policy

lowe

Thank you for the invitation to participate in this year's AFR Business Summit and it is great to be here in person. I would like to begin by congratulating the AFR on its 70th anniversary - that is quite an achievement in an industry with so much change. I look forward to many more years of business and finance reporting and analysis. The timing of this year's summit coincides with a lift in sentiment about the global economy. The rapid development of vaccines and their rollout have improved the global outlook and lessened some of the downside risks. The plan for further fiscal stimulus in the United States has also improved growth prospects there. The result has been a reassessment by investors of the outlook for inflation and interest rates around the world. Against this backdrop, I would like to begin by reviewing recent economic and financial developments. I will then turn to the importance of business investment in sustaining a strong economic recovery. Finally, I will discuss the outlook for monetary policy in Australia. Last week we received further confirmation that the Australian economy is recovering well, and better than expected. GDP increased by 3.1 per cent in the December quarter, following a similar rise in the previous quarter (Graph 1). These back-to-back large increases are materially better outcomes than we expected back in August. They reflect the success that Australia has had on the health front, the very large fiscal and monetary policy support, and the flexibility of Australians in getting on with their lives and businesses. As a result, we are now within striking distance of recovering the pre-pandemic level of output. There has also been positive news on the employment front over recent months. The recovery in employment has been V-shaped and there has been a welcome decline in the unemployment rate to 6.4 per cent (Graph 2). Job vacancies, job ads and hiring intentions remain strong. This suggests that the unemployment rate will continue to trend lower, although this trend could be temporarily interrupted when JobKeeper comes to an end later this month. These better-than-expected outcomes are very welcome news. However, they do not negate the fact that there is still a long way to go and that the Australian economy is operating well short of full capacity. There are still many people who want a job and can't find one and many others want to work more hours. And on the nominal side of the economy, we have not yet experienced the same type of bounce-back that we have seen in the indicators of economic activity. For both wages and prices, there is still a long way to go to get back to the outcomes we are seeking. In underlying terms, inflation is running at 1 1/4 per cent, and we expect it to remain below 2 per cent over at least the next 2 years Turning to other countries now, the recent experience has been mixed. A number are benefiting from a pick-up in international trade in goods, following the shift during the pandemic to spending on goods, rather than services. This shift has underpinned stronger conditions in the manufacturing sector, especially in east Asia, and broad-based increases in commodity prices (Graph 4). In contrast, in some other countries, virus outbreaks around the turn of the year have interrupted their recoveries. Looking forward, the rollout of vaccines has improved the prospect of a sustained recovery in the global economy. In the United States another important factor is the further large fiscal stimulus, amounting to 9 per cent of GDP, with this stimulus coming on top of the significant measures announced last year. The brighter global outlook has been associated with an increase in bond yields (Graph 5). This follows a period in which 10-year bond yields were at historic lows in many countries, including Australia. These historic lows reflected a combination of structural and cyclical factors. On the structural side, there has been, for some time, an elevated desire to save, relative to invest, which has kept real interest rates low. On the cyclical side, the steep declines in GDP, the uncertainty about the future and an expectation of a long period of very low inflation have each played a role. Recently, as the outlook improved it is understandable that yields moved off their historic lows, although explaining the exact timing and trigger for any change is always difficult. Initially, the repricing in the bond market was associated with additional volatility in financial markets. Subsequently, conditions settled down more quickly than they did in March/April last year, although further bouts of volatility are possible. The move higher in bond yields since November mainly reflects a lift in investors' expectations of future inflation, although there has also been some bring forward in the expected timing of future policy rate increases. The lift in inflation expectations is evident in the graph below (Graph 6). For most of the past year, expected inflation was well below the rates being targeted by central banks. This has now changed and expected inflation has moved to be closer to those targets. This suggests that investors have more confidence that the policy measures are working to stimulate the global economy and that the recovery will be strong enough to generate inflation close to target. If so, this would be good news. It is also worth noting that expected inflation rates are not especially high and are still not above central bank targets. The other element of the lift in yields is the bringing forward of the timing of the expected increases in policy interest rates. Current market pricing suggests an expectation that some central banks will increase policy rates next year and in 2023 (Graph 7). This is a change from the situation a few months ago, when longer periods of unchanged policy rates were expected. This change has occurred despite expected inflation remaining below the thresholds set by central banks for higher policy rates. Reflecting these global developments, we have seen a similar move in market expectations about future policy rates in Australia. I will return to this issue shortly when I discuss the outlook for monetary policy here. Before doing that, I would like to focus on one piece of the economic recovery in Australia that has been slow to click into gear: that is, private business investment. The left-hand side of the next chart shows the RBA's forecast for non-mining business investment prepared in February last year together with the actual outcomes (Graph 8). The right-hand side shows the same for consumption. The rebound in consumption has been strong, with growth of 12 per cent over the second half of last year. Investment is a different story. While there was a welcome pick-up in the December quarter, particularly in machinery and equipment investment, investment is still 7 per cent below the level a year earlier and over 10 per cent below where we thought it would be at the start of last year. Nonresidential construction is especially weak, with the forward-looking indicators suggesting that this is likely to remain so for a while yet. This weakness in business investment follows a run of years in which non-mining business investment as a share of nominal GDP was already low by historical standards (Graph 9). Since 2010, this investment ratio averaged 9 per cent, compared with 12 per cent over the previous 3 decades. This is a material difference and cumulates to slower growth in Australia's capital stock, with implications for our longer-term productive capacity. A durable recovery from the pandemic requires a strong and sustained pick-up in business investment. Not only would this provide a needed boost to aggregate demand over the next couple of years, but it would also help build the capital stock that is needed to support future production. Stronger investment would also support a more productive workforce and a lift in both nominal and real wages. Unfortunately, there is no magic ingredient for boosting business investment. A good starting point, though, is businesses having confidence that the economy will grow and that there will be demand for their products and services. Another important ingredient is having stable and predictable regulatory regimes. Access to finance on reasonable terms is also important. To this list, you could add businesses that are able to generate great new ideas and that have the risk appetite and the capability to back these ideas. Having a highly skilled workforce and management are obviously important elements here. Looking across the economy, there are investment needs and opportunities in areas as diverse as infrastructure, power generation and distribution, health and social services, food production, advanced manufacturing and digitalisation and data science. So there is no shortage of areas where additional investment would help our economy grow. I would like to highlight the important role that small business has in driving investment. My colleagues have recently been examining this using the ABS's BLADE database. One of the exercises that we have undertaken is to examine the investment and output of firms grouped by size - small, medium and large. The results of this work are shown in this next graph (Graph 10). Not surprisingly, large firms account for the biggest shares of output (blue bars) and investment (red bars). But small firms, on average, invest much more relative to their output than do other firms. There is, of course, a lot of variation among small firms, but many of them invest very intensively. In aggregate, small firms accounted for 32 per cent of investment in Australia from 2002-17, while accounting for only 17 per cent of output. This investment drives innovation, generates new ideas, stimulates competition and supports employment. So one of the important ingredients to the recovery in business investment in Australia is ensuring a supportive environment for innovative small and mediumsized businesses. I would now like to return to the outlook for monetary policy in Australia. Over the past year, monetary policy has complemented fiscal policy in cushioning the economic effects of the pandemic and in building the bridge to the recovery in economic activity and jobs. The RBA's policy measures have been keeping financing costs very low, contributing to a lower exchange rate than otherwise, supporting the supply of credit to businesses, and strengthening household and business balance sheets. In doing so, we have been helping in the national recovery effort. The Reserve Bank is committed to continuing to provide the necessary assistance and will maintain stimulatory monetary conditions for as long as is necessary. We want to see a return to full employment in Australia and inflation sustainably within the 2 to 3 per cent target range. These are our goals and we are committed to achieving them. An important element of our policy package is the cash rate target being set at what is the effective lower bound of 0.1 per cent (Graph 11). The Board will maintain this setting of the cash rate target until inflation is sustainably within the 2-3 per cent range. It is not enough for inflation to be forecast to be in this range. Before we adjust the cash rate, we want to see actual inflation outcomes in the target range and be confident that they will stay there. This is an evolution from the approach earlier in the inflation-targeting regime, in which forecasts of inflation played a more central role in decision-making about interest rates. We continue to pay close attention to the forecasts, but we want to see actual inflation outcomes consistent with the target before moving the cash rate. A question that investors have been grappling with recently is when will this condition for a higher cash rate be met? As I discussed earlier, over the past couple of weeks market pricing has implied an expectation of possible increases in the cash rate as early as late next year and then again in 2023. This is not an expectation that we share. For inflation to be sustainably within the 2 to 3 per cent range, it is likely that wages growth will need to be sustainably above 3 per cent. This is assuming that Australia generates ongoing growth in labour productivity and that the profit share of national income does not continue to trend higher. Currently, wages growth is running at just 1.4 per cent, the lowest rate on record (Graph 12). Even before the pandemic, wages were increasing at a rate that was not consistent with the inflation target being achieved. Then the pandemic resulted in a further step-down. This step-down means that we are a long way from a world in which wages growth is running at 3 per cent plus. The evidence from both Australia and overseas strongly suggests that the journey back to sustainably higher rates of wages growth will take time and will require a tight labour market for an extended period. Prior to the pandemic, multi-decade lows in unemployment rates were recorded in many countries, yet even then there was only a modest lift in wages growth and inflation. And here in Australia, even though unemployment rates in some states fell to levels last recorded in the early 1970s, wage growth remained subdued. The commonality of experience across advanced countries suggests that there are some powerful structural factors at work. These include: increased competition in goods markets, which makes firms very conscious of cost increases the trend towards more services being provided internationally advances in technology, which have reduced the demand for some types of skills and increased the demand for others changes to the global supply of labour and regulation of labour markets. Together, these factors have altered wage and pricing dynamics in almost all advanced economies and these changes are likely to persist. This means that, in the absence of another major shock, it is a long way back to seeing wage increases consistent with the inflation target. Wages, of course, are only one factor influencing inflation outcomes. We will be reminded of this when headline CPI inflation increases temporarily to around 3 per cent in the June quarter because of the reversal of some pandemic-related price reductions. Also, there are always relative price shifts occurring due to changes in the balance of supply and demand: recent examples include higher prices for homewares following strong demand during the pandemic and higher prices for meat as farmers rebuild herds after the drought. We will see more such examples as other sectors adjust to the altered balance of supply and demand due to the pandemic. In setting monetary policy, the Reserve Bank Board will look through these transitory fluctuations in inflation. The point I want to emphasise is that for inflation to be sustainably within the 2-3 per cent target range, wages growth needs to be materially higher than it is currently. The evidence strongly suggests that this will not occur quickly and that it will require a tight labour market to be sustained for some time. Predicting how long it will take is inherently difficult, so there is room for different views. But our judgement is that we are unlikely to see wages growth consistent with the inflation target before 2024. This is the basis for our assessment that the cash rate is very likely to remain at its current level until at least 2024. I also want to emphasise that the monetary stimulus is not just about achieving an inflation rate of 2 point something. It is just as much about achieving the maximum possible sustainable level of employment in Australia. Unemployment is a major economic and social problem and the Board places a high priority on a return to full employment. There is, inevitably, some uncertainty about exactly what constitutes full employment in our modern economy. Over the past decade, the estimates of the unemployment rate associated with full employment have been repeatedly lowered both here and overseas. So there is uncertainty. But based on this experience, it is certainly possible that Australia can achieve and sustain an unemployment rate in the low 4s, although only time will tell. As we progress towards full employment, we will be relying on the wages and prices data to provide a signal as to how close we are. The current signal is that we are still a long way away from full employment. Consistent with the judgement that the condition for an increase in the cash rate is unlikely to be met before 2024, the Bank remains committed to the 3-year yield target. We are not considering removing the target or changing the target from 10 basis points. The Board has, though, discussed the question of whether to keep the April 2024 bond as the target bond, or to move to the next bond - that is the November 2024 bond - later this year. If we were to keep the April 2024 bond as the target bond, the maturity of the yield target would gradually decline as time passes until the bond finally matures in April 2024. The Board has not yet made a decision on this question and will consider it again later in the year when it has more information about the economic recovery and the labour market. Later in the year, the Board will also consider the case for further extending the bond purchase program. We are prepared to undertake further bond purchases if that is required to reach our goals. Until then, we remain prepared to alter the timing of purchases under the current programs in response to market conditions. We did this last week when liquidity conditions deteriorated and bid-ask spreads widened noticeably, and will do so again if necessary. At its recent meetings, the Board has also discussed developments in the housing market, including the rising housing prices across most of the country. There are many moving parts at present: record low interest rates; a shift in preferences towards houses and away from apartments; strong demand for housing outside our largest cities; large government incentives for first-home buyers and home builders; and the slowest population growth in a century. Time will tell as to how these various factors ultimately balance out, but history suggests that shifts in population growth can have large effects on the housing market. I would like to reiterate that the RBA does not target housing prices, nor would it make sense to do so. I recognise that low interest rates are one of the factors contributing to higher housing prices and that high and rising housing prices raise concerns for many people. There are various tools, other than higher interest rates, to address these concerns, leaving monetary policy to maintain its strong focus on the recovery in the economy, jobs and wages. As part of this focus, we are continuing to pay close attention to lending standards, especially given the combination of low interest rates and rising housing prices. Looser standards would increase mediumterm risks and add to the upward pressure on prices, so would be of concern. Reflecting this, the Council of Financial Regulators has indicated that it would consider possible responses should lending standards deteriorate and financial risks increase. We are not at this point, but we are watching carefully. I will conclude by briefly drawing the 3 themes together - the recovery, investment and the outlook for monetary policy. The full recovery of our economy requires a further lift in business investment. Stronger investment will also boost our productivity and provide a firm basis for stronger growth in nominal and real wages. Globally, higher levels of investment relative to savings are also one of the keys to a return to more normal levels of interest rates over the medium term. The Australian economy is recovering from the pandemic and we expect this recovery to continue. We are also expecting further progress towards the RBA's goals, although the journey back to full employment and inflation consistent with the target is likely to be a long one. The RBA will maintain supportive monetary settings for as long as is required to achieve these goals. Thank you for listening and I am happy to answer your questions.

r210315a_BOA

australia

Opening Remarks

lowe

Good morning and welcome to this year's Business Analytics Conference. I am very pleased to be able to join you, not least because of the theme of this year's conference: Driving Recovery and Growth through Data Analytics. This theme brings together 2 issues that are very close to my heart - the recovery of the Australian economy from the pandemic and the critical role that investment in IT and data can play in sustaining that recovery. So I congratulate you on your choice of topic and I look forward to hearing your ideas. The challenges facing us all are large. At the Reserve Bank, we are seeking to support the economic recovery and a stronger labour market that is consistent with achieving the inflation target. And most of you at this conference are seeking to find new ways of using data to help businesses and organisations innovate, compete and succeed. These challenges are complementary. We will each be more successful if the other is successful. A stronger economy will provide businesses with the confidence and the resources to make the investments that are needed for our future. And conversely, our economy will be stronger because of your work, since the best decisions are those based on data, evidence and analysis. So our causes are linked. I will come back to this idea, but first a few words about the economic recovery. As a nation, we have responded very well to the pandemic. Australians have pulled together and been prepared to do what is necessary to contain the virus and support one another. Businesses have adapted quickly and innovated, with many making more progress on the digital front in a matter of months than they would have made in years. Governments also responded quickly and decisively, with extensive income support, increased spending on infrastructure and a large wage subsidy program. And monetary policy has also helped, reducing the cost of borrowing to historically low levels and supporting the supply of credit. The result has been a quicker and stronger economic recovery than was expected. In the December quarter, GDP increased by 3.1 per cent and we are now within striking distance of the pre-pandemic level of GDP. The number of people in jobs has also almost returned to the level before the pandemic. Looking across the range of indicators, Australia is doing much better than most other advanced economies. This, however, does not hide the fact that we still have a long way to go. The unemployment rate of 6.4 per cent is too high and the economy is operating well short of its capacity. Inflation and wages growth are also both lower than we would like. While we are expecting further progress to be made towards full employment and the inflation target, it is going to take some time before we reach our goals. One piece of the recovery that is yet to click into gear is business investment. Understandably, last year many firms deferred their investment plans and sought to reduce risk on their balance sheets. Late in the year there was a welcome pick-up in investment in machinery and equipment, but there is still a long way to go to get back to the level of investment before the pandemic, which itself was low by historical standards. If we are to have a strong and durable recovery, it is important that the recovery in business investment continues and broadens. Looking across the economy, there are investment needs and opportunities in many areas. The one I would like to focus on today is investment in IT, digitisation and data science. Investment in these areas is critical to lifting our nation's productive capacity. In many ways data is the new oil of the 21 century. Investing in data and our digital capability are critical to our future prosperity. These investments allow better decision making and a faster response to the changes in our economy and society. These investments are also crucial to organisations delivering the more personalised goods and services that many people are seeking. There are opportunities for digital innovation in every sector of our economy. Almost every organisation needs a strong digital capability to perform well, to innovate and lift their productivity. Technology and data analysis also hold the keys to solving many of the great challenges of our times, including controlling the pandemic, dealing with climate change and responding to increasing cyber threats. This all means that the discussions you are having at this conference are really important. If, as a nation, we are to capitalise on your work and the growing opportunities, we need to keep investing in the skills and knowledge of our people. This conference is a good example of this investment. Developing a strong digital workforce with skills in areas like predictive analytics, machine learning and artificial intelligence is just as important as investing in the hardware and software needed to support the digital economy. As part of our journey we also need to think about how our organisations function and make decisions, so that our people can work in more agile and flexible ways as they grapple with complex problems. It is by investing in both physical and human capital that we can boost our productivity, create employment and drive Australia's future prosperity. The importance of investing in the digital economy has been recognised by our governments. The Australian Government has a strong focus on this and is making additional investments in skills and training, streamlining regulatory processes and strengthening the nation's cyber security. The consumer data right, to give consumers greater access to and control over their data, will also help. This access has started with open banking, which will make it easier for Australians to switch between financial institutions and access financial products that better suit their needs. In time, Australians will benefit from this being extended to other areas. At the RBA, we are also investing significantly in digital infrastructure and data. The importance of this to us is reflected in the decision to make 'harnessing the power of data' one of our internal strategic focus areas for the next few years. We view data as a strategic asset, and are investing in the processes, technology and people to enhance the value we get from data. We have established an enterprise data office with responsibility for data management, for ensuring that our staff have the right skills and that we are using leading data technologies and methods in our analysis. This includes the use of machine learning and 'big data'. We are seeing the benefits from this focus on data in our analysis of the economy and financial system. For example, the Bank's staff use loan-level large datasets from securitisations to better understand developments in the market for housing loans and use detailed settlement data to measure bond market liquidity. They also use machine learning techniques to extract measures of sentiment from news articles as an economic indicator. And during the pandemic, we have been able to access and analyse a broader range of data to obtain real-time readings of economic conditions in a way that wasn't possible in the past. At the RBA, we also see the power of new technologies and data in our central banking operations. The RBA has played a significant role in building the New Payments Platform (NPP), a critical piece of national infrastructure, which enables us all to make fast payments on a 24/7 basis. As a provider of banking services to the Australian Government, the RBA has been working with its government banking clients as they modernise their payment systems using the NPP. As an example, Services Australia now routinely uses the NPP to make emergency welfare and disaster relief payments in real time to Australians in need. Payment messages through the NPP can also carry richer data, opening up opportunities for more efficient business processes and new digital services in the future. As an example of this, NPP will be able to support the adoption of e-invoicing, which will lower the cost of doing business. Another example where technology and data are opening up new possibilities is in the area of digital currencies. The RBA is conducting research on the technologies and policy implications of a potential wholesale central bank digital currency. This could use distributed ledger technology to support the settlement of transactions in the interbank payment system. Some of this work is taking place in the RBA's in-house Innovation Lab, where we are collaborating with external parties on a proof-of-concept. We look forward to sharing more details in due course. The Bank and the Payments System Board are also strongly supportive of forms of digital identity that can be used in both the public and private sector. An effective system of digital identity is important in promoting competition, security and innovation in the digital economy. The Australian Government is also supporting digital identity services for conveniently and securely accessing government services online. I would like to conclude by returning to the idea that the challenges facing the RBA and those of you attending this conference are complementary. The RBA is doing what it can to support the recovery from the pandemic and will maintain that support until we have achieved our goals for full employment and inflation. A strong economy will make for a more conducive environment for investments in data and technology. Similarly, your investments in data, technology and human capital will help make the economy stronger and more dynamic. We need these investments to develop the industries of the future and to equip Australians with the skills needed for that future. Australia needs your ideas, your ingenuity and your energy so that organisations across our country can seize the opportunities that will help deliver our future prosperity. I wish you the best for the conference and look forward to your insights on how we can best drive the recovery and growth through investment in data analytics. Thank you.

r210617a_BOA

australia

From Recovery to Expansion

lowe

Thank you for the invitation to join the Australian Farm Institute's conference. It is a great pleasure for me to visit Toowoomba and to learn more about the issues facing the farm sector and regional As we all know, the past year has been an extremely challenging one in the life of our nation. But as a country we pulled together, and we have been up to the task. The results are evident in our health and economic outcomes, which are better than elsewhere in the world. It is important that we don't lose sight of this. This morning, I would like to talk about how the economy is now transitioning from recovery mode to expansion mode, and highlight some of the issues that this raises, including for regional Australia. I will then conclude with some comments about the outlook for monetary policy. Back in March last year, the national economic strategy quickly turned to building a bridge to the day when the virus was contained. The idea was to use this bridge to help people and businesses get across to the other side. The hope was that by doing this, we could avoid much of the costly damage that would be caused by mass unemployment and widespread business failures. This was the right strategy, and it was supported by governments across Australia, the RBA and Australia's financial institutions. The results speak for themselves. Today, the level of employment in Australia is above its pre-pandemic level. Australia and New Zealand are the only advanced economies where this is the case (Graph 1). In the United States, employment is still nearly 5 per cent below the pre-pandemic level and in Spain it is 3 per cent below. The GDP data also paint a positive picture of the recovery, which has been V-shaped (Graph 2). The level of output in Australia is now above its pre-pandemic level; not many other countries are in this same position. The bounce-back has been quicker and stronger than was widely expected; back in August we did not expect the previous level of output to be regained before the first half of 2022, yet here we are already. There has also been a sharp V-shaped recovery in farm output (Graph 3). After the devastating drought, farm output is up 40 per cent since the middle of last year, and now stands at a record high. Rural exports are also at a record high. This recovery in the farm sector is positive news not only for those in the industry and the communities that support it, but it is also making a welcome contribution to the recovery in the national economy. As positive as these outcomes are, it is important not to lose sight of the fact that we are still in the recovery phase. Our international borders are still largely closed, outbreaks of the virus are still leading to periodic lockdowns, and many firms are still adjusting to changes in how people spend their money and where they work. It is also worth recalling that the economic recovery is being underpinned by unprecedented fiscal and monetary policy measures that will not last forever. So we still have a way to go before the recovery is complete. It is time, though, to be thinking about how we transition from recovery mode to expansion mode and consider the issues that will affect that transition. I would like to touch on 3 of these issues this morning, including: how household spending evolves in light of the substantial changes in household balance sheets the tightening of the labour market and its implications for wages and prices the need for further productivity growth. One of the stand-out features of the past year has been the large increase in household saving. Last June, the saving rate spiked to 22 per cent, the highest level on record (Graph 4). This increase in saving reflected the combination of: the boost to incomes from government support; the limited opportunities to spend; and households feeling uncertain about the future. While the saving rate has since declined as restrictions have been eased, it remains high by historical standards. The fact that households have saved more means that, in aggregate, household balance sheets are in better shape than they were previously. Household balance sheets have also been affected by the recent rise in housing prices. This rise has been a nationwide development, but was first seen in parts of regional Australia, with price gains in many areas outstripping those in the capital cities. (Graph 5). Global factors, including low interest rates, have played a role here. But there has also been strong demand for properties in regional Australia due to people moving out of the capital cities and fewer people leaving regional areas during the pandemic. The effects of this are evident not just in prices but in rental markets too, with rents rising quickly in many regional centres (Graph 6). How households respond to these changes in their balance sheets will help shape the next stage of the recovery. If households were to run down their additional savings quickly or if higher housing prices spurred more spending than usual, a stronger economic path than the one we have envisaged could eventuate. On the other hand, it is possible that households sit on these extra savings for a long time and restrain their spending because of uncertainty about the future. If so, this would slow the recovery. So this is an issue we are watching carefully. It is also worth noting that the rise in housing prices is encouraging more housing construction. The challenge here is to make sure that planning processes are sufficiently flexible to allow the supply side of the market to respond to the extra demand; regional centres should be better placed on this front than capital cities, although this is not always the case. A related challenge is to find the workers to build the new housing in regional Australia - an issue to which I will return shortly. The other aspect of the housing market that we are paying close attention to is the increase in household borrowing. The RBA does not, and should not, target housing prices. We do though have a strong interest in trends in household borrowing, especially given the already high level of household debt in Australia. It is important that lending standards remain sound in an environment of low interest rates and rising housing prices. At its meeting last week, the Council of Financial Regulators also discussed the risks that could arise if growth in household borrowing substantially outpaced growth in household income. This is not the case at the moment, but the Council did discuss possible policy responses to a scenario in which rapid growth in household debt posed heightened risks to the future stability of the economy. I would now like to turn to the second issue and that is the labour market. The recovery here has been much stronger than was anticipated. The result is that the national unemployment rate fell to 5.5 per cent in April, which is just a little higher than before the pandemic. Job vacancies and job ads are at high levels and hiring intentions are very strong. Given this, we are expecting the unemployment rate to trend lower over the months ahead, with our central scenario being that unemployment declines to around 4 1/2 per cent by the end of 2022. The improvement in the labour market is especially evident in many regional communities (Graph 7). For the first time in many decades unemployment in regional Australia is noticeably lower than it is in the capital cities. There is still a lot of variation across regions, but the average unemployment rate for regional Australia as a whole is at its lowest level in more than a decade. The labour market is uneven, though. Many people are still struggling to find work, while, at the same time, some firms are reporting that they are finding it difficult to find workers. Many of these reports come from businesses in regional Australia, including those in the agricultural, hospitality, mining and construction sectors. And in nationwide business surveys, many firms are now saying that finding suitable labour is a major constraint on output (Graph 8). Notwithstanding these signs of a tightening labour market, wages growth and inflation remain subdued and there have not been upside surprises. The Wage Price Index increased by just 1 1/2 per cent over the past year, with wages growth slow in the private and public sectors (Graph 9). And it is noteworthy that even in those pockets where firms are finding it hardest to hire workers, wage increases are mostly modest. There are some exceptions to this, but they are fairly isolated. This experience speaks to a broader dynamic in the economy that has been evident for some time and is contributing to the subdued wage and price outcomes. Most businesses feel they are operating in a very competitive marketplace and that they have little ability to raise prices. As a result, there is understandably a laser-like focus on costs: if profits can't be increased by expanding or by raising prices, then it has to be achieved by lowering costs. This has become the predominant mindset of many businesses. This mindset can be helpful in making businesses more efficient, but it also has the effect of making wages and prices less responsive to economic conditions. This mindset became entrenched during the resources boom when the exchange rate appreciated very significantly. When one Australian dollar was worth more than one US dollar, many Australian businesses felt that their Australian dollar cost structure was simply too high. You might recall that through this period many businesses were saying that Australian costs, including labour costs, were leaving them uncompetitive. This experience has left a lasting imprint on many businesses and it has reinforced the narrative about the importance of cost control. Against this background, the economy is now recovering from the pandemic and some firms are finding themselves facing labour shortages. At least some of these business face a choice: do they increase wages in an effort to attract new employees and put up their prices or do they pursue another strategy? Many firms are choosing this second option, relying on non-wage strategies to retain and attract staff. Some are also adopting a 'wait and ration' approach: wait until labour market conditions ease, perhaps when the borders reopen, and until then, ration output. For some, this is a better option than paying higher wages and driving up their own cost base. This is especially so if: increases in the cost base are difficult to reverse later on; there is a reluctance to increase prices; and the business expects labour market conditions to ease before too long. By waiting and rationing, firms can avoid entrenching a higher cost structure in response to a problem that might be only temporary. The underlying point here is that there are a range of factors that are contributing to limited upward pressure on wages, even in tight labour markets. I have previously talked about the effects of globalisation, technology and industrial relations arrangements. While there is always a degree of uncertainty about the future, we are not expecting the influence of these various factors to wane quickly. Some are structural in nature and others will not be overcome until a tight national labour market is sustained for some time. As I will discuss shortly, our monetary policy strategy is designed to achieve this. It is also noteworthy that fiscal policy is also seeking to achieve lower unemployment in Australia. I would now like to turn to a third issue that will shape the expansion: that is productivity growth. Earlier, I spoke about how the economic strategy during the early days of the pandemic was to build a bridge to the other side. On the fiscal front, that bridge was built by governments borrowing against future national income to support households and businesses in the here and now. This was the right thing to do. It was affordable and the higher level of public debt that has resulted from this is manageable. The stronger our future national income is, the more this strategy makes sense. It is for this reason that I have raised the issue of productivity growth. The best response to higher debt levels is stronger growth in future national income, underpinned by a more productive economy. Over the past year, Australia's national income has once again been boosted by the higher prices for our exports. Australia's terms of trade are now approaching the once-in-a-century peak reached during the resources boom a decade ago (Graph 10). There has been a lot of focus on the price of iron ore, but the prices of many agricultural commodities have also increased substantially (Graph 11). Since the start of 2019, wheat prices have increased by 15 per cent, beef prices are up by 20 per cent and lamb prices are up by 25 per cent. The prices of canola, sugar and cotton have also increased sharply over the past year. These higher commodity prices are welcome news and they are helping the national recovery. But, ultimately, it is a more productive economy that will form the basis of sustainable increases in future national income. As has been well documented, labour productivity growth in Australia had slowed prior to the pandemic (Graph 12). The reasons for this are complex and they are not fully understood, but it is likely that this slowing is related to the subdued levels of investment over recent times. From this perspective, it was pleasing to see a pick-up in business investment in the recent national accounts. Machinery & equipment investment increased by 10 per cent in the March quarter and was particularly strong in the manufacturing, construction, retail and farm sectors, as firms responded to the government incentives. The farm sector had been at the forefront of this pick-up in investment, with tractor sales surging over the past year (Graph 13). This pick-up in business investment is welcome, but we have a fair way to go to reverse the decline in investment over the past decade. If we are to build the capital stock that is needed for a more productive economy and a durable expansion, a further lift in business investment is required. This should be possible, as there are investment needs and opportunities in many areas of our country. The government has rightly identified the digital economy as one of these areas. The farm sector knows this, with some exciting opportunities in the area of agtech. Ongoing investment in infrastructure and human capital is also needed. Further investment is also required in the energy sector, where technology is evolving quickly, as are the attitudes of investors. The changes in the global energy system are opening up new sources of comparative advantage for Australia. We will need more investment to capitalise on this advantage, with much of this investment being in regional Australia. How well we do this will have a bearing on our future national income and the shape of the ongoing expansion. I would now like to turn to monetary policy, which has played an important role in building the bridge that I spoke about earlier. The RBA's actions have led to the lowest funding costs on record, a banking system that is flush with liquidity and very low bond yields. The actions have also meant that the exchange rate is lower than would otherwise have been the case and household and business balance sheets are stronger. This has been our contribution to the recovery in jobs and economic activity. At the Reserve Bank Board's next meeting we have 2 important decisions to make. The first is whether or not to extend the yield target from the April 2024 bond to the next bond, which matures in November 2024. And the second is whether, and in what form, to extend the bond purchase program once the current program is completed in September. The 3-year yield target was introduced in March 2020 during an exceptional period. Our judgement is that it has been a successful monetary policy response, which has helped keep funding costs low and reinforced our forward guidance about the cash rate. At the time the target was introduced, the 3-year government bond had a maturity date in early 2023. At that time, the Board recognised that the pandemic would require an extended period of very accommodative monetary policy. Reflecting this, the Board's view was that the probability was extremely low that the conditions for an increase in the cash rate would be met within 3 years. Adopting a 3-year yield target reinforced that message. Now, with the passage of time, the 3-year government bond has a maturity date of April 2024 and, in a few months' time, the maturity date will move to November 2024. In considering whether or not to extend the target to the November 2024 bond, the central issue is again the probability of the cash rate increasing over a 3-year window. In this context, the Board has reviewed a range of possible scenarios. In some of these, the conditions for an increase in the cash rate could be met during 2024, while in others these conditions are not met. The Board will review these scenarios again at its next meeting. The bond purchase program has also been an important part of the RBA's monetary policy response. It has lowered bond yields and funding costs across the economy and contributed to a lower exchange rate. With the current 6-month bond purchase program to be completed in September, the Board has been working through a range of options for what comes next. These options include: i. ceasing purchasing bonds in September; ii. repeating the current $100 billion purchase program over a similar time frame; iii. scaling back the amount purchased or spreading the purchases out over a longer period; or iv. moving to an approach where the pace of the bond purchases is reviewed more frequently, based on the flow of data and the economic outlook. We have made no decisions yet, other than to rule out the first option - the cessation of bond purchases in September. The RBA's bond purchase program is one of the factors underpinning the accommodative conditions necessary for our economic recovery. It is premature to be considering ceasing bond purchases. The key consideration in our decision here is how the RBA can best support the ongoing recovery of the economy. The Board wants to see the recent recovery transition into strong and durable economic growth, with low unemployment and faster growth in wages than we have seen recently. Over time, this will help achieve the inflation target. As part of the Board's overall strategy, it will not increase the cash rate until inflation is sustainably within the 2-3 per cent target range. Year-ended CPI inflation will temporarily spike in the June quarter to around 3 1/2 per cent due to the unwinding of some pandemic-related price reductions. There have also been price increases for some items due to pandemic-related interruptions to supply. But beyond this, inflation pressures remain subdued and are likely to remain so. For inflation to be sustainably in the 2-3 per cent range, wage increases will need to be materially higher than they have been recently. Partly for the reasons I talked about earlier, this still seems some way off. Thank you for listening. I look forward to your questions.

r210706a_BOA

australia

Today's Monetary Policy Decision

lowe

Good afternoon and welcome to today's briefing. The Reserve Bank Board met this morning by videoconference. At that meeting, we agreed on policy measures that will provide ongoing and important support to the Australian economy as it continues its recovery. In particular we decided to: retain the April 2024 bond as the bond for the yield target and retain the target of 10 basis points continue purchasing government bonds after the completion of the current bond purchase program in early September. We will purchase $4 billion of bonds a week until at least mid November maintain the cash rate target at 10 basis points and the interest rate on Exchange Settlement balances of zero per cent. The Reserve Bank Board is committed to achieving the goals of full employment and inflation consistent with the target. Our strategy is to do what we reasonably can with monetary policy to achieve low unemployment and a rate of inflation that is sustainably in the 2 to 3 per cent target range. Today's decisions, together with those we have taken previously, have us on a path to achieving those objectives. Today's decisions are taken against the backdrop of an economy that has bounced back earlier and stronger than expected. The Australian economy is on a positive path. Output is now above its pre- pandemic level and more Australians have a job than they did before the pandemic. The unemployment rate has returned to its pre-pandemic level, underemployment has declined and job vacancies are at a high level. So we are in a much better position than we thought we would be in. The recent outbreaks of the virus and lockdowns will affect the strength of the recovery in the near term. But Australia's experience has been that once an outbreak is contained and restrictions are eased, the economy bounces back quickly. Recent events have, however, reminded us again that it is difficult to predict the future. It is possible that we will experience further setbacks and we need to be prepared for this. But it is also possible that we experience further positive surprises for the economy; over most of this year we have had a run of better-than-expected data and this could continue. On the nominal side of the economy, we have not seen the same upside surprises in wages and prices that we have experienced in jobs and output. Both aggregate wage growth and underlying inflation remain subdued and we expect this to remain the case for some time yet. One issue we are watching carefully, though, is how the balance of supply and demand in the labour market is being affected by the closure of our international borders. There have been increased reports of labour shortages in parts of the country and a step-up in wage increases for some occupations. Even so, wage increases for most Australians are still modest and the expected pick-up in overall wages growth is still forecast to be only gradual. This is the background against which we made our decisions today. I would now like to turn to the specifics. the yield target . The 3-year yield target was introduced in March last year during an exceptional period. It has served its purpose of lowering funding costs in Australia and reinforcing the Board's forward guidance about the cash rate. In my view, it has been a successful monetary policy measure. At the time the target was introduced, the Board judged that the probability of the cash rate increasing over the subsequent 3 years - that was, until early 2023 - was extremely low. In March last year there were credible predictions that Australia's health system could be overwhelmed and it was difficult to envisage scenarios in which interest rates would increase before early 2023. The Board recognised that the pandemic was going to be a major drag on the economy and that the recovery would require an extended period of very low interest rates, especially given the already low rate of inflation. In these circumstances, the Board adopted a target for the yield on the 3-year government bond, which at the time had a maturity date of April 2023. Now, 16 months on, the maturity date for the 3-year bond has moved to April 2024 and it will soon move to November 2024. The Board has once again considered the likelihood of an increase in the cash rate target over a 3-year window, which now extends out to November 2024. The situation today is quite different from that in March last year; we are no longer looking over a cliff but instead transitioning from recovery to expansion. This improvement has widened the range of plausible scenarios for the cash rate. Our central scenario continues to be that the condition for an increase in the cash rate will not be met until 2024. But there are alternative plausible scenarios as well. This means that probabilities have shifted and the decision to adjust the approach to the yield target reflects this shift in probabilities. In particular, the Board has decided to maintain the April 2024 bond as the target bond, rather than extend the horizon to the bond with a maturity date of November 2024. This means that, as time passes, the maturity of the yield target will naturally decline. The Board remains committed to the target of 10 basis points, which is the same rate as the target for the cash rate. As has been the case since the target was introduced, we stand ready to operate in the market to support the target if that is necessary. I would now like to turn to the bond purchase program . This program has lowered risk-free yields across the yield curve in Australia, thereby lowering funding costs for all borrowers. In turn, this has contributed to a lower exchange rate than otherwise, freed up cash flows for households and businesses, and strengthened balance sheets by supporting asset values. The bond purchases have also led to portfolio rebalancing by investors and this too has supported the prices of other assets. It is through these channels that our bond purchases have supported the economic recovery in Australia. The second $100 billion tranche of purchases will be completed in early September. We will continue to purchase bonds after this date, providing ongoing support to the Australian economy. We will continue do so in the current 80/20 spilt between Australian Government Securities and the securities issued by the states and territories. These purchases will be at the rate of $4 billion a week, rather than the $5 billion a week under the current program. The Board will next review the rate of purchases at its November meeting. Its decision to do so, rather than lock in this volume of purchases for a longer period, reflects the balance of 2 considerations. The first is the benefit of being able to respond in a timely way to the flow of economic news. In a world characterised by a high degree of uncertainty, there is benefit from not being locked into a particular path for an extended period. The second is that our guidance about future bond purchases helps with market pricing. The more information the market has about these purchases, the more efficiently they can be reflected in market prices. The Board's judgement is that reviewing the situation in November strikes the right balance. It allows the possibility of a timely recalibration of the Bank's bond purchases in either direction. And it also provides as much guidance about future bond purchases as we reasonably can in an uncertain world. We are not locked into any particular path and bond purchases could be scaled up again if economic conditions warrant. As I have discussed on previous occasions, the reviews of our bond purchases take into account: the effectiveness of the bond purchases to date; the decisions of other central banks; and, most importantly, progress towards our goals for inflation and employment. We will use this same framework in our future reviews. We will continue buying bonds until there is further material progress towards the goals for full employment and inflation. We want to see clear evidence that the stronger economy is translating into a pick-up in aggregate wage growth and a lift in inflation towards the target. We will also be reviewing the ongoing rate of purchases in light of our forecasts for future progress towards our goals. So both the outcomes and the forecasts are important here. Today's announcement reflects this decision-making framework. We are still well short of our goals for full employment and inflation, and this means that a continuation of monetary support through bond purchases is appropriate. At the same time, though, the economy is on a better path than we had earlier expected and the outlook has improved. We have responded to this improved situation by adjusting the weekly purchases from $5 billion to $4 billion. The additional bond purchases that we announced today provide an ongoing important source of support to the Australian economy. I want to emphasise that the step-down from $5 billion to $4 billion does not represent a withdrawal of support by the RBA. The evidence is that central bank bond purchases have their impact through the total stock of bonds purchased, not the flow of those purchases. By mid November, our cumulative purchases under the bond purchase program will have amounted to $237 billion. We will hold a little more than 30 per cent of Australian government bonds on issue and 15 per cent of state and territory bonds. This represents a substantial and ongoing degree of support to the Australian economy. The adjustment in the rate of weekly purchases does not change this. The final part of today's decision was to maintain the cash rate target at 10 basis points and the interest rate on exchange settlement balances at zero per cent. The Board does not intend to increase the cash rate until inflation is sustainably within the 2 to 3 per cent range. It is not enough for inflation to be forecast in this range. We want to see results before we change interest rates. Any increase in the cash rate will take place after bond purchases have ended. For inflation to be sustainably in the 2 to 3 per cent range, it is likely that wages growth will need to exceed 3 per cent. That is on the basis that labour productivity continues to increase and that the labour share of national income remains broadly steady. The current rate of wage growth is materially less than 3 per cent and we expect it will be a few years still before it increases back above 3 per cent. Further progress on reducing unemployment and underemployment will be needed to get there. I want to make it clear that this focus on wages does not mean we have a target for wages growth or that wages growth necessarily has to have cleared a specific benchmark before we adjust interest rates. The condition for a lift in the cash rate relates to inflation, not wages. It is clear that inflation can increase for reasons unrelated to wages and there will be another example of this in the June quarter, when CPI inflation spikes to 3 1/2 per cent. Yet even so, history teaches that sustained changes to the inflation rate are accompanied by sustained changes in growth in labour costs. So, over time, these 2 go together. When the RBA staff last prepared a full set of forecasts in May, the central forecast was for growth in the Wage Price Index to pick up, but to do so only gradually. For inflation, the central forecast was for it to just reach 2 per cent by mid 2023. This is the basis of our guidance that we do not expect the cash rate to be increased until 2024 at the earliest. I want to re-emphasise the point that the condition for an increase in the cash rate depends upon the data, not the date; it is based on inflation outcomes, not the calendar. The central scenario remains that the condition for a lift in the cash rate will not be met until 2024. Let me conclude. The Australian economy has bounced back earlier and stronger than expected. More Australians have jobs today than they did before the pandemic. This is good news. Even so, we are still well short of our goals of full employment and inflation consistent with the target. The RBA is committed to achieving these goals. Today's decisions maintain the supportive monetary conditions that are needed to do this. Thank you for listening. I am happy to answer your questions.

r210708a_BOA

australia

The Labour Market and Monetary Policy

lowe

I would like to thank the Economic Society of Queensland for the invitation to speak today. I was looking forward to my first trip to Brisbane in 18 months, but given the current lockdowns that will have to wait for another day. When I spoke at this lunch 2 years ago, I talked about the accumulation of evidence that Australia could sustain an unemployment rate below 5 per cent without inflation becoming a problem. I also raised the possibility that the Reserve Bank would soon cut the cash rate to help secure both lower unemployment and inflation consistent with the target. Since then, a lot has happened: a global pandemic and the biggest peacetime economic contraction in our lifetimes; and not only did the RBA cut the cash rate, but we cut it as far as we reasonably could and the RBA's balance sheet has nearly tripled to over $500 billion. So a lot has changed since we last met. Even so, I would like to return to the same 2 themes that I talked about 2 years ago: first, the possibility of sustaining low rates of unemployment; and second, how the RBA's monetary policy strategy is contributing to this. I will begin with a brief update on recent labour market developments. I will then discuss the supply side of the labour market and its implications for wage and inflation outcomes. And finally, I will turn to the Reserve Bank Board's decisions earlier this week. The recovery of the Australian labour market this year has been remarkable. The number of Australians in a job has increased by over 250,000 since the turn of the year and the level of employment is now 1 per cent above its pre-pandemic level. The unemployment rate has also fallen sharply, and is now around the same rate as it was just before the pandemic (Graph 1). This sharp decline in unemployment has come as a welcome surprise. Back in February, we expected the unemployment rate to now be around 6 1/2 per cent and not reach the low 5s until the second half of 2023. Yet, here we are now. Labour force participation is near its record high, underemployment is the lowest it has been in nearly a decade and job vacancies are at a record high level. These outcomes point to the resilience of the Australian economy and the effectiveness of the health and economic policy response. One source of uncertainty for the near term is the recent outbreaks of the virus and the lockdowns. We are watching developments carefully, but it is important to remember that Australia's experience has been that, once an outbreak is contained and restrictions are lifted, the economy and jobs bounce back quickly. It is noteworthy that the positive surprises on jobs have not been matched with equivalent surprises on wages and prices. The Wage Price Index (WPI) increased by just 1 1/2 per cent over the past year and recent outcomes have been broadly in line with our earlier expectations (Graph 2). The same is true for inflation. This combination of surprisingly positive employment growth and subdued wages growth had become a familiar pattern before the pandemic. This is evident in the next couple of graphs. The first shows the RBA's successive forecasts for growth in the WPI from 2014 (Graph 3). The picture is very clear: wages growth was persistently lower than forecast. The next graph is similar, but shows successive forecasts for the level of employment (Graph 4). The picture here is not quite as clear, but employment growth has mostly been in line with, or exceeded, expectations, with the obvious exception of last year. As you would expect, we have been seeking to understand this experience and its implications for our policy settings. One straightforward explanation is that the low wage growth encouraged firms to substitute labour for capital, with the result being that employment grew quickly. The more important part of the story, though, is that the strong growth in labour demand was closely matched by a strong increase in labour supply. With both demand and supply rising, there was little need for the price - that is wages - to move. There are 3 elements of the supply story that I would like to touch on: the rise in labour force participation the ability of firms to tap into overseas labour markets when workers are in short supply in Australia the trend rise in underemployment. Labour force participation has been trending up since the middle of the previous decade and is currently around its record high (Graph 5). This upward trend was unexpected, coming after a decade of broadly sideways movement and the ageing of the population. The increase has been particularly large for women. There has also been a rise in participation by Australians older than 55 This recent trend reflects a mix of factors, including: the wider availability of flexible and part-time work; changes to child care arrangements; improved health outcomes for older Australians; and changes in the pension age. It is possible that higher debt levels and the decline in asset values during the financial crisis have also played a role. The most important of these factors is the increased availability of flexible and part-time work, with one in 3 workers now working part time. As hours of work have become more flexible, it has become easier for people with caring responsibilities and older Australians to participate in the paid workforce. This change has coincided with another shift in the economy - that is, an increase in demand for health services and social assistance, which has led to very strong growth in jobs in these areas. Many of these jobs are able to be performed by people who are seeking part-time and flexible work. So there has been a broadly parallel increase in labour demand and labour supply, and this has lessened the upward pressure on wages. The second supply side factor is the ability that firms have had to draw on overseas workers when skills or workers were in short supply in Australia. In some cases, firms hired workers from overseas directly to fill specific gaps, but in other cases they hired people who were already in Australia for other reasons, including to study and on working holidays. It is useful to distinguish the effects of this ability to draw on overseas labour markets from the impact of immigration more broadly. Immigration adds to both the supply of, and demand for, labour: when immigrants work they supply labour and their consumption of goods and services adds to the demand for labour. The precise balance between this extra labour supply and extra labour demand is difficult to determine and depends upon the specific circumstances. The picture, though, is clearer when firms are hiring workers to overcome bottlenecks and fill specific gaps where workers are in short supply. This hiring dilutes the upward pressure on wages in these hotspots and it is possible that there are spillovers to the rest of the labour market. This hiring can also dilute the incentive for businesses to train workers to do the required job. On the positive side of the ledger, hiring overseas workers to overcome bottlenecks allows firms to hire the people they need to operate effectively, and to expand and invest. This benefit was clearly evident during the resources boom, and there are a wide range of businesses and industries that have benefited from hiring foreign workers. Without this ability, output in Australia would have been lower. At the time of the previous census (in 2016), there were around 430,000 people working in Australia on temporary visas. In the food trades, these workers filled around 18 per cent of all jobs; and in the hospitality sector, they filled 13 per cent of jobs (Graph 7). Most of these workers were on either temporary visas for skilled workers or student visas. In contrast, in the farm sector it was more common for workers to be on working holiday visas. In conceptual terms, one can think of this ability to tap into the global labour market for workers that are in short supply as flattening the supply curve for these workers. A flat supply curve means that a shift in demand has only a small effect on prices, or in this case wages. In my view, this is one of the factors that has contributed to wages being less sensitive to shifts in demand than was once the case. The third element of the labour supply story is underemployment. When somebody is underemployed they are, by definition, willing to supply more labour, generally at the prevailing wage. This means that when demand is strong, businesses are able to call on underemployed workers to supply more hours without much upward pressure on wages. And then, when demand is soft, hours can be scaled back. Underemployment has become a much more prominent feature of the Australian labour market over the past couple of decades. Today, over 7 per cent of the labour force report that they are underemployed - more than double the rate in the 1980s (Graph 8). Most of these people work part time and, on average, are looking for an extra 14 hours per week. In aggregate, these extra hours amount to around 3 per cent of total hours available to be worked in the economy. The rate of underemployment varies significantly across industries and is highly correlated with the share of workers who work part time (Graph 9). For example, the underemployment rate in the accommodation and food services sector is around 20 per cent, while in mining it is less than 1 per cent. The high rates of underemployment mean that hours of work have become an important margin of adjustment in the Australian labour market. Hours can be scaled up and down when demand changes, rather than the alternative of people being hired and fired. The benefits of this were evident during the pandemic and the financial crisis more than a decade ago. Reflecting this, the RBA has for some time been paying attention to both unemployment and underemployment when assessing the degree of spare capacity in the labour market. Together, these 3 supply side factors help explain the labour market and wage outcomes over recent times. Strong labour demand was met with a strong supply response. The result was that the price of labour did not move much. A related factor I have spoken about recently is the laser-like focus on cost control in Australian business over the past decade or so. This focus has made firms wary of increasing wages, lest it hurt their competitiveness in an environment where it is difficult to increase prices. Many have instead relied on non-wage alternatives to attract and retain staff. Higher wages have often been seen as a last resort, especially in an environment where the supply side of the labour market is so flexible. There has also been a shift by some firms towards variable, as opposed to fixed, remuneration. This has the advantage to the business of avoiding a permanent increase in the cost base, but allowing higher remuneration to be paid for a time. This change is evident in the WPI measure including bonuses, which for most of the available history increased at the same rate as the measure excluding bonuses (Graph 10). But in the second half of the previous decade, the measure including bonuses increased at a faster rate as firms competed for workers. So what does this all mean for the future? The big change on the supply side has been the closure of our international borders. This has contributed to labour shortages in some areas given the strong pick-up in labour demand. In turn, some workers have received sizeable wage increases. However, the spillover effects to the broader labour market have been limited to date, and wage increases remain modest for most workers. Most firms retain their strong focus on cost control, with many preferring to wait things out until the borders open, and ration output in the meantime. The impact of this change on the supply side is evident in the sharp jump in the number of job vacancies, especially in the accommodation and food services sector (Graph 11). Whereas previously some of these vacancies could have been filled by people on visas, this is now more difficult to do. Since March 2020, the number of people in Australia on a visa with the right to work has fallen by over 250,000, which is a significant decline. Given this experience, an important consideration for the outlook is how long the borders remain closed. One plausible scenario is that they open gradually over the period ahead, especially for workers with skills that are in short supply. This would relieve some of the current pressure points in the labour market. Alternatively, it is also possible that the borders remain closed for an extended period and that the pressure points build further. If so, aggregate wages growth would pick up more quickly than currently expected, but production and investment would be also be constrained. In terms of domestic labour force participation, we are expecting further increases, but not a repeat of the large increase since the middle of the previous decade. Increased job opportunities are expected to continue to draw more people into the labour market. In addition, the more flexible work arrangements that are a legacy of the pandemic make it easier for some people to participate in the labour market. The reforms to child care should also help, although the ageing of the population works in the other direction. With all these moving parts, and the uncertainty about the future strength of labour demand, it is challenging to determine exactly when the spare capacity in the labour market will be absorbed and, hence, when we can expect a sustained lift in wages growth. While it is hard to be sure, it is likely that the unemployment rate will need to be sustained in the low 4s for the Australian economy to be considered to be operating at full employment. Underemployment will also need to decline further. To achieve this, a further period of strong employment growth will be required. One consideration here is that the closure of the borders is making it more difficult to match workers with jobs, opening the possibility that more generalised labour shortages occur at a higher rate of unemployment than we would have expected. Another source of uncertainty is the lack of historical experience upon which to draw. In the past 4 decades, the only time that Australia has had an unemployment rate close to 4 per cent was during the peak of the resources boom. So there is some uncertainty about how aggregate wages will respond at lower rates of unemployment. Given this lack of historical experience, 2 of my colleagues at the RBA - James Bishop and Emma Greenland - have approached this issue from a different angle. In particular, they have examined the relationship between the unemployment rate in nearly 300 individual local labour markets across Australia and the average increase in labour income in these markets using data from the Australian Taxation Office. The results are shown in Graph 12. The vertical axis shows how much growth in income in a particular labour market varies from the average and the horizontal axis shows the unemployment rate in each of the local labour markets. These results suggest a clear relationship: the lower unemployment is, the higher is relative income growth. This relationship is stronger when the unemployment rate in a local labour market dips below 5 per cent and strongest when unemployment dips below 4 per cent. While these results are subject to a range of qualifications, they suggest a couple of conclusions. First, tighter labour markets do generate stronger wage increases - the laws of supply and demand still work. And second, the relationship seems to be stronger at unemployment rates below 5 per cent. These are important conclusions from a policy perspective, especially given the RBA's strategy is to get the unemployment rate down so that wages growth picks up and inflation returns in a sustainable way to the target range. This brings me to our monetary policy decisions earlier this week. At our meeting on Tuesday, the retain the April 2024 bond as the bond for the yield target and retain the target of 10 basis points continue purchasing government bonds after the completion of the current bond purchase program in early September. We will purchase $4 billion a week until at least mid maintain the cash rate target at 10 basis points and the interest rate on Exchange Settlement balances of zero per cent. These measures will provide the continuing monetary support that the economy needs as it transitions from the recovery phase to the expansion phase. They will help lower unemployment and underemployment further and, in time, see inflation return to the 2 to 3 per cent target range. The Board is committed to achieving the goals of full employment and inflation consistent with target. The bond purchase program is helping us to make progress towards those goals. We decided to continue purchasing bonds because we are still some way from reaching those goals. However, at the same time we are responding to the stronger-than-expected economic recovery and the improved outlook by adjusting the amount purchased each week. This is consistent with the framework that we previously set out. Under that framework, bond purchases are reviewed in terms of: their effectiveness; the decisions of other central banks; and, most importantly, the progress towards our goals for inflation and employment. We are seeking to provide as much guidance about future bond purchases as we reasonably can in an uncertain world, while retaining the flexibility to respond in a timely way to changes in the state of the economy and the outlook. So we will be reviewing the size of our bond purchases again at our November meeting. In terms of interest rates, the condition that the Board has set for an increase in the cash rate is that inflation is sustainably within the 2 to 3 per cent range. It is not enough for inflation to be forecast in this range. We want to see results before we change interest rates. The bond purchases will end prior to any increase in the cash rate. For inflation to be sustainably in the 2 to 3 per cent range, it is likely that wage growth will need to exceed 3 per cent. That is on the basis that labour productivity continues to increase and that the labour share of national income remains broadly steady. The current rate of wage growth is materially less than 3 per cent. Partly for the reasons I have discussed, we still expect the lift in aggregate wages growth will be gradual. We also expect that it will take until 2024 for inflation to be sustainably within the 2 to 3 per cent target range. I would like to close by reiterating the 2 points I made earlier in the week. The first is that the condition for an increase in the cash rate depends upon the data, not the date; it is based on inflation outcomes, not the calendar. The second is that the step-down in the RBA's bond purchases from $5 billion to $4 billion a week does not represent a withdrawal of support by the RBA. The evidence is that central bank bond purchases have their impact through the total stock of bonds purchased, not the flow of those purchases. By mid November, our cumulative purchases under the bond purchase program will have amounted to $237 billion. We will hold a little more than 30 per cent of Australian government bonds on issue and 15 per cent of state and territory bonds. This represents a substantial and ongoing degree of support to the Australian economy. The adjustment in the rate of weekly purchases does not change this. Let me conclude on that note. Thank you for listening. I am happy to answer your questions.

r210806a_BOA

australia

Opening Statement to the House of Representatives Standing Committee on Economics

lowe

Good morning. Thank you for arranging this hearing via videoconference. These hearings are an important part of the accountability process for the RBA and my colleagues and I welcome this opportunity to explain our thinking and answer your questions. Later this morning, the RBA will be releasing our quarterly Statement on Monetary Policy. I would like to highlight 5 key themes from this report. The first is that the Australian economy has bounced back quicker and stronger than was earlier expected. The pre-pandemic level of GDP was regained in the March quarter, more than a year earlier than we had expected in August last year. But it is in the labour market where the recovery has been most remarkable. In June, the unemployment rate fell to 4.9 per cent, which is lower than it was before the pandemic. There has been strong growth in jobs across most parts of the economy and job vacancies have been at record highs. And in stark contrast to the experience of most other advanced economies, labour force participation and the number of hours worked had both recovered to above pre-pandemic levels. These outcomes are testament to the effectiveness of the public policy response, including the early success on the health front and the ability of Australians to adapt to changed circumstances. The economic policy response involved the public sector using its balance sheet to support the economy and keep people in jobs. Fiscal and monetary policy worked together well and the response of Australia's financial institutions also helped. Households and businesses also showed remarkable resilience and an ability to change how they do things. So, it is a positive story here. Now to the second theme, which is that the recovery has been interrupted by outbreaks of the highly infectious Delta strain of the coronavirus, especially in New South Wales. The outbreaks mean that GDP is likely to decline in the September quarter. How large the decline will be depends on the duration of the lockdowns and whether there are further material outbreaks elsewhere in Australia in the weeks ahead. As a rough rule of thumb, household consumption in areas that are locked down is typically around 15 per cent lower than it would be otherwise. In addition, the lockdowns have directly affected construction activity in NSW and delayed some investment plans. Some increase in the unemployment rate is also expected over the months ahead, although most of the adjustment in the labour market is likely to be through declines in hours worked and participation, rather than in job losses. As we assess the impact of the lockdowns on the economy, it is important not to lose sight of the fact that not all of Australia is affected. Significant parts of the Australian economy are still on the positive trajectory that was in place before the recent outbreaks. This is quite different from the situation in the first half of last year, when the whole of Australia was in lockdown. So, it is a mixed picture. The third theme from the Statement on Monetary Policy is that the economy is expected to bounce back quickly once the restrictions ease. The experience both in Australia and elsewhere is that once restrictions are lifted, spending recovers strongly, especially if people have confidence about the future. While the exact timing of the bounceback is difficult to predict, it is likely to start well before the end of the year. The vaccination program is ramping up and governments are providing significant targeted income support to help businesses and households get through this difficult period. This means that there is a pathway out of the current difficulties this year. At its meeting earlier in the week, the Reserve Bank Board considered a range of possible scenarios for the Australian economy over the next couple of years. Our central scenario is that the economy will return to strong growth in 2022, with GDP increasing by a little over 4 per cent, to be followed by growth of around 2 1/2 per cent in 2023. In this scenario, the unemployment rate resumes its downward path to reach around 4 1/4 per cent by the end of next year and 4 per cent the following year. The Board also considered upside and downside scenarios, the details of which will be published later today, with much depending on the health outcomes. One source of uncertainty is the possibility of vaccine-resistant virus strains emerging over time. Another is that it is still unclear what type of adjustments our society will have to make to live with COVID on an ongoing basis. Once vaccination rates are high enough, we will be living with a virus that is endemic rather than living through a pandemic. What this endemic phase looks like is still to be determined. On the upside, it is possible the Australian economy will again experience a run of positive surprises, as it did earlier this year. If we are successful in containing the virus over the months ahead, it is possible there will be stronger upswings in both investment and consumption than envisaged in our central scenario. The fourth theme is that we have not seen the same upside surprises in wages and prices that we have experienced in jobs and output, and that it will take some time for inflation to be sustainably in the 2 to 3 per cent target range. Both wages growth and underlying inflation are subdued and we expect this to remain the case for some time yet. While there have been reports of labour shortages in parts of the country and a step- up in wages for some occupations, wage increases for most Australians are still modest. Underlying inflation also remains low at around 1 3/4 per cent over the year to the June quarter. In contrast, the headline inflation rate spiked to 3.8 per cent in the June quarter, but this largely reflected the unwinding of some earlier COVID-19-related price declines. In our central scenario, both wages growth and underlying inflation pick up, but do so only gradually. The central forecast is for underlying inflation to be 1 3/4 per cent over 2022 and then 2 1/4 per cent over 2023. Growth in the Wage Price Index is expected to pick up gradually to 2 3/4 per cent over 2023, with growth in other measures of labour costs slightly higher than this. One source of forecast uncertainty here is that Australia has had little recent experience with the low unemployment rates that are being forecast. At the peak of the resources boom in 2008, the unemployment rate briefly got as low as 4 per cent, but before that the last time the unemployment rate was at 4 per cent was in the early 1970s. Our economy and our institutions were very different then than they are today, making it hard to draw any lessons. Notwithstanding the uncertainties, there are a number of factors that make it likely that the pick-up in wages and inflation will be gradual. These include: enterprise agreements that run for a number of years; a business mindset that is very focused on cost control; inflation expectations that are low; relatively high ongoing rates of underemployment; and that it will take some time yet before the spare capacity in the economy is fully absorbed. Together, the factors help provide a basis for expecting that Australia can sustain an unemployment rate in the low 4s, but time will tell. That brings me to the final theme of the Statement on Monetary Policy - that is, the RBA's package of monetary policy measures is providing substantial support to the Australian economy in the face of lockdowns and the expected resumption of the economic expansion. These monetary policy measures include: a yield target for the April 2024 Australian Government bond of 10 basis points the bond purchase program under which the RBA is purchasing bonds issued by the Australian Government and by the state and territory governments a cash rate target of 10 basis points. I would like to provide the Committee with an update on each of these elements of the package. First, the Term Funding Facility. A total of $188 billion was drawn down by financial institutions under this facility before the deadline for final drawings of 30 June. The interest rate on most of these funds is 10 basis points and the funding does not have to be repaid for 3 years. This means that, even though the facility is now closed to new drawings, it will continue to support low funding costs in Australia out to mid 2024. At its July meeting, the Board considered the yield target and decided to retain the April 2024 Australian Government bond as the target bond, rather than extend it to the November 2024 bond. The target remains at 10 basis points, the same as for the cash rate. The target has played an important role in keeping funding costs low and reinforcing our forward guidance regarding the cash rate, and it will continue to play this role over the next few years. The decision not to extend the target to the next maturity reflects a shift in the probabilities regarding future movements in the cash rate. When the 3-year yield target was introduced last year, it was difficult to conceive scenarios in which the cash rate would be increased over the subsequent 3 years, which at the time ran to early 2023. Eighteen months on, there are now plausible scenarios in which the cash rate is increased over a 3-year horizon, which now runs until late 2024. Given this shift, the Board decided that it was not appropriate to extend the yield target to the end of 2024. At our July meeting, we also decided that we would continue purchasing government bonds following the completion of the second $100 billion program in early September. In addition, we decided that the purchases would be at a rate of $4 billion a week until at least November, rather than the current $5 billion a week. We also indicated that we had a flexible approach and could adjust the rate of purchases in either direction in response to economic news and changes in the outlook. At the Board's meeting earlier this week we considered the case for delaying this tapering to $4 billion a week. The critical issue here is the outlook for the economy. As I discussed earlier, we are expecting a return to strong growth next year. Any additional bond purchases would have their maximum effect at that time and only a very small effect right now when the extra support is needed most. The Board also recognised that fiscal policy is the more appropriate instrument for providing support in response to a temporary and localised hit to income, and the Board welcomes the substantial fiscal response by governments in Australia. We will, however, keep the situation under review and are prepared to act in response to further bad news on the health front that affects the outlook for the economy over the year ahead. The final element of the package is the cash rate. As I have said previously, the Board will not be increasing the cash rate until inflation is sustainably in the 2 to 3 per cent range. We want to see results on inflation before we move, not a forecast of inflation in the target range. It will not be enough for inflation to just sneak across the 2 per cent line for a quarter or 2. We want to see inflation well within the target band and be confident that it will stay there. In making our assessments here, we will be paying close attention to growth in wages and broader labour costs. Under the central scenario, the condition we have set for an increase in the cash rate is not expected to be met before 2024. Finally, I would like to mention one other important area of the RBA's operations; that is, our role as banker to the Australian Government. Over recent weeks we have worked very closely with Services Australia to make sure that the COVID Disaster Payments are made quickly. Once an application is made to Services Australia for assistance, the money can be in the person's bank account in less than an hour. On a recent Sunday, Services Australia, with the assistance of the RBA, processed over 300,000 individual payments through Australia's fast payment system, with the money available to people immediately on the weekend. These fast payments are possible because of both the RBA's significant investment in our banking and payments infrastructure and our policy efforts over many years to encourage the banking system to develop a fast payments system. The RBA also operates the settlement system that transfers money between banks' accounts in real time, 24 hours a day, 7 days a week. It's pleasing to see how these systems can be used to directly and quickly help people who are in need. Thank you. My colleagues and I are here to answer your questions.

r210914a_BOA

australia

Delta, the Economy and Monetary Policy

lowe

Thank you for joining us today to support the Anika Foundation. This afternoon, I would like to talk about the implications of the pandemic for the economy and for monetary policy. But before I do that, I want to acknowledge the impact of the pandemic on young people. The past 18 months have been very difficult for young Australians. Their support networks have been disrupted, leaving many young people feeling isolated and anxious about the future. Many have also missed out on events that would normally frame their lives, such as celebrating achievements with their peers. Their education has also been disrupted and, for many, it has been harder to get that valuable support that a one-on-one connection with a teacher can provide. So, our young people are paying a heavy price. This is evident in the increasing incidence of mental health issues and the sharp rise in calls to support services. It is important that we remember this high price when we conduct a full accounting of the costs of the pandemic and the containment measures. It is in this context that I want to thank you again for your support of the Anika Foundation. The Foundation is doing important work in supporting the welfare and mental health of young people. Thank you for being part of that work. I would now like to turn to the economy and then monetary policy. On the economy, our central message is that the Delta outbreak has delayed - but not derailed - the recovery of the Australian economy. The outbreak is a significant setback for the economy and it has introduced an additional element of uncertainty about the future. But there is a clear path out of the current difficulties and it is likely that we will return to a stronger economy next year. Prior to the Delta outbreak, the Australian economy had considerable positive momentum. Domestic final demand increased by 1.7 per cent in the June quarter to be more than 3 per cent above its prepandemic level. GDP was 0.7 per cent higher in the June quarter and nearly 10 per cent higher over It was in the labour market, though, where the positive momentum was most evident. In June, the employment-to-population ratio reached a record high of 63 per cent and the unemployment rate fell to 4.9 per cent, the lowest it had been in more than a decade (Graph 2). The number of job vacancies had also reached a record high in May and there were increasing reports of labour shortages across the country. So things were looking pretty positive and, at the Reserve Bank, we were contemplating a further upward revision to our economic forecasts. But then Delta hit. The result is that the economy will now contract significantly in the September quarter. Domestic demand will contract sharply in the quarter, although stronger exports are expected to support the GDP figures. Our rough rule of thumb is that household consumption is around 15 per cent lower during a lockdown than would otherwise be the case. In addition, there have been disruptions to the construction sector and some investment plans have been delayed. The exact magnitude of the economic contraction in the September quarter remains to be determined but it is likely to be at least 2 per cent, and possibly significantly larger than this. This is a major setback, but it is likely to be only temporary. We expect the economy to be growing again in the December quarter, with the recovery continuing into 2022. The key drivers here are the increasing rate of vaccination and the easing of restrictions on economic activity. Australia has made significant progress on the vaccination front over the past month and further progress is expected over the weeks ahead. In the past couple of weeks, around 1 1/4 per cent of the population has been vaccinated each day, which is at the higher end of international experience. As a result, more than two-thirds of the eligible population has now had a single vaccination and more than 40 per cent are double vaccinated (Graph 3). Governments have indicated that, as these figures continue to increase, restrictions on activity will be eased. When this happens, we can be confident that economic activity will begin to bounce back. While it is hard to be precise about the pace and timing of this bounce-back, in the RBA's central scenario, economic activity is expected to be back on its pre-Delta track by the second half of next year. One of the uncertainties here is the possibility of further significant restrictions on activity. These could come in response to new outbreaks of Delta, the emergence of a new strain of COVID-19 or a decline in the potency of the current vaccines. These possibilities represent the main downside risks to the economy. Another source of uncertainty is how Australians will respond to the easing of restrictions, given that the easing is likely to take place with COVID-19 still circulating in the community. This is quite different from our earlier experience, when the number of cases was close to zero, and there was a very quick bounce-back. Whether the same will be the case this time remains to be seen. Much will depend upon our attitude to risk and how our society deals with the ongoing rate of infection. The experience overseas, though, provides an encouraging reference point. This experience suggests that having COVID-19 circulating in the community does not prevent a quick bounce back in spending, provided the population is highly vaccinated. Most people are keen to do the things they used to and they will spend if they have the opportunity and the income. My expectation is that the same will be true here, although we still can't be sure exactly what living with COVID-19 will look like in Australia. Another factor underpinning the view that the economy will bounce back is the substantial income support being provided by the Australian Government and by the states and territories. While this support is different to that provided earlier, for many individuals the value of that support is similar to that provided earlier. So with consumption restricted by the lockdown, it is likely that the aggregate household saving rate will increase again in the September quarter (Graph 4). While the increase won't be as large as that of last year, it will mean that many people have more money in the bank than they did pre-Delta. It is also relevant that broader measures of household wealth have increased recently (Graph 5). Housing prices are 19 per cent higher than they were before the pandemic and Australian equity prices are around 10 per cent higher. This lift in the net wealth of the household sector is one of the things that suggest that once the restrictions are eased, households will be well placed to start spending again. For businesses, it is a mixed picture. Many of the businesses we talk to are expecting an easing of restrictions later this year. They also remember that the labour market was tightening just a few months ago and are alive to the possibility that this could be again the case next year. This possibility is creating a strong incentive to keep in close contact with employees; it doesn't make much sense to let workers go, only to have trouble hiring when restrictions are eased. Many large firms also have balance sheets that are in good shape and they have expansion plans based on the expected easing of restrictions. Business investment was on an upswing pre-Delta, and it is reasonable to expect that we will return to this as restrictions are eased, demand picks up again and uncertainty starts to recede. At the same time, many small and medium-sized businesses are facing very difficult conditions. Many are in 'wait, survive and see' mode, having experienced a large drop in revenue. Government assistance is helping, but the longer they have to wait before reopening, the more difficult things will become and the greater the potential damage to this important part of the economy. For some businesses, there is a limit to how long they can wait. So the sooner we can open safely the better. I would like to turn to the labour market, where the numbers are going to be difficult to interpret over coming months. Hours worked, rather than headcount, are likely to be the better guide, because the lockdowns have meant that many people are working reduced or zero hours. The data for the unemployment rate will be especially difficult to interpret. When people are stood down for more than 4 weeks without being paid by their employer, they are counted as either unemployed (if they are actively searching, and available for, other work) or not in the labour force. This is the case even when they still have an attachment to their employer and can return to their jobs when the lockdowns end. This is different from the JobKeeper period, when government support was paid via firms' payrolls and many employees on zero hours for extended periods were classified as employed. Nationwide, hours worked fell by 0.2 per cent in July, with a large decline in New South Wales offset by increases in other states, including Victoria, where lockdowns were briefly lifted (Graph 6). At the same time, overall employment was broadly steady. Looking ahead, total hours worked are expected to decline by 3-4 per cent in the September quarter. There is uncertainty about the unemployment rate for the reasons I just spoke about, but it would not be surprising to see readings in the high fives for a short period of time. It is a positive sign that forward-looking indicators of labour demand have held up well. The number of job advertisements fell only a little in July and August, especially in New South Wales, and are still at high levels. The decline so far has been modest compared with the decline of around 60 per cent The experience differs considerably across industries. Hospitality, for example, has seen a similar decline in job advertisements to last year, although from a higher level (Graph 8). Meanwhile, the hiring markets for engineers, health workers and IT professionals have not been particularly affected. In the RBA's business liaison program we hear reports that firms are thinking twice before laying off staff. They recall the strong labour demand before the lockdowns and many have an expectation that activity will recover strongly when lockdowns end. But as I said earlier, this depends upon the easing of restrictions. I would now like to turn to monetary policy, where I will focus my remarks on our bond purchase program and the outlook for the cash rate. First, though, I want to emphasise that the RBA's package of monetary policy measures is providing ongoing and important support to the Australian economy as it deals with the Delta outbreak. This package includes: a record low cash rate a target of 10 basis points for the April 2024 Australian Government bond a bond purchase program under which we have already purchased $200 billion of government bonds, with more to come; and the low-cost term funding facility for Australia's banks, under which $188 billion has been provided for 3 years. This monetary policy package is working by: keeping funding costs and lending rates low across the economy; ensuring that the financial system is very liquid; supporting household and business balance sheets; and contributing to an exchange rate that is lower than it would be otherwise. It is through these transmission mechanisms that our policies are supporting, and will continue to support, the recovery of the Australian economy over the months ahead. At the Reserve Bank Board meeting last week, we considered how the bond purchase program should evolve in response to the Delta outbreak and the change to the economic outlook. The conclusion was that we will purchase $4 billion of bonds each week, as previously announced, but that we will extend the period over which we do this until at least mid February next year. This conclusion reflected a number of considerations. The first and foremost is the delay in the economic recovery and the associated increase in uncertainty about the future. Given that the recovery has been delayed, we considered it appropriate that we delay any consideration of a further taper in our bond purchases until next year. By February we will know more about how the economy is responding to the easing of restrictions than we will know in November. We also took account of the fact that the delayed recovery means that it will take longer to achieve our inflation goals. Continuing with the bond purchases at the announced rate for a longer period will also provide some additional insurance against downside scenarios. A second consideration the Board discussed was the appropriate roles of monetary policy and fiscal policy in response to the nature of the shock we are experiencing. This shock is largely the result of government efforts to contain the movement of people and economic activity. It is also expected to be only temporary, given the expected easing of containment measures over coming months. Throughout the pandemic, the RBA has seen its role as being part of the national effort to build a bridge to the other side and make sure that the economy is well placed to rebound strongly when the time comes. As I discussed earlier, the package of policy measures introduced over the past year has helped build that bridge. Having already put that package in place, our assessment was that fiscal policy is the more effective policy instrument in responding to the Delta outbreak. This is because fiscal policy can use the public balance sheet to offset the hit to private incomes during the lockdowns. In contrast, monetary policy works mainly on the demand side and the effects on income are felt with a lag; realistically, there is little we can do to offset the hit to demand in the September and December quarters. This is the role of fiscal policy and indeed there has been a sizeable and welcome fiscal response. A third and related issue we considered was that by continuing to purchase government bonds at the rate of $4 billion a week we will be adding to the support provided to the economy during the recovery phase. The evidence suggests that the expected stock of central bank bond purchases matters more than how many bonds the central bank buys each week. By February, our cumulative purchases under the bond purchase program will have amounted to $275 billion. We will hold around 35 per cent of the Australian Government bonds on issue and 18 per cent of the state and territory bonds. The RBA's purchase program started later than that of most other central banks but recently has been expanding faster relative to the stock of bonds outstanding (Graph 9). This represents a substantial and ongoing degree of support to the economic recovery. I would now like to turn to the more traditional part of our monetary policy package - that is, the setting of the cash rate. As I have discussed on previous occasions, last year we moved to an approach under which actual inflation, rather than forecast inflation, plays the more central role in our cash rate decisions. In today's low inflation world we do not want to run the risk that we increase the cash rate on the basis of a forecast that ultimately does not come to pass, leaving inflation stuck below the target band. We want to see actual results, not forecasted results, before we lift the cash rate. Once we do see these results, forecasts of inflation will again have a role to play. But we have to get there first. In particular, the Board has said that it will not increase the cash rate until actual inflation is sustainably within the 2-3 per cent target range. It won't be enough for inflation to just sneak across the 2 per cent line for a quarter or two. We want to see inflation around the middle of the target range and have reasonable confidence that inflation will not fall below the 2-3 per cent band again. Our judgement is that this condition for a lift in the cash rate will not be met before 2024. Meeting this condition will require a tighter labour market than we have now. Our assessment is that wages will need to be growing by at least 3 per cent. We remain well short of this. Even in industries where there has been strong demand for labour, wage increases remain mostly modest. This assessment was confirmed by the latest reading of the Wage Price Index, which showed an increase of just 1.7 per cent over the year to the June quarter, with wages growth slower than this in the Our judgement is that it will take some time for wage increases to lift to a rate that is consistent with achieving the inflation target. There is a lot of inertia in the wage-setting process and the experience of the past decade is unlikely to be reversed quickly. This inertia comes from among other things: multi-year employment contracts; a strong cost-control mindset of Australian business; and low and stable inflation expectations. This judgement stands in contrast to the expected path of the cash rate implied by market pricing (Graph 11). The current OIS curve implies a cash rate of around 25 basis points by end of 2022, 60 basis points at the end of 2023 and close to 100 basis points at the end of 2024. These expectations are difficult to reconcile with the picture I just outlined and I find it difficult to understand why rate rises are being priced in next year or early 2023. While policy rates might be increased in other countries over this timeframe, our wage and inflation experience is quite different. Finally, I would like to address the question of housing prices, as some analysts have suggested we might lift the cash rate to cool the property market. I want to be clear that this is not on our agenda. While it is true that higher interest rates would, all else equal, see lower housing prices, they would also mean fewer jobs and lower wages growth. This is a poor trade-off in the current circumstances. That is not to say that there aren't public policy issues to be addressed here. On the financial side, the issue is the sustainability of trends in household borrowing. We are continuing to watch this closely, with the Council of Financial Regulators discussing possible regulatory steps if lending standards deteriorate or credit growth accelerates too much. More broadly, society-wide concerns about the level of housing prices are not best addressed through increasing interest rates and curbs on lending. While monetary policy is contributing to higher housing prices at the moment, the way to address these concerns is through the structural factors that influence the value of the land upon which our dwellings are built. The factors include: the design of our taxation and social security systems; planning and zoning restrictions; the type of dwellings that are built; and the nature of our transportation networks. These are all obviously areas outside the domain of monetary policy and the central bank. Our job is to achieve the inflation target and support the return to full employment in Australia. The package of policy measures we have put in place has us on a path to do that. Delta is delaying progress, but it is not expected to derail our resilient economy. Thank you for listening and supporting the Anika Foundation. I am happy to answer your questions.

r211022a_BOA

australia

Universidad De Chile Conference on Central Bank Independence, Mandates and Policies

lowe

Thank you for your invitation to participate in this conference. You are addressing important issues and I appreciate the opportunity to share Australia's experience with you. At the outset, I want to acknowledge that there is no single right answer to the issues that are being discussed in this session: central bank mandates, the appropriate policy tools and coordination arrangements with the government. Ultimately, what matters are results. The evidence shows that the probability of a country achieving good results is enhanced by getting the structure right. This structure includes: the legal mandate of the central bank; the mechanisms for accountability; the way the political system works; and the process for appointing individuals to the central bank. The most effective combination of these elements will vary from country to country. In Australia's case, the key elements of the central bank mandate were passed into law in 1959 and have remained unchanged since. The 1959 legislation set out three objectives for the RBA's monetary policy: 1. the stability of the currency (widely interpreted as low and stable inflation) 2. full employment 3. the economic welfare and prosperity of the Australian people. Under this legislation, we have had many different monetary policy regimes: a fixed exchange rate against the US dollar; a fixed exchange rate against the trade-weighted index (TWI); an adjustable peg against the TWI; monetary targeting; and, since the early 1990s, flexible inflation targeting. This experience illustrates that legislation is only part of the story, with our broad legislation accommodating a wide variety of monetary policy regimes. In Australia, the choice of exchange rate regime is one that is made by the government. In my view, this is as it should be, as this choice has wide-ranging implications for how a country's economic system works. In our case, the decision by the government to float the Australian dollar in 1983 helped reshape the economy in a positive fashion. The floating exchange rate has also proven to be a great stabiliser of the economy, particularly in the face of large swings in Australia's terms of trade caused by movements in commodity prices. While the Australian Government determines the exchange rate regime, it is the RBA that makes decisions about intervention in the market. We rarely intervene and are transparent regarding the conditions under which we would do so. In particular, we only intervene if: (i) market liquidity has significantly deteriorated during a period of stress; or (ii) the exchange rate has moved a long way from fundamentals, with damaging consequences for the overall economy. The last time the RBA intervened in the foreign exchange market was during the global financial crisis, more than 13 years ago. So intervention is very unusual. We do not have an objective for the exchange rate, nor would it make sense to do so. In my view, adding an exchange rate objective to the central bank's other objectives would severely compromise the achievement of those other objectives and produce, on average, poorer results. Turning now to the inflation objective, Australia was an early adopter of flexible medium-term inflation targeting. From the outset, our target has been for CPI inflation to average between 2 and 3 per cent over time. We have focused on the medium term rather than the outcome in a particular year or over a specific forecast horizon. We never bought into the idea that the central bank needed to be placed into a straightjacket or surrounded by an electric fence to stop it from exploiting the short-run Phillips Curve. We have always had a flexible approach that allows for some variation in inflation from year to year. While financial markets are often concerned about whether inflation in a given year is 1.7 or 2.3 per cent, most people in the real economy rightly don't focus too much on this. What matters for overall welfare is that people are confident that their savings and their income will not be eaten away by inflation. It is also important that saving and investment decisions can be made without inflation figuring prominently on people's radar screens. There are various ways of achieving this, but we have found a flexible medium-term inflation target works well. In terms of the formalities, Australia's inflation target is not set out in legislation. It was originally set by the central bank, but soon after was codified in a written agreement between the central bank and the government. This agreement is reviewed whenever there is a change of government or central bank governor. Over the 25 years since the first agreement was signed, the language has evolved considerably but the numerical target of 2 to 3 per cent has been maintained and so too has the focus on the medium term. From my perspective, this arrangement has a couple of advantages. First, it enhances the credibility of the monetary regime, as it demonstrates that the inflation target is owned by both the government and the central bank. Second, it offers a degree of flexibility, as the target is not set in stone. The target and the accompanying language can be changed if both the central bank and the government agree. The other elements of the RBA's mandate are full employment and the economic prosperity of the people of Australia. In terms of full employment, we do not have a numerical target and I don't think it makes sense to do so. Experience has taught us that the non-accelerating inflation rate of unemployment (NAIRU) moves over time and is influenced by many factors outside the control of the central bank. The same could be said for the estimate of the employment-to-population ratio that is consistent with full employment and stable inflation. Setting the wrong targets would create a conflict with the inflation target, which would lead to policy uncertainty and poor outcomes. Despite the difficulty of setting a numerical target here, I am a strong supporter of the RBA's broad mandate, which includes not just full employment but also the economic welfare of the Australian people. I say this from two perspectives. The first relates to communication. I see a benefit in the central bank being able to communicate that it cares about more than just inflation control. To be clear, inflation control is, and always needs to be, core to what a central bank does. But ultimately, inflation control is only a means to an end; and that end is a productive economy, with people enjoying economic and financial stability, having jobs and achieving a high level of economic welfare. Having a broad mandate allows the central bank to pursue and articulate its goals in these broader terms. This can help build trust in the central bank and support public confidence in its decisions. That is not to say that a broad mandate is required for the central bank to speak in these terms, but I think it makes it easier to do so. The second perspective is that a broad mandate can provide an extra degree of freedom in responding to economic shocks. This is especially so in the case of supply shocks, where output and inflation move in different directions. A broad mandate allows the central bank more time to return inflation to target following shocks that push inflation below or above the target. Provided the inflation target is credible, this flexibility can be used in a way that does not prejudice the achievement of medium-term price stability. Importantly, this flexibility can help reduce the amplitude of cycles in activity and employment. It can also have the benefit of reducing financial stability risks, especially if cutting interest rates in response to a positive supply shock and lower inflation encourages excessive borrowing and asset overvaluation. Again, I want to make it clear that the central bank does not need a broad mandate to have this flexibility. It is possible that a central bank with only an inflation mandate would achieve the same results, especially if it has a flexible, rather than rigid, inflation target. The other topic of this session is the coordination arrangements with government. I have already spoken about the agreement on the inflation target, so I would like to touch on four other aspects of the relationship between the central bank and the government. First, the government appoints all the members of the Reserve Bank Board (which is the decisionmaking body for monetary policy). The Governor has a term of seven years and often serves a longer term. Other Board members are appointed for at least five years and often serve multiple terms. Besides the Governor and the Deputy Governor, all members of the Board are external and are prominent members of the business, academic or policy communities. The Secretary to the Australian Treasury (who is the most senior public servant in the Treasury Department) is also a full voting member of the Board. The Secretary participates as an economist in their own right, not as a representative of the government, but is able to share details of the government's fiscal and other plans. The Board is apolitical and there is not a tradition of Board members stepping down following a change of government. Board members (including the Governor) can have their appointments terminated only if they: become permanently incapacitated; become bankrupt; miss too many meetings; or fail to satisfy their obligations regarding the governance of a public sector entity. These termination provisions have never been used and are not a point of controversy. Second, there is a frequent exchange of views between the Governor and the Treasurer. This exchange is mostly on an informal basis, as circumstances require. The Treasurer does not attend meetings of the Board, nor has the right to do so. The government and the opposition support the independence of the RBA and when the government is asked about monetary policy, the typical response is that monetary policy is a matter for the independent Reserve Bank. Third, the RBA is the transactional banker for the Australian Government. In that role, it provides the government with a small overdraft facility that can be used only to deal with unexpected mismatches in the timing of government payments and receipts. While there is nothing in Australia's central bank law that prevents lending to the government, there is a longstanding written agreement that the central bank will not provide such finance. Furthermore, the government has no role to play in decisions about the RBA's bond purchase program. These decisions are taken independently by the Fourth, the Reserve Bank Act 1959 includes provisions for dealing with a situation in which there is a fundamental difference of opinion between the government and the central bank. In such a circumstance, the law states that the central bank is required to set out its position in writing. The government could then order the Bank to adopt a particular policy. If the government did this, it would then need to set out all the relevant documents before both Houses of Parliament within 15 sitting days. So there would be a high level of transparency about what was going on. I want to point out that these provisions have never been used. They effectively operate as a safeguard against the possibility of the independent central bank pursuing a policy that would be damaging to the national interest. In my view, there is a strong case for such a safeguard in a parliamentary democracy, especially one in which there is both a focus on institutions being accountable to the Parliament and a long tradition of political respect for policymaking institutions. Exercising this power would be a major political step and would draw strong interest from the media and financial markets, so it is not something that would be done lightly. At its core, the relationship between the government and the central bank in Australia is one based on constructive dialogue. This is reflected in the agreement regarding the inflation target that I spoke of earlier and the frequent discussions on issues of mutual interest. The government also supports a high level of transparency by the RBA, including through publications and speeches and public appearances before parliamentary oversight committees. I want to finish where I started: that there is no right answer to the questions that Chile is grappling with. But Australia's experience is that the combination of a freely floating exchange rate, a flexible medium-term inflation target and a broad mandate for the central bank can work well for a small open economy. Thank you.

r211102a_BOA

australia

Today's Monetary Policy Decision

lowe

Good afternoon and thank you for joining this webinar. The Reserve Bank Board met this morning. At our meeting we agreed to: 1. maintain the target for the cash rate at 10 basis points 2. continue to purchase government bonds at the rate of $4 billion per week until mid February 2022, with a further review to be undertaken then 3. discontinue the target for the yield on the April 2024 bond. I would like to take this opportunity to explain these decisions - particularly the decision to discontinue the yield target - and to answer your questions. I would like to start with some background and our updated forecasts. The Australian economy is now growing again, after the recovery from the pandemic was interrupted by the Delta outbreak. GDP is expected to record a solid gain in the December quarter, following the sharp contraction in the September quarter. And by the middle of next year, GDP is expected to be back on its pre-Delta path. Our central scenario is for the economy to grow by around 5 1/2 per cent over 2022 and by around 2 1/2 per cent over 2023. At the outset of the pandemic, economic policy, including monetary policy, set out to build a bridge to the other side. That other side is now clearly in sight. As restrictions are eased, spending is expected to pick up relatively quickly as people seek a return to a more normal way of life. The rapid increase in vaccination rates has been critical in getting us to this point. More broadly, the support provided by both monetary and fiscal policy means that the Australian economy is well placed to resume its expansion. The resilience of the economy continues to be evident in the labour market. A strong bounce-back in hours worked is now under way, after a sharp fall during the lockdowns. The unemployment rate is expected to trend lower over the next couple of years. Our central scenario is for the unemployment rate to reach 4 1/4 per cent by the end of next year, and 4 per cent by the end of 2023. This would be a welcome development. Australia has not experienced a sustained period of unemployment at levels this low since the early 1970s. Inflation, in underlying terms, remains low in Australia, at 2.1 per cent. Inflation is, however, a little higher than it has been over recent years. This increase largely reflects higher oil prices in global markets, higher prices for residential construction and strained global supply chains. Looking forward, we are expecting a further, but gradual, increase in underlying inflation. Our central forecast is for underlying inflation of 2 1/4 per cent in 2022 and 2 1/2 per cent in 2023. While these forecasts for inflation are higher than our previous forecasts, we are not expecting the surge in inflation that has been experienced in some other countries. The situation in Australia is different. We have not seen the same fall in labour force participation as experienced elsewhere, and the impact of other supply disruptions, including in energy markets, is less evident in our CPI. It is also relevant that the starting points for inflation and wages growth are lower in Australia than in many other countries. In addition, our business liaison suggests that wage growth remains modest, although there are some hotspots. Wages growth is expected to pick up as the labour market tightens, but this pick-up is expected to be gradual. So that is the economic backdrop against which today's decision was made. I will now turn to the yield target. The yield target was introduced in the exceptional days of March 2020. It was part of a package of monetary policy measures designed to help build that bridge that I spoke about before. That package has been effective and it is one of the reasons that the Australian economy is now well placed to recover from the pandemic. The yield target had two motivations. The first was to directly anchor the short end of the yield curve so that funding costs were low across the economy. In the exceptional circumstances of the time, we judged that the most efficient way of anchoring the curve was to target a risk-free yield further out along the curve than the cash rate. The second motivation was to reinforce the Board's forward guidance that the cash rate was very unlikely to be increased for three years, which at the time ran until March 2023. On both counts, the yield target has been effective and has supported the recovery of the Australian economy. But its effectiveness as a monetary policy tool declined as expectations about future interest rates shifted due to the run of data and the forecast progress towards our goals. At the time the yield target was introduced, the Board assigned a very low probability to an increase in the cash rate over the three-year horizon of the target - which at the time aligned with the maturity date of the April 2023 bond. Indeed, the central scenario was that the cash rate would need to be held steady beyond that date and the likelihood of an earlier increase in the cash rate was considered to be very low. Today, more than a year and a half on, the balance of probabilities is a little different. Given our forecasts, it is still entirely plausible that the first increase in the cash rate will not be before the maturity of the current target bond - that is, the bond with a maturity date of April 2024. But it is now also plausible that a lift in the cash rate could be appropriate in 2023. In our central scenario, underlying inflation reaches the midpoint of the 2 to 3 per cent range only in late 2023. Having underlying inflation reach the midpoint of the target range for the first time in seven years does not, by itself, warrant an increase in the cash rate. It is also relevant that wages growth at the end of 2023 is expected to be running at 3 per cent. While this is higher than it is now, it is still below the average over the two decades to 2015. This expected configuration of inflation and wages growth allows the Board to be patient in considering a lift in interest rates. It is also possible that the global inflation shock is more persistent than currently expected and that this is transmitted to Australia. There is also uncertainty as to how wages growth responds to the unemployment rate being near 4 per cent for an extended period. We have little historical experience to guide us and there is also the question of the impact on labour supply of the opening of the international border. Given this, it is possible that faster-than-expected progress continues to be made towards achieving the inflation target. The recovery of the economy and the recent inflation data have increased the probability of this. If this faster progress were to be sustained, there would be a case to lift the cash rate before 2024. It is, of course, also possible that we experience yet another setback that throws the economy off course and delays progress towards our goals. One source of such a shock would be a new strain of the virus or a decline in vaccine effectiveness. In this case, the cash rate would need to remain at its current level for longer than otherwise. At its meeting this morning, the Board considered these various possibilities and their implications for the yield target. One option discussed was to continue with the target on the basis that it remained consistent with our central forecasts for the economy. A second option considered was to lift the target yield or change the maturity of the target bond. However, this would not have been consistent with the Board's view that the yield target was an appropriate tool during an exceptional period, but not one to be used on an ongoing basis. The third option considered was to discontinue the target on the basis of the shift in the distribution of possible outcomes for the cash rate that I just spoke about. The Board decided on this third option. I want to make it clear that this decision does not reflect a view that the cash rate will be increased before 2024. As I have discussed, there is genuine uncertainty as to the timing of future adjustments in the cash rate. Given the information we currently have to hand, it is still entirely possible that the cash rate will remain at its current level until 2024. But it is also possible that an earlier move will be appropriate. Given this, the Board judged that there were more costs than benefits in seeking to anchor the yield on the April 2024 bond at 10 basis points. Given the progress towards our goals and the revised outlook, the Board judged that it was no longer sustainable to maintain the target of 10 basis points. The Board took into account the fact that the shift in the distribution of possible outcomes was being reflected in other term interest rates in Australia. If we had sought to pin the yield on the April 2024 bond at 10 basis points in the face of these developments, we would have ended up holding all the freely tradable bonds in the bond line, so that trading in that bond would cease. This would have further diminished the usefulness of the target. I recognise that the past few days have been turbulent ones in the bond market. Our decision to stand out of the market in the days between the release of the CPI and the Board meeting did result in uncertainty as to our policy and affected market pricing and liquidity. We faced a difficult choice over those days: stand out of the market until the Board had an opportunity to review the latest data and forecasts in a matter of a few days; or enter a thin market in an effort to defend a target that was losing credibility for the reasons I have spoken about. I thought the better approach was for the Board to review the situation and decide whether or not to confirm or discontinue the target. I would now like to turn to a broader point and that is the nature of the RBA's forward guidance. As I have stressed on previous occasions, our forward guidance is based on the state of the economy, not the calendar. Our focus has been on returning inflation sustainably to the 2 to 3 per cent range and doing what we reasonably can to reach full employment. These are our goals and it is progress on these fronts that will continue to determine decisions about the cash rate. These decisions are not driven by the calendar. We have, though, supplemented this state-based guidance with a reference to our forecasts and the calendar. We have done this to provide the community with our expected time frame and the factors that will influence that time frame. This in no way has constituted a promise that the cash rate would remain unchanged to any particular date. Rather, at the time of each policy statement we provided our best expectation of the timing of when the cash rate might change, recognising that expected timing can change. While on the issue of timing, the latest data and forecasts do not warrant an increase in the cash rate in 2022. I recognise that some other central banks are raising rates, but our situation is different. The Board will not increase the cash rate until inflation is sustainably in the target range. We are prepared to look through spikes in the inflation rate, as we have done with headline CPI inflation this year. For inflation to be sustainably in the target range, wages growth will have to be materially higher than it is now. This is likely to take time. The Board is prepared to be patient. Finally, in terms of the bond purchase program, we will be including the April 2024 bond in our regular auctions from next week. We will also continue with the program at the current rate of purchases until February, when we will review it again. That review will be based on the same three considerations as previous reviews: (i) the actions of other central banks; (ii) how our bond market is functioning; and (iii) most importantly, the actual and expected progress towards our goals for inflation and unemployment. Thank you. I am here to answer your questions.

r211116a_BOA

australia

Recent Trends in Inflation

lowe

Thank you for the invitation to speak to the Australian Business Economists again. I am glad to have this opportunity to gather together with some of you in person, rather than just speak to my computer camera. Today, I would like to focus on recent trends in inflation - both here and overseas. I will then discuss the implications for the RBA's monetary policy. Over recent months, concerns about inflation have moved to the centre of many people's radar screens, after years of being at the periphery. This has coincided with headline inflation rates in some countries rising to their highest rates in a long time. Understanding the reasons for this higher inflation and how persistent it is likely to be are important issues for households, investors and central banks. The recent concerns about inflation have come after many years of inflation being below central banks' targets. This first graph shows the gap between the average inflation rate over the 10 years to the end of 2019 and the target rate (Graph 1). The picture is pretty clear: the undershooting of inflation targets has been a common, though not universal, experience. The reasons for this are complex but include increasing globalisation, advances in technology and changes in the way labour markets work. Now in 2021, the common experience is higher inflation. CPI inflation has increased in most advanced economies, with a number now experiencing headline inflation rates above 4 per cent (Graph 2). Asia is an exception, though, with inflation rising by only a small amount in Japan and China. So not every country is in the same position. In those countries experiencing higher inflation, central banks and investors are asking themselves how persistent this increase will be. Is it just a temporary development associated with the pandemic? Or is it the start of a more persistent change in inflation dynamics in our economies? Most central banks and international organisations have concluded that the increase in inflation is likely to be only temporary. This is evident in the next graph, which shows the latest inflation data for a range of countries, together with the IMF's forecast for inflation in 2022 (Graph 3). In most economies, inflation is expected to be much lower next year, with inflation rates generally clustered around 2 per cent. A related question is to what extent policy interest rates will have to increase to achieve and sustain the forecast reduction in inflation rates? Current market pricing suggests that investors expect that most central banks in advanced economies will increase their policy interest rates by the end of 2022, with some - including New Zealand, Norway and South Korea - already having done so (Graph 4). It is noteworthy that only a modest increase in policy interest rates is anticipated, with rates expected to plateau at what would still be historically low levels. This is consistent with the view that the current increase in inflation is only transitory and that a period of contractionary monetary policy will not be required to return inflation to target. With that background, I would like to discuss some of the reasons why inflation has risen recently. While there are a range of idiosyncratic factors at work, many of the explanations boil down to a simple one - that is, a shift in the balance of demand and supply as a result of the pandemic. The best place to start is the very large shift in household spending patterns over the past year and a half. When households were locked down, they had difficulty spending on many household services and switched their spending to goods (Graph 5). Rather than taking a trip, going to the gym or eating out, people purchased goods for their homes, including fitting out their home offices and purchasing home exercise equipment. The result was an unprecedented switch in consumption patterns and the effect of this has reverberated throughout the global economy. This surge in demand for goods quickly ran up against a supply side that was not flexible enough. Modern supply chains are calibrated to operate on a 'just-in-time' basis. This reduces the cost of holding inventories, but it means that the global production system is not well suited to a sudden and large shift in demand. And there was the added complication that at the same time demand surged, supply was temporarily constrained as governments and firms took steps to contain the virus. The COVID-19 containment measures also affected the logistics industry. And so, once bottlenecks started to emerge, the problems in supply chains and in logistics fed off one another and compounded. So there was a perfect storm of sorts: very strong demand for goods combined with a hit to productive capacity. The result was a sharp increase in shipping costs around the world, a fall in inventories, increased delivery times and large rises in the prices of many goods (Graph 6). As time has passed, the hit to the supply side because of COVID-19 has been largely overcome, although there are ongoing supply problems in some areas. Today, the main issue is not a reduced ability of global producers to produce goods, but rather an inability to respond quickly enough to strong global demand. For many goods, producers are operating at an inelastic part of the global supply curve. A similar story has played out in many commodity and energy markets. Even before the pandemic, a number of these markets were operating at a point where the short-run supply curve was quite steep. As a result, even modest shifts in demand moved prices significantly. This is evident in the large increases in the prices of gas and many base metals recently (Graph 7). The situation has been compounded, especially in Europe and China, by adverse weather events that have directly reduced supply in some energy markets. The other side of this shift in consumption patterns has been reduced demand for services. This had seen services price inflation slow a bit, but not enough to offset the increase in goods price inflation. More recently, global services price inflation has picked up to be around its pre-pandemic level. Looking ahead, an important question is whether consumption patterns will normalise over time, and if so what effect will this have on prices. There is genuine uncertainty here. It is likely, though, that consumption patterns will return to something more normal. This is not only because we can once again consume many services, but also because households are unlikely to make repeat purchases of durable goods. A return to a more normal pattern would be associated with softer growth in the demand for goods and stronger growth in the demand for services. It is possible that this could coincide with a resolution of some of the lingering supply disruptions and an increase in global supply of goods as firms respond to higher prices. If so, the balance between demand and supply for goods could be quite different from what we have seen recently. This is one basis for thinking that the current elevated rates of inflation are temporary: a period of strong demand saw prices rise, which was recorded as higher inflation, but prices aren't likely to keep rising at current rates as conditions normalise, and some prices may even decline. More fundamentally, a critical issue is how the labour market responds. It is unusual to have persistently higher inflation without persistently higher wages growth (unless there is a shift lower in labour productivity growth). The two generally go together. There have been historical exceptions to this, and other factors that affect firms' costs and mark-ups can have persistent effects. But at the current juncture, the labour market is the key. From my perspective, there are a couple of issues to watch here. The first is how the higher inflation feeds through to inflation expectations and wage norms. It is possible that higher inflation leads workers to seek larger wage increases to compensate them for a loss of purchasing power. This is especially so if workers believe the higher inflation is here to stay. If a period of higher wages growth were to reset wage growth norms, this would have a persistent effect on overall inflation. The second issue is how the balance of supply and demand in the labour market shifts as economies open up and the demand for labour-intensive services increases. Among other things, this will depend upon how labour force participation evolves. Here, the experience has been quite different across countries. In the United States, labour force participation has not yet recovered and is still around 2 percentage points below its pre-pandemic level (Graph 8). In contrast, in Australia we were hitting record highs for participation just before the Delta outbreak and are expected to return to these highs in the coming months. This has also been the experience in several countries in Asia, including Japan, where workers remained attached to their employers throughout the pandemic and where labour force participation rates remained close to record highs. In the United States, the high incidence of COVID-19 infections resulted in a significant reduction in labour supply as people prioritised looking after their own health and that of their families. The closure of schools also had an effect. Further, the income-support arrangements were less successful than Australia's JobKeeper program in maintaining the attachment between businesses and employees. The result has been a significant shock to labour supply in the United States. This has not been the case in Australia. These developments are relevant because strong growth in the demand for services will require a sharp increase in hours worked. In countries where participation has fallen and fewer employee-employer relationships were preserved, one might expect more friction in the labour market. In these countries, labour market matching might be harder to achieve and there could be more upward pressure on wages and inflation. The high incidence of COVID-19 infections in some countries may also mean that some people are reluctant to take or return to customer-facing jobs. So these are issues to watch. We are already seeing some of these dynamics play out and they help explain differential wage outcomes across countries. In the United States and the United Kingdom there has been a sharp increase in wages growth (Graph 9). In contrast, this has not been the case in Australia or Japan, where there has been less of an effect on labour supply. To summarise, inflation in many countries rose as increased demand for goods quickly ran up against a supply side that was not flexible enough. In some countries, developments in energy markets, partly due to adverse weather events, have added to the upward pressure in inflation. Although there is some uncertainty, it is likely that inflation from these sources will moderate over the next 18 months as demand rebalances towards services and the supply of goods adjusts. Now, the critical issue for inflation is how the labour market responds, particularly as demand for services picks up. I would now like to turn to Australia. Many of the factors that have caused inflation to rise elsewhere are also at play in Australia, though most of these are more muted here. There are also significant differences as well, which I will discuss in a moment. As in the rest of the world, Australia has experienced a lift in inflation, although it is less pronounced than in many other countries. In underlying terms, inflation was 0.7 per cent in the September quarter and 2.1 per cent over the year to the September quarter (Graph 10). While this outcome was higher than expected, it is important to remember that at 2.1 per cent, underlying inflation is only just above the bottom of the 2 to 3 per cent target band and remains lower than the average for the past three decades. The higher price of oil in global markets has also affected the headline inflation rate in Australia, with petrol prices up by 24 per cent over the past year (Graph 11). The effects of the shift in consumption patterns are also evident. Some imported goods prices have increased because global goods prices have increased and domestic retailers are discounting by less in response to strong domestic demand. For example, new car prices have increased at the fastest rate since 2001 and the prices of electronics and computing equipment have fallen at the slowest rate for many years. The prices of some other consumer durables, including household furnishings (but not clothing), have also been increasing a little more strongly than in recent years. The shifting demand-supply balance is also evident in the higher cost of building a new home. Again, this is the result of a combination of global price rises for many building materials - including timber and steel - and a domestic price response to strong demand for new homes and renovations (Graph 12). The price of constructing a new dwelling - which has a weight of 8 1/2 per cent in the CPI basket - increased by 3.3 per cent in the September quarter and further increases are expected. So there are similarities with other countries. I would now like to turn to two important differences. The first of these is energy prices. Energy prices in Australia have been trending lower for a number of years, after earlier large price increases (Graph 13). This recent experience has mainly reflected lower wholesale electricity prices, which is in part a result of increased capacity from wind and solar generators. In contrast, a number of other advanced economies have experienced very large increases in electricity prices as their power systems struggle to meet demand. The second and more important difference is what has been happening in the labour market. Labour force participation in Australia remains high and the wage-setting processes - including multi- year enterprise agreements and the annual minimum wage case - impart a degree of inertia into aggregate wage outcomes. Wages growth is expected to pick up, but to do so only gradually. Our business liaison suggests that most businesses retain a strong cost control mindset and are seeking to use measures other than raising base wages to attract and retain staff. There are some jobs that are in very high demand where wages have increased, but we are yet to see a broad-based pick-up in wages growth. In contrast, as I discussed earlier, wages growth has already picked up markedly in some other countries. Turning to the outlook, we expect underlying inflation to pick up further, but to do so only gradually. On the one hand, some normalisation in consumption patterns here and around the world should partly alleviate the current upward pressure on inflation. But on the other hand, we are expecting a gradual pick-up in wages growth as the labour market tightens. In terms of the specifics, our central forecast is for the Wage Price Index to increase by 2 1/2 per cent over 2022 and 3 per cent over 2023 (although overall labour costs are expected to increase somewhat faster than this). Underlying inflation is expected to be 2 1/4 per cent over 2022 and 2 1/2 I would now like to turn to the implications of all this for monetary policy in Australia. The recent inflation data indicate that we are making better-than-expected progress towards our inflation objective. This is welcome news. But we still have a way to go. Underlying inflation has only just returned to the target range for the first time in six years and is only just above the bottom of that target range. In terms of the real economy, the recovery is back on track following the interruption caused by the Delta outbreak. This recovery is being underpinned by high rates of vaccination and expansionary policy settings. We are expecting the recovery to continue and the unemployment rate to trend lower, reaching 4 per cent by the end of 2023. The last time the unemployment rate was lower than this was in the early 1970s. Over the past 50 years, an inflation rate in the twos and an unemployment rate in the fours would have been considered very good outcomes. We need to remember, though, that we are in this place only because of extraordinary policy support. Over time, as a country we will need to refocus on the underlying drivers of growth in the economy and jobs. In terms of the cash rate, the Reserve Bank Board has said that it will not increase the cash rate until inflation is sustainably in the target range. It is hard to precisely define what 'sustainably in the target range' means. But we want to see underlying inflation well within the 2-3 per cent range and have a reasonable degree of confidence that it will not fall back again. The trajectory for inflation is also important, with a slow drift up in underlying inflation having different policy implications to a sharp rise. Another important consideration will be developments in the labour market. Unless labour productivity growth is very weak, it is likely that wages will need to be growing at 3 point something per cent to sustain inflation around the middle of the target band. This doesn't mean that we have a target for wages growth or that wages growth is the only determinant of inflation. Rather, we are using wages growth as one of the guideposts in assessing progress towards our goal and whether inflation is sustainably in the target range. As we get closer to that goal, you could expect us to provide further guidance, including our projections for inflation. Given the global and domestic forces I have discussed, the inflation outlook is more uncertain than it has been for some time. But our central scenario is that underlying inflation reaches the middle of the target by the end of 2023. If this comes to pass, it would be the first time in nearly seven years that we will be at the mid-point. This, by itself, does not warrant an increase in the cash rate. As I have said, much will depend upon the trajectory of the economy and inflation at the time. It is still plausible that the first increase in the cash rate will not be before 2024. There are, of course, other possibilities. It is possible that the global inflation shock is more persistent and that the rebalancing of consumption patterns does not result in an easing of inflation pressures. In addition, we have little historical experience as to how the Australian labour market works at an unemployment rate of 4 per cent. There is also the question of the effect on labour supply of the reopening of the international border. It is therefore possible that faster-than-expected progress continues to be made towards achieving the inflation target. If so, there would be a case to lift the cash rate before 2024. It is also possible that progress will be slower than expected, which would result in the cash rate staying at current levels for longer. Finally, I would like to repeat a point I made a couple of weeks ago - that is, the latest data and forecasts do not warrant an increase in the cash rate in 2022. The economy and inflation would have to turn out very differently from our central scenario for the Board to consider an increase in interest rates next year. It is likely to take time to meet the condition we have set for an increase in the cash rate and the Board is prepared to be patient. Thank you for listening. I look forward to answering your questions.

r211209a_BOA

australia

Payments: The Future?

lowe

Thank you for the invitation to speak at AusPayNet's annual Summit. This is the fifth time I have had the privilege of doing so. Each time, the world of payments has seemed more exciting and dynamic than it was a year earlier. No longer do people talk about payments as being the plumbing of the financial system. Instead, they talk about how what is happening in the world of payments is reshaping our financial systems and how it will continue to do so into the future. Today, I would like to talk about that future. Making specific predictions is difficult as none of us has a crystal ball. Even so, the general direction of change is reasonably clear, even if we don't know the final destination. This morning I would like to start by talking about this general direction of change. I will also discuss a number of specific near-term priorities and then look a little further into the future. I will finish with some comments on the importance of our regulatory arrangements being flexible enough to deal with this dynamic world. I would like to highlight five trends that are evident in the payments system and that I expect will The declining use of banknotes and the increasing use of electronic forms of payment. The greater use of digital wallets. The growing involvement of the 'big techs' in payments. The increasing specialisation within the payments value chain and the emergence of new business models. The growing community and political interest in the security, reliability and cost of payments. These trends mean that anyone involved in this industry is very busy. The shift away from using banknotes was in place before the pandemic, but has accelerated over the past two years and is likely to continue. The RBA will conduct our regular survey of consumer payment methods next year, but the data on cash withdrawals from ATMs tell the story (Graph 1). The value of ATM withdrawals over the past six months was around 30 per cent lower than the comparable period three years ago. While banknotes are still used for many transactions, the trend here is clear. In contrast, there has been a trend increase in the number of electronic payments and this trend too is likely to continue. There has been particularly strong growth in debit card transactions as people have switched from credit to debit. There has also been strong growth in account-to-account than the direct entry system (Graph 2). It is therefore appropriate that the industry is considering when the direct entry system might be wound down and how we move to the more modern payments infrastructure of the NPP. An increasing share of electronic payments is also being made through the digital wallets offered by the large technology companies, including Apple Pay, Samsung Pay and Google Pay. Many people are now choosing to make payments using their digital wallet, rather than using banknotes or a card from their physical wallet. I expect that this change has only started and has a long way to run yet. A related possibility is that digital wallets provide more than just access to existing bank and credit card accounts. In particular, they could contain digital tokens that could be used to make payments. As I will discuss later, these tokens could be issued by the central bank, or by a private bank or another entity. The final destination is not yet clear here, but it is highly likely that digital wallets will become more important. Another trend that is likely to continue is the increasing interest of 'big tech' firms in payments. The platforms used by these firms give them large networks that can be leveraged to quickly build a payments business. They are also able to combine payments data with other data from their platforms, often with cutting-edge technology. Some already provide digital wallets and are exploring how these digital wallets could be used for non-traditional payment methods. So it is highly likely that we will continue to see new business models emerge. At the same time, another trend is for smaller players to enter the market, focusing on specific elements of the payments value chain. This is bringing increased competition and making new business models possible. Over recent years, the 'fintechs' in Australia have driven innovation in areas such as online payments, point-of-sale acceptance technology, cross-border retail payments and buy now, pay later (BNPL) services. Some of these companies already play a material role in facilitating payments and I expect that we will see further innovation in these areas. This rapid change in the world of payments has brought with it increased community and political interest in payments. I expect that this interest will intensify, rather than diminish, given the importance of the issues to the community. These issues include: How to ensure that banknotes remain widely available for those who want to use them. As part of this, the RBA is currently undertaking a public consultation on banknote distribution arrangements. How to keep downward pressure on the cost of electronic payments, particularly for small merchants. As more payments are made electronically, the focus on the cost of these payments will increase. How to address competition issues that arise with the increased involvement of big techs in payments. One important issue here is the access arrangements for the devices and the digital wallets they offer. How to ensure that the electronic payments system is secure and available when people want to use it. Our economy is increasingly dependent on our digital infrastructure, so we need to make sure it is resilient to cyber threats as well as other operational risks. As is evident from this quick tour, the world of payments is dynamic and there is a lot of community interest in it. So there is a lot to talk about. I would now like to move from the general direction of change to five specific areas where the Payments System Board would like to see further progress. In each of these areas some progress has been made, but more is needed. The first of these is the new service on the NPP, which is expected to serve as a replacement for the current system of direct debits. The existing system of direct debits has worked well in some respects, but a more modern system is now needed. The PayTo service will allow households and businesses to authorise other entities to initiate payments out of their accounts, opening up a range of possibilities for innovation. We expect the industry to keep its commitment to a successful launch of the new system in July next year. The second area where we would like to see more progress is the 'payment with document' overlay on the NPP. This service, and particularly the ability to include a link to a document with a payment, would promote innovation and reduce costs. This service will aid reconciliation for recipients. And payers will find they need to devote fewer resources to managing customer queries. Unfortunately, progress by the industry has been slow here. Despite this, the RBA - as the Australian Government's banker - is working with the government and with the Commonwealth Bank to introduce the payment with a document service. We encourage others to join this effort. Further progress is also needed to deliver the benefits from open banking . Open banking strengthens competition and promotes innovation by giving customers the right to control and share their banking data with accredited third parties. It can help customers have a 'top down' view of their financial position and manage their upcoming payments. It can also help to streamline the credit assessment processes and help consumers get a better deal. The banks are making progress with implementation, but some have not met the target dates. It is important that progress does not slip here, especially as the number of accredited data recipients continues to increase. The fourth area where it would be good to see further progress is the development of widely accepted digital identity services . When I spoke at this conference three years ago, I spoke about how the digital economy needs a strong form of digital identity. I did so because I was concerned that Australia was slipping behind global best practice in this area. Since then, two frameworks for interoperable digital identity services have been developed, but there has not been a large-scale rollout of a digital identity service that can be used for a wide range of online (including private sector) interactions. So further progress on this front would be welcome. The final focus area I want to mention is cross-border payments. It still often costs about 5 per cent of the payment (and sometimes more) to send money internationally from an Australian bank and it usually takes more than one day to reach the recipient. We know from our discussions with the central banks of the South Pacific that too often it is disadvantaged people who pay the highest prices. This is an area where the financial sector is not serving the community as well as it could, or should. This is very much the sentiment of the G20's Roadmap to make cross-border payments cheaper, faster, more transparent and more accessible. The RBA is contributing to this effort and working with the Reserve Bank of New Zealand and other South Pacific central banks on a possible regional We are looking for the Australian payments industry to support these and other initiatives to improve the existing infrastructure for cross-border payments. A large effort is required here, but it is one that we need to make to provide better services to customers and to meet our international commitments through the G20. So these are the five specific areas that I wanted to highlight - the PayTo service, payment with a document, open banking, digital identity and cross-border payments. All have a heavy technology focus and I recognise the challenges of coordinating and investing in many technology projects at the same time. So, it is a full agenda. I would now like to move beyond these specific initiatives and discuss another issue on our agenda, but where there is more uncertainty about the future. Earlier I talked about how digital wallets are replacing physical wallets and that this trend is likely to continue. It is also likely that these digital wallets will contain more than just digital representations of the cards that are in our physical wallets. In particular, I expect that they are likely to provide access to new token or account-based digital forms of money. This could allow day-to-day payments to be made by moving tokens around rather than moving banknotes or value between bank accounts. How far we go in this direction and what form these tokens might take are yet to be determined. One possibility is that the tokens are issued by, and backed by, the RBA, just as we issue and back Australian dollar banknotes. This would be a form of retail central bank digital currency (CBDC) - or an eAUD. I have said previously that the RBA is open to this possibly. To date, though, we have not seen a strong public policy case to move in this direction, especially given Australia's efficient, fast and convenient electronic payments system. It is possible, however, that the public policy case could emerge quite quickly as technology evolves and consumer preferences change. It is also possible that these tokens could offer a lower-cost solution for some types of payments than provided by the existing technologies. And, as I will discuss in a moment, there are advantages in digital payment tokens being backed by the central bank. All this means we have been continuing to examine closely the case for a retail CBDC and working with other central banks on this issue. We are working through the relevant technical issues, as well as the broader policy implications of any shift away from a payments system based on the movement of value between bank accounts, to one that uses tokens. As part of this effort, we are planning to work with Australia's new Digital Finance Cooperative Research Centre. We will also be working with the Treasury on these issues and welcome the Government's announcement yesterday. Another possibility is that payment tokens are issued and backed by an entity other than the central bank, though still denominated in Australian dollars. These could be a form of stablecoin. If this is how the system develops, it will be important that these tokens are backed by high-quality assets and that they meet high standards for safety and security. One reason I say this is that a lesson from history is that privately issued and backed money all too often ends in financial instability and losses for consumers. This is one reason why national currencies are today ultimately backed by the state. So if privately issued stablecoins are ultimately the way things head, it will be crucial that they meet very high standards. And if there were to be multiple stablecoins, there would be advantages in them being interoperable. The RBA is working with domestic regulators and our counterparts around the world on the policy issues here. A third type of potential digital token is a cryptocurrency, not linked directly to the AUD or backed by a particular entity or assets. I remain sceptical that we will head in this direction for general purpose payments. It is likely that the asset used for the settlement of most transactions in the economy will remain some form of secure fiat currency with a stable value, rather than cryptocurrency with a volatile price. That is not to say there is no role for crypto-assets. They can help support innovation, especially where they are linked to smart contracts and used in decentralised finance (or DeFi) applications. There is value in experimentation to find out what works and what doesn't. But as the experiments are conducted, it is also worth considering whether the benefits of smart contracts and DeFi can be gained with some form of stablecoin or a CBDC, rather than a new unit of account with a volatile price. While on the topic of crypto-assets, I would like to repeat a point made recently by my colleague, Tony Richards. And that is, that anyone purchasing these assets should take care. There is still a lot of uncertainty about the long-term usefulness of these assets. Before investing, it is best to understand fully the underlying value proposition. Relevant considerations here include the usefulness to end-users of the underlying payments functionality, the security of the funds invested, price volatility, the stability of the intermediaries used and the ultimate backing of the asset - not to mention the significant energy consumption that is required to make a transaction using some of these crypto-assets. There is a lot to think about here before investing. I would now like to move to the wholesale side of the payments system. The RBA has been examining the case for some form of wholesale CBDC, which can be thought of as a new tokenised form of exchange settlement account balances. This could be used to settle transactions of tokenised assets on different blockchains. Yesterday, we released the report on Project Atom, which is a wholesale CBDC research project we conducted with four external parties. The project explored how access could be extended to a wide range of wholesale market participants and the suitability of distributed ledger technology for this kind of system. Overall, the project has confirmed that this is an area worth further research. The RBA is also in the midst of another significant wholesale CBDC project - Project Dunbar, which is being conducted with the BIS Innovation Hub and three other central banks - to explore the possible use of CBDC in cross-border payments. I would now like to move to the regulatory challenges posed by this fast moving world of payments. With so much change taking place, regulators and the payments legislation can't stand still. The digital economy is very important to Australia's future and we need a regulatory system that encourages innovation and ensures the system is safe and stable. Given this, the RBA welcomes the government's response announced yesterday to three recent The report of the Select Committee on Australia as a Technology and Financial Centre. There will be a lot of work for the Treasury and the other Council of Financial Regulators agencies to implement the recommendations that have been accepted by the government. I can't do justice to all the issues here but will touch briefly on some that relate directly to the Bank's responsibilities. The government's support for developing a strategic plan for the payments ecosystem is a positive step. Because payments systems are networks there is a need for coordination, which can be challenging amongst competitors. The Payments System Board sees part of its role as helping overcome these coordination challenges. Yesterday's announcement by the Treasurer will also help here. The RBA also supports the decision to introduce a new, tiered licensing regime for payment service providers. This should help encourage innovation and competition while promoting safe and resilient payment services. As part of this, we are keen to see the implementation of a new licensing framework for stored-value facilities, based on the model proposed by the Council of Financial Regulators a few years ago. We are also pleased to see the government's support for reviewing the Payment Systems (Regulation) Act 1998 to make sure it is fit for purpose. The payments ecosystem is becoming more complex and there are many more entities in the payments chain than there used to be. If the RBA is to meet its broad mandate to promote competition, efficiency and stability then we need to modernise the definitions that were included in the legislation more than two decades ago. Finally, I also want to note that the Council of Financial Regulators is continuing to review the regulatory treatment of different types of crypto-assets, including stablecoins. This is in line with the Senate Select Committee's view that we need a regulatory framework that better accommodates the various new digital assets. As I said earlier, if stablecoins and other types of privately issued digital payment tokens are to become more widely used for everyday payments, they need to be subject to a clear and effective regulation than encourages innovation and mitigates against risks to users and the financial system. To conclude, our payments system is changing quickly. Both the regulators and the government understand this and are seeking to put in arrangements that encourage innovation and competition and make sure we have a secure and efficient system. We have work to do here, but are moving in the right direction. AusPayNet is a valuable partner in this work and plays an important role in the governance of the Australian payments industry. I look forward to continuing the cooperation between AusPayNet and the Reserve Bank as we grapple with the challenges ahead and seize the opportunities offered by new technologies. Thank you for listening and I am happy to answer some questions.

r211216a_BOA

australia

The RBA and the Australian Economy

lowe

I would like to thank the CPA for inviting me to your Riverina Forum. It is a great pleasure for me to be able to join you here in Wagga Wagga, where I grew up. I had the good fortune of attending Sacred Heart Primary School in Kooringal, St Michael's and then Trinity Senior High School. It was at Trinity, though, where I first became interested in economics. And that was thanks to an inspiring teacher, Mrs King. In her classroom she explained how economics could be used to address the world's problems and how the right combination of the invisible hand of the market and government regulation could maximise the welfare of our society. I remember being struck by these powerful ideas and they have stayed with me through the years. In Wagga, I also learnt the value of hard work and the challenges of running a small business. During my high school years, my father had a petrol station and auto accessories shop at the bottom of Fitzmaurice St. It was an old-style, full service petrol station and I spent many hours on cold winter mornings and hot summer afternoons pumping petrol. The valuable life lessons I learnt there complemented those that I learnt in the classroom. Given that I am back here today as the Governor of the RBA, I would like to begin by saying a few words about what the RBA does and then turn to some of the current economic issues we are working through. You might be thinking that you know what the RBA does: it sets interest rates and conducts monetary policy. That would be correct, but our functions are much broader than that. As Australia's central bank, we print and issue Australia's banknotes. Our colourful polymer banknotes are some of the best in the world and include cutting-edge security features to guard against counterfeiting. These notes are printed at our print works in outer Melbourne, where we also operate a mega vault. Today, there is around $100 billion of banknotes on issue, which is almost $4,000 for every person in Australia. The banknotes are being used less for day-to-day transactions than in the past, but there is still very strong demand for them as a store of value. Reflecting this The RBA also has a broad responsibility for the stability of the Australian financial system. Through our operations, we ensure that liquidity in the overall financial system is adequate and we have the capability to act as the lender of last resort in an emergency. We do not directly regulate the banks, but we work closely with the prudential regulator, APRA, on issues that affect the stability of the financial system. The RBA is the Australian Government's banker. When you receive a Medicare refund, it is from a government account at the RBA. And when you pay your tax, it is to the Australian Tax Office's account at the RBA. The RBA also processed all the JobKeeper and COVID-19 disaster payments during the pandemic. The disaster payments were made through our infrastructure that allows payments to be made 24 hours a day, seven days a week. The RBA also operates the settlement system that is at the core of Australia's payments system. All banks have accounts at the RBA and these accounts are used to move money from one bank to another. Without this system, the economy simply wouldn't work. In addition, we regulate important parts of Australia's payments system, including the credit and debit card systems and ATMs. At present, we are exploring the possibility of a new form of digital money that could be used from a digital wallet. The RBA also regulates core elements of Australia's financial market infrastructure, which are central to trading in financial instruments, including on the ASX. We also manage Australia's foreign exchange reserves. We do this with around 1,400 people. We have offices in most capital cities in Australia as well as in New York, London and Beijing and we have an extensive business and community liaison program. We have a large balance sheet, which has grown a lot during the pandemic and now stands at We are owned by the public, with the Reserve Bank Board appointed by the Australian Government. We have both operational and policy independence from the government and I have a seven-year term as Governor. So that is the Reserve Bank of Australia. As an organisation, we seek to be transparent, accountable, analytical and independent, and always act in the public interest. It is a huge privilege to have the role that I have. The RBA is doing important work to help maximise the economic welfare of our society and we take our job very seriously. I would now like to turn to the Australian economy and cover three issues that we have been focused on recently: the economic recovery, the housing market, and inflation. You might recall that back in March last year we were standing on the edge of an abyss. There were credible predictions that tens of thousands of Australians would lose their lives, the health system wouldn't cope, there would be mass unemployment, and that the economy would suffer deep scars. Since then, there have been many difficult days, but we have avoided these dire predictions. This is thanks to a combination of unprecedented public health measures, rapid scientific breakthroughs, very large fiscal and monetary policy support, and the underlying resilience and adaptability of Australian households and businesses. Now, as 2021 draws to a close, the economy is in recovery mode. This follows a setback in the September quarter when GDP declined by 1.9 per cent due to the measures taken to contain the Delta outbreak (Graph 3). In the quarter, there were sharp declines in household consumption and hours worked. But on a more positive note, spending was more resilient than we had expected, providing further evidence that households and businesses are adjusting to living with the virus. It would not come as a surprise to many of you in this room that the farm sector has been one of the bright spots in the economy. Farm output has increased by more than 40 per cent over the past year and rural exports are up by 50 per cent (Graph 4). Incomes have also been boosted by multi- year highs in the prices for many agricultural commodities. So it is a positive story. More broadly, with lockdowns being lifted, spending is bouncing back quickly, especially on services. The Omicron outbreak does, though, represent a downside risk and it is difficult to know how things will develop from here. But we do expect the positive momentum in the economy to be maintained through the summer, underpinned by the opening up of the economy, the high rates of vaccination, significant fiscal and monetary support, and the strengthening of household and business balance sheets over the past year or so. Typically, in an economic downturn households dip into their savings. This downturn has been different - instead of dipping into their savings, households have added to them in a material way. In the September quarter, the household saving rate surged to near 20 per cent as governments supported incomes at a time when it was hard to spend (Graph 5). We estimate that the total additional savings by households during the pandemic has amounted to more than $200 billion and many businesses have also increased their cash reserves. Provided people have the ability to spend - and the confidence to do so - these additional savings will support strong growth in consumption over coming months. The recovery in the economy is also evident in the sharp rise in the number of job advertisements and job vacancies (Graph 6). There are also increasing reports that firms are finding it difficult to find workers. This is especially so in a range of professional services, the construction industry, agriculture and parts of the hospitality industry. Here in the Riverina, the number of job ads is also at a very high level, with the surge in ads larger than it has been in the capital cities and in many other regional communities (Graph 7). The unemployment rate has also come down significantly in regional Australia and is now below that in the capital cities by a wide margin, which is unusual (Graph 8). And here in the Riverina, the unemployment rate is substantially below the national rate and is also very low in absolute terms. Regional Australia is benefiting from two significant changes. The first is a re-evaluation of where, and how, people want to live following the pandemic. And the second is the advances in technology and changes in work practices that have reduced the need to be physically located in a workplace in a capital city. These changes are positive for many regional communities, creating new opportunities for growth and expansion. But they are also causing growing pains that need to be managed. Nationally, the labour market is expected to tighten further over the next couple of years. The RBA's central scenario is for the unemployment rate to reach 4 1/4 per cent by the end of 2022, and 4 per cent by the end of 2023 (Graph 9). If we could achieve this, these would be good outcomes - Australia has not experienced a sustained period of unemployment at levels this low since the early 1970s. As the unemployment rate declines and workers become harder to find, greater attention will need to be paid to training and skills development than has been the case over the past few decades. I would now like to turn to the second topic - the housing market. Housing prices have been rising very briskly across most of the country over the past year, although there are signs of some slowing recently in the largest capital cities. Rising housing prices have been a global phenomenon - from New York to Seoul to here in Wagga. This reflects both the low level of interest rates and a shift in preferences for how and where people want to live. The available data suggest that average housing prices in Wagga have increased by around 20 per cent over the past year, similar to the average increase in the capital cities (Graph 10). Another recent feature of many regional housing markets is a decline in the availability of rental accommodation. I understand that this is a problem here in the Riverina, with the published vacancy rate now at a very low level (Graph 11). This is one of the growing pains that I mentioned earlier, with the supply side of the housing market struggling to keep up with the sudden increase in demand. More positively, the supply side is adjusting. Over recent months, residential building approvals in Wagga have been at very high levels (Graph 12). In time, this will add to the stock of housing and aleviate some of the pressures that are currently being felt. A challenge here, as I mentioned before, is finding the workers to build these extra homes. In terms of the RBA's responsibilities, we do not target housing prices, nor would it make sense to do so. While higher interest rates over the past couple of years would have meant smaller increases in housing prices, they would have also meant that fewer people had jobs and wages growth would have been slower. That is not an attractive trade-off, nor is it one that is within our mandate to make. The solution to concerns about the high levels of housing prices isn't higher interest rates, but rather reforms that address the underlying balance of supply and demand. The RBA's focus, instead, has been on the sustainability of trends in household borrowing. It is important that during a time when interest rates are the lowest on record people do not borrow too much. At some point in the future, interest rates will increase from these record lows. The RBA has been working with APRA to require banks to factor appropriate buffers for higher interest rates into their calculations when deciding how to much to lend. It is important that both banks and households pay attention to these buffers. The third topic that I want to cover is inflation. After many years in which inflation was very low, it has recently increased sharply in the United States and Europe in the wake of the pandemic. In the United States, CPI inflation is currently at 6.8 per cent, the highest rate in almost four decades (Graph 13). This reflects a combination of higher energy prices, a decline in the number of people seeking work, which has boosted wages, and a supply side that has had trouble keeping pace with very strong demand for goods during the pandemic. These factors are expected to wane over the year ahead and inflation is expected to come down, although it is still uncertain by how much. The situation here in Australia is quite different. In underlying terms, inflation is 2.1 per cent and has only just returned to the 2-3 per cent target range for the first time in six years. In headline terms, it is higher than this at around 3 per cent, largely due to higher prices for petrol and constructing a new home. Nevertheless, headline inflation in Australia is much lower than it is in the North Atlantic. Two factors help explain much of this difference. The first is the different dynamics in electricity and gas prices. Here in Australia, electricity prices have declined, while, in contrast, they have increased sharply in a number of countries. The second factor is that wages growth remains relatively low in Australia. While aggregate wages growth has picked up recently, it has only returned to the low rates prevailing before the pandemic (Graph 14). There are certainly hot spots in which wages are increasingly briskly, but most workers are still receiving wage increases starting with a two, and sometimes lower than this. The RBA is expecting wages growth to pick up further but, at the aggregate level, to so do only gradually. This partly reflects elements of Australia's wage-setting processes, which create inertia in aggregate wage outcomes. These processes include enterprise agreements that tend to only get renegotiated once every two to three years, the annual review of award wages by the Fair Work Commission and public sector wages policies. The expected pick-up in wages growth is forecast to be associated with a steady but gradual increase in inflation in underlying terms. In the RBA's central scenario, published in early November, underlying inflation is expected to increase to 2 1/2 per cent over 2023. So, we are in quite a different position from the United States. I would like to finish with a couple of points about monetary policy. The first relates to the RBA's bond purchase program, which has provided important additional support to the economy during the pandemic. It has led to lower funding costs, supported asset values and led to a lower exchange rate than would otherwise have been the case. The Board will consider the future of this program at its next meeting in February. Ahead of that decision, we had a preliminary discussion of three options at our meeting last week, with all three options based on the premise that the economy does not experience another serious setback: The first option discussed was to further taper the bond purchases from the current rate of $4 billion a week, with an expectation that the purchases would come to an end in May. The second was to taper further and then review the situation again in May. The third option was to cease bond purchases altogether in February. In deciding between these options, the Board will use the same three criteria that it has used since the outset: the actions of other central banks, how the Australian bond market is functioning, and most importantly, the actual and expected progress towards the goals of full employment and inflation consistent with the target. We have made no decision yet. Much will depend upon the news we receive between now and when we meet in February. Importantly, we will receive further readings on inflation and the strength of the labour market (including the labour force survey later this morning) and learn about the strength of spending in the economy over the summer. We will also learn more about the actions of other central banks and the effects of the Omicron variant. The first option, namely to reduce the pace of purchases from mid-February with an expectation of a likely end point in May, is broadly consistent with the Bank's forecasts in November for employment and inflation. If better-than-expected progress towards the Board's goals was made, then the case to cease bond purchases in February would be stronger. Alternatively, if progress is slower than expected, or if the outlook becomes more uncertain, the case for retaining flexibility and reviewing again in May would be stronger. The second point that I want to make is that the Reserve Bank Board will not increase the cash rate until actual inflation is sustainably in the 2-3 per cent target range. We are still a fair way from that point. In our central scenario, the condition for an increase in the cash rate will not be met next year. It is likely to take time for that condition to be met and the Board is prepared to be patient. Thank you for listening. I am happy to answer your questions.

r220202a_BOA

australia

The Year Ahead

lowe

This is the fourth time that I have addressed the National Press Club. Thank you for having me back. As I've done on each of the three previous occasions, I have titled my remarks 'The Year Ahead'. I will talk about our latest forecasts, the outlook for monetary policy and yesterday's decision by the Reserve Bank Board to end the bond purchase program. In summary, I remain optimistic about Australia's prospects. Our economy has weathered the pandemic much better than was expected, jobs growth is strong and unemployment is low, household and business balance sheets are generally in good shape and wages growth is picking up. These are all welcome developments. At the same time, though, the country faces challenges. The pandemic is not yet behind us and the sharp pick-up in inflation in some parts of the world, particularly in the United States, has added a new element of uncertainty to the outlook. We also face the challenge of lifting productivity growth, including through investing in the workforce skills and technologies that are needed to generate sustained increases in real wages. And over time and as conditions allow, we will need to navigate a return to more normal settings of monetary policy. A useful place to start is to look to the year just past for lessons. To do this, the table below shows the outcomes for the key economic variables in 2021 as well as the RBA's central forecasts at the start of last year. Per cent The picture is pretty clear. The economy performed significantly better last year than we had expected - GDP growth is likely to have been around 5 per cent, compared with our forecast of 3 1/2 per cent. This is despite the setback caused by the Delta outbreak. The unemployment rate also declined by more than we had expected and now stands at 4.2 per cent, the lowest rate since the peak of the resources boom. These stronger GDP and labour market outcomes have translated into higher inflation than we were expecting. We had expected underlying inflation to be 1 1/4 per cent over 2021, yet the actual outcome was 2.6 per cent. Headline inflation was higher still at 3.5 per cent, boosted primarily by a sharp increase in petrol prices and the cost of constructing new homes. Wages growth was also higher than we were expecting, although the difference here is smaller than for the other variables and wages growth remains low. This experience is a reminder of the difficulty of economic forecasting in a pandemic, but also points to three broader observations. The first is that the economy has been remarkably resilient. The second is that the link between the strength of the real economy and prices and wages remains alive. And the third is that the supply side matters for both economic activity and prices. These three observations are also relevant for the year ahead. We will be releasing a full set of updated economic forecasts on Friday in the quarterly Statement on Monetary Policy. Ahead of that, I can summarise the key elements of our forecasts. I will start with GDP. Our central forecast is for the economy to grow by 4 1/4 per cent this year and One source of ongoing uncertainty here is the possibility of further virus outbreaks, with the past month or so reminding us of the risks. Prior to Omicron, the economy had established strong positive momentum, bouncing back quickly following the easing of the Delta restrictions. This momentum wasn't sustained into the new year, with Omicron leading to many people having to isolate, interrupting supply chains and affecting spending as people sought to limit their activities. Yet, once again, the resilience of the economy has been on display. Australians have adjusted and adapted, and we still expect GDP to grow in the March quarter, although only modestly. The worst of the disruptive economic effects from Omicron now appear to be behind us, with supply chain and workforce management problems gradually being addressed. As case numbers trend lower, we expect a strong bounce-back over the months ahead. While Omicron has delayed the recovery of the Australian economy, it has not derailed it. That recovery is being underpinned by a number of factors. These include household balance sheets that are in generally good shape, with households having accumulated more than $200 billion in additional savings over the past two years. An upswing in business investment is also underway and there is a large pipeline of residential building to be completed over the next year or so. Macroeconomic policy settings are also supportive of growth, with governments planning significant infrastructure spending and monetary policy very accommodative. Turning now to the labour market, the outlook has continued to improve. The unemployment rate has declined to the low fours earlier than we had expected and a further reduction is expected. Our central forecast is for the unemployment rate to decline to around 3 3/4 per cent by the end of this year and be sustained at around this rate during 2023 (Graph 2). If this comes to pass, it would be a significant achievement. Australia has not experienced unemployment rates this low in the past half century - the last time we had the unemployment rate below 4 per cent was in the early 1970s. The decline in the unemployment rate has been accompanied by a welcome decline in underemployment, which is at its lowest rate in 13 years. It has also been associated with a rise in labour force participation. This stands in stark contrast to the United States and the United Kingdom, where labour force participation has declined (Graph 3). In Australia, the share of working age Australians with a job has never been higher than it is now. The forward-looking indicators suggest that the demand for workers remains strong. Job vacancies reached a record high in November and job advertisements have also increased strongly (Graph 4). The information from our business liaison program is that Omicron has not changed this story. More than half of businesses still report that they intend to increase headcount over the coming months and very few expect to reduce their workforces. There has also been an increase in staff turnover and ongoing reports of difficulties finding workers for certain roles. Once the labour market disruptions from Omicron have dissipated, we expect some of the additional demand for labour to be met with a further rise in labour force participation. We also expect an increase in average hours worked as part-time workers wanting additional hours have more success in finding the hours they are seeking. Turning now to inflation, there has also been an upside surprise (Graph 5). The pick-up in inflation reflects both the strength of the economic recovery and the significant disruptions on the supply side. Headline inflation, in particular, has been boosted by the 32 per cent increase in petrol prices over the past year and the 7 1/2 per cent increase in the cost of constructing new dwellings. There have also been larger price increases for a wide range of consumer durables. In the December quarter, there was also less discounting because firms faced very strong demand as most of the country emerged from lockdowns at a time when inventories were low and firms had trouble filling their shelves. Looking ahead, we expect underlying inflation to increase further over coming quarters, largely reflecting the ongoing difficulties on the supply side, including currently from Omicron (Graph 6). As these problems are resolved, some moderation in inflation is expected. Then, over time, stronger growth in labour costs is expected to become the more important driver of inflation. The central forecast is for underlying inflation to be around 2 3/4 per cent over both this year and next. Wages growth has picked up as well, but it has only just returned to the rates prevailing prior to the pandemic (Graph 7). A further pick-up is expected, though there is substantial inertia in aggregate wage outcomes even if there are large wage increases in some pockets. This inertia stems from multi-year enterprise agreements, the review of award wages that takes place on an annual basis and public sector wages policies. Our central forecast is for the Wage Price Index to increase by 2 3/4 per cent this year and 3 per cent over 2023. Broader measures of labour costs, which also matter for inflation, are expected to be growing at a faster rate than this. This reflects the increase in superannuation contributions and pay increases that arise from job switching and job reclassifications in a tight labour market. So that is a summary of our central forecasts. I would like to return, though, to a point I made at the outset: that actual outcomes can be quite different from the central forecasts. This is especially so in a global pandemic, with all its uncertainties. We still can't be certain how the pandemic will evolve and how people will respond to further outbreaks. There are also major geopolitical uncertainties at present and our major trading partner, China, is going through a difficult adjustment in its property market. Domestically, one issue that we will be watching closely is how households use all the savings accumulated over the past two years. On the inflation and wages fronts there are also a range of significant uncertainties. These partly stem from the uniqueness of the period in which we are living. Over the past two years there has been very strong demand for goods globally just at the time that the ability of the economic system to produce and distribute goods was impaired. This strong demand colliding with impaired supply means higher prices and higher published inflation. It is still unclear as to whether, and at what pace, the demand for goods will normalise as infection rates decline. There is also uncertainty as to how quickly the supply and distribution problems will be resolved, although there has been positive news on some fronts recently. We can't rule out the possibility that some of the recent price increases are reversed as a more normal balance between supply and demand is re-established. In any case, for inflation to be sustained at current rates the prices of many goods would have to keep increasing at their recent rates, not just settle at higher levels. All of this means that there are significant uncertainties as to the persistence of the recent price pressures. They may be the start of a period of persistently higher inflation, but they could also simply be a shift in the level of prices as a result of this unique period. There are also uncertainties regarding the supply side of the labour market and how wages respond. We are experiencing a unique combination of record labour force participation, a pandemic preventing some people from working, and a gradual reopening of our international borders after they have been closed for two years. In addition, we have no contemporary experience as to how labour costs will evolve in a world where the national unemployment rate is below 4 per cent. We do know, though, that wages growth remained modest a number of years ago when the unemployment rates in New South Wales and Victoria were temporarily around 4 per cent. The point here is that there are many unanswered questions. We are unlikely to know the answers quickly. There are many moving parts on both the demand side and the supply side of the economy and it will take time for these various issues to be resolved. This is relevant to the Board's deliberations about monetary policy to which I will now turn. I want to start with the decision the Board took yesterday to end the bond purchase program. The final purchases under this program will take place on Thursday 10 February. In taking this decision, the Board considered the three criteria that have guided it from the outset: (i) the actions of other central banks; (ii) the functioning of our own bond market; and (iii) most importantly, the actual and expected progress towards our goals of full employment and inflation consistent with the target. All three criteria pointed to the same conclusion: that is to bring the bond purchase program to an end. Most other central banks have already completed their programs, or will shortly do so. The Federal Reserve has announced that it will end its program in March and the Bank of Canada, the Bank of England, the Riksbank and the Reserve Bank of New Zealand have all ended their programs. This is relevant because one of the reasons we introduced our program was that other central banks were buying bonds. If we hadn't also done this, our bond yields and exchange rate would have been higher than they have been and this would have impeded the recovery from the pandemic. In terms of the second criterion, our bond market is continuing to function reasonably well and the RBA's stock lending activities are supporting this. But there have been some pressure points recently. This is evident around the three-year mark, where there has been a gap between the price of the physical bonds and the futures contract. Among the range of bonds we are purchasing, the RBA owns 42 per cent of Australian Government Securities on issue and 60 per cent of some individual bond lines (Graph 8). Our assessment is that the market could accommodate further purchases by the RBA, but that there would be a rising probability of additional strains emerging. The most important consideration was the third one - that is, the actual and expected progress towards our goals. Since November, we have made better progress than we were expecting, which is good news. The unemployment rate now stands at 4.2 per cent and underlying inflation is at 2.6 per cent. For the first time in some years, the achievement of our goals is within sight. In these circumstances, the Board judged that now was the right time to draw the bond purchase program to a close. There are four additional points that I would like to make. The first is that our bond purchase program has played an important role in achieving this progress towards our goals, complementing our other monetary policy measures. The purchases have lowered funding costs, supported asset values and led to a lower exchange rate than would otherwise have been the case. As a result, more people have jobs and inflation is closer to the target. The second point is that the cessation of our bond purchases does not represent a tightening of monetary policy. The accumulated international evidence is that it is the stock of bonds purchased, not the flow of purchases, that provides the economic support. By mid-February, the RBA will have purchased over $350 billion of government bonds under our various programs and our balance sheet will have more than tripled since the start of the pandemic to around $650 billion (Graph 9). These purchases and the expansion of our balance sheet are providing ongoing support to the Australian economy. The third point is that we have not yet made a decision about reinvesting the proceeds of maturing bonds. Unlike many other countries, there are not maturities of government bonds in Australia every week or month (Graph 10). The large gaps in the maturity profile mean that we have more time to make a decision. The next maturity of an Australian Government bond is in July 2022. Ahead of this, the Board will consider its approach to reinvestment at its meeting in May, with the key considerations being the state of the economy and the outlook for inflation and unemployment. The fourth and final point is that the decision to end the bond purchase program does not mean that an increase in the cash rate is imminent. I recognise that in a number of other countries the ending of the bond purchase program has been followed closely, or is expected to be followed closely, by an increase in the policy rate. This is in contrast to earlier episodes of quantitative easing and reflects their current circumstances, which are quite different from our own. While inflation has picked up in Australia, it remains substantially lower than the 7 per cent rate in the United States, 5.4 per cent in the United Kingdom, and 5.9 per cent in New Zealand, and it has not been accompanied by strong wages growth as is the case in the United inflation and low wages growth are key reasons we don't need to move in lock step with others. As I have said on previous occasions, the Board will not increase the cash rate until inflation is sustainably within the 2 to 3 per cent range. Given the recent inflation data and the forecasts I discussed earlier, I would like to provide some additional detail on our thinking here. We do not have a specific definition as to what 'sustainably in the target range' means. The actual rate of inflation is relevant as are the trajectory and the outlook. So too is the breadth of price increases and the factors driving them. Based on the evidence we have, it is too early to conclude that inflation is sustainably in the target range. In terms of underlying inflation, we have just reached the midpoint of the target range for the first time in over seven years. And this comes on the back of very significant disruptions in supply chains and distribution networks, which would be expected to be resolved over the months ahead. It also comes at a time when aggregate wages growth in Australia remains low and is at a rate that is unlikely to be consistent with inflation being sustained around the midpoint of the target range. As I discussed earlier, there is a range of significant uncertainties here that will take time to resolve. We are in the position where we can take some time to obtain greater clarity on these various issues. Countries with higher rates of inflation have less scope here. The Board is prepared to be patient as it monitors the evolution of the various factors affecting inflation in Australia. It is also relevant that Australia is within sight of a historic milestone - having the national unemployment rate below 4 per cent. This is important because low unemployment brings with it very real economic and social benefits for many Australians and their communities. Full employment is one of the RBA's legislated objectives and the Board is committed to playing its role in achieving that objective, consistent with also achieving the inflation target. As we navigate towards full employment, we have scope to take the time to distil the balance between supply and demand in the economy. Over the course of this year, we will be watching how the various supply-side problems resolve and the effects on prices. We will be watching consumption patterns and whether they normalise. We will also be looking for further evidence that labour costs are growing at a rate consistent with inflation being sustained within the target range. We expect this evidence to emerge over time, but it is unlikely to do so quickly. Finally, I want to make it clear that the RBA is committed to achieving the inflation target, which remains at the centre of our monetary policy framework. We don't want to see inflation too low or too high. We will do what is necessary to maintain low and stable inflation, which is important not only in its own right but also as a precondition for a sustained period of full employment. To conclude, the year ahead will no doubt have its challenges and its surprises. But standing here in early February, we are closer to full employment and achieving the inflation target than we had anticipated. It has been a difficult few years for the country, but our economy has proven to be resilient and Australians are adapting to living with the virus. This augurs well for the future. I wish you all the best for the year ahead. Thank you for listening. I look forward to answering your questions.

r220211a_BOA

australia

Opening Statement to the House of Representatives Standing Committee on Economics

lowe

Members of the Committee Good morning. My colleagues and I look forward to the day where we can return to in-person hearings. We hope that will be for the next hearing. I would like to focus my introductory remarks today on three issues: the economic recovery; the outlook for inflation; and the RBA's monetary policy decisions. At the time of the previous hearing in August, we were in the early days of the Delta lockdowns and were expecting a strong bounce-back when the restrictions were eased. This bounce-back did eventuate and the economy had strong momentum late last year. Then Omicron hit, which has been a significant setback for many people and businesses. Yet, once again, the economy has proven to be resilient. Despite the disruption caused by Omicron in January, we still expect positive growth in GDP in the March quarter, with spending and hours worked already recovering. Reflecting this resilience, the outlook for the Australian economy has improved since we last met. We estimate that GDP increased by around 5 per cent over 2021 and are expecting GDP growth of around 4 1/4 per cent over 2022 and 2 per cent over 2023. This outlook is being underpinned by a number of factors. These include household balance sheets that are in generally good shape, with households having accumulated more than $200 billion in additional savings over the past two years. An upswing in business investment is also under way and there is a large pipeline of residential building to be completed over the next year or so. Macroeconomic policy settings are supportive of growth, with governments planning significant infrastructure spending and monetary policy remaining very accommodative. The resilience of the economy is evident in the Australian labour market, where the outlook has continued to improve. A year ago, our central forecast was that the unemployment rate would be close to 6 per cent at the end of 2021. The outcome was much better than this: 4.2 per cent. There has also been a welcome decline in underemployment as many people have been able to obtain additional hours. Labour force participation has increased and the share of the working age population with a job has never been higher than it is now. The forward-looking indicators suggest further growth in jobs over the months ahead with vacancies at a very high level. Our central forecast is for the unemployment rate to decline to below 4 per cent later this year and remain below 4 per cent next year. If this comes to pass, it would be a significant milestone. Australia has not experienced unemployment rates this low since the early 1970s, almost half a century ago. The main source of uncertainty about the outlook continues to be COVID-19. The pandemic is not yet behind us and it is entirely possible that there will be more outbreaks. It also remains to be seen how households use all those savings that they have accumulated over the past two years. There are major geopolitical uncertainties and our largest trading partner, China, is working through a difficult adjustment in its property market. The sharp pick-up in inflation in parts of the world, especially in the United States, has come as a surprise and is an additional source of uncertainty about the outlook. For the first time in several decades, inflation has become a major issue in the global economy, although it is worth noting that inflation rates in most of Asia remain low. In the United States, CPI inflation is running at more than 7 per cent and in the United Kingdom it is expected to be at a similar rate soon. In Germany, inflation is 5.7 per cent and in New Zealand it is 5.9 per cent. These are the highest rates in decades and the higher inflation is turning out to be more persistent than earlier expected. This lift in inflation largely reflects the surge in global demand for goods during the pandemic coinciding with a reduced ability of the global economic system to produce and distribute goods. A related factor in a few countries, including the US and the UK, has been a decline in labour force participation, which has reduced the supply of labour and contributed to stronger wages growth. Higher prices for petrol, electricity and gas have also pushed inflation up in many countries. In Australia, we too have had higher inflation than we and others expected, although the increase here is smaller than in many other countries. In headline terms, inflation is 3 1/2 per cent and in underlying terms it is 2.6 per cent. We are feeling the effects of global supply-chain problems and higher oil prices, but we have not seen the same increases in goods prices as have occurred in the United States. It is also relevant that the prices that Australian households pay for utilities are little changed and have not gone up sharply like the prices of utilities in Europe. Rent inflation has also been lower in Australia than elsewhere. Looking ahead, we expect a further lift in underlying inflation. There is also likely to be a shift in the drivers of inflation. Our central forecast is that underlying inflation will increase to 3 1/4 per cent in the coming quarters, before easing to around 2 3/4 per cent. This increase in the short term primarily reflects the ongoing effects of supply-side disruptions, most recently due to Omicron, at a time of strong demand. As these supply-side pressures are resolved, some of the current upward pressure on prices is expected to abate. An offset to this, though, is expected to be stronger growth in labour costs due to the tighter labour market. Wages growth has picked up recently, but only to the low rate prevailing before the pandemic. The vast bulk of Australians are still experiencing wages increase of no more than 2 point something per cent, although there are areas where the increases are much larger than this and non-wage benefits are also increasing. A further pick-up in overall wages growth is expected, although this is likely to be a gradual process given the institutional features of our labour market - including multi- year enterprise agreements, an annual review of award wages and public-sector wages policies. We are also expecting broader measures of labour costs to pick up faster than the Wage Price Index. There is, however, more than the usual degree of uncertainty around the outlook for inflation and wages. It is still unclear as to whether, and at what pace, the demand for goods will normalise as infection rates decline. The speed at which the supply side of the economy can respond to changes in the demand side is also uncertain. And we have no contemporary experience to assess how wage outcomes will evolve at a national unemployment rate below 4 per cent. A broader uncertainty is the extent to which other central banks will have to increase interest rates to return inflation to lower rates. Central banks and financial markets expect that a decline in inflation to target can be achieved without real policy interest rates returning to positive territory. It is entirely possible, though, that countries with higher inflation rates will need a bigger adjustment in interest rates than currently anticipated. If so, this could result in an abrupt adjustment in financial conditions. I would now like to turn to Australian monetary policy, where there have been a number of significant developments since we last met, including the discontinuation of the yield target, the cessation of the bond purchase program and a change in the outlook for interest rates. The yield target for the April 2024 bond was discontinued in early November. Up until that point the target had played an important role in anchoring the yield curve and keeping funding and borrowing costs low in Australia. In early October, the yield on the target bond was sitting at close to zero per cent. But then, a flow of stronger-than-expected data, both here and abroad, resulted in a shift in the distribution of possible future outcomes for the cash rate. In particular, these data implied that there was a reasonable probability of an increase in the cash rate before 2024. This assessment was reached by both the RBA and financial market participants and it was reflected in market prices. In these circumstances, the Board judged that there were more costs than benefits in seeking to continue to anchor the yield on the April 2024 bond at 10 basis points. The removal of the target was associated with volatility in the bond market. The RBA is conducting a review of the whole experience with the yield target and the results will be published later this year. In terms of the bond purchase program, the final purchases were made yesterday. All up, across the various programs, the RBA has purchased $350 billion of bonds issued by the Australian Government and by the states and territories. These purchases have lowered funding costs, supported asset prices and led to a lower exchange rate than otherwise. As a result, more people have jobs and inflation is closer to target. The stock of bonds purchased will also continue to support accommodative financial conditions in Australia. The decision to end the bond purchase program followed a review of the three considerations we have used from the outset: (i) the actions of other central banks; (ii) the functioning of our bond market; and (iii) the actual and expected progress towards our goals. All three considerations pointed to the same conclusion - to end the program. Of these three considerations, the most important was that faster-than-expected progress has been made towards our goals of full employment and inflation consistent with the target. The final development has been the change in expectations about the future path of interest rates. Since the onset of the pandemic, the Board has said that it will not increase the cash rate until inflation is sustainably in the 2 to 3 per cent range. When we last met, this condition was not expected to be met before 2024 in the RBA's central scenario. Since then, the economy has performed better and inflation has been higher than in that scenario. As a result, interest rate expectations have moved higher. It is too early, though, to conclude that inflation is sustainably in the target range. In underlying terms, inflation has just reached the midpoint of the target band for the first time in over seven years. And this comes on the back of very large disruptions to supply chains and distribution networks, which are expected to be only temporary. It also comes at a time when aggregate wages growth is no higher than before the pandemic, which was associated with inflation being persistently below target. In these circumstances, the Board is prepared to be patient. We have scope to wait and see how the data develop and how some of the uncertainties are resolved. Countries with higher inflation rates have less scope here. I recognise that there is a risk to waiting but there is also a risk to moving too early. Over the period ahead we have the opportunity to secure a lower rate of unemployment than was thought possible just a short while ago. Moving too early could put this at risk. At the same time, we are committed to maintaining low and stable inflation and will do what is necessary to achieve this important goal. The stronger the economy and the more upward pressure on prices and wages, the stronger will be the case for an increase in interest rates. I would like to end with a brief reflection about the past couple of years. Throughout the pandemic, the RBA has had to make decisions in a highly uncertain environment in which there have been many moving parts. Over the two years, we have sought to provide the support the Australian economy needed and to play our role in building the bridge to the other side. Our actions have also been motivated by providing the country with insurance against the possibility of large downside risks that could have damaged the economy and hurt the welfare of the Australian people. Throughout this period, some things have worked out as expected but there have been plenty of surprises along the way. The RBA is committed to fully examining this experience in an open and transparent manner and to drawing lessons for the future. I will close on that note. In the interests of time, I will not make any introductory remarks regarding the many payments system issues that the RBA is working on, but we would welcome the opportunity to talk about these during the hearing, if that were possible. Thank you. My colleagues and I are here to answer your questions.

r220309a_BOA

australia

Recent Economic Developments

lowe

Thank you for the invitation to participate in this year's AFR Business Summit. It is very good to be with you again. I would like to cover four issues today: 1. The resilience of the Australian economy and some of the major uncertainties, including the invasion of Ukraine by Russia. 2. The journey towards full employment in Australia. 3. The recent inflation data. 4. The implications of these developments for monetary policy in Australia. Last week we received further evidence of the resilience of the Australian economy. In the December quarter, GDP increased by 3.4 per cent, which was one of the biggest quarterly increases on record. Over the final months of the year, there was a very strong bounce-back in household consumption following the mid-year Delta lockdowns. Over 2021 as a whole, the economy grew by 4.2 per cent, outcome by global standards, which is something we should not forget. The data available so far for the March quarter suggest a continuation of positive growth, despite the setback caused by the Omicron outbreak. As COVID infection rates have declined, spending and hours worked have both bounced back quickly. The flooding in eastern Australia is causing severe disruptions in some areas at the moment, but GDP is expected to increase by around 4 1/4 per cent this year. This outlook is being supported by the opening of Australia's international borders, the substantial accumulation of savings by households over the past two years, a large pipeline of construction activity and ongoing support from macroeconomic policy. Against this generally positive outlook, the main sources of uncertainty are COVID-19 - which is not yet behind us - and the tragic war in Ukraine. This war is first and foremost a catastrophic event in human terms, but it is also a new major risk to the global economy. It is difficult to know what the full implications are, but from today's viewpoint, the main economic effects stem largely from higher commodity prices. The most obvious of these is the price of gas in Europe, which has more than doubled since the start of February (Graph 2). Oil prices are also up by 40 per cent, as are thermal coal prices. The prices of many base metals, including nickel and aluminium, are also up sharply. The prices of agricultural commodities have also been affected, with the price of wheat in global markets up by 40 per cent since the start of February. For the countries in Europe, this rise in commodity prices represents a negative shock to their terms of trade and thus to their national income. This alone will cause a slowdown in economic activity. It will also cause CPI inflation to be higher than it would have otherwise been. Australia is in a different position because we export many of the commodities whose prices are rising. This means that our terms of trade will rise over the months ahead, which will provide a boost to our national income. This boost is likely to be evident mainly in the form of higher profits for companies in the resources sector and higher tax revenue. At the same time, the rise in global oil prices is causing higher petrol prices at the bowser. This will eat into household budgets, push up costs for many businesses and crimp spending in some areas. Given this, I expect that most of this extra national income will be saved, rather than flow through into higher spending. Looking beyond the impact on commodity markets, the war in Ukraine poses other significant downside risks for the global economy. From both a humanitarian and economic perspective, there is a lot riding on how events develop here. I would now like to turn back to the more positive story - that is the resilience of the Australian economy, which is especially evident in the labour market. At the start of last year, our central forecast was that the unemployment rate would now be at 6 per cent. Yet over recent months, the unemployment rate has been 4.2 per cent and underemployment has fallen to the lowest rate in We expect this improvement in the labour market to continue. There was, however, a setback in January, with total hours worked in Australia declining by nearly 9 per cent, as many people isolated due to Omicron and others took holidays that had been put off last year. Looking forward, the high level of job vacancies and the information from our business liaison program both suggest that there will be strong growth in hours worked and the number of jobs over the months ahead. Our central forecast is that the unemployment rate will fall to below 4 per cent over the course of this year and remain there next year. The last time that the unemployment rate was that low was almost half a century ago (Graph 4). If we reach this milestone, it would be a significant achievement. The AFR's headline was prompted by the introduction to the RBA's 1963 Annual Report, which was released the day before. From today's perspective, that introduction is remarkable in that it does not mention the word 'inflation' or the CPI, but just has a vague reference to the notion of price stability. The final sentence of that introduction, though, is more timeless. It is just as relevant today as it was back 60 years ago when it was written. That final sentence reads: 'In the longer-run, growth depends on many factors; but with the advance of science and technology, standards of education and the up-grading of skills have become of increasing importance.' These words from the past serve as a timely reminder that science, education and the development of skills are key to our future prosperity and rising real incomes. As Australia charts its way back to full employment, it would be wise to keep this counsel from 1963 in mind. Investment in these areas will also help build the resilience that we need to guard against future shocks, wherever they come from. I would now like to move to the other issue of the day - and that is inflation. After many years in which concerns about high inflation were at the periphery of the radar screen, they have now moved to the centre in a number of countries. This is especially so in the United States, where the CPI increased by 7 1/2 per cent over the year to January, which is the fastest rate in 40 years. Inflation rates in the United Kingdom, Germany, Canada and New Zealand are also at their Rightly, this increase in inflation is receiving a lot of attention. It is important, though, to recognise that inflation rates in much of Asia remain low and not much different from before the pandemic. In China, CPI inflation is running at just 0.6 per cent and in Japan it is 0.5 per cent. Australia sits somewhere in the middle, but closer to the experience in Asia. Headline inflation here is 3 1/2 per cent, less than half the rate in the United States. In underlying terms, inflation is running at 2.6 per cent. This is the first time in more than seven years that it has been above the midpoint of medium-term 2 to 3 per cent target band. There are a few factors that explain this difference with the United States. I would like to mention three of these. The first is the different developments in the gas and electricity markets. In the United States, household gas prices are up by nearly 25 per cent over the past year and electricity prices are up by more than 10 per cent (Graph 6). In contrast, the prices that Australian households pay for energy have risen only modestly. Our gas and electricity markets are not closely connected with those in the rest of world and the increased capacity from wind and solar generators has put downward pressure on wholesale electricity prices. A second factor is the different behaviour of goods prices. In the United States, goods prices (excluding energy) are up by 9 per cent over the past year. In Australia, they are up by 3 per cent (Graph 7). In the United States, there was a very strong surge in demand for goods during the pandemic and firms had trouble meeting this due to supply-chain problems and, in some areas, a shortage of workers. The result has been a big increase in prices. The same general dynamic has been at work in Australia, but the surge in demand for goods has been less pronounced here and the pandemic has not had the same effect on the availability of workers. A third and more enduring factor is the different trends in labour costs. In the United States, and the United Kingdom, wages are rising much more quickly than they were previously (Graph 8). In contrast, in Australia, but also in Japan and some European countries, wages are increasing at a similar rate to before the pandemic. One factor contributing to these differing experiences is the different trends in labour force participation. In the United States and the United Kingdom, labour force participation is still below its pre-pandemic level. In contrast, in Australia, we are near record highs in terms of participation. The JobKeeper program helped workers remain attached to their employers during the pandemic and this has helped the labour market recover with fewer strains than in the United States. It is worth noting that participation rates have also recovered in many Asian nations, including Japan. The point I want to make here is that while there is a common thread to inflation stories across many economies, there are important differences as well. These differences are relevant to the setting of monetary policy, to which I will now turn. Now that the bond purchase program, the yield target and the provision of new funding under the Term Funding Facility have come to end, the focus of the Reserve Bank Board's monthly monetary policy decisions has once again returned to the level of the cash rate. Since the onset of the pandemic, the Board has said that it will not increase the cash rate until inflation is sustainably in the 2 to 3 per cent target range. It has indicated that it wants to see evidence that inflation will be sustained in this range, rather than simply be forecast to do so. This focus on outcomes and evidence reflects both the uncertain times we are living in, which has made forecasting more difficult than usual, and the persistent undershooting of the inflation target over earlier years. The recent lift in inflation has brought us closer to the point where inflation is sustainably in the target range. So too have recent global developments. But we are not yet at that point. In underlying terms, inflation has just reached the midpoint of the target band for the first time in over seven years. And this comes on the back of very large disruptions to supply chains and distribution networks, some of which are still expected to ease. It also comes at a time when aggregate wages growth is no higher than it was before the pandemic, which was associated with inflation being persistently below target. In these circumstances, we have scope to wait and assess incoming information and see how some of the uncertainties are resolved. We can be patient in a way that countries with substantially higher rates of inflation cannot. There are two issues, in particular, that we are paying close attention to. The first is the persistence of supply-side price shocks and the extent to which developments in Ukraine add to these supplyside inflation pressures. The second is how labour costs in Australia evolve. Prior to the war in Ukraine, there was some evidence that the supply-side issues in the global economy were gradually being resolved (Graph 9). Delivery times had shortened a bit, global car production was increasing again and the prices of semiconductors had come off their peaks. Businesses were also responding with new investment and changes in processes to ease capacity constraints. These developments were providing a basis for expecting that supply-side inflation pressures would ease over time, both globally and here in Australia. But, now, the war in Ukraine and the sanctions against Russia have created a new supply shock that is pushing prices up, especially for commodities. This new supply shock will extend the period of inflation being above central banks' targets. This runs the risk that the low-inflation psychology that has characterised many advanced economies over the past two decades starts to shift. If so, the higher inflation would be more persistent and broad-based, and require a larger monetary policy response. At the moment, financial market pricing suggests that CPI inflation will decline from its current high rates in the North Atlantic economies to around 2 per cent without real interest rates ever going into positive territory. A shift in inflation psychology would challenge this view, so this is a critical issue. The second issue we are watching closely is the evolution of domestic labour costs. The latest data confirmed that aggregate wages growth remains modest. The Wage Price Index (WPI) increased by 2.3 per cent last year, with the broader measure including bonuses increasing by 2.8 per cent (Graph 10). The national accounts measure of average hourly earnings increased a bit faster than this at 3.3 per cent. This measure is more volatile than the WPI as it captures changes in the composition of employment, which have been large during the pandemic. There are certainly pay rises that are much larger than 3 per cent taking place for some jobs, but the evidence is that most working Australians are still experiencing base wage increases of no more than 2-point-something per cent. This is also consistent with what we are hearing through our business liaison program. The RBA's central forecast is for growth in aggregate labour costs to pick up further as the labour market tightens. This pick-up is likely to be gradual, though, given the multi-year enterprise agreements, the annual review of award wages and public sector wages policies. There are, however, uncertainties about the future growth of labour costs. This is partly because we have no contemporary experience of a national unemployment rate below 4 per cent. The closest experience we have is that in the years leading up to the pandemic some of the larger states had unemployment rates around 4 per cent and wages growth hardly moved. It is also unclear, at this stage, what effect the opening of the international borders will have on the balance between supply and demand in the labour market. There is also the question of how wages respond to the current higher rates of headline inflation. There is a risk if these higher inflation rates are sustained as a result of a sequence of negative supply shocks, that wages growth picks up more quickly than forecast as workers seek compensation for the higher inflation. In this uncertain environment - and with the starting points for wages growth and underlying inflation in Australia - we can take the time to assess the incoming information and review how the uncertainties are resolved. Given the outlook, though, it is plausible that the cash rate will be increased later this year. I recognise that there is a risk to waiting too long, especially in a world with overlapping supply shocks and a high headline inflation rate. But there is also a risk of moving too early. Australia has the opportunity to secure a lower rate of unemployment than has been the case for some decades. Moving too early could put this at risk. There are benefits to the economic welfare of Australia of a period of relatively steady growth in which people get jobs, have training and develop skills. This is one path to sustaining a lower unemployment rate than was thought possible just a short while ago - not as low as was thought possible back in 1963, but lower than was thought possible just five years ago. I want to finish with the point that it is only possible to achieve a sustained period of low unemployment if inflation remains low and stable. Recent developments in Europe have added to the complexities here. The Reserve Bank will respond as needed and do what is necessary to maintain low and stable inflation in Australia. Thank you for listening and I am happy to answer questions.

r220621a_BOA

australia

Inflation and Monetary Policy

lowe

I would like to thank AMCHAM for the invitation to speak today. It is a pleasure to be here. It is a challenging time in the global economy. Most countries, including the United States and Australia, are experiencing the highest rates of inflation for many years. The tragic events in Ukraine have led to sharp increases in the prices of food and energy. And interest rates are rising around the world from the record lows during the pandemic. All this is happening at a time when unemployment rates are as low as they have been for many decades and household budgets are under pressure. So, it is a complex policy environment. Today, I would like to begin by focusing on the recent inflation data and the outlook for inflation. I will then turn to how monetary policy is responding to the higher inflation. I would also like to share with you some of the observations from the Reserve Bank Board's review of the yield target, which was published earlier this morning. This review is one element of a broader set of reviews the Board is undertaking of our pandemic response. We want to be transparent and open, and to learn lessons for the future. First to inflation. The rise in inflation is a global story - it is occurring everywhere (Graph 1). In the United States and Europe, inflation is above 8 per cent and the peak has not yet been reached in some countries. Inflation has also picked up across Asia, although it is lower there than in the North Atlantic. Japan is a notable standout; while inflation in Japan has picked up, it is only just above 2 per cent. Australia is no exception to the general trend, although inflation here remains below that of most other advanced economies. In headline terms, inflation in Australia was 5.1 per cent over the year to the March quarter, which is the highest rate in many years (Graph 2). In underlying terms, the inflation rate was 3.7 per cent, which is higher than it has been in recent years, but still lower than it was during the resources boom. In both headline and underlying terms, inflation is much higher than we had earlier expected. The fact that inflation is higher everywhere tells us that there are powerful global factors at work. During the pandemic, supply chains were interrupted around the world, delivery times were pushed out and firms' costs of production rose. The inevitable result has been higher prices. And on top of this, Russia's invasion of Ukraine has caused major disruptions to the global markets for energy and food. As a result, oil prices have increased by 28 per cent since February and global food prices, including the prices of wheat and vegetable oils, have increased sharply (Graph 3). There has also been strong growth in demand globally, supported by stimulatory fiscal and monetary policy around the world. When major events like these occur, it simply isn't possible to insulate ourselves here in Australia from their effects. We live in an interconnected world and big shocks in global markets affect our domestic markets and the prices that we pay. Petrol prices in Australia are up by 37 per cent over the past year, which alone is adding around 1 percentage point to headline inflation (Graph 4). Another example where disruptions to global production are having an effect in Australia is the price of new cars, which has increased at the fastest rate for many years. As important as these global influences are, they do not provide a full explanation for higher inflation in Australia. Increasingly, domestic factors are also at play. Following the strong recovery from the pandemic, growth in domestic spending is now testing the ability of the economy to meet the demand for goods and services. This is particularly evident in the labour market, with many firms reporting that the availability of labour is a significant constraint on their ability to operate and/or expand (Graph 5). Many parts of the construction sector are also operating at, or close to, full capacity. And some public infrastructure investment is being delayed or scaled back because of capacity constraints. Not surprisingly, this pressure on domestic capacity has led to a broadening of inflation pressures in Australia. Reflecting this, the share of items in the CPI basket with annualised price increases of more than 3 per cent is at the highest level since 1990 (Graph 6). When the RBA published its latest set of forecasts in early May, we expected that inflation would peak at around 6 per cent at the end of this year. The information available since then has led us to push this forecast peak higher. Since early May, petrol prices have risen further due to global developments and the outlooks for retail electricity and gas prices have been revised higher due to pressures on capacity in that sector. As a result, we are now expecting inflation to peak at around 7 per cent in the December quarter. Following this, by early next year, we expect that inflation will begin to decline. I would like to highlight three factors that lie behind this assessment that inflation will moderate next year. The first is that some of the pandemic-related supply-side problems in the global economy are gradually being resolved. Firms have been adjusting to their new operating environment and solving the problems in global production and logistic networks - as a result, delivery times have shortened a little from last year, the prices of semiconductors have declined from their recent peak and the global production of cars is showing signs of a recovery (Graph 7). While it is still possible there will be further setbacks, the global production system is adjusting and this should help lessen some of the inflationary pressures. The second factor is a more technical one, but one that we should not lose sight of. It is important to remember that inflation is the rate of change of prices. It is not a measure of the level of prices. This means that for inflation to stay high, prices have to keep increasing at an elevated rate; if prices simply remain steady at a high level, the rate of inflation falls to zero. As an example of this, if global oil prices were to stay at the current elevated level, the annual rate of increase in oil prices would fall from 66 per cent to zero per cent. This might not be of much comfort to people struggling with the current high level of prices, but it would mean that the rate of measured inflation would decline. The third factor that provides confidence that inflation will decline is the tightening of monetary policy that is underway around the world, including here in Australia. The higher interest rates globally will help to create a more sustainable balance between the demand for goods and services and the ability of our economies to meet that demand. Achieving that balance is not straightforward and there are risks involved, but higher interest rates will lessen the current inflationary pressures. This brings me to the Reserve Bank Board's recent decisions. In May, the Board increased the cash rate target by 25 basis points and, in June, by a further 50 basis points (Graph 8). These were the first increases in the cash rate since 2010. The Board judged that, given the inflation data and outlook that I have just discussed, it was no longer appropriate for interest rates in Australia to remain at the COVID-emergency levels. The increase in the cash rate in May followed the higher-than-expected CPI outcome in the March quarter and evidence from business surveys and our own liaison that growth in labour costs had picked up and would continue to do so in the months ahead. In June, we decided to make a bigger, 50 basis points, adjustment on the basis of the additional information suggesting a further upward revision to an already high inflation forecast. The Board also gave consideration to the fact that the level of interest rates was still very low. The Board is committed to doing what is necessary to ensure that inflation returns to the 2 to 3 per cent target range over time. High inflation damages the economy, reduces the purchasing power of people's incomes and devalues people's savings. It is also regressive, hurting most those who are least well equipped to protect themselves. So it is important that we chart our way back to an inflation rate in the 2 to 3 per cent target range. We do not need to, nor can we, get there immediately. Australia has long had a flexible mediumterm inflation target, which, by design, can accommodate deviations of inflation from target. For a number of years inflation was below target and now it is above. What is important here is that we chart a credible path back to an inflation rate of 2 to 3 per cent. That path will be easier to navigate if the inflation psychology in Australia does not shift too much. A lesson from the 1970s is that if an inflation shock shifts people's expectations about the ongoing rate of inflation, it becomes harder to reverse. Applying this lesson to today, it is important that the higher rate of inflation this year does not feed through into ongoing inflation expectations. If it did, the period of higher inflation would persist and it would be more costly to reverse. To date, mediumterm inflation expectations have been well anchored at around 2 to 3 per cent, suggesting that people believe we will get back to target. We want to do what we can to make sure this remains the case. Higher interest rates have a role to play here, by helping ensure that spending grows broadly in line with the economy's capacity to produce goods and services. Higher interest rates can also directly affect expectations by demonstrating the commitment of the RBA to return inflation to target. As we chart our way back to 2 to 3 per cent inflation, Australians should be prepared for more interest rate increases. The level of interest rates is still very low for an economy with low unemployment and that is experiencing high inflation. I want to emphasise though that we are not on a pre-set path. How fast we increase interest rates, and how far we need to go, will be guided by the incoming data and the Board's assessment of the outlook for inflation and the labour market. As we make that assessment each month, the Board will be paying close attention to developments in the global economy, the evolution of labour costs and how household spending is responding to higher interest rates. The recent news on household spending has been broadly positive, with spending bouncing back following the Omicron setback. Household balance sheets are generally in good shape, with households overall having accumulated more than $200 billion in additional savings during the pandemic. Furthermore, the current rate of saving out of income remains materially higher than it was before the pandemic, so there is a degree of flexibility in many household budgets. It is also relevant that strong employment growth is continuing and that there are many job opportunities at the moment. However, on the other side of the ledger, many households have not previously experienced a period of rising interest rates. Households are also experiencing a decline in real incomes because of the higher inflation and some of the large gains in housing prices over recent years are being unwound. Given these various considerations, we will be watching household spending carefully as we chart our way back to 2 to 3 per cent inflation. I would now like to shift gear and turn to the review of the yield target, which the RBA released earlier this morning. First, some background. As part of its pandemic response in March 2020, the RBA implemented a target for the yield on three-year Australian Government bonds. At the time, the target was 25 basis points. This target was part of a comprehensive package designed to lower funding costs in Australia and support the supply of credit. The Board chose to directly target the yield on three-year government bonds, rather than implement a program of bond purchases. It judged that, in the circumstances of the time, this was a more direct way of influencing the interest rates that matter most to the cost of finance in Australia. The target was lowered from 25 basis points to 10 basis points in November 2020 and was discontinued a year later, in November 2021. For most of the time the target was in operation, the RBA did not need to buy bonds to achieve the target, although there were a few episodes when we entered the market to keep the three-year yield consistent with the target (Graph 9). All up, the RBA purchased around $36 billion of three-year bonds in support of the target. The review published this morning discusses the main decision points and lessons from this experience. It concludes that the yield target was successful in lowering funding costs and supporting credit provision. In doing this, it helped the economy recover from the pandemic. But these benefits came with complications. If similar circumstances were to arise in the future, the Board would likely make different choices, although it has not ruled out using a yield target again in some form. Given the yield target was part of a policy package, it is difficult to disentangle its specific contribution to the declines in the interest rates faced by households and businesses. But following the introduction of the target, lending rates fell considerably, especially fixed rates. Indeed, banks lowered the interest rates for their three-year fixed-rate loans to be well below the new variable rate for the first time and the fixed-rate share of new housing lending rose to new highs (Graph 10). This helped support the housing market and household finances during the pandemic. One particular feature of the yield target that the review draws attention to is that it was construed as a form of time-based guidance. This interpretation was reinforced by the Bank's communication that, in the central scenario, policy interest rates were unlikely to be increased until 2024. This time- based element of our communication was helpful in the dark days of the pandemic, sending a strong message that the RBA would provide the support that was needed. But the yield target was not a flexible policy instrument as times changed. It also created a communication challenge given that the Board's decisions were, in fact, dependent upon the state of the economy, not the calendar. As the health situation improved and the economy turned out much better than expected, the yield target became a less effective policy. Other market interest rates for similar terms moved away from the yield on three-year government bonds, limiting the transmission of the target to the real economy. This was in contrast to the first phase of the pandemic, when the target was closely aligned with market interest rates. The review also draws attention to the fact that the Board maintained a very strong focus in its decision-making on insuring against downside risks. At the time the target was adopted, there were credible forecasts that tens of thousands of Australians would die, the demand for hospital beds would exceed capacity and a vaccine would be years away. The unemployment rate was expected to reach double-digit levels and there were fears that there would be deep economic scarring and a generation of Australians would face lost opportunity. In this environment, the Board was very concerned about downside risks to the economy. It sought to provide insurance against these potentially very bad outcomes, and the yield target was part of this. It certainly recognised that things could turn out better than expected, but its priority was guarding against the downside. This was on the basis that if the downside did prevail, the costs to our society and our economy would be very high and there would be little further scope for the Bank to respond. On the other hand, if the worst outcomes were avoided and the upside prevailed, the policy could be adjusted, as it ultimately was. The review discusses various decision points and the different decisions that could have been made at these points. With hindsight, it can be argued that there was too much focus on the downside risks to the economy and the need to insure against them, and too little focus on the possibility that things could work out better than expected. But in real time, in which decisions had to be made under great uncertainty, the review notes that the focus on the downside risks was understandable. The Board recognises that opinions will differ as to whether it struck the right balance. As part of its review, the Board has agreed to strengthen its scenario analysis in future decision- making. It also recognises that the way the target ended in late 2021 was disorderly and caused some reputational damage to the Bank. It accepts that earlier communication from the Bank could have eased the situation, although the end of a target that was losing credibility was always likely to generate some volatility in market prices. The Board has not ruled out using a yield target again in extreme circumstances, but views the probability of doing so as low. The use of a yield target in some form would need to be evaluated against other policy options, including a bond purchase program. Such a program offers more flexibility, but it does carry other risks. These include larger potential financial costs for the central bank and the possibility of impaired bond market functioning as central bank bond holdings increase. There can also be challenges in unwinding a large bond purchase program. To assist with its future policy choices and to learn further lessons from recent experience, the Board will undertake a review of Australia's experience with the bond purchase program later this year. It will also undertake a review of the Bank's approach to forward guidance. Consistent with our commitment to transparency and accountability, these reviews will also be published. Thank you for listening and I am happy to answer questions.

r220908a_BOA

australia

Inflation and the Monetary Policy Framework

lowe

I would like to begin by thanking everybody who is attending today in support of the Anika Foundation. It's been a hard time for young people over the past couple of years, so the Foundation's work supporting young Australians is more important than ever. Thank you for your support. Last year, this event was held online as we were in the midst of the Delta outbreak. At the time, the economy was contracting, inflation was below the target band and the normalisation of monetary policy still seemed to be in the distance. A year on, a lot has changed. We are no longer in lockdowns, the economy has performed well, unemployment is at a 50-year low, inflation is the highest it has been in years and interest rates are being increased quickly. Today, I would like to focus my remarks on the pick-up in inflation. After a number of years in which inflation was below target, it is now considerably above target and is expected to go higher still in the short term. The extent of this turnaround in inflation has come as a surprise to many, including us. So, I would like to begin by exploring some of the lessons from this surprising burst in inflation. I will then discuss why, in my view, flexible inflation targeting remains the appropriate monetary policy framework for Australia. I will conclude with some remarks on the importance of returning inflation to target over time and how the RBA's recent monetary policy decisions will help achieve this. First, to the very large surprise in inflation. When I spoke at the Anika Foundation event last year, CPI inflation in Australia had been below 2 per cent for a number of years and, in underlying terms, was just 1.6 per cent highest rates in many years. This lift in inflation has come as a surprise. A year ago, the RBA was forecasting that inflation over 2022 would be just 1 3/4 per cent. Now, we are expecting CPI inflation this year to be around 7 3/4 per cent. This is a very big change and a very large forecast miss. The RBA has plenty of company in not predicting this lift in inflation. This next graph shows our forecasts of underlying inflation a year ago, as well as the range of forecasts from private-sector economists (Graph 2). Some forecasters were certainly expecting higher inflation than we were, but the magnitude of the pick-up in inflation has taken everybody by surprise. The same is true internationally. This next graph shows Consensus forecasts for headline inflation in August last year for the United States, the euro area, the United Kingdom and Canada (Graph 3). In all four cases, inflation was expected to be close to 2 per cent by now. Instead, the latest readings of CPI inflation in these four areas are Forecast misses of this scale should lead to soul-searching by forecasters and they certainly have at the RBA. It is important that we learn from this and improve our understanding of the inflation process. One starting point for understanding the unexpected surge in inflation is the big lift in energy prices stemming from Russia's invasion of Ukraine and various problems in the production of energy around the world. Analysis by the European Central Bank suggests that around three-quarters of the surprise in inflation in the euro area reflects unexpected developments in the markets for oil, gas and electricity. England estimates that higher energy prices will directly boost CPI inflation by 6 1/2 percentage points this year. And in Australia, the price of petrol at the bowser increased by 32 per cent over the past year (Graph 4). The direct effect of this alone has been to add 1.2 percentage points to Australia's CPI inflation, and on top of this there are second-round effects of higher fuel prices. While this lift in energy prices explains some of the surge in inflation, it is by no means the full story. We can make some further progress in understanding this surge by using the standard workhorse models of inflation, which explain inflation by inflation expectations and the aggregate output gap. Strong demand at a time of impaired supply - and thus a closure of the output gap - certainly helps explain part of the recent higher inflation. But these models fall well short of explaining the magnitude of the lift in inflation and, in my view, face some real challenges. One of these challenges is that the focus on the aggregate output gap is insufficient in a world in which shocks are highly uneven across sectors. We need to pay more attention to developments in individual sectors. One of the distinguishing features of the past two years is that the shocks have been highly asymmetrical. In 2020 and 2021 there was a huge increase in demand for goods and a decline in demand for services. This was particularly evident in the United States, where the demand for goods surged by close to 20 per cent in less than a year and the demand for many services was weak (Graph 5). A similar, although less pronounced, pattern was evident in Australia. This surge in demand for goods occurred at the same time as the supply side was constrained. This was partly because COVID interrupted production. But it goes beyond this. Even in good times, the supply side would have had trouble coping with a 20 per cent surge in demand in a short period of time. Just-in-time inventory management and long supply chains had made the system less resilient and less able to respond to rapid and unexpected shifts in demand. The result was that many industries quickly found themselves on the sharply upward sloping part of the supply curve, and prices increased. And there was no offsetting deflation in those parts of the economy where demand was weak. One lesson here is that what is happening at the sectoral level is important in influencing the overall inflation dynamics in our economy - it's not just the aggregates that matter. Resources don't move freely between sectors, which means that the composition of demand and supply is important, not just the overall level of demand. One relevant example in Australia has been in the home-building sector. Over the past year, the cost of building a new home has increased by 20 per cent (Graph 6). This alone has added close to 2 percentage points to headline inflation. Very strong demand in this sector - partly due to low interest rates and government grants totalling up to $35,000 for some first home buyers - came up against COVID-related problems on the supply side. The result was a big jump in prices, which has had a material impact on the overall inflation rate in Australia. The other element in the workhorse models of inflation is inflation expectations. Inflation expectations have picked up a little, but the measures derived from financial prices suggest there is a high degree of confidence that inflation will return to target (Graph 7). This suggests that a pick-up in inflation expectations is not a primary driver of the sharp rise in inflation. There is something here, though, that is worth watching that is not easily captured in our standard models - and that is the general inflation psychology in the community. By this, I mean the general willingness of businesses to seek price increases and the willingness of the community to accept price increases. Prior to the pandemic, it was very difficult for a business person to stand in the public square and say they were putting their prices up. And a common theme from our liaison was that, because most businesses had trouble putting their prices up, wage increases had to be kept modest. That was the mindset. Today, business people are able to stand in the public square and say they are putting their prices up, and they can point to a number of reasons why. The community doesn't like it, but there is a begrudging acceptance. And with prices rising, it is harder to resist bigger wage increases, especially in a tight labour market. So the psychology shifts. Or as the Bank for International Settlements put it in its recent annual report: when inflation is high, it becomes a coordinating mechanism for pricing decisions. In other words, people really start to pay attention to changes in costs and prices. The result can be faster and fuller pass-through of cost shocks and more frequent price and wage adjustments. There is some evidence that is already occurring, which is contributing to the strength of the pick-up in inflation. So, it is something to watch. I would now like to turn to the monetary policy framework, as this framework guides the Reserve Bank Board's decisions about interest rates each month. At a very high level, the RBA's job is to support the maximisation of the economic welfare of Australians, with the tools and responsibilities of a central bank. Delivering medium-term price stability is fundamental here. Since the early 1990s, our operating definition of 'price stability' has been that inflation averages 2 point something per cent. At this level, inflation is something that most people don't normally need to worry about. In terms of the policy framework, we adopted a flexible inflation targeting framework around three decades ago and this has been supported by successive governments. Under that framework, our operating objective has been to have consumer price inflation average between 2 and 3 per cent over time. I would like to highlight two aspects of this formulation. The first is the focus on 2 to 3 per cent . This focus has provided an important nominal anchor for inflation expectations in the Australian community. While the inflation rate has varied from year to year, it has always returned to the 2 to 3 per cent range. It has also averaged 2 point something per cent since the early 1990s. The second is the on average, over time aspect of the target. This formulation has provided the Board with the flexibility to pursue price stability in a way that, in its judgement, best contributes to full employment and the general welfare of the Australian people, which are both legislated objectives of the RBA. The RBA was an early adopter of flexible inflation targeting, eschewing the hard-edged stricter versions of inflation targeting that were popular in the 1990s. That was the right call. I note that the recent reviews by the Federal Reserve, the European Central Bank and the Bank of Canada have all concluded that some form of flexible inflation targeting is the preferred monetary policy regime in their countries. In my view, flexible inflation targeting has served Australia well and remains the best monetary policy regime for Australia. It is certainly worth examining alternatives as part of the current Review of the RBA, but I do not see a strong case for a move away from this broad approach. Flexible inflation targeting is not a perfect monetary policy regime, but it is hard to do better. Any monetary policy regime is likely to face challenges in today's changing world. Our economies are adjusting to the ageing of the population, the emergence of new digital technologies, climate change, slower productivity growth and a less interconnected global economy. These changes are affecting the dynamics of inflation and will continue to do so. As our economy continues to adapt, the strong nominal anchor and the flexibility provided by flexible inflation targeting will both be very helpful. These attributes are difficult (although not impossible) to replicate with another monetary policy regime. There are, though, some elements of the design of our flexible inflation target that could helpfully be looked at as part of the current Review. The first is whether 2 to 3 per cent is the appropriate nominal anchor and operating definition of 'price stability'. Many other countries have chosen 2 per cent as their nominal anchor. As part of the Review, it is worth examining the arguments for and against a change to the nominal anchor. The second element is how to best think about the 'flexible' part of flexible inflation targeting. Flexibility means that the Board's decisions are not determined by a rule - we have the flexibility to achieve the broad objective of price stability in a way that maximises welfare. A more rules-based, or highly parameterised approach, to monetary policy would provide less scope to respond in this way. Flexibility also means that the Board faces choices and trade-offs. For example, when supply shocks occur, there can be a short-term trade-off between inflation and growth. And in other circumstances, there can be a trade-off between achieving an inflation objective in the short term, via lower interest rates, and the build-up of macroeconomic and financial stability risks. Our legislation provides the scope to make these often difficult choices in the national interest. There is, though, a question here about accountability. Given the flexibility, the Bank's performance is sometimes hard to judge at any single point in time. This can complicate the task of holding us to account. Given this, it is important that the Bank explains when trade-offs are being made, including how and why. I hope the Review will provide a further opportunity to examine how the RBA has managed these trade-offs in the past and how it might manage and explain them in the future. I would now like to turn to the Board's monetary policy decisions over recent months. The Board is committed to doing what is necessary to ensure that inflation returns to target over time. High inflation is a scourge. It damages our standard of living, creates additional uncertainty for households and businesses, erodes the value of people's savings and adds to inequality. And without price stability, it is not possible to achieve a sustained period of low unemployment. It is important, therefore, that this current surge in inflation is only temporary and that we once again return to the 2 to 3 per cent range. The Board is committed to the return of inflation to target. It is seeking to do this in a way that keeps the economy on an even keel; it is possible to achieve this, but the path here is a narrow one and it is clouded in uncertainty. I would like to highlight three sources of this uncertainty. The first is the global economic environment. In the United States, the Federal Reserve has indicated that a period of tight monetary policy and below-trend growth will be required to get inflation under control. In Europe, real incomes are suffering very big declines because of sharply higher energy costs, and this will weigh on spending and growth. And in China, the economy is being affected by the authorities' approach to COVID, major stresses in its property industry and drought in parts of the country. Some slowing in the global economy will help bring inflation down, but a sharp slowing would make the job of delivering a soft landing here in Australia much harder. The second source of uncertainty is domestic in nature - and that is how inflation expectations and the inflation psychology in Australia adjust to the period of high inflation. If workers and businesses come to expect higher inflation, and wages growth and price-setting behaviour adjusts accordingly, the task of navigating that narrow path will be very difficult, if not impossible. A shift higher in inflation expectations will require higher interest rates. In time that would mean a sharper slowing of the economy. It is in our national interest that we avoid this. The third source of uncertainty is how households respond to higher interest rates. Interest rates are increasing for the first time in 12 years and they are rising quickly. The full effects of this are still to be felt. Household budgets are also under pressure from higher inflation, and housing prices are declining after large gains (Graph 8). On the other hand, many households have built up large financial buffers, including through offset accounts, and the household saving rate remains higher than it was before the pandemic. Many households are also benefiting from the strong labour market, with a higher share of Australians having a job than ever before. It is still difficult to know how all of these factors will balance out, but recent data continue to suggest resilience in consumer spending. We are paying close attention to these various uncertainties, but also recognise that there have been a number of developments that should prove helpful in navigating the narrow path. The first is that the supply side of the global economy is gradually improving and the demand for goods is stabilising - which means that a better balance of supply and demand is being established. Shipping costs are declining and delivery times have shortened (Graph 9). Many commodity prices have also reversed their rises following Russia's invasion of Ukraine. It is also noteworthy that inflation expectations in Australia remain consistent with the inflation target. In addition, wages growth has picked up, but not nearly to the same extent as in the United States (Graph 10). This is an important difference. While there are some areas where wages are rising very quickly in Australia, aggregate growth in wages has not responded materially to the higher inflation and is not inconsistent with inflation returning to target over time. It is important that this remains the case and that we avoid the cycle of higher inflation leading to higher wages growth and then higher inflation - a cycle like that would end in higher interest rates and a sharper slowing in the economy. It is in this environment in which we have been increasing interest rates. Since May, the Board has raised the cash rate target by a cumulative 2 1/4 percentage points, including a 1/2 percentage point rise earlier this week (Graph 11). This increase in interest rates - from what was a historically low level - is to ensure that the current period of high inflation is only temporary and that a more sustainable balance between demand and supply is established. To repeat an earlier point, price stability is necessary for a strong economy and a sustained period of full employment. So, it is important that we achieve this. The Board expects that further increases in interest rates will be required over the months ahead. The Board is not on a pre-set path, especially given the uncertainties that I have spoken about. We are conscious that there are lags in the operation of monetary policy and that interest rates have increased very quickly. And we recognise that, all else equal, the case for a slower pace of increase in interest rates becomes stronger as the level of the cash rate rises. But how high interest rates need to go and how quickly we get there will be guided by the incoming data and the evolving outlook for inflation and the labour market. Thank you very much for listening and for supporting the Anika Foundation. I look forward to answering your questions.

r220916a_BOA

australia

Opening Statement to the House of Representatives Standing Committee on Economics

lowe

Inflation is then expected to start declining, to be back around 3 per cent late in 2024. Global factors explain much of this increase in inflation. Russia's invasion of Ukraine resulted in major disruptions to energy markets, increasing retail energy prices around the world. And COVID-related interruptions to global production are still rippling through global supply chains, pushing prices up. The demand for goods in global markets has also been very strong over the past few years as people switched their spending from services to goods. The result of impaired supply and strong demand has been higher prices around the world. Important as these global factors have been, they are not the full story for why inflation is high in Australia. Demand here has been very strong relative to the ability of our economy to meet that demand. This is clearly evident in the labour market, where the number of job vacancies is at a record high and firms are finding it hard to hire workers. There are also capacity constraints in many sectors, including the building of infrastructure and the housing industry. This strong demand is, in part, a result of the policy approach during the pandemic. During 2020 and 2021, both fiscal and monetary policy provided very considerable economic support to households and businesses. At the RBA, we did this to provide a financial bridge to the day when the virus was contained and to provide some insurance against the possibility of very bad economic outcomes. As we sit here in Canberra today, it can be easy to forget how dire the outlook was in 2020: there were credible projections that the unemployment rate would reach 15 per cent, spending was collapsing, our hospitals were expected to be overflowing and a vaccine seemed years away. It was a scary time. In that environment, the Reserve Bank Board wanted to do what it could to help and to shore up confidence. We also were also seeking to provide some economic insurance against the worst possible outcomes. In the event, vaccines were developed in record time and our economy - with the support of monetary and fiscal policies - proved to be very resilient. We avoided the dire outcomes that many thought likely. And today, many people are returning back towards their pre-pandemic way of life and are spending again, including on travel and services. We saw further evidence of this last week in the National Accounts, with the Australian economy growing by 0.9 per cent in the June quarter, and by 3.6 per cent over the year. These are good outcomes, and they are better than those being recorded in most other countries. Given the resilience of our economy and the surge in inflation, it is understandable that some people are questioning whether or not too much support was provided by the RBA over the past two years. Judgements on this will differ. But in those dark days of the pandemic, the Reserve Bank Board judged that the bigger policy mistake would have been to do too little, rather than too much. If we had done too little and the worst had occurred, Australians could have paid a heavy price. As things turned out, thankfully, the worst was avoided. So it has been appropriate to unwind the very easy monetary conditions of the pandemic years and address the higher inflation that has emerged so quickly. This brings me to the third change since February - that is the increase in interest rates from the extraordinarily low levels during the pandemic. Since May, the cash rate has been increased by a cumulative 2 1/4 percentage points and now stands at 2.35 per cent. Like the rise in inflation, this increase has come sooner, and has been larger and faster, than was earlier expected. Previously the RBA had forecast that the damaging effects of the pandemic on our economy would be long lasting and that inflation would remain low. On that basis, we had expected that interest rates would remain low for some years. I am frequently reminded that many people interpreted our previous communication as a promise, or a commitment, that interest rates wouldn't rise until 2024. This was despite our statements on interest rates always being conditional on the state of the economy. This conditionality often got lost in the messaging. We are currently working through the implications of this for our future approach to forward guidance and communication more generally. Now that inflation is as high as it is, we need to make sure that inflation returns to target in reasonable time. A powerful lesson from history is that low and stable inflation is a prerequisite for a strong economy and a sustained period of full employment. High inflation damages our economy, worsens inequality and devalues people's savings. High inflation also makes it very difficult to sustain, or increase, real wages. It is a scourge. It is for these reasons that the RBA is committed to returning inflation to the 2 to 3 per cent target range over time. I know that higher interest rates are unwelcome for many people, especially those who have borrowed large sums over recent times. Higher interest rates are putting pressure on households, just at the time that higher petrol prices and grocery bills are squeezing budgets. So it is a difficult and a concerning time for some people. The alternative, though, of allowing higher inflation to become entrenched would be even more difficult and it would damage our economic prospects. The RBA will do what is necessary to make sure that higher inflation does not become entrenched and we are committed to returning inflation to the 2 to 3 per cent target range. We are seeking to do this in a way that keeps the economy on an even keel. It is possible to achieve this, but the path here is a narrow one and it is clouded in uncertainty. One important source of uncertainty is the global economy, where the outlook has deteriorated. The situation in Europe is very troubling, not least because of the extraordinary increases in energy prices. And in the United States, the Federal Reserve has indicated that monetary policy will need to become restrictive to lower inflation. The Chinese economy is also facing major challenges due to the combination of COVID, a severe drought and very weak conditions in the property sector. It will be difficult for Australia to stay on that narrow path to a soft landing if there is further material bad news on the global economy. Another factor that will determine how successfully we navigate that narrow path is how inflation expectations and the general inflation psychology evolve in Australia. To date, medium-term inflation expectations have remained well anchored, which is good news. But the general inflation psychology appears to be shifting; it is easier for firms to put their prices up and the public is more accepting of this. Wages growth has also picked from the very low rates of recent years and a further increase is expected due to the very tight labour market. Stronger wages growth is something that the RBA had been seeking for a number of years and some pick-up is welcome. It is also important to note that, to date, the stronger growth in wages has not been a major factor driving inflation higher and, at the aggregate level, growth in labour costs remains consistent with inflation returning to target. Looking forward now, it is important that we avoid a cycle where higher inflation leads to higher wages and inflation remaining high. This type of cycle would lead to higher interest rates, a weaker economy, and higher unemployment. Businesses, too, have a role in avoiding these damaging outcomes, by not using the higher inflation as cover for an increase in profit margins. A third issue we are watching carefully is household spending. Consumer sentiment has fallen, household disposable income is under pressure from higher interest rates and higher inflation, and housing prices are declining after large gains. On the other hand, many households are benefiting from the strong labour market, including by finding jobs and getting more hours of work. Some households are also continuing to save at a higher rate than before the pandemic. Quite a few have also built up large financial buffers, although many other households have only very limited buffers. In the face of these competing factors, the recent data suggest that spending has remained resilient so far. There is, though, considerable uncertainty as to how these factors will balance out over the months ahead and we are watching the situation carefully. In terms of the outlook for interest rates, the Reserve Bank Board expects that further increases will be required to bring inflation back to target. We are not on a pre-set path, though, especially given the uncertainties I have just spoken about. The increase in interest rates has been rapid and global and we know monetary policy operates with a lag. At some point, it will be appropriate to slow the rate of increase in interest rates and the case for doing that becomes stronger as the level of interest rates increases. As I have said previously, the size and timing of future interest rate increases will be guided by the incoming data and the Board's assessment of the outlook for inflation and the labour market. On a different matter, as you would know, the Government has commissioned a review into Australia's monetary policy arrangements and the RBA. Both the Board and the Bank's staff welcome this review and we have already had constructive discussions with the Review Panel. We look forward to discussing with this Committee the topics raised by the Review at this and future hearings. To complement the external review, the RBA is undertaking internal reviews into the three-year yield target, the bond purchase program and our approach to forward guidance. The yield target review was published in June and the review of the bond purchase program will be published next week. The forward guidance review will be published later this year. Finally, since this is the first hearing of this Committee under the 47th Parliament, I would like to draw your attention to some of the RBA's other responsibilities. We are the banker to the Commonwealth Government. We operate the Official Public Account and are the Government's main transactional banker, providing banking services to the ATO, Services Australia and many government departments. Over the past couple of years we played an important role in making the COVIDrelated and flood disaster payments in real time. We made sure that people received their money quickly, often on weekends and outside of business hours. We are also responsible for the core of Australia's payment system, which allows money to move from one bank to another. As part of this work, we operate the centre of Australia's real-time fast payments system, which makes it possible for money to move between bank accounts in a matter of seconds at any time of the day or week. We also print the nation's banknotes. While cash is being used less and less frequently for transactions, there is still strong demand for our banknotes. On average, there are 18 $100 notes and 38 $50 notes on issue for every person in Australia. The total value of notes on issue is $102 billion, which averages around $4,000 per person. That is a high number. The RBA has important regulatory responsibilities in the payments system, which are overseen by the Payments System Board. We supervise the central counterparties that are operated by the ASX and that are at the heart of Australia's financial market infrastructure. We also have regulatory responsibilities for efficiency, competition and stability in Australia's retail payments system. One issue that we are currently examining closely is the public interest case for the RBA to issue a digital form of the Australian dollar, which could complement the physical banknotes that we currently issue. We have an open mind as to whether it will be in the public interest to do this. We are currently working with the Digital Finance Cooperative Research Centre on potential use cases and also working with other central banks on this important issue. Thank you. My colleagues and I are here to answer your questions.

r221101a_BOA

australia

Remarks at the Reserve Bank Board Dinner

lowe

Good evening. On behalf of the Reserve Bank Board, I would like to warmly welcome you to this community dinner. This is the first time the Board has met outside Sydney since October 2019. We are delighted that we are able to do so in this beautiful and historic city of Hobart. It's a great pleasure to be back here. Thank you very much for joining us this evening. Earlier today, the Board held its meeting in the Cabinet Meeting Room here in Hobart. I would like to thank the Premier very much for his hospitality. Your Cabinet Room was an ideal place for the Board to discuss the state of the Australian and global economies and decide upon the level of interest rates in Australia. As you are probably aware by now, the Board decided to increase the cash rate by a further one-quarter of a percentage point to 2.85 per cent. I will talk about the reasons for this in a moment. The previous time that the Reserve Bank Board met in Hobart was back in April 2016. The economy was in a very different position then from where it is today. Inflation was below target and surprising on the downside, wages growth was very slow, the unemployment rate was close to 6 per cent and interest rates were trending lower, with the cash rate then at 2 per cent. The global economy was growing a bit slowly, but it was broadly okay. How much things can change in just a few short years. A couple of weeks ago, I was in Washington DC with the Australian Treasurer at the G20 and IMF meetings. It was a sobering experience. We heard that: inflation globally is way too high; the rising cost of living is hurting many households; the world is falling behind on the agreed carbon reduction targets; war is once again tragically occurring in Europe; and the global economy is becoming more fragmented. As you can imagine, there was not much cheer around, even for somebody like myself who sees the glass as half full. I recount this, though, for a couple of reasons. The first is as a reminder of how difficult the global backdrop is at present. There is no escaping the fact that we are living through a challenging period. It's true that the choices that we make here in Australia during this period will help shape our own destiny, but we can't ignore the global environment. The second reason is that as I listened to my colleagues from around the world, my thoughts kept returning to the idea of how fortunate we are to live in Australia. We live in peace and we enjoy a level of material prosperity that few other people in the world experience. Our economy has bounced back better than most from the COVID-19 disruptions and we are benefiting from a surge in the prices of our key exports. And for the first time in almost 50 years, it is possible to say that almost all Australians who want a job can find one. Our public services are of a generally high quality and our public finances are in better shape than those of many other countries. And our natural assets mean that Australia is well positioned for the clean energy transition. We have a lot to be thankful for. None of this is to deny that we face some pretty serious challenges, but as I listened to the finance ministers and central bank governors in Washington DC, I kept thinking I wouldn't want to trade our place for anybody else's. Today, the Board heard how the Tasmanian economy too has bounced back well from the COVID disruptions. Gross state product per capita has grown a bit more quickly here than in the other states and the unemployment rate is the lowest in many years. Visitor numbers are recovering and investment is in an upswing, with Tasmania set to play an important role in Australia's energy transition. On the other side of the ledger, though, household budgets are under strain from cost-of-living pressures, the rental market is very tight and many firms are finding it hard to find workers. Even so, it is important to remember that we are in a better position than many others around the world. One challenge that is facing all Australians is high inflation. Over the year to September, the inflation rate was 7.3 per cent. This is the highest rate in more than three decades and we are expecting inflation to increase further to reach around 8 per cent later this year. After that, inflation is expected to moderate. This is due to the ongoing resolution of supply-side problems, a decline in commodity prices and higher interest rates which will establish a better balance between supply and demand in the economy. I would like to take the opportunity to assure you that the Board is resolute in its determination to return inflation to the 2 to 3 per cent target range. We will do what is necessary to achieve that. At our meeting today we discussed the damage that high inflation does to people; it is a scourge. High inflation devalues your savings. It worsens inequality in our society and it undermines our living standards. It hurts us all by impairing the functioning of our economy. It is for these reasons that the Reserve Bank Board will make sure that this episode of high inflation is only temporary. I understand that the higher interest rates that are needed to bring inflation under control are unwelcome by many people, especially those who have borrowed large amounts over recent times. At our meeting, we discussed how the higher interest rates are putting pressure on family budgets, just at the time that high petrol prices and grocery bills are also squeezing budgets. We are conscious of this and are certainly taking it into account. This morning, we also discussed the consequences of not raising interest rates, and allowing high inflation to persist and become entrenched in expectations. If this were to happen, the evil of inflation would be with us for longer and the eventual increase in interest rates needed to bring it down would be greater. This would increase the risk of a severe recession and a sharp rise in unemployment. It would be much better to avoid such a costly outcome and so we have acted strongly to avoid it. I want to acknowledge, though, that we are travelling along a narrow path here. The Board is seeking to return inflation to the 2 to 3 per cent range while at the same time keeping the economy on an even keel. It is still possible to do this, but there is a lot of uncertainty and we could be knocked off that narrow path, not least because of developments elsewhere in the world. At our meeting we also discussed an updated set of economic forecasts. Our central case is that we do stay on that narrow path. Economic growth, though, is expected to slow next year because of the deterioration in the global economy and the squeeze on household finances. Our central forecast is that the unemployment rate holds steady for a while at what is a historically very low level, but then increases a bit as the economy slows. Inflation is expected to start declining early next year and then take a couple of years to return to the 2 to 3 per cent range. In the short term, the east coast floods are adding to the upwards pressure on food prices, and next year there are likely to be very large increases in the prices that households pay for gas and electricity. To control inflation, the Board has already increased interest rates substantially. We moved in large half percentage point increments for four months, but at this and the previous meeting, we returned to more standard quarter percentage point increases. The earlier large increases were required to move interest rates quickly away from their pandemic levels to address the rapidly emerging inflation problem. But as interest rates moved back to more normal levels, the Board judged that it is appropriate to move at a slower pace while we assessed the data, the economic outlook and the impact of the rate rises to date. We are conscious that interest rates have been increased by a large amount in a very short period of time and that higher interest rates affect the economy with a lag. If we are to stay on that narrow path, we need to strike the right balance between doing too much and too little. The Board's base case remains that interest rates will need to go higher still to bring inflation back to target and our forecasts have been prepared on that basis. We are not on a pre-set path, though. If we need to step up to larger increases again to secure the return of inflation to target, we will do that. Similarly, if the situation requires us to hold steady for a while, we will do that. Given the uncertainties regarding the outlook, we will be watching very carefully how the economy and the inflation pressures evolve over the summer. Finally, while it is interest rates that keep the Reserve Bank in the news, I hope that you know that we do a lot more than just set interest rates. We are the banker to the Australian Government, so we process all social security payments, tax payments and Medicare refunds. We also operate the core of Australia's payments system. When you send money from your bank to another bank it goes through the Reserve Bank. We also operate a central part of Australia's 24/7 realtime payments system. I hope that you all have a PayID, so that you can take best advantage of this technology. If you don't have one, I encourage you to go get one. We also print Australia's banknotes. It comes as a surprise to many people just how many banknotes are in circulation. The total value of notes on issue is over $100 billion - that's around $4,000 per person in Australia. This is despite cash being used less and less for transactions. Our analysis is that most of these banknotes are being held as a store of value. On average, there are 18 $100 notes and 38 $50 notes on issue for every person in Australia. I don't have my share of these or know many people who do. As interest rates have risen recently, I thought that the attractiveness of holding banknotes as a store of value might decline, but there is little sign of that yet. Time will tell, though. The Reserve Bank is also responsible for the design of Australia's banknotes. Given this, we are currently considering the design of the $5 banknote following the passing of Queen Elizabeth II. We recognise that this is an issue that is of national interest and there is a long tradition of the monarch being on Australia's banknotes. Indeed, the monarch has been on at least one of Australia's banknotes since 1923 and was on all our notes until 1953. Given this tradition and the national significance of the issue, the Bank is consulting with the Australian Government regarding whether or not the new $5 banknote should include a portrait of King Charles III. We will make a decision after this consultation with the government is complete. Again, thank you very much for joining us this evening. We are looking forward to learning more from you over dinner about how things are going here in Tasmania.

r970530a_BOC

canada

Flexible Exchange Rates in a World of Low Inflation

thiessen

There is a good deal of discussion these days about Economic and Monetary Union (EMU) in Europe--about the benefits and difficulties of organizing such a union. However, today I would like to examine a somewhat different issue, one that is at the other end of the spectrum; namely, How is the international system of flexible exchange rates working these days? This is not to denigrate or deny the importance of the challenges surrounding the EMU initiative, nor its relevance for those who will be directly or indirectly affected by its debut. But while many European countries have operated under a fixed exchange rate regime during the post-Bretton Woods period, most other industrial economies have chosen to operate under a flexible currency arrangement. The three major currencies, those of the United States, Japan, and Germany, float against one another. So I thought what I might do this morning is focus on flexible exchange rates and discuss, in particular, how they have performed over the past few years. The main message I would like to convey to you is that, when all is said and done, the flexible exchange rate system has not done badly over the past 25 years. And in the last three or four years, it has done rather well in an environment characterized by low inflation and improved fiscal performance across the major industrial countries. Exchange rates have, for the most part, moved in the "right direction." And short-run exchange rate volatility has diminished, notwithstanding some evident cyclical swings of the U.S. dollar. The initial reason for adopting floating exchange rates was more a matter of circumstance than a considered choice. The Bretton Woods system, which was established shortly after the Second World War, collapsed in the early 1970s, forcing most industrial countries onto a flexible exchange rate regime as an "interim measure." Attempts to rescue the Bretton Woods system in the summer of 1971 and the fall of 1973 proved unsuccessful. The reputed reasons for the collapse of the system were the inflationary macropolicies pursued by the United States during the late 1960s and early 1970s and the unwillingness of other countries either to inflate their economies to the same extent or to allow the U.S. dollar to devalue. But the true reasons for its demise were more deep-seated. This system, which had been viable, although prone to periodic crises, throughout the 1950s and 1960s, was clearly unable to cope in a world of liberalized trade and international capital mobility. The Bretton Woods system, while laudable in concept, proved to be flawed in practice. The main problem was that the imbalances that the system was supposed to address, through discrete changes in the parity value of the affected currencies vis-a-vis the U.S. dollar and gold, proved to be much larger and more intractable than the architects of the system had ever envisaged. Moreover, countries were reluctant to adjust their currencies, even when the problems were shown to be fundamental. Thus, authorities would often subvert domestic economic objectives, such as price stability, economic growth and full employment, in order to protect outdated parities. As a result, the system was in disequilibrium more often than not. And its adjustable nature did not prove flexible enough to help countries deal with the shocks that regularly hit the international financial system. While the adoption of floating exchange rates may have been more a matter of necessity than choice, floating rates did promise greater independence in the conduct of monetary policy and better insulation from external shocks. Advocates of a floating regime, partly influenced by Canada's favourable experience with such a system in the 1950s, suggested that exchange rates would automatically adjust to correct external imbalances in an orderly and continuous manner. And this would give domestic policymakers greater freedom than under the pegged rate system as well as obviate the need for official intervention and large international reserves. Needless to say, experience under the floating rate system has not been problem-free. Events did not unfold quite as its proponents had suggested, and the past 25 years have been characterized by volatile short-term movements and sizable long-term swings in most of the major currencies. The magnitude of these currency movements and our evident inability to explain them in a comprehensive, precise manner, led many observers to presume that such movements were driven by market speculation and that they were largely disconnected from economic fundamentals. There is no simple way to resolve this issue. Nonetheless, it is possible to identify some of the forces that have influenced exchange rates through this period, either by shaping their broad movements or, at times, by contributing to uncertainty and hence to excessive volatility in these rates. I would stress, in particular, the uncertainty over the future course of monetary and fiscal policies, which made it difficult for financial markets to cope with the macroeconomic pressures of the day. What forces am I talking about? In the 1970s, we had the two oil shocks, one at the beginning and one at the end of the decade. These may have been precipitated by political developments in the Middle East, but the initial shock was encouraged by the pursuit, among the major industrial countries, of higher output and employment through monetary ease and a willingness to tolerate increased inflation. Subsequently, the monetary accommodation of the price effects caused by the oil shocks added to the turbulent environment that followed. The 1970s and early 1980s turned out to be a period of high and variable inflation in many countries. High inflation, balance-of-payments difficulties arising from the oil shocks, and the large fiscal transfers necessary to support economic activity in energy-dependent countries, were the catalyst for much of what followed in the 1980s. Excessive government spending and rising public indebtedness were coupled with tighter monetary policy, as authorities struggled to maintain social services, restore full employment, and dampen the inflationary pressures that had been allowed to grow in the 1970s. The effects of this uncomfortable policy mix hit the major industrial countries with varying severity and triggered a debt crisis in the developing world. Success on the inflation front was mixed, adding to the strains that the exchange rate system was expected to cope with. While the problems in the industrial countries were generally less severe than those in the developing world, they nevertheless caused serious dislocations. Because of differences in the mix of fiscal and monetary policies in the United States compared with Germany and Japan, the U.S. dollar appreciated sharply against the deutschemark and the yen through the first part of the 1980s. In turn, these developments led to an accumulation of very large current account imbalances among these three major countries. In these circumstances, the flexible exchange rate system did not perform as well as it might have. But it is not obvious that any other alternative would have been practicable, and I doubt very much that a fixed exchange rate system for the U.S. dollar, the mark, and the yen could have survived these strains. The three major currencies were not the only ones subjected to tensions. Uncertainty about whether and how fiscal imbalances might be corrected, and considerable cross-country differences in actual and expected inflation contributed to major exchange rate pressures among other currencies in the 1980s and early 1990s. By 1992-93, these pressures had reached the breaking point in continental Europe and the United Kingdom, putting extreme stress on the Exchange Rate Mechanism (ERM). As well as causing the United Kingdom and Italy to leave the arrangement, the situation necessitated a widening of the ERM intervention bands. Although it is still early days, conditions in exchange and asset markets have improved considerably since 1993. Short-term exchange rate volatility, and even the trend movements in bilateral rates, while still significant, are much smaller than those of the previous two decades. I believe that this improved perfomance has a lot to do with the convergence we have seen in recent years towards low and stable rates of inflation among the major industrial countries. But progress on the fiscal front has also been essential, helping to reduce risk premiums and stabilize expectations, both with regard to the long-run viability of the fiscal track in many countries and the prospects for continued low inflation. Thus, I would argue that consistently low inflation and improved fiscal positions have brought about more stable, "better behaved" exchange rates, just as theory would have predicted. This is not to say that exchange rates have remained absolutely stable over the past four years. They have not. But movements have been more orderly, unlike those of the earlier periods, and most of the observed trends can be explained by the different cyclical positions of countries, the different monetary and fiscal responses, and by changes in world commodity prices. Exchange rate movements have, at times, appeared to contribute to trade imbalances or exacerbate existing ones. But this should not be interpreted as evidence that markets are pushing rates in the wrong direction. Indeed, imbalances often reflect the fact that economies are at different points of the business cycle. For example, Japan has, until very recently, seen the value of its currency decline, on balance, against the U.S. dollar, even though the country is running a large and growing trade surplus. It is obvious that much of the recent movement in the U.S. dollar/yen exchange rate has been driven by the different cyclical positions of the two countries. Thus, the relatively low yen has been helping to rejuvenate demand in Japan. Meanwhile, a strong U.S. dollar has been helping the United States to counter inflationary pressures that would otherwise require stronger doses of interest-rate medicine. Of course, it is possible for exchange rates to overreact, even in the benign environment I described a moment ago. But the chances of a serious misalignment are much lower when markets are operating in a climate of greater predictability, provided by a monetary policy grounded in domestic price stability. When exchange rates are not anchored by a credible commitment to price stability, it is difficult, if not impossible, for markets to perform the tasks that are expected of them. As you know, Canada has been one of the strongest proponents of a flexible exchange rate system. We were the only major industrial country to operate under such a system in the 1950s and early 1960s, and we were the first major country to adopt it again in the 1970s. As a medium-sized open economy that relies on exports of primary commodities more than our principal trading partners, we are vulnerable to external shocks and appreciate the "shock absorber" effect provided by a flexible exchange rate. Let me tell you briefly how the Canadian economy has performed under the flexible exchange rate system and describe the main forces that have been acting on our exchange rate. The most significant trend movement occurred over the 1976 to 1986 period, when the Canadian dollar experienced a large depreciation vis-a-vis the U.S. dollar, falling from roughly parity to a low of 69 cents (U.S.) in February 1986. During this time, annual inflation rates in Canada exceeded those in the United States by about one per cent, on average. While on a yearly basis this may not sound like much, cumulatively the differential was rather significant and can explain most of the trend depreciation in the Canada-U.S. exchange rate over this period. As for the cyclical swings that accompanied the trend depreciation of the Canadian dollar, they reflected a number of factors. Among these, the most significant has been the variability in the world prices of primary commodities, which remain an important component of our exports. But the most worrisome factor during the 1980s and 1990s was the growth of the fiscal deficit and the destabilizing effect that this had on financial markets, including the foreign exchange market. Rising public debts and deficits contributed importantly to the risk premiums in interest rates on Canadian dollar assets and were the catalyst, if not the cause, of unsettling episodes in 1986, 1992, and 1994. Fiscal policy concerns, at times coupled with political uncertainty, proved to be a volatile mix and led to serious financial market turbulence and speculative pressures, complicating the task of monetary policy. Fortunately, the situation has recently improved considerably. Inflation in Canada is stable, at its lowest level in decades. And it has been somewhat below that in the United States since 1992. This implies a potential appreciation of the Canadian dollar vis-a-vis the U.S. dollar over time, if the inflation differential persists. But other factors also tend to favour a stronger Canadian dollar. First, deficit reduction by Canadian governments has eased the uncertainty that had pervaded financial markets, thereby shrinking risk premiums in interest rates and reversing the currency weakness caused earlier by these premiums. Second, Canadian industries are in a stronger competitive position than they have been for years, and this has contributed to a sharp reduction of the persistent deficit in the current account of our international balance of payments. Third, primary commodity prices are firm and likely to move higher with the pickup in global economic activity. In light of all this, it is not surprising that several analysts, as well as the Bank of Canada, expect a stronger Canadian dollar in the future and think that the currency is currently undervalued relative to its longer-term fundamentals. Why, then, has the Canadian dollar not been stronger? The explanation lies mainly in the different cyclical positions of the Canadian and U.S. economies. The more accommodative monetary conditions pursued in Canada during the past two years have been consistent with the needs of an economy characterized by considerable excess capacity and an inflation rate that has tended to be in the lower half of the current 1 to 3 per cent target range. Thus, lower interest rates and a relatively low Canadian dollar have been temporarily appropriate for economic reasons. While no central bank ever wishes to have a weak currency, since late 1995, the Bank of Canada has encouraged easier monetary conditions--conditions that, at times, have taken the form of lower interest rates and a somewhat softer dollar. Put another way, the Bank did not purposely push the dollar lower, but simply aimed for the path of monetary conditions that seemed appropriate given sluggish domestic economic conditions. The particular mix of interest rate and exchange rate adjustments necessary to achieve the desired path of monetary conditions is not under the direct control of the Bank of Canada. It is essentially determined by the markets. However, the Canadian economy has been gathering momentum lately, and prospects are good for continued robust expansion through 1997 and into 1998, in response to the substantial past monetary easing. With the margin of excess capacity in the economy still fairly wide, there is ample room for strong growth in coming quarters without a resurgence of inflation. However, as the slack is absorbed, the Bank will need to pursue less stimulative monetary conditions, consistent with a durable, low-inflation economic expansion. In other words, for cyclical as well as for more fundamental reasons, the prospects are good for a stronger Canadian currency. In summary, I would say that the exchange market for the Canadian dollar has worked rather well in recent years, interpreting and responding to both the fundamental trends in our economy and the cyclical differences between Canada and the United States. I believe that fiscal discipline and a credible commitment to low inflation are key ingredients of that good performance.

r970618a_BOC

canada

The Canadian economy: Challenges and prospects

thiessen

Once a year, the Bank of Canada's Board of Directors meets outside Ottawa, alternating among the provinces. I am delighted that this year's out-of-town meeting has brought us to the beautiful and historic city of Quebec. I would like to take this opportunity to talk to you about recent developments in our economy. But first, let me take a moment to bring you up-to-date on some of the Bank's recent initiatives to strengthen its regional contacts. As part of this effort, we have just set up new representative offices in Calgary and in Halifax, and are expanding our existing offices in Montreal, Toronto, and Vancouver. What is behind all this? We have learned from experience that both the economy and monetary policy work better when Canadians are well informed about the major economic issues of the day and about the focus of monetary policy. That is why in the last few years we have been trying to increase public awareness and understanding of these matters, by regularly providing more information on the economy and explaining what monetary policy is up to and why. But to do our job well, we at the Bank must also be on top of what is happening in the economy, from one end of this country to the other. We also need to listen to the views and concerns of Canadians about the economy and monetary policy. The Bank has always kept in touch with the regions and has monitored all the available regional economic data. What we are now aiming to improve is our ability to interpret these data. For this, we need to increase our contacts with businesses, governments, associations, economic analysts, and the public--in all parts of Canada. We expect that our new and expanded regional representative offices will help us do just that. While the central focus of the regional offices will be on the economy and monetary policy, we also expect our representatives to play a broader role in communicating with the public on all aspects of the Bank's responsibilities. This would include, for example, our increased efforts to ensure that Canadians are aware of the anti-counterfeiting features in bank notes. Public awareness is an important deterrent to counterfeiting activities. Our representative offices will also oversee the new arrangements for the distribution of bank notes to financial institutions. They will ensure that these arrangements are carried out efficiently and that the currency system continues to provide good service to Canadians. The city of Quebec was the site for our second pilot of the new system for bank note distribution. Bank notes are now moving directly from financial institutions with surplus notes to those that need them. Notes are now returned to the Bank of Canada only to be destroyed when they are no longer fit for use. I hope that we can count on your help to make the new regional initiatives work. I would especially like to encourage you to contact our two senior representatives for the province of Quebec in Montreal--Louis-Robert Lafleur, Economics Representative and Lorraine Laviolette, Operations Representative--to obtain information, express your point of view, or get in touch with the Bank in Ottawa. As I said earlier, it is important for Canadians to be well informed about the economy and about monetary policy. Thus, I welcome the attention that economic issues have been receiving in the last few years. There are three questions related to monetary policy that are raised frequently and that I would like to discuss with you today. First, why is the Bank still preoccupied with controlling inflation when it is so low and does not seem to be a threat any longer? With this continued focus on inflation, isn't there a risk that monetary policy will fail to provide the support necessary for incomes and employment to grow? Second, if low inflation is good for the economy, why have we not seen more of its dividends in our economic performance? Third, the Bank has taken a rather optimistic view of Canada's economic prospects for this year and next. What is the basis for this, when we are still undergoing economic restructuring and have been experiencing its effects on consumer confidence? Over the past five years, inflation in Canada has averaged less than 2 per cent a year. Why, then, is the Bank of Canada still so focussed on its target range for inflation control? Why not put more emphasis on economic growth and employment? My response to the first question is simply this: a commitment to low inflation is the best contribution monetary policy can make over time to a well-functioning economy--an economy that delivers growth in output and employment. Why? Because such a commitment gives Canadians confidence that the value of their money will not be eroded by inflation. Low inflation generally means less uncertainty about the future, which allows people to make sounder economic decisions. And, as uncertainty about inflation diminishes, interest rates go down. In contrast, high inflation makes it difficult to interpret price changes and encourages speculative rather than productive investments--all of which tends to increase economic inefficiency. We know from past experience that this leads only to painful boom-and-bust cycles and not to a stable economy. But what about the concern that this focus on inflation control may conflict with the achievement of full economic recovery and job creation? In fact, when the Bank takes action to keep inflation inside the target range, monetary policy operates as an important stabilizer for the economy, helping to maintain sustainable growth over time in output and employment. How does this work? When the economy is expanding at an unsustainable pace, pushing hard on the limits of production capacity and threatening to send the trend of inflation through the top of the target range, the Bank will tighten monetary conditions to cool things off. But the Bank will also respond when the economy is sluggish, and inflation is likely to fall below the bottom of the target range, by easing monetary conditions. This is what we did from late 1995 to late 1996. Now, I do not want to leave the impression that your central bank can somehow "fine-tune" the economy. We can't, because it takes time for the effects of monetary actions to work their way through the economy. However, this approach to policy provides monetary support which, over time, will help output and employment to grow at their potential. So, by focussing on the inflation-control targets, the Bank is doing the right thing for the economy. As you can see, there are good reasons why we must remain committed to our inflation-control targets. Of course, the targets were introduced to help reduce a high inflation rate. But I believe that they continue to be the best basis for the conduct of monetary policy even now that inflation is low, and the aim is to keep it low. With all the good news on the inflation front over the past five years, why has Canada not fared better in terms of overall economic performance? I believe that this has a lot to do with the magnitude and complexity of the transformation that our economy has been going through in recent years, in response to two major challenges. First, there has been the global challenge, stemming from rapid technological advancements and increasingly open and competitive world markets. Second, there is the domestic challenge, arising from the need to unwind the economic imbalances and excesses of the 1970s and 1980s. I am referring here to rapidly rising production costs, speculative activity (particularly in the real estate sector), the large budgetary deficits of Canadian governments, and accumulating public indebtedness. To be sure, the restructuring process has been difficult and stressful. It has meant layoffs--both in the private and, more recently, the public sectors--causing a great deal of uncertainty. Moreover, in 1994 and early 1995, investor nervousness about our fiscal and political situations led to temporary sharp increases in domestic interest rates in the wake of turbulent global financial markets. All of this left Canadians anxious about the future and cautious about spending. In these circumstances, is it any wonder that the benefits of low inflation have been slow to materialize, and the recovery from the recession of the early 1990s has been more gradual than expected? There is no getting around the short-run costs to Canadians of these difficult, yet absolutely necessary, structural adjustments. But neither should we lose sight of the impressive, longer-term improvements that have been taking place in our economy. I have already mentioned our favourable inflation performance. The sharp decline in inflation from the high levels of the 1970s and 1980s has contributed to lower interest rates, more effective cost control by businesses, and a more stable economic environment overall. Canadian firms have been investing in new technology and streamlining their operations to become more efficient and productive. With this, and a more outward-looking focus, they have been able to take advantage of a competitive exchange rate to break into new world markets and expand their market share. Considerable progress has also been made in restructuring the public sector. Deficits have been reduced substantially, and governments have been moving towards less vulnerable debt positions. The ratio of government debt outstanding relative to the size of our economy is expected to fall this year, and should continue to do so in the years ahead. This is very good news, since a decline in this ratio is essential to fully restore our financial health. But that is not all. With our success in exporting and with the reduced budgetary deficits of Canadian governments, the persistent deficit in the current account of our international balance of payments has been sharply reduced. This means that, as a nation, we are no longer rapidly building up foreign debt. As is the case elsewhere in Canada, people in Quebec are all too familiar with the stresses and strains of adjusting to changing economic realities. A large number of Quebec businesses have undergone extensive restructuring in this decade, involving the acquisition of new high-tech equipment, the rationalization of activities, and the upgrading of labour skills. The public sector has also begun its own adjustment process recently. Such restructuring is by no means easy. But the changes that have taken place have made a number of Quebec's industries (telecommunications, office equipment, aircraft, construction) highly competitive. And all of these changes should provide this province with the base for a better economic future. I believe that the emphasis of Canadian monetary policy on low inflation, which has contributed to greater economic stability and low interest rates, is supporting the adjustment process in the Quebec economy. The difficulties associated with the economic transformation in Canada have no doubt acted as a drag on output and employment. But I believe we are now at the stage where the payoffs from these necessary adjustments have begun to outweigh the difficulties. One of the major benefits has been the marked decline in our interest rates since late 1995. Many interest rates in Canada are now at their lowest levels since the 1960s. And for maturities of up to 10 years, they are appreciably lower than comparable U.S. rates. This decline in interest rates represents a substantial stimulus to domestic spending. However, it takes considerable time--one to two years--for monetary policy actions to have an effect on the economy. So, it is only recently that we have seen unmistakable signs of the response to these lower interest rates. This explains some of the gloom during the past year regarding Canada's economic prospects. Recent evidence, particularly from the interest-rate-sensitive sectors of the economy, is very encouraging. The economic results for the second half of 1996 and the first quarter of 1997 confirm that, much as expected, there have been significant increases in household spending on housing, motor vehicles, and consumer durables. And businesses continue to increase their capital spending. Moreover, after a slow start to the year, growth in private sector employment has resumed. Given the lags involved, the substantial past easing of interest rates should continue to support robust growth in domestic spending for some time. And with strong U.S. demand for our exports, the Bank feels that there is good reason to expect a solid economic expansion in the period ahead. What then are the implications for inflation? Because there is still a fairly wide margin of spare production capacity in the economy, there is room for strong growth in coming quarters, without too much concern about a flare-up in inflation. But as slack in the economy is taken up, we won't need as much monetary stimulus as we have now to keep the economy on a sustainable, low-inflation growth path. Put another way, it is only by maintaining Canada's low rate of inflation that monetary policy will help to consolidate a durable economic expansion. And this is the type of expansion that delivers improved economic conditions and benefits for Canadians. What is my message to you today? Canada has been through a difficult period of major economic changes, some of which are still unfolding. But we have also made remarkable progress in restoring the credibility of our economic policies and laying the foundation for a more efficient, prosperous economy in the future. We are now in better shape than we have been in years to face the economic challenges of the future.

r970916a_BOC

canada

The recent economic record in Canada and the challenges ahead for monetary policy

thiessen

It has been a little over two years since my last public speech to an audience in the United States. During this time, a lot has happened in terms of economic developments in our two countries. One thing that continues to impress me is the remarkable performance of the U.S. economy, which has achieved six years of steady economic expansion, with high rates of job creation and low inflation. As a neighbour and major trading partner, Canada has certainly benefited from the strong U.S. economy. But I think that what is happening in the United States is relevant to Canada in other ways. First, it offers a yardstick that we Canadians often use to judge the performance of our own economy. Second, as the unused capacity in the Canadian economy is gradually absorbed, monetary policy in Canada will be facing challenges similar to those that the Federal Reserve has had to confront in trying to steer the U.S. economy on a path of durable, non-inflationary expansion. The recent U.S. experience in this area is, therefore, particularly interesting for us. Today, I would like to discuss the recent economic record in Canada and the challenges ahead for monetary policy. In doing so, I will emphasize the Bank of Canada's continued commitment to explicit targets for keeping inflation low. Along with their other benefits, these targets help anchor market expectations about future movements in the exchange rate. The role of the exchange rate in the operation of Canadian monetary policy is another topic I will discuss today. Let us first take a quick look at how the Canadian economy has performed in the recent past, in comparative terms. In terms of economic growth and job creation, there is no doubt that Canada has not done as well as the United States in the 1990s. And even though, in my view, there are good explanations for this, the fact remains that Canada has some catching up to do in this regard. Why has the growth in output and employment been more modest in Canada than in the United States in recent years? I believe that the reasons lie in the major transformation that the Canadian economy has been going through since the beginning of this decade. This transformation has been in response both to the universal forces of globalization and technological change, and to the need to unwind the domestic excesses and imbalances that had built up in the 1970s and the 1980s. Let me remind you that, through that period, high actual and expected inflation had led to escalating production costs, speculative activity, and the accumulation of debt by households, by businesses, and by Canadian governments. Our foreign indebtedness was also rising rapidly, as were the risk premiums in our interest rates, leaving us in a very vulnerable position indeed. By the late 1980s, the situation had become untenable. Canada had to adjust. Of course, the United States also had to cope with many of these changes. Why has the restructuring been more intense and disruptive in Canada? In my view, the most important reasons are that the distortions arising from high inflation were more severe in Canada and that the adjustments to globalization and technological change were slow in coming. As a result, Canada had to do more and do it faster. The short-run disruptions associated with the economic restructuring have been significant. Plant closings, cutbacks in major government programs, and layoffs in both the private and public sectors caused a great deal of uncertainty among Canadian households. And it did not help that interest rates rose sharply in 1994 and early 1995 as investor nervousness about Canada's fiscal and political situation increased in the wake of turbulence in global financial markets. All of this left Canadians anxious about the future and cautious about spending, which acted as a drag on output and employment. But there have also been some particularly encouraging results from the restructuring. Canada has made rather dramatic economic adjustments in recent years, and as a result has emerged with a much sounder economic foundation. Inflation has averaged just under 2 per cent during the past five and a half years--well below that in the United States. With the benefit of low inflation and low interest rates, Canadian businesses have been investing in new technology and streamlining their operations to become more efficient, productive, and internationally competitive. Canadian governments have taken steps to reduce their deficits and to move towards less vulnerable debt positions. And, with our success in exporting and these improved fiscal positions, the persistent large shortfall in the current account of our international balance of payments has narrowed markedly. These improvements in Canada's economic fundamentals have not been lost on financial markets. They are the reason why risk premiums demanded by investors on Canadian dollar assets have declined sharply over the past two years. They are also the reason why the markets today see a potential for upward movement in the Canadian dollar over time, thus allowing interest rates on maturities up to 30 years to remain below comparable U.S. rates. This is a view of the Canadian dollar that we at the Bank of Canada share. These low Canadian interest rates represent a substantial stimulus to domestic spending. Because of the lags involved, it has taken households and businesses some time to respond. But now we have strong evidence, particularly from the interest-rate-sensitive sectors of the economy, that the consumer is back. And businesses continue to increase their capital spending. Moreover, the latest surveys of consumer and business confidence point to continued expansion in domestic spending in coming months. What is particularly heartening is that total employment growth has picked up recently, despite the cutbacks in the public sector, and that the number of full-time jobs has increased significantly. Altogether, it seems to me that the Canadian economy has the potential for a long period of sustained growth in output and employment, with rising productivity and improving living standards. What does monetary policy need to do to help realize this potential? With the economy gathering momentum, the challenge for monetary policy in the period ahead will be to encourage monetary conditions that preserve Canada's good inflation performance, because low inflation is a prerequisite for a durable economic expansion. Experience has taught us that monetary stimulus which pushes too hard on the economy's capacity limits for too long inevitably leads to rising inflation and painful boom and bust economic cycles of the kind we suffered in Canada from the 1970s to the early 1990s. Concern about inflation risks at this stage may seem misplaced. But monetary policy actions have their full effects on the economy with relatively long lags. So what we must be concerned with is not the current rate of inflation but rather what may happen in 1998 and beyond. To maintain a low and stable rate of inflation in the period ahead, we must conduct monetary policy in a forward-looking, pre-emptive manner. This means that we should be ready to take action early to ensure that, as slack is absorbed, the pace of economic activity converges smoothly with the path implied by potential output--that is, the economy's capacity to produce on a sustained basis. It is our view that the Canadian economy should indeed absorb the existing unused capacity over the course of the next couple of years. Thus, there will be a need to move to less-stimulative monetary conditions in the period ahead. Taking timely, measured steps in that direction is the recipe for avoiding the more substantial, and potentially more disruptive, tightening that would be required later if monetary policy actions were unduly delayed. As the Canadian economy approaches full capacity, we will have to contend with the considerable uncertainty that surrounds the estimation of potential output. The recent experience in the United States, where despite a high level of resource utilization there has been no sign yet of generalized inflationary pressures, raises the possibility that past relationships have been altered by structural changes at both the national and international levels. It is possible that technological innovations have increased the flexibility and efficiency of production processes. Heightened global competition and low inflation worldwide may have led to a reduction of inflation expectations and to a change in price- and wage-setting behaviour. Monetary policy must somehow find a way to take all of these factors into consideration in order to avoid systematic misjudgments on potential output and the risk of inflation. I believe that Canada's inflation-control target provides a useful framework within which to do that. Let me explain. Our target, set jointly with the Government of Canada, calls for inflation to be held within a range of 1 to 3 per cent. One attraction of an explicit inflation-control target is that it allows a ready assessment of macroeconomic performance by looking at the trend of the inflation rate relative to the target range. If it looks as though the trend of inflation will push through the top of the target range, this implies that demand in the economy has been unsustainably strong. Conversely, if it appears that the trend of inflation is about to fall through the bottom of the range, this suggests weak demand and a persistent margin of unused capacity. Moreover, if we somehow continually misjudge the economy's capacity to produce, we will in all likelihood witness an unexpected trend in the inflation rate. For example, if the rate is persistently lower than would have been expected in the past at the current levels of aggregate demand, and it is tending to press the bottom of the target range, chances are that the economy has more room to absorb higher levels of demand than previously thought. Thus, the targets provide a check on systematic errors in estimating potential output. However, if monetary policy is going to take account of such signals, the central bank had better make sure that its inflation-control strategy is a credible one. Why? Because only if it is widely accepted that the central bank will keep inflation under control, will businesses and individuals not respond immediately to signs of strong demand pressures by seeking to raise prices and wages. The recent U.S. experience attests to this. Indeed, strong credibility has been a key factor that has enabled the Fed to take account of the possible changes in economic structure that I mentioned earlier and to steer the U.S. economy successfully towards levels of aggregate demand and employment that in the past would have been thought incompatible with maintaining low inflation. It is by conducting monetary policy prudently during the economic upswing that we at the Bank of Canada will have the credibility needed when our economy begins to operate at levels that test its potential to produce. I would now like to take a moment to underscore the important role that the exchange rate plays in the conduct of Canadian monetary policy and to explain what I meant earlier when I used the term "monetary conditions". In a medium-sized, open economy, like Canada's, a good deal of the impact of monetary policy actions is channelled through the exchange rate. But because financial markets do not always respond to events in completely predictable ways, we do not know exactly how interest rates and the exchange rate will move and interact. That is why we at the Bank have found it useful to construct an index of monetary conditions to help us keep track of the combined effect of these two variables on aggregate demand in Canada. To understand how we use monetary conditions in practice, let us look at the recent situation where cyclical differences have meant that the Canadian economy has been weaker than the U.S. economy. In these circumstances, the need for accommodative monetary conditions in Canada required the Bank of Canada to take action to lower interest rates. But the magnitude and timing of those interest rate reductions depended, to an important degree, on the exchange rate response. With the Canadian dollar roughly stable between late 1995 and late 1996, the easing in monetary conditions could take place through measured declines in interest rates. The strengthening Canadian dollar through the latter part of 1996 accelerated the decline in interest rates, as the Bank of Canada sought to maintain the degree of monetary ease achieved in the autumn of 1996. With the economy gathering momentum since then, persistent weakness in the Canadian dollar through June 1997 prompted a small increase in interest rates in order to offset an undesired further easing in monetary conditions. I might add that, since cyclical differences have required interest rates in Canada to be below those in the United States, there has been--rightly--a strong market perception that the relative weakness of the Canadian dollar is temporary and that a future appreciation will compensate investors for the lower yields on Canadian dollar assets. But experience has taught us that this process of exchange rate/interest rate interaction works well only if there are no concerns in the markets about Canadian economic policies. As we found out in 1994-95, when there were concerns about fiscal policy, a decline in the value of the Canadian dollar can generate a loss of confidence and expectations of further depreciation of the currency, not of subsequent appreciation. The upshot of all this is that, with a floating currency, market participants need a consistent and credible policy framework to help anchor their expectations about future movements in the exchange rate. Such a framework rests, above all, on a firm undertaking by the authorities to preserve the domestic purchasing value of the currency. I believe that our inflation-control targets, by giving a clear, precise view of this commitment, provide a strong underpinning for the external value of the Canadian dollar. What is my main message to you today? Canada is in better shape now than it has been for many years to face the economic challenges of the future and to reap the benefits of changing technology and an increasingly integrated world economy. But, for this scenario to unfold, there will have to be continued commitment by the authorities to prudent, credible economic policies. As far as monetary policy goes, this means a pledge to maintain Canada's good inflation performance. That is a pledge I can give without reservation.

r971007a_BOC

canada

Challenges ahead for monetary policy

thiessen

Today, I would like to talk about some of the important issues and challenges facing monetary policy in the period ahead and how the Bank of Canada proposes to deal with them. This is not an unusual topic for me since the business of central banking is seldom without challenges. But what a difference the past two years have made to the challenges we face! Let me remind you that it was in late 1995, when investors' concerns about Canada's fiscal and political problems finally began to recede, that the Bank of Canada was able to take action to provide substantial monetary support to the economy. This action, which continued over the next year or so, was designed to offset both the direct impact on the economy of fiscal restraint and the effects on consumer confidence of the difficulties and uncertainties arising from the major restructurings that were necessary in both the private and public sectors. In response to the monetary stimulus, the economy has gathered momentum and finally seems to have pulled free from the difficulties associated with the restructuring. Indeed, economic activity has accelerated this year and has expanded by about 4 per cent over the course of the past 12 months. With the economic momentum expected to continue at a solid pace in the period ahead, monetary policy now faces new challenges. Over the next year or two, as the remaining slack is absorbed and we move towards full use of the economy's capacity to produce, the issue for monetary policy will be to try toensure that this process goes smoothly and that inflationary pressures do not re-emerge. Further down the road, we will also have to concern ourselves with the conduct of monetary policy as the economy operates under conditions of full capacity. With all the structural changes that have taken place in Canada and around the world in recent years, one important issue will be to gauge just how rapidly our economy can grow on a sustainable basis--that is, without generating inflation pressures--and what this implies for the employment picture in Canada. The challenge for monetary policy at that stage will be how best to deal with the uncertainty surrounding estimates of the economy's potential to produce. The conduct of monetary policy through the economic upswing and then under conditions of full capacity are the two topics I would like to discuss with you today. Let me start with the immediate challenge for monetary policy--to promote monetary conditions that will preserve Canada's good inflation performance through the current economic upswing, thereby helping to make this economic expansion a long- lasting one. As I mentioned, monetary conditions in Canada have been very stimulative for over a year. With growing evidence that economic activity was expanding smartly, the Bank of Canada began reminding Canadians that, as slack in the economy is taken up, there would be a need to move to less-stimulative monetary conditions. We took a step in that direction last week when we raised our Bank Rate by 1/4 of a percentage point to 3 3/4 per cent. This kind of action can set off alarm bells in the minds of some people. They may wonder why the Bank of Canada is"slamming on the brakes" when the economy has only just begun to pick up and the unemployment rate is still high. I would like to respond to any such concerns by explaining what Canadians can expect from their central bank in the period ahead and why. But before I do so, I would like to remind you that, when we at the Bank talk about how stimulative monetaryconditions have been, we are not just looking at short-term interest rates (which are still near their lowest levels in decades and well below comparable U.S. rates). Monetary conditions also take into account the effects on the economy of changes in the exchange rate for the Canadian dollar. For example, the relatively low value of our dollar has been a major source of stimulus for Canada's export sector. So a proper assessment of the degree of monetary ease in the economy has to consider both our low interest rates and the relatively low Canadian dollar. Now, what about the perception that any move by the Bank of Canada to less-stimulative monetary conditions means"slamming on the brakes" for our economy? Let me stay with the automobile analogy for a moment. To get the economy moving, the Bank has been pressing hard on the monetary accelerator. But once the economy picks up speed, just as with a car, you need to ease off gradually on the accelerator and steady your cruising speed at a safe level. If you press hard on the accelerator for too long, you will reach speeds that are unsafe. You risk losing control and getting into serious trouble. The same holds true for the economy. Too much monetary stimulus can lead to an exhilarating temporary burst of economic activity. But it will almost certainly also lead to inflation-related distortions that undermine both the expansion and the economy's efficiency over the longer term. The end result, as we know only too well from past experience, is high interest rates, punishing debt loads, recession, and higher unemployment. A further complication is that it takes between a year to a year and a half for the economy to fully respond to changes in the degree of monetary stimulus. In this sense, the economy is like a car that doesn't respond immediately when you ease off on the accelerator but only a mile or so further down the road. With such a car, you want to be able to look a long way ahead to see what is coming, and you want to take action early to ensure that your speed is appropriate. This is why monetary policy must focus on the future, rather than the present, and why the Bank must act in a forward-looking, pre-emptive manner. In other words, if we want our economy to reach full capacity relatively smoothly, without the risk of repeating the painful, inflation-related boom and bust cycles of the past, we must be ready to take timely action. If we wait to act until the economy is going flat out and pressing hard on the limits of its capacity to produce, we will have waited too long. Thus, some combination of a further rise in short-term interest rates and an increase in the value of the Canadian dollar will likely be necessary in coming months. I hasten to add that such a rise in short-term rates is the best way to preserve medium- and long-term rates at low levels. And it is these longer-term rates that are so important for the investments in new technology and other initiatives to increase productivity that Canadian businesses need to stay competitive. Let me reassure you that we are not talking about anything like the short-term interest rate increases that we saw in the 1970s and 1980s, or even in 1995. In an environment of low inflation and improved fiscal health, interest rates should not have to get that high again. You will not be surprised that I cannot give you in advance precise information about any further action the Bank may take to reduce the amount of monetary stimulus in the economy. What I can tell you is that it is the strength of the momentum of demand, and thus how quickly the economy approaches the limits of its capacity to meet that demand, that will determine the timing and extent of our response. Close monitoring of the strength of demand in the economy, and timely, measured steps in the right direction, will help us avoid the more substantial, and potentially more disruptive, tightening that would be required later on if monetary policy actions were unduly delayed. Moreover, the magnitude of the increase in short-term interest rates will be influenced by the extent of the exchange rate response. I hope this makes it clear that what the Bank of Canada has in mind, and is aiming for, is a "gradual easing off on the accelerator" in the months ahead, so that there will be no need to "slam on the brakes" later on. Next, let me say a few words about the challenges that await us further down the road. One of the more remarkable international economic developments of the past few years has been the performance of the U.S. economy. That economy has had six years of solid economic expansion, with high rates of job creation and low inflation. In the late 1980s, when the U.S. unemployment rate dipped below 6 per cent, there were strong inflationary pressures. Compare this with the present situation: the U.S. economy has been expanding at an average rate of about 3 1/2 per cent for 8 quarters, current levels of demand are above most estimates of its capacity to produce, and the unemployment rate has been at or below 5 per cent for several months. Yet inflation has remained well behaved. What is happening? Are we operating in a different environment? There are, of course, some temporary factors--such as the appreciation of the U.S. dollar, the decline in energy prices, and the slack in overseas economies--that are currently helping to suppress inflationary pressures in the United States. However, a number of observers are suggesting that other, more permanent factors may also be contributing. One possibility, which has been rather widely discussed recently, is that all the structural changes that have taken place in the United States have raised the production capacity of the economy and reduced the risk of inflation. I believe that another important factor in this success story has been the strong credibility of monetary policy in the United States. By persuading Americans that it is determined to maintain low inflation, the U.S. Federal Reserve has given itself room to test the potential of the economy without triggering the quick response in wages and prices from worried workers and businesses that we saw during the years of high inflation. How does this U.S. experience relate to Canada? Can we also look forward to an improvement in the longer-term performance of our economy? Unfortunately, it is not possible to make that judgment in advance, given the complexity of the factors affecting economic performance. How rapid growth can be and still be sustainable, and how low our unemployment rate will go, will ultimately depend on the flexibility, efficiency, and productivity of Canadian enterprises. I am referring here to the effective use of new technology; the skills, training, and adaptability of our labour force; our ability to control costs; and the initiative and ability of Canadian businesses to find and develop new and expanded foreign markets for their products. The contribution that monetary policy can make towards realizing this potential is to ensure that the pace of economic expansion remains sustainable. This essentially means encouraging monetary conditions that will allow the economy to test the limits of its capacity to expand, but without setting off inflation and the costly boom and bust cycles of the past two decades. As in the United States, the problem in Canada is that there is considerable uncertainty regarding the level of economic activity that can be accommodated by our capacity to produce and how rapidly this capacity will expand over time. This is where the Bank of Canada's inflation-control target should prove useful as we try to steer the economy along a sustainable growth path. That target is to hold inflation inside a range of 1 to 3 per cent. One of the advantages of such an explicit target is that it provides a ready measure of the state of the economy by comparing the actual trend of inflation against the target range. If the trend of inflation looks as though it will be pushing through the top of the target range, this implies that demand in the economy has been unsustainably strong, and monetary conditions must be tightened. But if inflation is persistently lower than past history and the existing levels of demand would suggest, and it is tending to press the bottom of the range, chances are that there is more room for the economy to expand than previously thought, and monetary conditions can be easier. However, if the Bank of Canada is going to respond to such signals, we must ensure that our inflation-control strategy is a credible one. It is by conducting monetary policy in a prudent manner during the economic upswing that the Bank can provide Canadians with assurance that inflation will remain under control when the economy begins to operate at levels that push against the limits of capacity. If businesses, individuals, and investors are persuaded that inflation will stay low, they will not respond immediately to signs of strong demand pressures by seeking to raise prices and wages and by pushing up interest rates. Such an environment provides the flexibility necessary for the economy to test the limits of growth and employment without immediately putting the economic expansion at risk. In conclusion, let me just say that the period ahead will be an exciting one. At no time since the 1960s have we had in place the conditions that would permit the Canadian economy to fully realize its potential. With inflation under control and increasingly favourable fiscal positions, we now have anopportunity to see what our economy is capable of delivering, in terms of sustained growth in output and employment and improving standards of living. The Bank of Canada's role is to make sure that monetary policy provides the right background--a stable, low-inflation environment.

r971201a_BOC

canada

What can monetary policy do to help the economy reach its full potential?

thiessen

Today, we meet against a backdrop of some uncertainty in the international economy. I would like to begin my remarks with an assessment of what the recent financial and economic events in Asia could mean for Canada. The nervousness and uncertainty that spread around the world in the wake of the problems in Southeast Asia highlight the growing interactions among national economies and financial markets. The events in Asia also underscore how crucial prudent macroeconomic policies and sound financial sector management are to good economic performance. The measures that have been taken, mainly through the International Monetary Fund, are important first steps for the affected Asian economies in dealing with their problems. I believe that these measures have helped to contain at least some of the potential spillover effects to other countries and, thus, they are helping to settle global financial markets. Canada's direct trade links with Southeast Asia are not large. However, those with Japan and Korea are more important to us, and there are also potential effects on our other trading partners that need to be taken into account. The problems in Asia and their possible implications for the world economy are probably the source of some of the recent softening in world commodity prices. Because of the importance of commodities to Canada, this softening has been a factor behind the recent weakness in our currency. Our judgment at this stage is that the overall impact of these recent developments on Canada does not look likely to be large. However, we are sensitive to the fact that some industries and regions will be affected more than others. I can assure you that we will continue to monitor the situation very closely, in view of the uncertainty that remains about the likely outcome of events in Asia. Even with this uncertainty, however, recent suggestions that there is a risk of worldwide deflation strike me as being very pessimistic. Developments in Asia will slow somewhat the pace of global economic expansion. But as long as the world's largest economy, the United States, is pressing against its capacity limits, with the possibility of upward pressure on its inflation rate, the risk of worldwide deflation looks rather remote. Certainly, from Canada's perspective, the U.S. economy is by far the most important influence. I would now like to turn from these recent events and talk about the Bank of Canada's longer-term strategy for monetary policy. In any discussion of strategy, the place to start is with the objective. In conducting monetary policy, the Bank of Canada's ultimate objective is to help the Canadian economy achieve its full potential. And that means more jobs and rising standards of living. I am sure that all Canadians would agree that this is an appropriate objective. The Bank pursues this objective through a policy aimed at keeping inflation low and stable. Today, I would like to explain why such a policy is the best way to achieve Canada's full economic potential and to extend the current expansion. In this connection, I will review the recent U.S. experience in this area--an experience that I find both relevant and instructive. The performance of the Canadian economy over the past 25 years has been rather disappointing. The economy has suffered from recurring bouts of boom and bust, and unemployment has been very high. The growth of productivity and, thus, the improvement in our standard of living have been very gradual. Canada is not unique in this respect. Most industrial countries have shared this experience to varying degrees. And that includes the United States. Since the early 1990s, however, the U.S. economy has performed remarkably well and substantially better than other industrial economies. That country has enjoyed a solid, six-and-a-half-year-long economic expansion. Over that period, employment growth has averaged 2 per cent per year. The unemployment rate has declined from a peak of 8 per cent to under 5 per cent. Household incomes have risen by 2 1/2 per cent a year (after correction for inflation). U.S. businesses have become highly competitive, even in areas where prospects did not look all that good at the end of the 1980s. What's more, inflation has been on a declining path, albeit with some help from temporary factors (such as an appreciating U.S. dollar, declines in energy prices, and the slack in overseas economies). Why has the U.S. economy done so well? Are there any lessons here for Canada? There are, undoubtedly, a number of factors behind this striking U.S. performance. But, to me, there are at least two that seem to have been particularly important: the early adjustment of that economy to changing technology and globalization; and the credible, low-inflation policy pursued by the U.S. central bank. The Americans started adjusting in earnest in the 1980s to the new realities of heightened global competition and rapidly changing technology. As a result, they are ahead of most other industrial countries on that score. And, with improving productivity and highly competitive enterprises in a wide range of sectors, the U.S. economy has been able to expand rapidly and to support rising employment on a sustained basis. But taking full advantage of that improved potential for economic growth has required a climate of confidence in monetary policy. Bringing inflation down in a credible manner has helped to create that climate. And because of this, the U.S. monetary authorities have been in a position to encourage the economy to test its full capacity to produce, to create jobs, and to support rising incomes. This would not have been possible in an environment of high inflation and high inflation expectations. In such an environment, businesses, workers, and investors respond swiftly to any signs of demand pressures by pushing up prices, wages, and interest rates. And this has the effect of undermining the sustainability of the economic expansion. What precisely did the U.S. Federal Reserve do? In the early 1990s, problems in the banking sector were restraining the economic recovery in that country by limiting access to financing and undermining confidence. To counter these "headwinds," as Alan Greenspan called them, the Fed responded by providing a high degree of monetary stimulus. Then, in early 1994, when it became evident that the economy had started to pick up steam and move ahead on its own, the Fed began withdrawing the excess monetary stimulus. This timely, pre-emptive action to moderate monetary stimulus accomplished two things. First, it sent a strong reassuring signal to investors, businesses, and consumers that the Fed would not let inflation break out as the economy surged ahead. Indeed, after short-term rates went up in 1994-95, long-term rates declined, as investors became more confident that the economic expansion would remain non-inflationary and, thus, sustainable. Second, the pre-emptive action helped avoid the need for stronger, more disruptive, tightening later on. The less-accommodative monetary conditions that have prevailed since then certainly have not stopped the U.S. economic expansion dead in its tracks, as some had feared at the time. On the contrary, the expansion has continued at a healthy pace. And with widespread belief in the Fed's commitment to low inflation, there has been some room to explore the possibility that capacity has improved. As a result, the Fed has been able to set monetary conditions that have encouraged output and employment to expand at rates that in the past could not have been sustained. And both unemployment and inflation have come down at the same time. To be sure, with tightening labour markets, there is some risk of an increase in inflation pressures in the United States. Thus, one cannot rule out the possibility that the Fed may have to raise interest rates somewhat further at some point. But any future increases in interest rates should not have to be large and may be conditioned by the implications of the recent international developments I mentioned earlier. What parallels can we find in all this for Canada? The adjustment in Canada to the forces of technological change and globalization has run behind that in the United States. Because the restructuring was delayed, Canada had to respond in a more dramatic fashion. We had to do more and do it faster. More importantly, our fiscal situation was more precarious and required stronger medicine. As a result, we ended up with more pronounced short-run disruptions and more catching up to do in terms of output and employment. These difficult but necessary adjustments in the private and public sectors of our economy were Canada's parallel to the U.S. headwinds. To compensate for the direct impact of these adjustments, as well as for their indirect effects on consumer confidence, the economy needed a substantial amount of monetary support. The Bank of Canada was able to provide such support once investor concerns about Canada's fiscal and political problems began to subside in late 1995. We did that by systematically reducing interest rates over the next year or so. As in the United States in 1991-92, short-term rates in Canada were brought down during 1995-96 from over 6 per cent to about 3 per cent--their lowest level in over 30 years. At the same time, the Canadian dollar has been relatively low, providing support to the export sector. When we put interest rates and the exchange rate together--as we must in order to correctly gauge the amount of monetary stimulus--it is clear that monetary conditions in Canada have been exceptionally stimulative for well over a year. This was entirely appropriate while our economy was still struggling against the headwinds of private and public sector restructuring. To return to my automobile analogy of recent speeches, we needed to put the "pedal to the metal" to buck those headwinds and get the economy going. The monetary stimulus has done its job. The economy has been gathering speed and absorbing unused capacity. We now expect it to have expanded by about 4 per cent from the end of 1996 to the end of 1997. The diminishing effects of fiscal restraint, along with evidence of continued strong demand, output, and money growth, suggest another year of healthy expansion in 1998. Thus, in terms of the economic cycle, we are about where the Americans were in 1994. As we move towards full capacity over the next year or so, the task for monetary policy will be to try to ensure that this process goes smoothly and that inflationary pressures do not re-emerge. I want to make it clear that the Bank does not see an overheated economy at this point, nor a threat of inflation lurking around the corner. There is still unused capacity and, thus, room for strong expansion for some time yet. But, with monetary policy actions taking between one to two years to have their full effects on the economy, we always have to look ahead. And we have to ask, What sort of monetary support will the economy need at that point? The measures--especially the fiscal measures--needed to restructure our economy will be largely in place by then. Thus, monetary policy will no longer need to compensate for these sources of restraint on demand. By gradually easing off on the monetary gas pedal, we can steady our economy at a safe cruising speed down the road. As we look still further down the road, we will face other important issues. How well will our economy perform once it reaches full capacity? How rapid can growth be and still be sustainable? And how far can we reduce our unemployment rate? Given the complexity of the factors affecting economic performance, it is not possible to make precise predictions on these matters. Much will depend on the flexibility, efficiency, and productivity of Canadian enterprises; on how effectively new technology is used; on the skills, training, and adaptability of our labour force; on our ability to control costs; and on the initiative and ability of Canadian businesses to develop new products and new and expanded foreign markets for those products. Still, I believe that the restructuring that has taken place in the Canadian economy provides good reason to think that our potential to grow and create jobs is the best we have had in years. I also believe that continued credible fiscal and monetary policies have an important role to play. The best contribution monetary policy can make towards achieving that potential is to ensure that the economic expansion remains sustainable over the medium term. As we have learned over the past 25 years, a sustained expansion is not possible unless we can avoid a resurgence of inflation and the painful cycles of boom and bust that go with it. Thus, the challenge for monetary policy will be to set monetary conditions at levels that allow the economy to expand at a pace that makes full use of its production capacity and at the same time preserves low inflation. It is by conducting monetary policy prudently during the upswing that the Bank can assure Canadians that inflation will not break out when the economy begins to operate at levels that push against capacity limits. If we succeed in providing that confidence, we will then have the flexibility that will allow us to carefully explore the limits of growth and employment without immediately putting the economic expansion at risk. Let me summarize my main messages to you today. The extraordinary monetary stimulus of the recent past has accomplished its task. It has supported the economy through a period of difficult but necessary restructuring. As the impact of this restructuring subsides and our economy enters a phase of self-sustaining expansion, we will no longer need the same amount of monetary stimulus. Because the economy takes time to respond to monetary policy actions, the Bank has to focus on the future. This means taking steps early to ensure that we will reach full capacity at a sustainable cruising speed. Of course, projections of future economic trends need constant reassessment. And that is particularly true at a time of nervous financial markets and uncertainty about the implications that events in Asia may have for the world economy. As I said earlier, the Bank continues to monitor the current global situation carefully. Aside from any complications that could arise from a prolonged period of international instability, the Canadian economy in the next year or so should absorb the unused capacity that we now see. At that point, we will begin to see concrete evidence of the kind of payoffs we are going to get from the economic restructuring process we have been through. With low inflation and a sound fiscal position, the Canadian economy is now in a better position than it has been for years to weather the impact of unexpected international developments and to make progress in generating higher incomes and employment.

r980205a_BOC

canada

International developments and the prospects for the Canadian economy

thiessen

World economic activity had strengthened and was expected to accelerate further, with the benefit of low inflation, reduced fiscal imbalances, and stable or declining interest rates. In Canada too, output and employment growth had picked up. And the economy was expected to gain momentum in 1997, supported by strong U.S. demand and the lowest domestic interest rates in many years. Low inflation and a dramatic improvement in our fiscal situation had made those low interest rates possible. Today, the views about the global economy are more mixed. The buildup of events in Asia since last summer has cast a cloud over the economic picture. The International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD) have scaled back their projections for world economic growth this year. In early December, they suggested that global output growth could be 3/4 to 1 percentage point slower in 1998 than previously expected. But the news on the external side is certainly not all negative. There have also been some positive surprises recently. For example, the underlying economic momentum in our major trading partners, other than Japan, looks to be stronger than expected a few months ago. And longer-term interest rates have been declining in most industrial countries, which should help underpin global economic expansion. Today, I would like to give you an update on the Canadian economy and discuss the prospects for the period ahead in light of the latest international developments. My conclusion and main message is that, even with the current uncertainties on the external horizon, Canada's economic outlook remains positive. An important basis for this conclusion is that the underlying foundations of the Canadian economy are sounder than they have been for many years. Thus, we are in a better position to weather the impact of unexpected international developments and to make progress in generating higher incomes and employment. Let us start with a quick look at our economic performance in 1997. Based on the most recent information available, the Bank of Canada estimates that the Canadian economy expanded at a rate of about 4 per cent from the fourth quarter of 1996 to the fourth quarter of 1997. Exports were the mainstay of the economic recovery until mid-1996; but since then the expansion has become more broadly based. Over the past year and a half, spending by Canadian households on consumer goods and by businesses on investments in technology and new equipment has been the driving force in the economy. The strong pickup in economic activity has also contributed to a substantial increase in employment. Over 380,000 new jobs were created in the private sector last year, offsetting many times over the 13,000 jobs lost in the public sector because of restructuring. Even more encouraging is the fact that a good part of this increase in employment represented full-time jobs. Moreover, the unemployment rate fell to 8.6 per cent by year-end from 9.8 per cent at the end of 1996. Inflation has remained low, and within our target range of 1 to 3 per cent for most of 1997, although it did end the year somewhat below target. Some of the factors that contributed to this recent greater-than-expected slowing in the trend of inflation are of a temporary nature and are expected to unwind in coming months. But some of the other dampening influences at work may be more persistent than seemed likely earlier. So, although we see the trend of inflation moving back inside the target range in the near future, on balance it will probably be somewhat lower in 1998 than previously expected. I would also like to underline the additional progress made during the year in the area of public finances, where government deficits have been further reduced. More importantly, the ratio of public debt relative to the size of our economy is finally falling. This is a major contribution towards the sounder economic foundations that I mentioned earlier. Altogether then, 1997 turned out to be a good year for the Canadian economy. But what about prospects for the current year? How important are the latest international events when viewed from a Canadian perspective? And what is their likely impact on our economy? There is no doubt that what started as financial turbulence related to difficulties in Thailand has become a more widespread problem than anyone would have thought likely some months back. An erosion of market confidence led to strong downward pressure on exchange rates and to sharply higher interest rates in the affected Southeast Asian countries and, subsequently, in South Korea. These market difficulties in turn uncovered and exacerbated financial and economic weaknesses that had been plaguing these countries for some time. The international community, including Canada, has taken steps, primarily through the IMF, to help these countries deal with their problems. Some of the initial uncertainties involved in setting up and getting these IMF adjustment programs going have been resolved. And there are now some encouraging signs of improved confidence and financial stability in the region. Among the industrial countries, Japan is the one most affected by the spillover effects from its Asian trading partners. Not only are its trade links with them important, but this external shock comes at a time when the Japanese domestic economy is much less buoyant than was anticipated earlier. Substantial loan exposure by Japanese banks to the Asian region has also weakened an already ailing financial sector in that country. But it is important to note that Japan has the financial wherewithal to deal with its banking difficulties and that a series of measures to combat these problems and to strengthen the economic recovery have already been taken. Additional financial sector and fiscal measures were announced recently. At this stage, the situation in Asia is still evolving, and, while prospects have improved, we cannot be sure just how quickly and effectively the Southeast Asian, Korean, and Japanese economies will respond to the adjustment measures that have been taken. What about the potential effects of all this on Canada? Since our trade with Asia, including Japan, makes up less than 10 per cent of our total exports, the direct effects will be relatively modest. But we must also take into account the indirect effects that work through our other major trading partners and through the prices of some of the products we sell abroad. Indeed, the implications of the Asian crisis for global economic growth and for primary commodity prices on world markets will probably have a more important impact on Canada than the reduction of our exports to Asia. The fallout from Asia will no doubt have a dampening effect on Canadian output growth for the current year. But there are also other, more positive, developments that could well work to mitigate this effect. As I said before, economic performance in our major trading partners in the West, particularly the United States, has been somewhat stronger than anticipated. And even though our short-term interest rates have risen, Canadian longer-term rates have been falling, along with their counterparts in the United States and Europe, reflecting declining inflation and lower inflation-risk premiums. These longer-term rates are an important element in both business investment decisions and household spending on consumer durables and housing. The Bank continues to monitor the situation carefully and to appraise the overall effect of these positive and negative influences on our economy. It is clear, however, that economic growth in 1998 will not be as robust as appeared likely last fall. And some Canadian regions and industries, particularly those with heavier reliance on primary commodities and exports to Asia, will no doubt feel the impact more than others. As well, there are the economic effects of the recent ice storm in Eastern Ontario, Quebec, and the Maritimes to consider. But I want to stress that, for the economy as a whole, the outlook is still favourable for continued expansion in output and employment, and for a further gradual reduction in the margin of unused capacity. Next, I would like to say a few words about recent developments in world financial markets. The key feature of these developments has been the sharp appreciation of the U.S. dollar. Measured against all major currencies, the value of the U.S. dollar has risen by about 4 per cent since late September. Two main factors have combined to push the U.S. dollar up. The first is the remarkable strength of the U.S. economy relative to the economies of its major trading partners. Indeed, the U.S. economy has been expanding more rapidly and operating at higher levels of capacity than were thought to be sustainable in the past. The second factor is the attraction that the large, efficient, and liquid U.S. financial markets hold for nervous investors in search of a safe haven because of the events in Asia. The dampening effect of the Asian problems on expectations for primary commodity prices has also been a factor behind movements in the currencies of countries, like Canada, that are important producers and exporters of such products. With all this going on, the Canadian dollar has declined by just under 5 per cent against the U.S. dollar since late September. Because other major currencies have also fallen against the U.S. dollar during this period, the Canadian dollar has declined much less against these currencies. Nonetheless, given the importance of our trade with the United States, the effective value of the Canadian dollar, measured on a trade-weighted basis against all the major G-10 currencies, has declined significantly in recent months. This decline in the value of our currency led to a further substantial easing of monetary conditions. But, as I said before, even with the effects of the Asian crisis, the Canadian economy is on track to continue expanding and moving towards full use of its potential. In these circumstances, the extent of the recent further monetary easing was not appropriate. That is why we moved last week to rebalance monetary conditions, and to provide support for the Canadian dollar, by raising the Bank Rate by 1/2 of a percentage point to 5 per cent. It is probably too early to be drawing conclusions and lessons from this latest episode of world financial turbulence. Still, when it comes to Canada, it is worth noting the different reaction in domestic financial markets this time compared with our experience during the Mexican currency crisis of early 1995. Back then, the international financial turmoil had the effect of focussing market attention on Canada's fiscal problems, causing investors to demand higher risk premiums. And this led to sharply higher longer-term rates in Canada. This time, as I mentioned, domestic longer-term rates have been falling, along with comparable rates in the United States and Europe, to their lowest levels in 30 years. What this tells me is that it pays to have one's house in order. Now we can see more clearly the importance of the remarkable progress that has been made since 1995 in fiscal deficit reduction. A declining ratio of public debt relative to the size of our economy will help to further reduce our vulnerability to international shocks. From a monetary policy perspective, the best contribution your central bank can make to helping the economy cope with external shocks is to ensure that inflation remains under control. Nothing is as important to investors, especially during turbulent times, as the assurance that comes from the protection that low and stable inflation provides for the value of money. In closing, let me reiterate that, in view of the uncertainties involved, it is difficult at this time to make precise assessments of the likely effects of the Asian crisis on the Canadian economy. But in making judgments about our economy, we must also consider the positive influences of the economic momentum in many of our major trading partners, as well as the prospects for domestic demand in Canada. The main factors at play in the outlook for domestic demand suggest that business and household spending should continue to grow. In particular, monetary conditions are very stimulative, providing considerable encouragement for expansion. All in all, the economic outlook remains positive. And with our low inflation rate and greatly improved fiscal position, the Canadian economy is now in better shape to withstand the impact of the Asian crisis and to continue to make headway in improving the well-being of Canadians.

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canada

The Future Performance of the Canadian Economy

thiessen

Governor of the Bank of Canada to the Canadian Club of Winnipeg It can take anywhere from one to two years for monetary actions to have their full effect on the economy. Because of this, the conduct of monetary policy must be based on a view of what the economy will be like -- not tomorrow, not in a month -but rather in one to two years' time. That is why in speeches in Vancouver and Toronto last year I spoke about where the Canadian economy might be heading in the future; what this might imply for our economic performance over the medium term; and what should the contribution of monetary policy be. Understandably, these important issues can get pushed aside because of the public focus on the current economic situation and on recent movements in short-term interest rates and in the external value of the Canadian dollar. Today, I would like to use this opportunity to revisit these medium-term issues. In doing so, I will be underlining the crucial role played by productivity improvements in our economic performance. The best place to start is with a brief review of the recent record. Recent economic performance As we approach the end of the decade, we can take satisfaction in the good economic performance of the past two years and in the notable improvements in our economic fundamentals. The Canadian economy has expanded at an average annual rate of 4 per cent since mid-1996 and, even with the dampening effects of the Asian crisis, it is expected to continue to grow at a healthy pace this year. This should contribute to further gains in employment and reduce the amount of unused capacity. Inflation is low, and we are committed to keeping it low. Last month, together with the federal government, we announced that we would extend our target of holding inflation inside a range of 1 to 3 per cent to the end of 2001. Moreover, government deficits have virtually disappeared, and the ratio of public debt relative to the size of our economy is finally on a downward path -- for the first time in about 25 years. Low inflation and improved fiscal health represent major contributions towards the sounder economic fundamentals I mentioned a moment ago. They are no doubt the main reason why our interest rates have been below U.S. rates. The other key area where there have been important improvements in recent years is in the private business sector. Since the early 1990s, Canadian businesses have taken up the challenge of structural adjustment, which their U.S. counterparts had started several years earlier, in response to the gathering momentum of technological change, globalization, and heightened competition. With the benefit of low inflation and low interest rates, Canadian businesses have been investing in new technology and streamlining their operations to enhance productivity. Their success in doing so will be crucial to our future economic performance. The importance of productivity growth Why this emphasis on improving productivity? Whether viewed from the perspective of an individual firm or of the economy as a whole, it is almost impossible to overemphasize the importance of rising productivity for overall performance and prosperity. Productivity growth is what allows firms to hand out real wage increases, while holding their production costs down and remaining profitable. From a broader perspective, productivity growth is a key element that determines economic welfare and the general well-being of a society. At any point in time, our perception of how well we are doing economically is probably influenced by where we happen to be in the cyclical fluctuations that affect any economy. But over the longer term, the trend in productivity growth for the economy as a whole is the basis for growing incomes and rising standards of living. Now, I know that for some people any discussion of the need to increase productivity can be rather unsettling. They tend to associate improvements in productivity in an individual company with downsizing and layoffs. And from there it is only a short step to the belief that strong economy-wide productivity gains can only mean a more difficult job market and higher unemployment. But the history of industrial economies shows that growth in productivity has actually gone hand in hand with improved overall employment conditions. This is borne out by the experience of countries like Japan in the 1980s and, more recently, the United States and the United Kingdom. That was also our experience in Canada during the 1950s and 1960s. Canada's productivity record So how has Canada fared in the productivity department since the 1950s and 1960s? Not all that well, I'm afraid. After a relatively strong showing from the end of the Second World War to the early 1970s, our productivity performance became rather lacklustre. Productivity growth is estimated to have slowed from an average rate of about 2 per cent in the 1950s and 1960s to less than 1 per cent in the 1980s and 1990s, although it has picked up recently with the recovery in economic activity. I should note that economists do not fully understand why productivity growth in Canada (and, indeed, in other industrial countries) has slowed so sharply since the mid-1970s. I do not propose to try to untangle this puzzle today. Nonetheless, there are a few points I would like to make with respect to the Canadian situation. The sharp rise in the world price of oil in the 1970s no doubt dealt a major shock to Canadian industry. Because of our climate and because of the importance of primary commodity production in our economy, we are major users of energy. Adapting to higher energy costs certainly took considerable time. In my view, two other important factors inhibited productivity improvements through much of the 1970s, 1980s, and early 1990s: large fiscal deficits and high inflation. Government deficits through the 1980s and early 1990s tended to crowd out private sector investment by appropriating an ever-increasing share of Canadian savings. It was, of course, possible for businesses and governments to get foreign financing. But the accumulation of a large public sector debt and the rapid buildup of foreign indebtedness eventually resulted in appreciable premiums being built into our interest rates. High inflation through the 1970s and 1980s had a similar effect on interest rates. For these reasons, interest rates were high, even after adjusting for inflation. This discouraged some of the investment that would have contributed to gains in productivity. Moreover, because high inflation increases uncertainty about the future, businesses and individuals seek protection from its ravages or try to profit from it. Either way, scarce economic resources were diverted from productive investments towards hedging and speculative investments. I do not mean to suggest that the factors I have mentioned here explain all of our productivity problems. But they no doubt worked against the investment that was needed to help us adjust to both the oil price shocks of the 1970s and the global forces of the past two decades, and to make headway in terms of productivity growth. Let me now turn to the question of what we can expect in terms of productivity in the future. Future productivity trends and Canada's economic potential Increases in productivity do not just happen. We need to work hard to achieve them. In a world of rapid technological change and intense international competition, there are opportunities and incentives for productivity gains -- provided we do what is necessary to take advantage of the possibilities. Productivity comes from the interaction of business investment in new capital equipment, a skilled labour force, and the adoption of new technology. It takes entrepreneurship and innovation to pull it all together. Typically, this interaction works best when businesses operate in a stable, low-inflation economic environment and when markets are competitive. Producers are then under pressure to perform in terms of price, quality, and service. With low inflation, a balanced fiscal position, and low interest rates, the economic policy environment is better now than it has been for over 25 years. This should provide the underpinnings for solid economic growth and increased savings and investment in the future. With this support from improving economic policy conditions, business investment has indeed been buoyant, particularly since mid-1996, and notably in high-technology equipment such as computers. As well, more and more businesses, led by high-tech enterprises, are reported to have introduced new production technologies. Progress has also been made in learning new skills, removing labour market rigidities, and improving the adaptability, flexibility, and efficiency of our labour force. But more undoubtedly needs to be done in this area. It is likely that these trends will continue in the future, and will spread to sectors that have been lagging behind. With ongoing technological change, deregulation, trade liberalization, and intensified global competition, the pressures and incentives are certainly there for further productivity gains. Thus, the trends are positive, and the direction of our economy is clear. What is not clear is just how much our economic performance will improve. We cannot attach precise estimates to future growth in productivity. Neither can we judge the end results of the major structural changes that have taken place in the private sector of the Canadian economy. Because of this, we need to take a somewhat agnostic view about the production potential of the Canadian economy and about the lowest unemployment rate that can be sustained over time. Monetary policy response -- making the most of the economy's production potential What are the implications of all this for the conduct of monetary policy? When we at the Bank look one to two years into the future to set a course for monetary policy, we must take into account changes in the trends that affect the potential of the economy to produce over time. At the same time, we must recognize that our ability to predict that potential is restricted by the many uncertainties involved. In these circumstances, the best way for monetary policy to help the economy realize its potential is to focus on encouraging a sustained economic expansion over time. How do we do this? By keeping inflation low. As we move towards full capacity over the next year or so, it will be important to set monetary conditions at levels that forestall a resurgence of inflation and the painful boom and bust cycles that go with it. A responsible, credible monetary policy will allow us to explore the limits of the economy's capacity to produce, to create jobs, and to support rising standards of living. The recent U.S. experience amply demonstrates the advantages and benefits of such a policy. I believe that the recent extension of the inflationcontrol targets and the increasing credibility of those targets give monetary policy more scope to test the limits of our economic potential than at any time since the 1960s. Now that I have discussed the rationale behind the Bank of Canada's medium-term strategy, let me explain our recent actions to raise the Bank Rate. As I said earlier, the underlying momentum of the Canadian economy remains positive. Despite the problems in Asia, Canada's external environment is still favourable, given the strength in our major non-Asian trading partners, particularly the United States. In addition, the dampening effects on domestic demand from the fiscal consolidation efforts of the past four years are diminishing. And monetary conditions continue to support the economic expansion. Given these circumstances, the persistent decline in the external value of the Canadian dollar through December and January implied a further easing in monetary conditions that looked to us to be excessive. Moreover, the speed of the decline in the currency risked undermining investor confidence in Canadian dollar assets. That is why we took action. Concluding thoughts Let me conclude by summarizing my main points today. For much of the period since the 1960s, we have not had conditions in place that would allow the Canadian economy to fully realize its potential. With low inflation and a sound fiscal position, we now have the foundation that should permit us to move towards full capacity and to explore what our economy can deliver in terms of sustained growth in output and employment and better standards of living. Canada's private sector has been responding to the universal challenges of rapid technological change, globalization, and heightened competition by undertaking major restructuring initiatives to become more efficient, productive, and competitive. Although we do not know for sure just how much more productive we are going to be as a result of these initiatives, there is good reason for optimism. The best contribution the Bank of Canada can make to this process is by continuing to provide a stable, low-inflation environment. With an eye to the medium term, this will require setting a course for monetary policy that will ensure that the Canadian economy reaches full capacity smoothly and then continues to grow over time at a non-inflationary and therefore sustainable pace. The longer economic growth is sustained, the more benefits we will see in terms of improved incomes and employment.

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canada

Opening Statement before the Standing Senate Committee on Banking, Trade and Commerce

thiessen

Governor of the Bank of Canada before the Standing Senate Committee on My colleagues and I look forward to our yearly appearance before your committee because it gives us an opportunity to present an account of how the Bank has worked to fulfil its objectives over the past year. It is also an opportunity for a discussion with you on a range of economic and monetary issues. I can report that the Bank has taken further steps to improve its communication with Canadians and to be accountable for its actions. We have increased our contacts with individuals, a range of business and other groups and provincial governments. The most important initiative we have taken is to establish new regional offices in Calgary and Halifax and to expand our operations in Montreal, Toronto and Vancouver. These regional offices will multiply our contacts with Canadians across the country and help us gather information from a wide range of sources. Recently, we have taken another step to ensure that we benefit from expertise outside the Bank on monetary policy. We have created the position of Special Adviser to bring outside experts into the Bank for one-year terms. Over time, this will also provide a number of university and private sector economists with first-hand knowledge of the Bank and its role. Professor David Laidler of the University of Western Ontario has been chosen to fill the visiting economist's position for a one-year term starting in August. When I spoke to you a year ago, prospects for global economic growth were very promising. World economic activity was strong, with low inflation and stable or declining interest rates. In Canada too, output and employment growth had picked up, helped by our low interest rates and dramatically improved fiscal situation. As it turned out, the Canadian economy performed very well in 1997, with growth of over four per cent through the year and a strong increase in employment. Today, the outlook for both the world and the Canadian economy is still positive, though the problems in Asia have led to a scaling back of earlier projections for world economic growth. The effects on the Canadian economy of the problems in Asia are likely to come mainly via our other major trading partners and through the prices of some of our exports, especially primary commodities. These effects will no doubt have a dampening influence on economic activity in Canada this year. That is particularly true of British Columbia, which has a heavy reliance on the primary commodity sector and on exports to Asia. But there are other factors working in the opposite direction. With the exception of Japan, the economic performance of our major trading partners, particularly the United States, has been somewhat stronger than anticipated. And here in Canada, we have a much sounder economic foundation than in the past, thanks to our low inflation, improved fiscal health, and the progress that has been made in private sector restructuring. This puts us in a better position to withstand shocks such as those emanating from Asia. Except for some temporary influences, inflation has remained within our target range of 1 to 3 per cent over the past year. By pursuing a monetary policy designed to keep inflation low, the Bank of Canada is contributing to making the economic expansion in Canada as long-lasting as possible, while also providing a buffer against outside shocks. The longer economic growth is sustained, the more benefits we will see in terms of improved incomes and employment. In line with our commitment to keep inflation low, together with the federal government, we announced in February that we would extend our current target range to the end of 2001. This extension will allow our economy more time to demonstrate its ability to perform well under conditions of low inflation before we define longer-term targets for price stability. On balance, the Canadian economic outlook remains positive. The IMF recently projected economic growth of 3.2 per cent in Canada this year, which will put us at the top of the list of G-7 industrialized nations in this respect. This is generally in line with our own projections. We expect continued gains in incomes and employment through this year and next. Just how large those gains will be on an ongoing basis over the medium-term will depend on how successful the private sector restructuring I mentioned earlier will be in putting the Canadian economy on a track of rising productivity.

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Release of the Monetary Policy Report

thiessen

This morning we released our seventh Monetary Policy Report. Since the release of our last Report in November, there have been an unusual number of international and domestic developments which have had important economic and financial consequences. Among the most important events have been the crisis in Asia, declines in commodities prices, and the persistent weakness of the Japanese economy. At the same time, the U.S. economy has been considerably stronger than expected. At home, there were strikes by Ontario's teachers and by Canada's postal workers in the fourth quarter of 1997, as well as the January ice storm in eastern Canada. These developments have resulted in a higher-thanusual degree of uncertainty. Adding up the effects of recent events, we see the economy continuing on a solid growth path, but not at the same rapid pace as in 1997. Despite the effects of developments in Asia, the economy is being supported by a vigorous U.S. economy and accommodative monetary conditions. Inflation is expected to remain inside our target range. While the uncertainty surrounding the outlook is greater than normal, the risks appear balanced. This outlook implies that the economy would reach a level close to full capacity during the course of 1999. It is the Bank's judgment that over the next six months, the recent range of monetary conditions would be broadly appropriate in the absence of further shocks. However, given the degree of uncertainty that is likely to persist, monetary conditions may continue to fluctuate over a relatively wide range. Beyond the next six months, if the underlying momentum of activity remains as strong as is currently expected, less-stimulative monetary conditions would appear to be called for as the economy approaches and achieves full capacity. This would ensure that inflation remains low, and that continued gains in output and employment can be sustained. Thank-you.

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Globalized Financial Markets and Monetary Policy

thiessen

Governor of the Bank of Canada to Globalization -- that is, the growing integration and interdependence of national economies -- is changing dramatically the economic landscape. Countries are trading more goods and services, an increasing number of firms now operate across national borders, and savers and borrowers have greater access than ever before to global financial markets. Over the past decade, world trade has grown twice as fast as world output, foreign direct investment three times as fast, and both currency trading and share trading about ten times as fast. Not everyone agrees that all this is good for individual national economies or for the world community at large. Among those who take a dimmer view of globalization one concern is that the increased influence of international financial markets is eroding the ability of national governments to set their own macroeconomic policies. They also worry that powerful financial markets may be the main cause of crises such as those in Mexico in 1994-95 and in Southeast Asia in 1997. You will probably not be surprised to hear that I do not share these negative views. And today, I would like to discuss one particular aspect of globalization -- how national monetary policies work in an environment of globalized financial markets. I will draw heavily on Canada's own experience to support the view that monetary policy can continue to function effectively in this increasingly integrated world. Canada has a long history of being open to global markets for goods, services and capital. This interaction with the rest of the world has proven very successful, in my view, and has benefited Canadians and our foreign partners enormously through the years. With open international markets, Canadians have been able to sell their products and services abroad and to enjoy a wide variety of imported goods, some of which could not readily be produced at home. And we have been able to set up businesses and pursue investment opportunities abroad. Even more importantly, we have been able to use foreign savings to finance the large investment projects that were necessary to develop our industrial infrastructure and to increase our production potential, especially in the resource and manufacturing sectors. We have also had access to technological innovations and processes developed elsewhere. This has allowed us to combine new capital equipment and a skilled labour force more efficiently, thereby improving productivity and, thus, our incomes and standards of living. Nonetheless, there are concerns in Canada, as well as elsewhere, about the rapid increase in international financial flows and the implications thereof. How does the free movement of capital affect the conduct of national monetary policies? Capital mobility and the implications for monetary policy The growing integration of national financial markets, as evidenced by the dramatic growth in the volume of cross-border capital flows since the early 1970s, has no doubt changed the environment in which national economic policies are conducted. Globalization tends to bring such policies under closer market scrutiny and to uncover and draw attention to any deep-seated economic problems that may exist. But I would not conclude from this that we have become captives of the markets and that we have lost control of our national monetary policies, as some argue. First, let us be clear as to what "having control" over one's own monetary policy actually means. When people talk about an independent or autonomous monetary policy, they often take it to mean the ability of a central bank to set domestic interest rates without being influenced by developments outside national borders. This is not realistic -- unless of course a country is completely cut off from the rest of the world! The moment a country wants to make use of foreign savings, or invest a portion of its domestic savings abroad, a link between domestic and foreign interest rates is inevitable. As a major user of foreign capital, Canada has long lived with interest rates that are closely related to those in the United States and other foreign financial markets. But even with integrated financial markets, there is still room for monetary policy independence via exchange rate movements. Thus, monetary policy autonomy requires a flexible exchange rate regime. With a fixed exchange rate, the national authorities essentially adopt the monetary policy of another country -- the country whose currency serves as the anchor. If interest rates go up in the anchor-currency country, interest rates will also have to rise sufficiently in the country with fixed exchange rates to ensure that the peg is maintained. Thus, if monetary policy is focused on a fixed exchange rate, the central bank cannot at the same time pursue a domestic objective. In the case of the European Union, where member countries have decided to adopt a single currency -- the euro -- they have essentially opted to give up the potential for an independent national monetary policy and to transfer the policymaking power to a supranational agency -- the European an independent European monetary policy will require that the euro float against other major outside currencies, such as the U.S. dollar and the Japanese yen. Thus, in a world of open and integrated financial markets, the exchange rate is a major channel through which monetary policy actions are transmitted to the economy. Moreover, it is movements in the exchange rate that permit domestic interest rates to diverge from their foreign counterparts for a period of time. For example, an increase in official interest rates by the central bank, in response to demand and inflation pressures in the economy, leads to a stronger currency, which also works to restrain those pressures. At the same time, the appreciation of the currency creates the conditions for other domestic rates to follow the rise in official rates, to levels that may now be above those prevailing abroad. This is because the exchange rate is now seen to be above its expected value and is thus likely to decline in the future. Under these circumstances, financial markets will bid up domestic interest rates to compensate for the anticipated decline in the external value of the currency. Having clarified the issue of monetary policy independence, I would now like to discuss the effects of increased capital mobility on the conduct of monetary policy. A higher degree of capital mobility enhances still further the role of the exchange rate in the monetary transmission process. This is not a bad thing. It just means we have to ensure that we always take the exchange rate into account when considering the monetary policy stance that is appropriate for our domestic economic circumstances. That is why in Canada we have developed the concept of "monetary conditions" to keep track of the combined effect on the economy of movements in both interest rates and the exchange rate. With a flexible exchange rate system, the increased role of the exchange rate in the monetary transmission mechanism also means that it is crucial that investors' expectations of future currency movements are firmly anchored by clear and credible domestic macroeconomic policies. Thus, the central bank must have a strong commitment to preserving the internal value of the currency by keeping inflation low. That is why in Canada we have adopted explicit targets for inflation-control. But this is not enough. The fiscal situation must also be seen to be under control. Otherwise, as fiscal deficits and debts keep accumulating, investors will come to fear that inflationary policies will be used in the future to reduce the burden of debt. Canada's experience during the Mexican currency crisis of 1994-95, and more recently through the Asian problems, is very instructive in this regard. The Mexican crisis focussed the spotlight on our fiscal problems at the time, consequently driving risk premiums in our interest rates sharply higher. During the recent Asian crisis, however, with our public finances in better shape, and with clear, strong policy commitments by both the fiscal and monetary authorities, financial markets have been more stable and our longer-term interest rates have been falling. Of course, pressures on the exchange rate can also be triggered by so-called "real shocks." In Canada, such shocks are frequently associated with swings in world prices of primary commodities. In cases like these, a flexible exchange rate can act as a "shock absorber," allowing some of the necessary adjustments to the shock to take place through movements in the value of the currency. Canada's long-standing preference for flexible exchange rates has been driven largely by the benefits such rates offer in facilitating adjustments to external shocks. This is an important consideration for us, given our strong reliance on international trade and foreign savings. As a major exporter of primary commodities, Canada has often been hit by sharp swings in the world prices of these products which, in turn, have caused large capital movements. Indeed, the decisions to float our exchange rate in 1950 and again in 1970 (after a short period of fixed exchange rates), were related to strong inflows of foreign capital associated with a surge in commodity prices. In both cases, we chose to allow the Canadian dollar to float up, rather than try to maintain a fixed exchange rate and risk a destabilizing inflationary monetary expansion. Overall, I am persuaded that a flexible exchange rate regime is the best way for a country to take advantage of today's integrated capital markets and to deal with the external shocks that arise from time to time. Exchange rate fluctuations: Is taxing currency transactions the Some critics have argued that integrated international financial markets have given rise to large, short-term speculative flows of capital that can cause unwarranted exchange rate pressures. Such speculative transactions, they say, disrupt domestic macroeconomic policies, result in temporary misallocations of resources, discourage trade, and encourage further unproductive financial transactions as businesses and individuals seek to protect themselves. Based on these arguments, some people have resurrected the idea of discouraging currency transactions using a tax similar to the one proposed by Professor James Tobin in the The case for taxing global financial transactions rests on the notion that such a tax will discourage short-term flows, which are viewed as destabilizing, without affecting longer-term flows that are presumed to be desirable and based on fundamentals. But short-term flows are by no means all undesirable and destabilizing. And there is no way of discriminating between useful flows and destabilizing speculative ones. For example, because foreign trade and investment inflows and outflows are not always fully offsetting, short-term capital flows are typically needed to balance out a country's external accounts. These capital flows occur in response to actual and anticipated movements in the exchange rate, and thus serve to smooth out exchange rate fluctuations. Because such flows are often driven by small differences in perceived rates of return at home and abroad, they could well be discouraged by a transactions tax. On the other hand, speculative flows that actually "bet" on a sharp movement in a currency, have rather large expected returns and are unlikely to be discouraged by the tax. In the end, a transactions tax would likely increase, rather than decrease, exchange rate volatility, as well as reduce market liquidity and raise the cost of capital. Needless to say, where financial market fluctuations reflect changes in domestic macroeconomic policies that put investors at greater risk than before, the tax would be aimed at treating the symptoms rather than the cause of the problem. In all, I find the case for a tax on currency transactions completely unconvincing. Promoting greater financial market stability If a tax is not a good idea, how else can we promote greater stability in international financial markets and reduce potential disruptions to domestic policymaking? I have already talked about the value of a flexible exchange rate system in facilitating adjustment to "real" shocks and allowing national authorities to pursue an independent monetary policy. Flexible exchange rates can also be helpful in moderating the size of, and aiding in the adjustment to, capital flows. In addition, governments are increasingly coming to the realization that the issue of international financial stability is best addressed not by retreating into isolation or by falling back on distorting, costly restrictions, but rather through sound and transparent domestic economic policies. International co-operation can also help. It can help by encouraging countries to pursue national policies that lead to economic stability, thereby reducing the risk of sudden changes in market sentiment and sharp exchange rate fluctuations. And it can help by setting widely accepted standards for transparency and disclosure. Such standards should support more informed market judgments about the riskiness of investments, especially in emerging market economies, and thus help avoid the crises that can be triggered by the sudden uncovering of problems. international initiatives to improve the functioning of financial markets have been undertaken, mainly under the auspices of the Settlements. These initiatives seek to enhance the transparency and disclosure of economic and financial data, strengthen the surveillance of national and global financial systems, develop mechanisms for support in times of crisis, and provide training in financial sector supervision. Recognizing the importance of these efforts, Canada has recently proposed the creation of a new international process to provide "peer review" of national financial regulatory and supervisory systems. Efficient and prudently managed national financial systems can reduce the risks, and maximize the benefits, of international capital flows. In this regard, national supervisory authorities need to ensure that financial institutions have appropriate risk-management systems in place to help minimize risks, particularly with respect to mismatching of maturities and currencies. This would make it easier to cope in the event that short-term inflows switched to outflows. One of the main problems in Asia was that domestic financial institutions were borrowing short-term, in foreign currency, to invest in illiquid domestic assets. Concluding thoughts To summarize, globalization has been broadly beneficial to the world economy. International financial markets have facilitated access by borrowers to a larger pool of global savings and have enhanced investment opportunities for savers worldwide. Yes, international capital flows have at times disrupted national financial markets. But such episodes more often than not were caused by unsustainable domestic policies and pointed to the need for adjustment. In view of the overall benefits of greater access to global capital markets, it would not serve us well to restrict the free flow of funds. The best way to maximize the benefits of financial globalization and reduce the risks of disruptions to national macroeconomic policies is to ensure that these policies are sound and sustainable. In addition, financial systems need to be prudently managed and supervised -- both nationally and internationally. Here in Canada, we are following this advice in our domestic macroeconomic policies. And we are also strongly supporting and contributing to global initiatives designed to promote financial market stability worldwide.

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Opening Statement before the House of Commons Standing Committee on Finance

thiessen

Governor of the Bank of Canada before the House of Commons Mr. Chairman, my colleagues and I are pleased to appear before your committee on a regular basis following the release of the Bank of Canada's . It gives us a chance to discuss with you a range of economic and monetary issues. More generally, our semi-annual Report and sessions such as this one provide an opportunity for us to account for our actions and the results of those actions. Before I turn to our recent would like to say a few words about the objective of monetary policy. In February 1998, the government and the Bank of Canada jointly reaffirmed that Canada's monetary policy can best contribute to good economic performance by remaining focussed on inflation control. Keeping inflation low helps businesses and individuals to make sound economic decisions, and it helps moderate cyclical fluctuations in incomes and employment. The February announcement extended our 1 to 3 per cent target range for inflation control out to the end of 2001. Let me remind you that monetary policy has its effects on the economy with long lags. For that reason, decisions about policy actions to achieve this target for inflation-control have to be forward-looking and thus are based on projections of an uncertain future. Since the release of our previous last November, there have been an unusual number of unanticipated international and domestic developments that have had important economic and financial consequences for Canada. These include the extent of the crisis in Asia, declines in primary commodities prices, and the persistent weakness of the Japanese economy. At home, there were strikes by Ontario's teachers and by postal workers, as well as the January ice storm in eastern Canada. In the United States, the economy has been substantially stronger than expected. These developments have resulted in a higher-thanusual degree of uncertainty surrounding the economic outlook. When we add up the effects of recent events, we see the economy continuing on a solid growth path, although not at the same rapid pace as in 1997. Despite the effects of developments in Asia, our economy is being supported by vigorous U.S. economic activity and by accommodative monetary conditions. Inflation is expected to remain inside our target range. While the uncertainty surrounding the outlook is greater than normal, the risks appeared balanced to us when we wrote this . Since then, there have been some signs of greater momentum in the economy, but they are not yet sufficient for us to revise our overall view. This outlook implies that the economy would reach a level close to full capacity sometime during the course of 1999. As we noted in the , this path for the economy suggested to us that the recent range of monetary conditions would be broadly appropriate during the next six months in the absence of further shocks. Let me stress that this is a judgement about the level of monetary conditions that currently looks appropriate. If there are economic or financial shocks that hit us from outside or the economy has more or less momentum than we can see at this time, we would of course reassess that judgement. Let me also remind you that when we talk about monetary conditions we are talking about the combined influence of shortterm interest rates and the exchange rate for the Canadian dollar. Given the degree of economic uncertainty that is likely to persist this year, monetary conditions may fluctuate over a relatively wide range, as they have recently. Beyond the next six months, if the underlying momentum of the economy remains as strong as we currently anticipate, less-stimulative monetary conditions would be called for as the economy approaches and achieves full capacity. I want to emphasize just how important it is to ensure that our economy reaches full capacity in a smooth and sustainable way. What we have learned over the last 25 years is that taking risks that could set off an inflationary boom means taking risks of falling into a serious recession, which would inevitably follow. It is by keeping the current economic expansion on a non-inflationary, sustainable growth path that we will get the best gains in incomes and employment that our economy is capable of producing.

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The outlook for the Canadian economy and monetary policy

bonin

The outlook for the Canadian economy and monetary policy In mid-May we published our semi-annual on monetary policy, covering data up to April 24 . That means we now have new data available for the last two months. Furthermore, our report also pointed to a much greater-than-usual degree of uncertainty about the outlook for the Canadian economy. While recent weeks have not dispelled that uncertainty, they have provided us with more information about the impact of the shocks that have hit the Canadian economy over the last six to nine months. In my remarks today, I want to go over Canada's economic outlook with you, in light of these recent data, and discuss their consequences from the standpoint of formulating and conducting monetary policy. Balancing the central bank's independence in monetary policy is its duty to account for its stewardship. The , published twice a year, is one of the vehicles we use to give an account of our actions. It sets out the Bank of Canada's judgments on the economic situation in Canada, as well as in the rest of the world, and gives analysts like yourselves in both the private and public sectors the chance to compare their opinions with those of the central bank. Exchanges of view of this kind are very important indeed. Let me remind you what the objective of monetary policy is in Canada. The goal of monetary policy is to create a climate favourable to sustained growth in economic activity and in job creation as well as to rising standards of living for Canadians. How can monetary policy do that? By creating and maintaining conditions of low inflation. Hence, inflation control is not an end in itself, but rather the means whereby monetary policy contributes to solid economic performance. In a low-inflation climate, the economy works better. Low inflation helps businesses and individuals to make sound economic decisions and it helps moderate cyclical fluctuations in incomes and employment. That is why in February 1998, the government and the Bank of Canada jointly reaffirmed that Canada's monetary policy can best contribute to good economic performance by remaining focussed on inflation control. The 1 to 3 per cent target range for inflation was thus extended to the end of 2001. Since adopting these targets back in 1991, Canada has seen considerable progress in the fight against inflation. Inflation has fallen and has remained at a low level. Economic decisions by businesses are now predicated on the continued existence of low inflation. Businesses are endeavouring to control costs and to improve productivity, the key factor in raising standards of living. Thanks to low inflation and the progress made in fiscal consolidation, interest rates are low. Indeed, medium-and long-term rates are now at or near their lowest levels in decades, thus contributing to the low cost of capital. Now let us take a look at how the Canadian economy has performed recently. Overall, 1997 was a very good year. The economy grew at a rate of 4.1% from the fourth quarter of 1996 to the fourth quarter of 1997. And the solid macroeconomic underpinnings of the Canadian economy have begun to show up in the labour market. The strength of economic activity has prompted a substantial rise in employment. For the year as a whole, more than 380,000 new jobs -- mostly full time and in the private sector -- were created far outweighing the loss of 13,000 jobs in the public sector. Strong employment gains have continued in the first five months of 1998, totalling about lowest level since 1990. The pace of economic activity slowed in the fourth quarter of 1997 to 2.8%, compared to an average of 4.4% over the first three quarters of the year. The recently released National Accounts estimates indicate that growth in the first quarter of 1998 was about 3.7%. A key feature over the past six to nine months has been the number of unanticipated developments that have hit the Canadian economy. The Ontario teachers' strike and the postal workers' strike cut about one percentage point off the fourth quarter growth of last year. The January ice storm that hit eastern Ontario, Quebec and the Maritimes also had a negative impact in the first quarter of 1998, although reconstruction work due to take place later in the year and into 1999 will boost activity. Finally, the fallout from the Asian crisis and weaker commodity prices are also having a dampening effect on growth, particularly in British Columbia. Fortunately, the effects of these negative shocks have been significantly offset by the decline in medium-and long-term interest rates, by the amazing performance of the U.S. economy and better than expected economic conditions in Continental Europe. All these shocks have resulted in a higher-than-usual uncertainty and have complicated the conduct of monetary policy. Declining interest rates have encouraged business spending on machinery and equipment and household spending on durable consumer goods, so that final domestic demand has been an important source of economic expansion in 1997 and early 1998, with investment alone rising sharply. With low interest rates and continued marked gains in good employment, household confidence has been high, leading to robust consumption expenditures. What about the external sector? Thanks to the strength of the American economy, the volume of exports has also been rising sharply. There has also been a substantial increase in non-energy commodities exports in spite of declining prices. However, exports to Japan and other Asian countries, which account for about 8% of Canada's total merchandise exports, declined in the second half of 1997 and early 1998. Overall, exports grew substantially over that period, but imports have also risen sharply so that the current account deficit widened in 1997. Amongst the factors responsible for the widening deficit, there was a sharp jump in domestic demand for products with a high import component notably machinery and equipment and other durable goods. In the first quarter, a notable improvement occurred with the current account deficit as a percentage of GDP falling back to less than 2%. Before turning to the outlook, let us deal briefly with the factors affecting inflation. Wages have again risen at a moderate pace. With productivity improving, costs have been kept under control. Price inflation has been kept below 2% for the past six years now. Indeed, in late 1997 total CPI and core CPI (i.e. excluding the more volatile components of food and energy as well as the effect of changes in indirect taxes) fell below the target range of 1 to 3 per cent, reflecting the impact of temporary factors. More recently, core inflation has been at or slightly above the bottom of the range. Now let's look more closely at the Canadian outlook for 1998 and 1999. To do so, it is useful to examine prospects abroad and their impact on our economy. In the United States, economic activity was even stronger than anticipated during the first quarter of 1998. Growth should slow somewhat during the course of the year to a more sustainable pace in response to some expected loss of competitiveness and weak Asian demand, which became apparent in recent trade numbers. However, I must caution you that this slowing of the U.S. economy has been expected for a while, as the economy is really pressing against the limits of its capacity to produce. Yet, we keep being surprised by the strength of their economy. And for an economy that is deemed to be in excess demand, the United States has had remarkably good results with regard to inflation. In Europe, the outlook for 1998 is also somewhat brighter than two months ago. What about Asia? This is the major source of concern for the world economy. While the financial situation in the countries that faced a crisis in the second half of 1997 and early 1998 now looks somewhat better, these countries still face considerable economic adjustment, and of course Indonesia has been going through a major political crisis. In Japan, conditions are quite uncertain notwithstanding important policy measures that have been taken. After contracting sharply in the second quarter of 1997, the Japanese economy showed little recovery during the second half of the year. Not much improvement is expected in 1998 given the aftermath of the Asian crisis, the fragility of the financial sector, and weak business and consumer confidence. The outlook remains good for the Canadian economy in spite of the Asian difficulties and lower commodity prices. We are still expecting that our economy will grow at a 3.5% pace through the middle of 1999. This is somewhat weaker than what we were anticipating in the fall of 1997, but still robust growth. This would imply that the economy will achieve full capacity during the course of 1999. This assessment is based on the prospects of strong final domestic demand and assumes a modest recovery of the prices of commodities for which Canada is a major exporter. In spite of a modest pick up in inflation resulting from past depreciation of the Canadian dollar, inflation is expected to remain below 2%, that is well within the target range. What are the consequences of this outlook for the conduct of monetary policy in Canada? In our May , we acknowledged that the uncertainty surrounding the outlook is much greater than usual. However, the risks associated with it appear balanced. The main downside risks relate to developments in Asia and commodity prices. Offsetting these is evidence, particularly from the continuing strength of the U.S. economy and from the expansion of the money supply, narrowly defined, in Canada, that the underlying momentum of the economy might be stronger than we expect. When all these factors are considered, it is the Bank's judgment (not commitment) that between now and the November report, monetary conditions in the recent range would be broadly appropriate in the absence of further shocks. This would be consistent with the above outlook of robust aggregate demand, the economy continuing to take up slack, and inflation inside the target range. Given the degree of uncertainty that is likely to persist over this period, monetary conditions -- which refer to the effects of both short-term interest rates and the exchange rate on the economy and inflation -- may continue to fluctuate over a relatively wide range. Subsequently, if the underlying momentum of activity remains as strong as is currently expected, less-stimulative monetary conditions would be called for as the economy approaches and achieves full capacity. Over the past couple of months, we have seen no reason to fundamentally change these views. The economies of both the U.S. and Continental Europe appear a bit stronger while there is still a great deal of uncertainty in Japan, and commodity prices remain soft. The prospects for inflation in Canada -- the objective of Canadian monetary policy -- have also not changed. Overall, while there have been some signs of greater momentum in the economy, the outlook for the Canadian economy appears to be broadly in line with what we saw in the Monetary Policy Report. To sum up, if we keep in mind that the objective of monetary policy in Canada, as has been reaffirmed recently, is to keep the annual inflation rate within a target range of 1 to 3 per cent, then the economic outlook facing us at present is compatible with that objective. 1997 was an exceptionally good year, despite the fact that the Canadian economy was hit by a series of shocks originating both at home and abroad. The pace of economic growth appears likely to be a little slower in 1998 and the first half of 1999. However, it should nevertheless allow further slack to be taken up, and thus bring output close to the economy's limit of capacity. With the exception of Asia, where uncertainty continues to reign, international conditions are favourable to Canada. These include sound economic growth, weak inflation, and low interest rates. But the slowdown that has afflicted the more important Asian economies is certainly not unrelated to the weakness in prices for commodities, where Canada is still a major exporter. While the most recent data suggest that Canada's economic outlook is somewhat more favourable than was anticipated a couple of months ago, the fact remains that this outlook carries with it a larger margin of uncertainty than normal. Therefore, more than ever, we must constantly be reviewing our judgments about the economic and financial situation. Nevertheless, we continue to believe that, between now and the publication of the next , due in November, the appropriate course would be to keep monetary conditions within their recent range, provided there are no new shocks. This approach should be consistent with the expected strength of aggregate demand, the continued absorption of unused resources, and an inflation rate within our target range. In closing, let me stress how important it is to make sure that our economy reaches its full capacity in a gradual and sustainable manner. We have learned over the past 25 years that, if we allow the economy to overheat and become inflationary, then we run the inevitable risk of plunging it into a severe recession. It is by keeping the economy on a track of noninflationary and sustainable growth that we will achieve the greatest returns in terms of the income and employment that our economy is capable of generating.

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Global uncertainties and the Canadian economy

thiessen

Governor of the Bank of Canada Global uncertainties and the Canadian economy I am delighted to have been invited to speak to the Board of Trade on this occasion when the Bank of Canada's Board of Directors is meeting here in St. John's. This past year, we have had to deal with the implications for our economy and our currency of increased global uncertainty and pressures arising from the problems that originated in Southeast Asia. I am sure that the effects of these developments, especially on primary commodities, such as oil and nickel, are already very familiar to Newfoundlanders. To understand what is going on, we need to look at the nature of the forces that are currently affecting our economy. We also need to correctly identify cause and effect when it comes to the decline in the external value of our currency over the past 12 months. The commentary on this subject has not always been helpful. I would like to start my presentation with a quick review of international developments, focusing on the extent to which the problems in Southeast Asia have persisted and spread. Next, I will discuss the implications of these developments for the Canadian economy and give you the Bank's latest assessment of the outlook. I can tell you now that I believe that the key trends in our economy remain positive. Lastly, I will talk about the decline in the external value of the Canadian dollar and about the response of monetary policy to that decline. The world around us For over a year now, volatility and uncertainty have been the main traits of the international environment in which Canada operates. The financial crisis started in Southeast Asia in the summer of 1997, then spread to South Korea, and in turn exacerbated the domestic economic difficulties that Japan was already facing. Recently, Russia has been added to the list of afflicted countries, and now some countries in Latin America are under pressure. As with the crisis in Asia, the financial problems in Russia have reverberated around the world through foreign exchange, stock, and bond markets, touching off concerns of still further contagion. It is certainly easier now, with the benefit of hindsight, to see the extent to which many investors from industrial countries were attracted to higher-yield investments in emerging-market countries, without fully appreciating the risks involved. When investors suffered substantial losses in certain markets, they sought to reduce their exposure to emerging markets more generally. But this rapid withdrawal of funds brought to the surface areas of weakness in some of these economies, making investors still more nervous. The recent events in Russia are a prime example of this process. The apparently contagious nature of these developments has led to some pessimistic predictions of recession in the world economy. How concerned should we be about this? While the international environment has turned out to be more difficult than most people had thought earlier, let me reassure you that it is certainly not all negative. To be sure, the situation in Japan is worrisome -- not only because of that country's economic importance but also because of its strong trade and financial links with other troubled Asian economies. But, and this is an important but, Japan has the capacity and the financial wherewithal to turn its situation around. With resolute action to speed up the implementation of measures to deal with its ailing banking sector and to kickstart its domestic economy, the present concerns would dissipate. More importantly, economic activity in the United States has been very robust and is expected to remain healthy. In Canada, too, and in Europe the situation is positive. This is certainly not insignificant, for North America and Europe together account for more than half of world output. And recent declines in medium- and long-term interest rates to record low levels are helping to sustain domestic spending in all industrial countries. With this as background, I would now like to turn to the impact of these international developments, and of the associated uncertainties and pressures in financial markets, on How is our economy faring? The international developments of the past year have affected our economy more than previously anticipated. And there is no doubt that those Canadian industries and regions that depend on the production of primary commodities are facing considerable difficulties. To appreciate this particular link between recent international developments and the Canadian economy, let me point out that Asia, including Japan, absorbs between 30 and 35 per cent of the world output of certain key primary materials. So it is not surprising that world commodity prices have been hit hard by the Asian crisis. The recent events in Russia, which is a major commodity producer, have added to the uncertainty about the outlook for the world supply and prices of primary commodities. Because of all this, the U.S. dollar prices of commodities that are important to Canada have fallen by about 15 per cent over the past 12 months. While commodities are less important to us than they used to be, they still make up about 30 to 35 per cent of our merchandise exports. Although Canadians have to deal with these difficulties coming from abroad, it is important to remember that, overall, our economy is still in good shape. This is, first and foremost, because some basic aspects of our economic situation have improved markedly in the last few years. We now have a low rate of inflation, a fiscal surplus, and a declining (though still high) public debt-to-GDP ratio. As well, Canadian businesses have undertaken major restructuring and investment initiatives to increase their productivity. Because of these fundamental strengths, we are now better positioned to weather sudden shocks. As for the near-term outlook, there are also a number of positive elements in the picture. Economic activity in the United States, our main customer, remains high. And here in Canada, the latest indicators suggest continued expansion in consumer spending and business investment, supported by higher employment and low medium- and long-term interest rates. This year, the Canadian economy will not repeat the 4 per cent growth experienced through 1997. But it may still expand by 2 1/2 to 3 per cent (fourth quarter over fourth quarter). Clearly, a good deal of uncertainty surrounds any estimate at this juncture, given the international situation. For one thing, it is difficult to judge how quickly and effectively Japan will deal with its problems, and what this will mean for the rest of Asia. The extent of the impact from the recent spreading of the crisis to Russia and the pressures in parts of Latin America is also uncertain. But, at the same time, most forecasters have consistently underestimated the resilience of the U.S. economy, and may still be doing so. Implications for the Canadian dollar One of the most talked-about economic events in Canada over the past year has been the decline in the external value of our currency. At its lowest point, in late August 1998, the Canadian dollar had depreciated by about 13 per cent against the U.S. dollar and by more than 7 per cent against the German mark from its average value in the first half of 1997, before the Asian crisis erupted. Since that low point in late August, the Canadian dollar has recovered somewhat against the U.S. dollar. What has caused these movements? Exchange rates will typically reflect developments in Canada and abroad. Thus, it is important to keep in mind that the recent movements in the Canadian dollar are the consequence of developments that have occurred over the past year. They are not the cause of the difficulties we are now facing, as some of the recent commentary seems to suggest. It is also important to note that our exchange rate is the price of the Canadian dollar expressed in terms of the currency of another country, usually the U.S. dollar. So, the exchange rate will be influenced by events affecting both countries. If we are to correctly interpret movements in the Canada/U.S. exchange rate, we must also look at what has been happening to the United States, not just to Canada. And that makes any interpretation more complex. Until very recently, the U.S. dollar has been exceptionally strong against all currencies. In part, this reflected the buoyancy of the U.S. economy. But in the difficult and uncertain global environment of the past year, the strength of the U.S. dollar also came from its role as the major international currency. After the Asian crisis, and with renewed vigour in the days following the events in Russia, international investors sought shelter in U.S. dollar assets. Indeed, the turmoil in financial markets in late August seemed to be the result of a worldwide reassessment of risks by investors following the announcement of the Russian debt moratorium. Thus, to the extent that the depreciation of our currency reflected the appreciation of the U.S. dollar against all currencies, the cause was the global flight of funds into But that is not the whole story. The downward pressure on our currency over the past year was also related to events that were seen as affecting Canada more specifically. As I explained earlier, one important event was the marked decline in the prices of the key primary commodities we export. The drop in these prices has meant lower incomes and wealth for Canadians. The profit outlook for many of our resource industries has deteriorated and production and employment in those industries are likely to be affected. And the market value of companies in those sectors has reflected these developments. Moreover, lower net export earnings from our primary commodities imply, all else being equal, a larger deficit in our balance of international payments and a greater need for foreign borrowing than would otherwise be required. All these commodity-related developments have led to downward pressure on our exchange rate. And the lower dollar spreads the wealth and income effects of falling commodity prices across the economy. In effect, a lower Canadian dollar means higher domestic prices for all those goods that are imported and for many of the import substitutes we produce here. For a given level of income, these higher prices imply a decline in living standards for Canadian consumers. Retailers who feel unable to pass on these price increases to consumers will have to absorb them in lower profits which, in turn, will mean lower returns for their shareholders. The bottom line is that the decline in commodity prices has made us less well off than we were before. And we have to adjust to this reality. These effects are unavoidable, even if we were able to prevent the Canadian dollar from falling. In fact, if the currency were not allowed to move at all, the adjustment would be slower and more costly, taking place through reductions in wages which usually involve sharper fluctuations in output and employment. Under a floating exchange rate, the process is facilitated by some downward movement in the dollar which spreads the burden of adjustment. Over the years, this has been an important justification for a flexible exchange rate in Canada -that adjusting through exchange rate movements to the shocks that periodically hit our economy makes for a generally smoother and fairer process than adjusting through reductions in output, employment, and wages. But I do not want to leave you with the impression that foreign exchange markets always know the appropriate value for a currency. They sometimes push too far once a trend is established in one direction or another. Indeed, I believe that during this latest episode of global financial turbulence, markets exaggerated the commodity connection of the Canadian dollar. For example, our exports of highly manufactured goods, apart from the important motor vehicle sector, have grown by nearly 20 per cent over the past 12 months, and now represent about 30 per cent of our merchandise trade. This development seems to have been largely overlooked. Monetary policy response So, what can and should the Bank of Canada do about the exchange rate in times of international financial turbulence and major external shocks? First of all, let me remind you that the objective of Canadian monetary policy is to hold the rate of inflation within a range of 1 to 3 per cent. This target, jointly agreed upon by the government and the Bank of Canada, reflects the conclusion that low inflation will contribute to a stronger, more stable economic performance over time. If we are to fulfill our commitment to keep inflation low and stable, monetary policy must remain focused on that objective. The exchange rate and interest rates are the channels through which monetary policy operates and they must be allowed to adjust to help achieve the inflation targets. But what if the momentum of currency movements pushes the Canadian dollar beyond any level that is justified on economic grounds? Judgments as to what is, or is not, justified are very difficult to make, but there are times when the good economic news gets lost in the face of a persistent currency decline. On those occasions, Canadian authorities need to remind investors of the positive trends in our economy. And to reinforce the message, the Bank may intervene, on behalf of the Minister of Finance, to support the currency by buying Canadian dollars in the foreign exchange market. But we do know that this kind of intervention will be effective only if a good number of investors share our belief that the currency movement has been overdone. The Bank can also respond to currency declines with Bank Rate changes. There are two sets of circumstances in which this would be appropriate. The first is when the magnitude of the currency decline threatens to push the economy off a sustainable, non-inflationary growth path. Remember that a declining currency is a source of stimulus to the economy, because it encourages exporters and producers of import substitutes to expand their activities. That is why the Bank always puts the exchange rate and interest rates together in order to measure the amount of monetary stimulus in the economy. If a declining currency leads to monetary conditions that are persistently too easy and inconsistent with the inflation targets, the Bank will offset that with higher short-term interest rates. The second situation that would prompt a Bank Rate increase is when there is a potential loss of confidence in the Canadian dollar. If confidence is undermined, both Canadian and foreign investors will move out of investments denominated in Canadian dollars unless they are compensated with substantial premiums in interest rates. Higher premiums, which translate into higher medium- and long-term interest rates, are very costly for the economy. It was because of such concerns that the Bank responded strongly to the decline in our currency during the Mexican crisis in early 1995. The recent Bank Rate increase at the end of August was also designed to counter a potential loss of market confidence. In this case, investor nervousness was exacerbated by the financial crisis in Russia and was reflected in a sharp decline in our currency and rising medium- and long-term interest rates. Since the Bank Rate increase, the Canadian dollar has recovered and medium- and longer-term interest rates have come down. Concluding comments I have placed a great deal of emphasis on recent international developments in my remarks today because the implications of these developments for the Canadian economy and the exchange rate are important and complex. Let me summarize my main points. For the past year, our economy has had to cope with the fallout from the Asian crisis, which has turned out to be more widespread and prolonged than most of us had predicted. Although we are having to deal with these difficulties and with the ongoing global uncertainty and pressures, it is important to remember that there is still a significant positive element in Canada's external environment coming mainly from a resilient U.S. economy. And there is still considerable underlying buoyancy in our domestic economy. What's more, the improvement in our basic economic foundations puts us in a better position than before to withstand the present adversity. In addition to pressure from the worldwide strength of the U.S. dollar, some of the downward movement in the Canadian dollar over the past year was a reflection of the impact of lower commodity prices on our economic well-being. However, by early August, it appeared that investors were exaggerating the importance of these effects and losing sight of the overall positive fundamentals in our economy. The Bank intervened, buying Canadian dollars, to encourage market participants to pause and reassess their views of the Canadian economy. When that pause was overwhelmed by a new wave of nervousness precipitated by the events in Russia in mid-August, the Bank raised the Bank Rate to forestall a loss of confidence in the currency and thus reverse a costly increase that was taking place in medium- and long-term interest rates. Since then, these interest rates have come down. Let me conclude by pointing out that, despite all the recent attention on the Canadian dollar because of exceptional external developments, the fundamental focus of monetary policy remains on keeping the trend of inflation in Canada inside a target range of 1 to 3 per cent. Low inflation is the best contribution the Bank of Canada can make towards improved overall economic performance over time. It also provides the best underpinning for a sound Canadian dollar in the long run.

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The Canadian Experience with Targets for Inflation Control

thiessen

Broad assessments of the experience to date with inflation targeting in industrial countries can be found in Almeida and Goodhart (1998) and Bernanke et al. (1998). Individual country experiences can be found in Leiderman and Svensson (1995). For an assessment of the potential advantages and disadvantages of inflation targeting in developing countries, see Masson et al. Governor of the Bank of Canada It is an honour to have been asked by the School of Policy Studies and the John As an economist who worked as a banker for most of his career, Douglas Gibson brought an interesting perspective to public policy issues, to the relationship between government and business, and to the contribution of outside economists to government policies. I noted with particular interest a comment by Gibson in his 1981 essay in honour of John Deutsch. He points out that few academic economists in Canada up to that time "appeared to appreciate the destructive influence of inflation on the economy and on society." That comment provides a convenient link to my topic for this year's Gibson Lecture. What I propose to do is to reflect on Canada's experience using explicit targets aimed at low rates of inflation as the focus for conducting monetary policy. But let me first set the scene by putting the inflation targets in the context of various approaches to monetary policy. With the sharp rise in worldwide inflation in the 1970s, the costs of inflation became more and more evident. Consequently, central banks increasingly focused their attention on how to get inflation down and keep it down. One lesson that came out of this period was the adopted inflation targets in the first half of the 1990s. importance of having some sort of "nominal anchor" to ensure that monetary policy does not lose sight of the objective of inflation control, given the long lags in the operation of monetary policy. The traditional nominal anchor for small countries has been a fixed exchange rate that links the currency of the small country to that of a larger trading partner that has been successful in controlling inflation. Among the larger countries, many central banks turned to monetary aggregates as an intermediate target for monetary policy around the mid-1970s as relatively high inflation became entrenched in the world economy. Subsequently, with inflation and inflation expectations persisting at uncomfortable levels in many countries during the 1980s, the policy innovation in the early 1990s was the introduction of explicit inflation-control targets in eight countries. The main factor that countries choosing to use explicit inflation-control targets have in common is a history of higher-than-average inflation. In some cases, they had previously used monetary aggregates and/or a fixed exchange rate without success or with only limited success. And, unlike countries with a history of relatively low inflation (such as the United States, Germany, and Japan), the history and consequent problems of policy credibility in inflationtargeting countries meant that they were unable to rely upon a general qualitative commitment to low inflation. The key objectives of Canada's inflation targets, when they were originally announced in 1991, were to prevent inflation from accelerating in the short run in the face of the introduction of the new Goods and Services Tax (GST) and a sharp rise in oil prices and, in the longer run, to bring inflation down to a level consistent with price stability. Over time, the importance of other favourable characteristics of inflation targets as a permanent operating framework for monetary policy has become increasingly apparent to us at the Bank of Canada. The most notable of these characteristics are increased transparency, better accountability, improved internal decision-making, and a mechanism for responding to demand and supply shocks that reduces potential fluctuations in output. I would not argue that explicit inflation targets are the only way to achieve good macroeconomic results. Indeed, the worldwide reduction of inflation in the 1990s across countries with different frameworks for monetary policy clearly indicates that there are a number of ways to achieve low inflation. Rather, I will argue that explicit inflation targets bring a discipline to monetary policy that is helpful in providing a more stable and predictable environment for the economic decisions of businesses and individuals. Moreover, I believe that The government's announcement came as part of its annual budget, while the Bank issued a press release and a background note setting out practical details regarding the operation of the targets. A discussion of some of the practical issues surrounding the operational use of the targets can be found in Freedman (1995). the benefits of the clear operating framework provided by such targets will make them increasingly attractive in democratic societies that demand accountable public institutions. I will begin this lecture with a brief history of inflation targets in Canada and go on to an assessment of the performance of the Canadian economy during the period in which inflation targets have been in place. I will then turn to a discussion of the favourable characteristics of inflation targets, over and above achieving a low rate of inflation. After examining the main criticisms of explicit targets for low inflation, I will offer some concluding remarks about the contributions that the targets have made to the conduct of monetary policy in Canada over the last eight years. A brief history of inflation targets in Canada In response to the persistence of high inflation during the 1970s, the Bank of Canada adopted a narrowly defined monetary aggregate (M1) as a target in 1975. When this aggregate became increasingly unreliable and turned out not to have been all that helpful in achieving the desired lessening of inflation pressures, it was eventually dropped as a target in 1982. Subsequently, the Bank embarked on a protracted empirical search for an alternative monetary aggregate target, but no aggregate was found that would be suitable as a formal target. Thus, from 1982 to 1991, monetary policy in Canada was carried out with price stability as the longer-term goal and inflation containment as the shorter-term goal, but without intermediate targets or a specified path to the longer-term objective. In February 1991, explicit targets for reducing inflation were introduced through joint announcements by the Bank and the federal government. These announcements confirmed price stability as the appropriate long-term objective for monetary policy in Canada and specified a target path to low inflation. The first guidepost was set for the end of 1992 at a target rate of 3 per cent for the 12-month increase in the consumer price index (CPI). This was to be followed by a reduction to 2.5 per cent for mid-1994 and to 2 per cent by the end of 1995. These targets had a band of plus and minus 1 percentage point around them. The announcements specified that after 1995 there would be further reductions of inflation until price stability was achieved. At the time the targets were announced, there was upward pressure on prices in Canada from two major shocks -- the sharp rise in oil prices following the Iraqi invasion of Kuwait and the effect on the price level of replacing the existing federal sales tax at the manufacturers' level by the broader-based GST. These shocks had led the Bank and the government to be concerned about a deterioration of inflation expectations and the possibility of additional ongoing upward pressure on wages and prices. The fact that Canada had recently gone through a period of inflationary pressure induced by excess demand added to those concerns. By providing a clear indication of the downward path for inflation over the medium term, the key near-term aim of the targets was to help firms and individuals see beyond these price shocks to the underlying downward trend of inflation at which monetary policy was aiming, and to take this into account in their economic decision-making. In the longer term, the inflation-reduction targets were designed to make more concrete the commitment of the authorities to the goal of achieving and maintaining price stability. In addition, by providing information on the specific objectives to which the Bank's monetary policy actions would be directed, the targets were intended to make those actions more readily understandable to financial market participants and to the general public. In this way, the targets would provide a better basis than before for judging the performance of monetary policy. In December 1993, on the occasion of the announcement of my appointment as Governor, the Bank and the Minister of Finance issued a joint statement on the objectives of monetary policy. In this statement, the newly elected government and the Bank recommitted themselves to price stability as the goal of monetary policy. It was also agreed that the 1 to 3 per cent target range for inflation would be extended through 1998, and that a decision on the definition of price stability would be postponed. There were two reasons for this extension. First, because it had been a long time since Canada had had low rates of inflation, it was felt that more experience in operating under such conditions would be helpful before a long-term objective was set. Second, since inflation had dropped rather dramatically and unexpectedly during 1991, it was unlikely that Canadians had completely adjusted to the improved inflation situation. More time was therefore needed to make that adjustment before announcing any further changes to the target. In February 1998, the government and the Bank announced that the 1 to 3 per cent target range would be extended again, this time to the end of 2001. This extension reflected the fact that the economy had not yet reached full capacity in the current cyclical upswing. It would, therefore, be helpful to have the economy demonstrate more fully its ability to perform well under conditions of low inflation before determining the appropriate long-run target consistent with price stability. The government and the Bank now plan to determine this long-run target before the end of 2001. Inflation targets and economic performance in Canada What did we expect in the way of economic performance from the inflation targets? First, we expected a lower rate of inflation and reduced inflation expectations. Second, the achievement of a lower inflation rate and the commitment embodied in the targets to maintain that lower inflation rate were expected to result in lower interest rates. Third, with lower See Bank of Canada (1991) on the benefits of price stability. This critique of Bank policy can be found in Fortin (1996). A detailed response can be found inflation, we anticipated that the economy would function more efficiently and without the sharp fluctuations caused by inflationary booms and subsequent recessions. What has the outcome been thus far? Chart 1 shows the rate of inflation over the period of inflation targets. Following the initial announcement of the targets in February 1991 (when the 12-month rate of increase in the total CPI was at 6.8 per cent), inflation fell rapidly. Indeed, for much of 1992 it was below the bottom of the target range. Since then, with the exception of a brief period in 1995, the trend of inflation has been in the lower half of the target range. The speed of the decline in inflation during 1991 was surprising. It reflected a much more severe economic slowdown than either the Bank or most other forecasters had expected. In part, the depth of the 1990-91 recession was due to international factors, such as lower-than-expected growth in the United States and an unexpectedly sharp decline in raw materials prices. But in Canada, it also reflected the unwinding of distortions in asset prices and debt accumulations associated with the preceding period of inflationary pressures. It is unlikely that the 1991 announcement of the path for inflation reduction had a significant immediate impact on the expectations of individuals, businesses, or financial market participants. On balance, I think that it is the low realized trend rate of inflation in Canada since 1992 that has been the major factor in shifting expectations of inflation downwards. But the targets have probably played a role in convincing the public and the markets that the Bank would persevere in its commitment to maintain inflation at the low rates that had been achieved. Moreover, there are some recent indications that the 2 per cent mid-point of our target range is becoming an important anchor for current expectations and for long-range corporate planning. If we examine interest rates and the growth of output and employment over the period of inflation targets, the first point to note is that the recovery from the 1990-91 recession was less vigorous than typical in the post-war period. The growth of domestic demand, in particular, was subdued until mid-1996 (see Chart 2). Moreover, the economic expansion in Canada was considerably less robust than that in the United States. While some observers have attributed the sluggishness of the recovery to the adoption of inflation targets and the associated conduct of monetary policy, this criticism overlooks the major restructuring that took place in Canada in both the private and public sectors over this period. Whereas the United States had undergone a period of intense private sector restructuring starting in the mid-1980s, the corresponding Canadian restructuring did not take place until the first half of the 1990s. At The concept of monetary conditions includes movements in short-term interest rates and in the exchange rate, the two channels through which monetary policy operates. See Freedman about the same time, after two decades of continuous fiscal deficits and public sector debt accumulation in Canada, unprecedented corrective actions were required to put public finances onto a sounder path. Both sets of actions were essential to move Canada towards a better-functioning economy. The short-run consequences, however, included a weak employment situation and an associated lack of consumer confidence. And these resulted in sluggish domestic demand and a weaker-than-expected recovery in the Canadian economy. Monetary conditions were easing through much of this period. However, for quite a long time the Bank was unable to provide as much monetary stimulus as it would have liked because of fiscal, political, and international developments that, at times, caused financial markets to be nervous and volatile. It was only after 1995, with improved credibility on the fiscal front and subsequent to the Quebec referendum campaign, that the Bank was able to achieve a durable reduction in short-term interest rates. As the credibility of both monetary and fiscal policy improved, Canadian interest rates across the maturity spectrum moved to levels below comparable interest rates in the United States. In response to easier monetary conditions, domestic demand in Canada recovered, with a strong expansion beginning in mid-1996 and continuing through 1997. One of the main conclusions that I would draw from the Canadian experience of the 1990s is that, while low inflation is necessary for good economic performance, it is not sufficient by itself. While monetary policy was able to achieve a rate of inflation that was within the target range for most of the period, other factors also played an important role in determining interest rate movements and output and employment growth. Does the important role played by non-monetary factors mean that the inflation targets and the low rate of inflation were not helpful? Not at all. The ability of businesses to undertake a major restructuring was greatly enhanced by the stable low-inflation environment. And while fiscal and political uncertainty resulted in appreciable financial market volatility, as well as vulnerability to external shocks in the period before 1996, I believe that the situation would have been considerably worse without the anchor provided by low inflation and the inflation targets. And, in conjunction with improved fiscal policy, they have facilitated better economic performance in the more recent period and have allowed us to weather the current international financial problems with fewer difficulties than before. Targets should continue to provide a sound foundation for good economic performance and for coping with the international shocks that are bound to hit us from time to time. Increased monetary policy transparency and accountability When the government and the Bank agreed on the initial targets in 1991, the main concern was to lay out a path for the reduction of inflation on the way to price stability. Despite the emphasis that the Bank had for some years placed on price stability as the objective of monetary policy, the period over which the objective was to be achieved was a source of uncertainty among the public. Thus, one of the key benefits of the targets was expected to be increased transparency with respect to the objective of monetary policy, leading to a reduction of public and financial market uncertainty. The announcement in 1991 also noted that the targets should provide a better basis for judging the performance of monetary policy. Criticisms of monetary policy had often implicitly assumed that the Bank should be pursuing policy objectives other than price stability. By setting out a clear objective, and with the commitment of the government to that objective, the Bank hoped that future public assessments of monetary policy performance would focus more clearly on its record of achieving price stability. There is no question that explicit targets for inflation control make the objective of monetary policy more transparent and provide a better basis than before for holding the central bank accountable for its conduct of monetary policy. I have not tried to pull together evidence that, with a clearer objective, public commentary on monetary policy since 1991 has involved fairer assessments of the performance of the Bank of Canada. And it is difficult to demonstrate conclusively that, overall, financial and economic uncertainty in Canada have been less than they would have been without targets. Nonetheless, it is my qualitative assessment that those improvements have taken place. And the targets have certainly had a major impact on the Bank itself. With respect to transparency, we found that explicit targets provided a strong incentive that encouraged us to become more forthcoming about how we would operate to achieve those targets. As I have discussed elsewhere, we have taken initiatives to explain more fully our assessment of economic developments and our outlook for output and inflation. We have clarified how we make judgments about the actions needed to achieve the inflation target, and how we operate in markets to implement those judgments. The directors of the Bank are appointed by the government for three-year terms. By tradition, there are two directors from Ontario, two from Quebec, and one from each of the other provinces. The Governing Council is composed of the Governor, the Senior Deputy Governor, and the Moreover, the Bank's senior staff now spends much more time than before on public explanations and discussions across the country about monetary policy and central bank operations. All these initiatives were designed to make the implementation of monetary policy and the achievement of the targets more effective. Explanations and discussions are also part of the process whereby the Bank accounts to the public for its actions. Accountability implies that the central bank must either achieve the target or explain what unanticipated events caused it to miss the target and what it is doing to rectify the situation. Thus, we have a strong incentive to ensure that the public is well informed about the circumstances that could affect our achievement of the objective. It is not surprising that in some countries inflation targets and increased autonomy for the central bank have gone hand in hand. An autonomous central bank has traditionally fitted somewhat awkwardly in a democratic society. However, once targets are set and the central bank is charged with achieving those targets, it is much more feasible for Parliament and the public to hold the managers of monetary policy to account for their performance. In Canada, no new arrangements for central bank accountability have been put in place since 1991. But in fact the existing arrangements have adapted quite well to an inflationtargeting environment. The Bank of Canada Act gives the Bank's Board of Directors the responsibility for ensuring that the institution is well run. This includes assessing the performance of the Governor and of the other members of the Governing Council, who are responsible for managing the Bank. The inflation targets have made those performance assessments more straightforward. When it comes to monetary policy -- the Bank's most important responsibility -- there is now a clear measure of what constitutes successful performance. The second part of the accountability arrangement for the Bank of Canada is the directive power given to the Minister of Finance under Section 14 of the Bank of Canada Act. With the new practice of agreed targets between the Bank and the Minister, the directive power, In addition, if the Minister decided that the actions that the Bank was taking to achieve the agreed targets were inappropriate, he could use the directive power. Once again, this would be an expression of non-confidence, which would probably lead to the Governor's resignation and replacement. which has never been used, now seems even less likely to be used. Nonetheless, if there were a fundamental disagreement on the targets when they came up for renewal, the Minister could impose his will via a directive. That would likely lead to the Governor's resignation and a new Governor, who was prepared to accept the desired targets, would have to be chosen. As long as no directive is in force, the Bank must take full responsibility for its monetary policy actions. However, this directive power implies that the Minister must also take a broad, ultimate responsibility because he has the power to change monetary policy. Quite evidently, this is a power to be used only in extreme circumstances. Nevertheless, this arrangement defines the nature of the Bank's relationship to the Minister of Finance in the area of monetary policy. In today's world, the accountability of public institutions goes beyond traditional legislated arrangements. In democratic societies, the general public now demands much more information and an accounting of performance from public institutions. Here again, by establishing a clear performance objective, the inflation-control targets have made it easier for the Bank to account for its stewardship to Parliament and the general public. Improved internal decision-making The explicit target for policy and the associated increase in transparency and accountability of the Bank of Canada have also had an impact on our internal decision-making processes. Other central banks that have adopted inflation targets have also noted the improvement in the process of internal decision-making that has resulted. The improved decision-making can be attributed largely to the focus on a clear objective and the consequent need to develop a robust framework that maximizes the likelihood of realizing that objective in the light of the long lags between monetary policy actions and their effects on inflation. The inflation-targeting framework typically has a number of components -- a procedure for projecting the future rate of inflation, a set of quantitative estimates of the relationships that link the central bank actions and the rate of inflation, and the development of information variables that provide early warning to the authorities that economic and financial events are, or are not, proceeding in line with the inflation outlook. For a detailed discussion of the Canadian framework for making policy, see Duguay and policy frameworks of those countries using inflation targeting as the basis of their policy. For a discussion of the uncertainty surrounding the transmission mechanism, see Thiessen (1995). In Canada, the policy process works as follows. The Bank makes a projection of inflation one to two years ahead. This is based in large part on our assessment of international and domestic economic developments and their implications for the path of real output in the Canadian economy relative to potential output. In this framework, minimizing the difference between the projected rate of inflation six to eight quarters in the future and the target rate becomes the effective intermediate objective for monetary policy. A full projection is undertaken every quarter, reassessed mid-quarter, and carefully monitored in between. The idea is to re-examine the scenarios on which policy actions are based as new information becomes available. In this context, I would note that we are very aware of the uncertainty surrounding both the projection and the transmission mechanism that links our actions to demand and inflation. While it is still early to offer any definitive judgments, I would suggest that so far one of the most important results of the targets has been an increase in the internal discipline of the policy-making process. The Bank's commitment to the targets and the need to explain and justify any inability to meet the targets have resulted in a better-focused internal debate on the appropriate policy actions to take and has probably reduced the likelihood that decisions to take such actions will be put off. The response to demand and supply shocks under inflation targeting In addition to their positive effects on transparency, accountability, and decisionmaking, the inflation targets also provide a mechanism that helps monetary policy to deal with demand and supply shocks in a way that reduces economic fluctuations. If the inflation forecast suggested that aggregate demand was expanding at an unsustainable rate and would be pressing on capacity so that the trend of inflation would likely go through the top of the target range, the Bank would tighten monetary conditions to offset the demand and inflationary pressures. Conversely, if demand was weak relative to capacity and the trend of inflation looked likely to move below the bottom of the range, the Bank would ease monetary conditions, thereby providing stimulus to the economy and reducing the downward pressure on inflation. By operating in this way, the Bank effectively reduces the magnitude of the fluctuations in real output and income that are inherent in a market-based economy. Because of this economic-stabilizer characteristic of targets in response to demand shocks, and the helpful See Freedman (1996). The ability of the U.S. monetary authorities to adopt a wait-and-see position in response to shocks in recent years is closely related to the very high degree of credibility that the Federal Reserve has achieved. role of the top and bottom of the range in communicating the way in which the Bank responds to such shocks, the Bank has recently been giving more emphasis to the target range than was the case initially. Moreover, to the extent that explicit targets and their successful achievement give Canadian monetary policy more credibility, the Bank of Canada has more potential room for manoeuvre in dealing with demand shocks. For example, following an upward demand shock, policy credibility can give the Bank more room to see how large and how long-lived the shock is likely to be and how much pressure it seems to be putting on the economy's capacity to produce. The Bank will have this greater latitude only insofar as inflation expectations are more firmly anchored by the targets and are not dislodged by a delay in responding to a shock. Inflation targets have also turned out to be helpful in dealing with certain types of supply shocks. For temporary shocks to food and energy prices, our operational focus on a core rate of inflation (the CPI excluding food, energy, and the effect of changes in indirect taxes) makes it clear that the focus of monetary policy is on the trend of inflation and not on such temporary fluctuations. Removing indirect taxes from our core measure of inflation implies that the Bank will accommodate first-round effects of tax changes on the price level. However, we have also made it clear that we would not accommodate any ongoing inflation effects that might come from attempts to adjust salaries and wages to seek compensation for tax increases. Another type of supply shock that may become relevant in the period ahead is the possibility that the widespread restructuring that we have seen in the Canadian economy, along with new technology and high levels of business investment, will lead to growth rates and levels of potential output higher than currently estimated on the basis of past experience. In such an event, the economy will be able to expand faster and operate at higher levels of output than previously thought without generating inflation pressures. A credible inflation target can help the Bank probe to find out where the limits of potential output really are. Consider a case where inflation remains under downward pressure even as the economy operates at levels of activity that the Bank believes to be consistent with full capacity. The risk of having inflation go below the target, and the accountability issues that this would raise, should ensure that the Bank will not make persistent errors in underestimating potential output. This operational framework should help to make clear to Canadians that a monetary policy focused on inflation targets does not ignore fluctuations in employment and output, or result in a persistently underperforming economy. Some criticisms of targeting on low inflation Let me now turn to the main criticisms that have been levelled at the Bank's targets for low inflation. They are: the possibility of downward rigidity in nominal wages; the floor of zero on nominal interest rates; and a concern about deflation. You will note that none of these criticisms is directed at inflation targeting as such, but at the choice of a target for inflation control that is very low. Wage rigidity Are wages rigid to the degree that they would be slow to decline even in the face of slack in the labour market? And what are the implications of such a situation for the working of the economy and for monetary policy? In other words, is some level of inflation needed to "grease the wheels" of the economy and eliminate the potential effect of such rigidity? The evidence thus far, although still fragmentary, suggests that wages can and do decline. It is also worth emphasizing that with positive productivity growth, the average wage will normally rise over time even in an environment of stable prices. In such circumstances, unchanged nominal wages will enable a decline in unit labour costs equal to the rate of productivity growth, if such a decline is needed. Furthermore, the resistance to downward adjustments of nominal wages that built up during the period of high inflation is likely to lessen as the public becomes accustomed to low inflation. Given that the behaviour of nominal wages adjusted to the period of high inflation starting in the 1970s, I see no reason why it will not adjust equally to the current period of low inflation. Indeed, there is now some evidence, in Canada and in other low-inflation countries, of an increase in the relative importance of variable pay schemes (bonuses, etc.) as opposed to increases in base wage rates. If sustained, this development would help to increase wage flexibility. As I have said in the past, I have a great deal of difficulty with the idea that wage earners in Canada are subject to a permanent money illusion that can, and should, be exploited by the monetary authority. How can monetary policy be eased when inflation is very low and interest rates are close to zero? One of the criticisms of the goal of price stability, or a very low inflation rate, is that it rules out using negative real interest rates (i.e., interest rates lower than the rate of inflation) to provide stimulus to the economy should this become necessary. This line of argument implies that one should avoid targeting a very low rate of inflation because of the added flexibility that the possibility of having negative real interest rates gives to policy-makers at a time of economic weakness. In assessing this criticism, it is important to remember that the achievement of price stability is likely to lead to a lessening in the amplitude of business cycle fluctuations. In the post-war period, deep recessions (of the sort that might, in extreme cases, call for negative real rates) have typically been preceded by periods of strong inflation pressures. These pressures resulted in significant economic distortions, which, in turn, affected the depth of the subsequent downturn. In the absence of such inflationary distortions, the downturns are likely to be much milder. Hence, there is less likelihood that a period of negative real interest rates would ever be called for. Moreover, while nominal short-term interest rates cannot be less than zero, it is worth underlining that a near-zero nominal rate will still imply a real interest rate that is appreciably below its equilibrium value and will provide considerable stimulus to the economy. Finally, in a small open economy with a flexible exchange rate regime, monetary conditions can become easier as a result of both interest rate and exchange rate movements. Even if there were only limited easing possible via the interest rate, there could still be a sufficient adjustment of monetary conditions to support a recovery and avoid having inflation persistently below the target range. Some critics have suggested that targeting a low inflation rate, such as the present 1 to 3 per cent range, raises the potential problem that a negative shock could readily push Canada into deflation. The first point to clarify is that what is relevant here is a decline in the general level of prices of goods and services, not in asset prices as some people seem to think. Furthermore, the use of the term "deflation" to describe a small decrease in prices for a short period of time, rather than a period of sustained price declines, can be very misleading. In Canada, the term deflation is associated in the public mind with the depression of the 1930s, when prices fell more than 20 per cent over a four-year period. The concerns about persistent deflation are that households will decide to defer consumption expenditures in the expectation that prices will be significantly lower in the future than at present and that the economy will enter into a debt-deflation spiral. Such responses are highly unlikely in the case of small price declines over short periods of time. The fact that under inflation targeting the authorities are committed to bringing the rate of change in prices back inside the target range would reduce even further the likelihood that deflationary expectations would take hold in such circumstances. I would contend that inflation and deflation are equally to be avoided. Both imply increased uncertainty for economic agents, and both have negative implications for economic performance. That is why the Bank treats the risk of inflation moving above the top or below the bottom of the range with equal concern. Concluding remarks It is too early to be able to draw very strong conclusions about the impact of inflation targets on actual economic performance in Canada. We really do require a longer period of time for targets to demonstrate their ability to deal successfully with the peak of an economic upturn without the trend of inflation moving persistently outside the target range. Nonetheless, some conclusions can be drawn at this point. In Canada, inflation has remained within the target range for most of the period in which targets have been set. Because of this, the outlook for inflation has, in recent years, been more stable and predictable than at any time since the 1960s. And, consequently, most nominal interest rates have been lower than at any time since the 1960s. It would appear that business investment in Canada has been encouraged by the low interest rates and stable inflation outlook. Among individuals, stable inflation has encouraged both savers and borrowers to move further out along the maturity curve. This provides greater security for these individuals -- a benefit that is particularly important for those who are not expert in, or do not wish to devote a great deal of time and energy to, financial matters. A common criticism of inflation targets in Canada is that the United States has managed to achieve better output and employment performance since 1991, with an inflation rate that is currently only one percentage point higher than in Canada. However, as I have argued in this lecture, there have been a number of factors at work that account for differences in economic performance between Canada and the United States, of which the most important probably were fiscal policy and the resulting higher public debt levels in Canada. I would add that monetary policy credibility has been less of a problem in the United States than in Canada. To an important extent, this reflects the somewhat lower average U.S. inflation rate from the early 1970s to the beginning of the 1990s. It also reflects the fact that the U.S. dollar is the major international reserve currency, and for that reason there is strong ongoing demand to hold U.S. dollar-denominated assets that does not exist for Canadian-dollar assets. In these circumstances, the commitment provided by inflation-control targets will be far more useful in attracting and holding investors to a relatively small, open economy like Canada's than to the United States. However, I would argue that the transparency and accountability of monetary policy and the resulting discipline on central bank decision-making that the targets encourage would be good for any country. And the greater predictability of the inflation outlook under a targeting regime should contribute to good long-term economic performance everywhere. Moreover, the automatic-stabilizer feature of targets should reassure those who worry that the central bank is overly concerned about inflation to the exclusion of the real economy. Finally, I would argue that transparency and accountability give autonomous central banks legitimacy in a democratic society. Since I am persuaded that central bank autonomy provides the strongest guarantee of having a low-inflation monetary policy over time, I believe that it is important to ensure that such autonomy remains acceptable in democratic societies. Only with explicit performance targets will accountability arrangements be truly effective. Inflation-control targets are by no means a miracle solution for monetary policy. But I believe that they provide a framework that leads to better policy decisions, better economic performance over time, and a more accountable, and therefore more sustainable, position for autonomous central banks. ------. 1991. . Proceedings of a conference held by the edited by Tomas in Canada . A Symposium sponsored by the Federal . A conference of central banks on the use of , a conference of central banks on the use of inflation targets organised by the Bank of England, 9-10 March 1995, edited by Andrew G. ------. 1996-97. "Does Canada need more inflation to grease the wheels of the economy?" Notes for remarks to the Board of Trade of Metropolitan Toronto.

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Opening Statement before the House of Commons Standing Committee on Finance

thiessen

Governor of the Bank of Canada before the House of Commons Mr. Chairman, I am pleased to appear before you today as part of your study of Perhaps it might be helpful if I were to start by clarifying the Bank of Canada's role in this area. The Bank has no formal responsibility for the development of financial legislation. However, we do have a vital interest in the efficiency and safety of the financial system, because it can affect the transmission of monetary policy, because of our role as lender of last resort, and because of our regulatory oversight role for large-value clearing and settlement systems. As well, I am an ex officio member of the Financial Institutions Supervisory Committee (FISC), which is chaired by the Superintendent of Financial Institutions, and an ex officio member involved in a number of international discussions on financial system issues. As a result, the Bank has traditionally played an advisory role to the Minister of Finance and his Department on policy regarding financial legislation. I would note with respect to the specific measures proposed in the Task Force Report that there are very few with direct implications for the Bank of Canada. None of the Task Force's recommendations have any significant implications for the conduct of monetary policy. And a similar conclusion can be reached for many of the other operations of the Bank. With respect to the payments system, where the Bank has an interest, the Task Force recommended that financial institutions other than deposit-taking institutions be permitted to join the Canadian Payments Association. This issue illustrates the potential tension between competition and safety concerns that can arise in formulating policies for the financial sector. Consumers could benefit from greater competition through expanded choice and additional convenience, as well as from potentially lower prices for payment related services. At the same time, however, new entrants to the system may raise potential risk concerns. These concerns could increase the costs or reduce the quality of payments services if it turned out that new and more complex measures were needed to control risks introduced by these new participants. In principle, I am inclined to support expanded participation in the payments system, but it is important that the detailed issues associated with such expanded access be fully addressed and that we not underestimate the complexity of doing so. The Task Force also discussed the issue of oversight of the payments system in Canada. As the federal government's July 1998 discussion paper indicated, more comprehensive public sector oversight may be necessary to help ensure that the payments system arrangements are compatible with the public policy objectives. Two broad questions related to this issue need to be examined. First, what should be the scope of such oversight? The Task Force has suggested that this oversight should be applied to the activities of the Canadian Payments Association. However, there is also the question as to whether there are any grounds for extending this type of oversight to private payment network arrangements, such as Interac, or future networks supporting the use of e-money. A second issue to be addressed is who should carry out such oversight activities. While the Task Force recommends that the Minister of Finance carry out this function, the Department of Finance's discussion paper suggested a number of alternatives. Any arrangement that is chosen will have to take into account the existing role of agencies with responsibilities in this area. The Competition Bureau has a general responsibility for competition issues (and has already intervened in the payments area) and the Bank of Canada has a statutory oversight responsibility related to control of systemic risk in large-value payment systems. Whatever arrangements are decided on, they presumably will have to find a way to ensure that the twin objectives of efficiency and safety are adequately recognized, and that the roles and responsibilities of the various agencies are clear. In the area of financial sector supervision, the Task Force recommended that a board of directors be created to oversee the operations of the Office of the Superintendent of Financial Institutions. The proposed board would be made up mainly of independent directors but also include ex officio members, including the Governor of the Bank of Canada. In general, I believe a board of directors can be an important part of the governance arrangements of public sector institutions. That is certainly true of the Board of the Bank of Canada. However, it is crucial that the role of the Board is clearly articulated. In the case of OSFI, it will be important to be explicit about the respective roles of the Minister, the Superintendent and the proposed board. I must also say that I have some reservations about the proposed inclusion of ex officio directors on the board. I believe that it can be difficult for officials who are heads of public institutions to carry out the fiduciary duty to another public institution that membership on a board of directors requires. With respect to the broad issues examined by the Task Force, I think we would all agree that an efficient and strong financial sector is one of the key requirements for achieving a strong and internationally competitive domestic economy. Over the past three decades, the changes to the legislation governing the activities of financial institutions have sought to increase the competition associated with the delivery of financial services. However, these changes have always been made in the context of a continuing concern about safety in the financial sector. The MacKay Task Force has adopted a similar framework in considering possible future changes. All of the changes proposed by the Task Force to increase the amount of competition in the financial sector are worth considering. However, it is possible that with more new entrants and the greater organizational flexibility being proposed, there could be an increased likelihood of failure of regulated financial institutions. A healthy, competitive marketplace does not preclude an occasional institution failure, and while it is not something one wants to see very often, we need to recognize this possibility. Thus, I think that it is very important to consider changes to the regulatory framework that might serve to identify potential problems and to reduce the costs associated with financially impaired institutions by ensuring an early exit from the financial sector. One should also consider whether increased disclosure and other means could be used to strengthen market incentives for financial institutions to manage the risks they face in a prudent fashion, thus reducing the likelihood of failure. Mr. Chairman, your committee is examining issues of vital importance to all Canadians. We strongly agree with the Task Force's desire to promote greater competition in the financial services sector. The forces of change are very strong and there is a need for a regulatory framework that can assist in producing a more efficient financial system, while at the same time addressing concerns about the safety of the system. The challenge will be in finding the appropriate balance between these two public policy objectives.

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Release of the Monetary Policy Report

thiessen

This morning we released our eighth Monetary Policy Report. The period since our last report has certainly been an eventful one from a monetary policy perspective. During the past six months, global economic uncertainties intensified, particularly following Russia's decision in August to declare a debt moratorium. Many emerging market countries were faced with large capital outflows and widening interest rate spreads as investors looked for safe havens. More broadly, spreads between private sector and government bonds also increased, and market liquidity fell. As a result of the economic and financial upheavals in the international area, estimates for global economic growth in 1998 and 1999 have been revised downward. Nevertheless, economic activity in the major industrial countries, particularly in North America and Europe, is still expected to be reasonably well sustained. We expect the Canadian economy to continue expanding over the next year on the basis of the projected sustained domestic demand in the United States and accommodative monetary conditions in Canada. However, the turbulent international developments have created greater-than-usual uncertainty around the economic outlook. Financial stability is particularly important to household and business confidence. Thus the extent to which growth in Canada's economy will take up slack over the next year will depend on how quickly international and domestic financial markets stabilize. Preserving confidence among investors in Canadian financial markets will therefore be an important consideration for the Bank over the near term. And I welcome the greater stability we have seen in financial markets in recent weeks. The fundamental focus of monetary policy over the medium term continues to be on keeping inflation within the target range. Inflation is expected to remain in the lower half of the Bank's target range of 1 to 3 per cent over the next year. Preserving low and stable inflation is how monetary policy can best contribute to improved overall economic performance over the long haul, and indeed to the long-term maintenance of confidence in financial markets as well. Let me conclude by underlining again that the global economic situation continues to be uncertain. But let me also say that the Canadian economy has been coping with the difficult consequences of global instability better on this occasion than in the recent past because of the improvements in fiscal policy and inflation control and the steps taken by the private sector to become more productive and competitive.