Mr Macfarlane's statement to the House of Representatives Standing Committee on Economics, Finance and Public Administration  (Central Bank Articles and Speeches, 15 Dec 98)
Central bank: rba | Type: speech | Date: 1998-12-15

## Mr

Macfarlane's

statement

to

the

House

of

Representatives

Standing

Committee

on Economics, Finance and Public AdministrationOpening statement by the Governor of the Reserve Bank of Australia, Mr I.J.

Macfarlane, House of Representatives Standing Committee on Economics, Finance and Publi Administration in Sydney on 15/12/98.

## Thank you, Mr Chairman,It is a pleasure to be here in front of your Committee again.

As you mentioned, the nee adjustments to the composition of the Committee after the October Federal election me we are meeting about five weeks later than our normal timetable.

Given the uncertainty timing of the hearing, and the importance we attach to regular communication with the about the economy and the Bank's activities, we decided to keep to the regular time releasing our Semi-Annual Statement on Monetary Policy , which came out in early November.So there is a substantial gap between the Statement and this hearing.

On the whole, we feel that our Statement still represents a reasonable summary of our views on events that had taken over the preceding six months.

The world has not changed dramatically since the Statement was issued.

We have, however, made an adjustment to the stance of monetary policy, follow December Board meeting.

This was as a result of our continual process of evaluating i information, and our assessment of the outlook for the year ahead, and the various risk to

our

forecasts.

Our

judgement

was

that,

even

though

most

of

the

data

coming

in suggesting

growth

was

running

ahead

of

earlier

expectations,

the

likelihood

was

that would decline in 1999.

At the same time, the likelihood of overshooting the inflation judged to have declined.

Hence, we viewed a small further easing of policy as a prudentThe good economic outcomes over the past year will, I suspect, be a recurring featur discussion today.

It might be helpful, therefore, if I start by reviewing the forecas seven months ago and make some observations about how recent developments compare wit them.What I said last time could be summarised as:- GDP would grow by about 3 per cent during 1998;- the unemployment rate would remain relatively stable;- we had passed the trough of inflation and it would rise gradually, reaching about by the end of the year; and- the current account deficit would average about 5½ per cent of GDP for 1998.I

also

said

that

I

thought

this

combination

of

events

would

be

a

reasonably

good

r Australia in view of the difficult external situation we were facing, particularly amon export

markets.

In

the

event,

the

external

situation

did

not

get

any

better,

but economic performance has exceeded our expectations, and, to the best of my knowledge expectations of virtually all forecasters.It now looks as though GDP growth during 1998 will be about 4 per cent, rather than t cent that seemed likely in May.

A good deal of the additional growth is attributable outcomes than we had expected in the June and September quarters.

The remainder is a re upward revision to earlier data across most of the recent quarters.

Consistent with t than expected growth, the rate of unemployment has continued to edge down, rather than flat.

Over the past three months it has averaged 7.9 per cent, compared with 8.1 per first quarter of 1998 and 8.7 per cent in the first quarter of 1997.On inflation, it seems clear that the trough has passed, and our best guess for the ri over the four quarters to December 1998 is, in round figures, still about 2 per cent. true to say that inflation shows signs of not increasing by as much as historical r might have led us to expect, given the fall in the exchange rate.

On the current accoun now looks as though it has averaged around 5 per cent of GDP in 1998 rather than the cent we expected at the last hearing.I would summarise the situation as being one where the forecast errors were within th ranges that occur with forecasts of this type.

The thing we can take some comfort from, is that no-one can accuse us of being Pollyannas because in each case the outcome was better than the forecast.

Growth has been stronger, the widening in the current acco smaller and, at the margin, the rise in inflation slightly smaller than we had expected.I now propose to make a few general comments about how we are expecting future event unfold.

Over

the

course

of

the

year

before

the

Asian

crisis

commenced,

that

is

1996 economy grew by 4½ per cent.

In the first year affected by the Asian crisis - 1997/98 4¼ per cent.

Despite starting 1998/99 at a similar pace, we have to accept that we w able to continue at this rate.

Growth through 1998/99 is more likely to be somewhere 2½ and 3 per cent.

Implicit in this is that the coming quarterly growth rates will b lower than the ones we experienced over the past year.Some slowing seems to be inevitable, given the weaker outlook for the world economy.

Si last met in May, most forecasters have revised down expectations.

The IMF, to take j example, has revised down its forecast for world growth in 1998 from 3 per cent to 2 and for 1999 from 3¾ per cent to 2½ per cent.

If these estimates are a reasonable guide external

environment

will

remain

difficult

and

income

from

external

sources

constrai course, domestic demand has been, and remains, much stronger than external demand, a Australia's expenditure has run ahead of national income over the past year.

But that be expected to continue to grow at the same pace indefinitely, and so both domestic dem GDP growth must be expected to come down over coming quarters.

With slower growth in offing, we expect that the unemployment rate will flatten out.

Of course, we said that now we are suggesting it will occur at a slightly lower rate of unemployment than we expected.We expect the four-quarters-ended increase in the CPI to be about 2½ per cent by the e financial year - that is, in the short term, we expect inflation performance to be co our

target.

Of

course,

any

forecast

of

inflation

beyond

that

period

is

only

as

g assumption about the future path of the exchange rate.Given

the

current

tendency

towards

lower

commodity

prices,

we

are

assuming

some

fur widening in the current account deficit to about 5½ per cent of GDP in 1998/99.

With a figure of this size, it would not be surprising to see a quarter or two of it running cent of GDP.

I made the same comment in March this year, and again in May at our pre hearing.

I expected that it would have come to pass by now, but it has not.

It would n me, however, if it does happen some time in the next year.This set of outcomes, or something like it, would represent a good performance for an in

its

eighth

year

of

expansion

facing

a

difficult,

but

not

disastrous,

external

en expect that it would be well received by the domestic and international investment co though one can never take this for granted.

And, of course, if the assumptions we ar about the world economy turn out to be too optimistic, all bets would be off.I now come to the second part of my testimony, in which I attempt to answer the questio we have done better than most other countries in Asia or the Pacific Rim.

In doingconscious that the story is not yet over, so this is really an interim report.

I thi factors have been involved and I will list them in no particular order.

As we go throu will become apparent that they are all intertwined.First, I think the Asian crisis hit at a time when the Australian economy was in good s for cyclical reasons.

By mid-1997, the economy was growing strongly and inflation was than our target.

Had we not received a contractionary impulse from the Asian crisis, we been facing the need to tighten policy because of a potential overheating.

No-one will but it is a possibility.

I am conscious that attributing our performance over the past our good starting point is rather superficial because it does not explain why the start so good.

But I will come back to that later.Second, I think we have benefited from the flexibility of our exporters, who have swit the contracting Asian markets into the expanding North American and European ones, and number of other markets we do not usually think of as being important to us.

The natur exports - with so much of them being commodities - has helped, but the efforts of our companies and authorities should not be ignored.

Even so, it has not proved possible t exports from falling, and over the year to the September quarter they fell by 2 per centThird,

Australia

has

benefited

from

a

greatly

improved

perception

of

the

soundness economic policies.

The fact that the budget has moved back into surplus - where it sho the mature phase of an economic expansion - has been important.

So has nearly a decade inflation.

Also important on this occasion has been the recognition that Australia sco such factors as its regulation of banks, other financial institutions and stock exchan its

underlying

body

of

commercial

law

and

accounting

practice

is

at

or

close

to

wo practice.Not only have the international capital markets taken a better view of Australia, but w to have more confidence in ourselves.

Business and consumer confidence initially fel Asian events unfolded, but they did not fall excessively - for the most part they fel above average to about average.

In the past three months, they have tended to rise m again

as

figures

about

the

economy

have

confirmed

that

it

has

performed

better

tha expected.The fourth explanation for why growth has held up is a catch-all one - the economy just be more flexible and adaptable than before.

The only clear evidence of this is that pr whether labour productivity or total factor productivity - has increased faster in the earlier decades.

For example, total factor productivity has increased at an average an 1.7 per cent during the expansion of the 1990s, compared with 0.7 per cent in the 1980 per cent in the 1970s.

To me, this suggests that the painful adjustments that have been the past decade or so are paying off.

By this, I mean the changes that have been made t competition

in

previously

sheltered

industries.

This,

of

course,

includes

great orientation, but also greater competition in utilities and transport, which has redu other

industries.

It

also

includes

the

downsizing

of

the

public

sector,

which

ha resources.

Finally, our labour relations practices and wage setting machinery now have of flexibility that has surprised the sceptics.I now come to a fifth factor, which most commentators view as being important - name fact that in response to a contractionary external shock, the Australian dollar was all down.

This is the way the textbooks say the situation should be handled, and is in sha to the severe domestic squeeze that can result in the cases of countries with fixed or exchange rates.The domestic economy has benefited from the lower exchange rate because exporters' inc have been held up and the incentive to export maintained (while at the same time assis industries that are competing against imports).

The domestic economy has also benefited we have not had to put up interest rates in order to maintain our external parity (a exchange rate) or to prop up a floating rate that threatened to fall so far that it w undesirable

inflationary

consequences.

Raising

interest

rates

in

response

to

an contractionary shock is not something that you normally would want to do, although in circumstances it may become necessary.I have heard people say that it is a good thing that, unlike some other countries, we w in the face of a falling exchange rate.

I can assure you all that we were never rela followed the Australian dollar on virtually a daily basis for 15 years, I know that yo take it for granted.

While the floating rate is the best system we have had, like al freely determined in unconstrained markets the Australian dollar is prone to bouts of or overshooting.

On three occasions - in January, June and August - a downward oversh threatened and we responded with foreign exchange intervention.

On each occasion, stabi re-established and, unlike the experience of the mid-1980s, we did not raise interest this does not mean that that option was not on the table.

It was, and financial market as a result, 90-day rates were well above cash rates in both June and August.

Fortunat turned out well, and so the option did not have to be used.Thus, the exchange rate was centre stage.

The general direction of its movement was per a very useful function, yet the short-term dynamics were such that it often threatened far.

It has been a delicate balancing act, but one with a favourable outcome.

Over th years,

the

economy

has

been

able

to

grow

at

over

4

per

cent

per

annum

without

sign upward pressure on inflation (which has averaged 1.6 per cent over the same period). better than almost anyone expected.Another way of approaching the question is to ask why we at the Reserve Bank were a accept this continuation of high growth and depreciating exchange rate without having t monetary policy (in fact, being able to ease it slightly at the beginning of this month) is that the combination has not to date seriously threatened our inflation target.

Why out this way?The

answer,

I

think,

is

that

we

are

beginning

to

receive

the

big

dividend

that

low provides.The

economy

has

gradually

adjusted

to

nearly

a

decade

of

low

inflation

and,

altho adjustment is still not complete, the benefits are becoming apparent.

Inflationary expe much lower and more stable; wage contracts are now often two or three years in duration including housing mortgages, often

have

interest

rates

fixed

for

long

periods;

and know that they can no longer automatically pass on any cost increase secure in the kn that

it

will

get

lost

among

the

multitude

of

other

price

increases.

This

new

le environment allows the floating exchange rate to do its job of stabilising the domesti in the face of an external shock.

It does so by reducing the tendency for the expansion of a falling exchange rate to be dissipated in the form of rising inflation.

It also saying that the low inflation environment makes the task of monetary management a lot eaI think we can take some satisfaction about how events have turned out over the past t but we should not become complacent.

This particular episode, which started as a region crisis, is far from over.

We should not think that we can see the end of it just be already been running for 18 months.

For a start, the United States has only recently slowdown, and uncertainty about the US outlook seems greater at present than for some t addition,

Japan

remains

gripped

by

powerful

contractionary

forces.

That

could

put

copressure on commodity prices.

Much has been said recently about how Asia has passed the of its problems, and on many measures this is so.

But the contractions have been very many cases, and no-one is expecting a quick or strong recovery.I do not wish to say any more at this stage.

You will note that I have dealt exclusiv domestic economy, but I think that is appropriate since I have spoken so much recently places about Asia, the world economy, and international financial markets.

My colleagu are, of course, happy to answer any questions you may have on the topics I have not co for that matter, on the ones I have.