Philip Lowe: Resilience and ongoing challenges
Keynote address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the
UDIA National Congress 2016, Adelaide, 8 March 2016.
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Accompanying charts can be found at the end of the speech.
I would like to thank Craig Evans for assistance in the preparation of this talk.
It is a real pleasure for me to be back in Adelaide today. I would like to thank the Urban
Development Institute of Australia (UDIA) for the invitation to be part of your National Congress
in this beautiful city.
I previously spoke at a UDIA National Congress in 2010. That year it was held in Sydney. On
that occasion, I spoke about how and why the Australian economy had come through the
severe global downturn in much better shape than most other countries. I spoke about the
expected upswing in mining investment and the positive effect that it was likely to have on our
economy over the next few years. And I spoke about three specific challenges: the need to
expand the supply side of the economy; the need to get a better balance between supply and
demand in the housing market; and the need to ensure that inflation remained low and stable.
In the six years since then, a lot of water has flowed under the bridge. The global economy
has had a recovery of sorts, although the average growth rate is still below what it was before
the crisis. In Australia, the expected boom in mining investment did take place, leading to a
large increase in our production capacity. For a time, this did result in the economy growing at
an above-average pace, but this has been followed by a few years where growth has averaged
below trend as mining investment returned to more normal levels. In terms of the challenges
that I spoke about six years ago, the issue of expanding the supply side of the economy and
boosting productivity growth is just as pressing as it was then. A bit more positively, in the
housing market we now appear to have a better balance between supply and demand. And in
terms of inflation, the outcomes in Australia - and almost everywhere around the world - have
been lower than was earlier expected.
Today, I thought it might be useful to again touch on these broad themes - the resilience of
our own economy, the productivity challenge, the balance in the housing market and the
inflation outlook.
The resilience of the Australian economy
So first to the Australian economy. Here, the main point to emphasise is the resilience of our
economy and its ability to adjust.
A few years back when we were looking down from the peak in the mining boom, there was
considerable trepidation in some quarters about how Australia would manage over coming
years. With commodity prices already declining and talk of an upcoming mining investment
cliff, there were concerns about where the growth in output and, more importantly, the growth
in jobs would come from.
As things have turned out, though, we have managed pretty well so far, despite what has been
a fairly difficult environment. Over the past two years, the prices of our commodity exports have
declined by 40 per cent (Graph 1). Mining investment has also declined by almost 40 per cent,
which is the equivalent of nearly 3 per cent of GDP. Yet over these two years, our economy
has continued to expand at a reasonable pace, with growth over 2015 having been a bit
stronger than was earlier expected and not too different from the long-term average.
Importantly, there has also been sufficient growth in aggregate demand over recent times to
keep the unemployment rate broadly steady and to accommodate a rise in the participation
rate (Graph 2). Again, taking the past two years together, annual employment growth has
averaged almost 2 per cent, which again is not too different from its long-term average. It is
also a bit above population growth, so the share of the working-age population that is employed
has also risen by around 1⁄2 percentage point over the past two years.
The job creation has been particularly strong in a range of household services (Graph 3).
Health care has been a stand-out, with annual growth in jobs averaging about 41⁄2 per cent
over the past two years. There has also been strong growth in jobs in business services,
following a period of weakness a few years ago when exploration activity and pre-construction
work in the resources sector were being scaled back. In contrast, there has been little job
creation in the goods-related industries over recent years.
This picture of our economy adjusting reasonably well to the changed circumstances is also
evident in a number of other indicators. Over recent times, most business surveys have
suggested that conditions have been around, or a little above, average. Business credit growth
has picked up after having been subdued for quite a while. And last week's national accounts
confirmed that growth in household spending has also picked up.
While none of these indicators suggests that we are on the cusp of a return to the type of
growth rates we saw before 2008, they do suggest that the economy is successfully
rebalancing following the mining investment boom.
This resilience reflects, in part, the flexibility of three key prices: the exchange rate, the price
of money (or interest rates), and the price of labour.
The effect of the exchange rate depreciation is evident in the improved conditions and
prospects for a number of industries, including tourism, education, agriculture and parts of
manufacturing. Just as the earlier appreciation helped the economy avoid overheating during
the resources boom, the depreciation is now helping the economy adjust to lower commodity
prices and lower investment in the resources sector.
The effect of low interest rates is most clearly evident in residential construction activity, which
increased by 10 per cent over 2015. This strong growth is having positive spillovers to other
parts of the economy. Over coming quarters, we can expect a further increase in residential
construction, although at a slower rate than seen recently.
Finally, the low wage growth is one of the factors that has underpinned the reasonably positive
employment outcomes. Over the past year, the Wage Price Index (WPI) has risen by just 21⁄4
per cent, the lowest outcome in the 17-year history of this series (Graph 4). Lower still is the
growth rate in average hourly earnings measured by the national accounts. This measure,
which takes into account compositional and other effects that are not captured by the WPI, is
unchanged over the past year. These types of wage outcomes are much lower than what most
people had become used to and lower than suggested by the historical relationship between
wages growth and unemployment. While this low wage growth is one factor constraining
consumption growth for many individual households, importantly, it means that more people
have jobs and this is clearly a positive for both aggregate household spending and the broader
society.
So the flexibility in these key prices - the exchange rate, interest rates, and wages - has served
us well.
Our central scenario remains for growth in output to be a bit below trend over 2016, but then
gradually to strengthen as the drag from lower commodity prices and mining investment
wanes, and more of the increased capacity in the LNG sector comes on line.
The main risks to this central scenario still seem to lie in the international sphere.
The first couple of months of 2016 have been volatile ones in bond, equity and commodity
markets. Our largest trading partner, China, is going through a difficult transition to a more
consumption-led and service-based economy and is dealing with high levels of corporate debt
and the complications of opening its capital account. On the monetary front, interest rates in
the United States were recently increased for the first time in nine years, while the Bank of
Japan unexpectedly moved one of its key interest rates into negative territory. In doing so, it
joined the European Central Bank, the Swiss National Bank, the Swedish Riksbank and the
Danish central bank with negative rates. And in a number of countries, there is an expectation
that yet further monetary easing will take place.
It remains to be seen what all this means for us. The recent international data have been mixed
but, at this stage, do not suggest that momentum in the global economy has been lost. The
monetary easing abroad is a complication for us, as it tends to put downward pressure on the
currencies where the easing is taking place and thus upward pressure on the Australian dollar.
More positively, lower oil prices - which primarily reflect increased supply capacity - are mostly
good for global growth: they lower the cost of production for almost every firm in the global
economy and put more money in the hands of consumers. The lower oil prices do, however,
create financial strains for some economies and for some companies.
So there are lot of cross-currents here that we are watching very carefully at the moment.
I now want to move to the three challenges that I spoke about in 2010.
Expanding the supply side - productivity
The first of these was expanding the supply side of the economy - or lifting our productivity.
Six years ago, the focus was on ensuring that the economy had sufficient productive capacity
to avoid overheating during a period of strong demand flowing from the resources boom.
Today, the focus is a little different. While we have done a pretty good job of adjusting to our
changed circumstances, the not-so-good news is that growth in real income per capita in
Australia has stalled (Graph 5). Indeed, average real income is no higher today than it was in
2008. This follows a 17-year period in which growth averaged a remarkable 3.1 per cent per
year. During this earlier period, we benefited from: (i) strong productivity growth in the 1990s;
(ii) a very large rise in our terms of trade; and (iii) favourable demographics, which helped
increase the share of the population in paid employment.
In all three of these areas, recent outcomes have not been as kind. It is more than coincidental
that the timing of this change in our fortunes broadly coincides with the timing of increasing
pressure on the federal budget, an increase in the general sense of economic uncertainty,
slower gains in some asset prices and slower growth in wages and profits. Inevitably, when
income growth is weak the effects are felt broadly through the community.
Looking ahead, we should be able to look forward to somewhat better outcomes than over the
recent past. We could expect that the drag on our national income from falling commodity
prices will eventually lessen. And if current trends in employment continue, we could look
forward to some further increase in the share of the population in paid employment. Both of
these would be positive for real income growth. Australia's fundamentals also remain sound.
We have a tremendous base of natural resources, a talented, diverse and growing workforce,
a stable political and legal system, a highly regarded university system, and we are well placed
to benefit from the increasing demand for services from Asia.
But there is no escaping the fact that future growth in the average income of Australians relies
largely on our ability to lift our productivity. While the rebalancing and resilience of our economy
is certainly something to welcome, the longer-term challenge is to lift our living standards
through finding new things to do and better ways of doing what we currently do. The need for
this is made more pressing by the fact that the growth momentum in the global economy is
less than it once was.
Ultimately, productivity growth is heavily reliant on decisions made by businesses. But policy
decisions can also make a difference. Here, there is no shortage of ideas. They cover
strengthened competition policy, better provision and pricing of transportation infrastructure,
developing a strong innovation culture, creating strong incentives for entrepreneurship and
hard work, and investing in high-quality education. The task we collectively face, then, is to
identify the right specific policies in each of these areas and then find ways of implementing
them. Clearly, this is not an easy task, but neither is it an impossible one.
Housing
I would now like to turn to the second issue - the balance in the housing market.
Again, when I spoke six years ago, the focus was on the pressures in the housing market
arising from the rather unusual situation of having the growth rate of the population exceed
that in the number of dwellings by a substantial margin (Graph 6). Since then, population
growth has slowed, and the rate of growth in the dwelling stock has increased so that it now
once again exceeds that of the population. Reflecting this increase, the share of GDP
accounted for by the building of new dwellings has risen significantly and is now close to the
various peaks reached over the past 50 years (Graph 7). Notwithstanding this, with spending
on alterations and additions being relatively subdued, overall investment on residential
construction remains some way below the previous peaks.
This increase in the supply of dwellings has come on the back of a large run-up in housing
prices in Australia's two largest cities. But the increase in supply now looks to be contributing
to some moderation in the rate of increase in housing prices in these cities. It is also putting
downward pressure on rents, with the CPI measure of rent inflation running at just 1.2 per cent
in 2015, the lowest for 20 years (Graph 8). Whether or not these trends are maintained remains
to be seen, and so we continue to watch developments in the housing market very closely.
However, the overall picture does appear to be one of a better balance between supply and
demand than was the case in 2010.
As I noted earlier, the lift in residential construction has been an important element in the
cyclical rebalancing of the economy. In the period ahead, we can expect a further increase in
residential construction, although at a slower rate than took place last year. While this more
modest increase will mean a more modest boost to overall GDP growth from home-building, it
should assist with the sustainability of the current boom in residential construction. It is unlikely
to be in our collective interest to have a further surge in the construction of new dwellings, as
a share of the economy, then to be followed by what would surely be a larger and more
prolonged decline later on. Overall, the recent data on building approvals suggest that we are
on a reasonable path here.
From a longer-term perspective, the challenge of providing an adequate supply of reasonably
priced housing for an increasing population rests largely on the flexibility of land supply and, in
particular, the supply of well-located land. This is because high housing costs largely reflect
high land prices, not high construction costs. Here, it is zoning regulations and the
transportation infrastructure that can make a material difference. In both areas, progress has
been made since 2010, but there is more to be done.
Inflation
The final issue is the inflation outlook.
Six years ago, inflation rates in almost all advanced economies were below the midpoint of
central bank targets. This remains the case today (Graph 9). The average core inflation rate
across the advanced economies is very similar to that in 2010, and headline inflation rates are
lower than they were then, because of the decline in oil prices over the past year.
Six years ago, Australia was one of the few advanced economies in which inflation was not
below the midpoint of the target (in our case, 21⁄2 per cent) (Graph 10). This was, perhaps, not
surprising given the mining investment boom that was then taking place. But today, as in many
other countries, we too find ourselves below the midpoint of the target, although by only a
relatively small margin. Importantly, unlike most of these other countries, inflation in Australia
does remain consistent with the medium-term target.
It would appear that in many advanced economies the inflation dynamics are a little different
from those in the past. In earlier decades, it was very rare for central banks to worry that
inflation and inflation expectations were too low. Yet today, we hear this concern quite often,
and the 'unconventional' has almost become conventional.
One factor that has contributed to the low inflation outcomes is the fall in oil prices. But a more
fundamental influence has been the low wage increases in most advanced economies. In a
number of these economies, including the United States, Japan, Germany and the United
Kingdom, the low wage increases have coexisted with fairly strong employment growth and
not-so-strong output growth. This is evident in Graph 11. The left hand panel shows, for each
country, average employment growth over the past two years relative to the long-term average.
Similarly, the right hand panel shows recent GDP growth rates relative to the long-term
averages. The pattern is reasonably clear: employment growth has been quite strong relative
to historical trends, but output growth has not. It is also worth noting that each of these four
countries is at, or near, conventional estimates of full employment.
The commonality of this experience of low wage outcomes, strong employment gains and
relatively subdued output growth suggests that some global influence may be at work. One
possibility is that workers in the advanced countries perceive that they have less bargaining
power than they had before, either as an after-effect of the financial crisis and/or the
incremental globalisation of many service industries. Another possibility is that it is a reflection
of the subdued growth in the global production of goods and the relatively strong growth in
services, where output is more difficult to measure.
Whatever the reason, the dynamics of labour markets are critical to the future path of inflation.
It is possible that wage outcomes will remain very subdued even in countries with strong labour
markets. If this turns out to be the case, then it is likely that inflation rates will also continue to
be very low and monetary policy very accommodative. Alternatively, what we might be
witnessing is just a slightly longer lag in the normal relationship between employment growth
and wages. If this is the case, a pick-up in wage growth and inflation may not be too far away.
Here, the United States is a test case of sorts given that its recovery is most advanced.
Recently, there have been some signs of a pick-up in inflation there and it will be worth
watching what happens quite closely over the next few months.
For us, here in Australia, the continuing low wages growth means that CPI inflation is also
likely to remain relatively low. While there is some upward pressure on the retail prices of
imported goods as a result of the depreciation, this pressure is being muted by stronger
competition following the entry of a number of overseas-based retailers into the Australian
market.
As the Reserve Bank has indicated for some time, this low inflation outlook provides scope for
easier monetary policy should that be appropriate in supporting demand growth in the
economy. An important factor here will be whether the growth in aggregate demand continues
to be sufficient to accommodate the growth in our labour force.
So, this brings me to the end of my remarks. I wish you the best of success for your National
Congress. I hope that in another six years' time we can still be talking with some satisfaction
about the resilience and growth in the Australian economy. And I suspect that the issues of
productivity growth, the balance in the housing market and the inflation dynamics will be just
as relevant as they are today, and as they were in 2010.
Thank you and I would be happy to answer any questions.
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