Glenn Stevens: Still interesting times
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Chamber of
Commerce and Industry (Western Australia) and the Chamber of Minerals and Energy
(Western Australia) Corporate Breakfast, Perth, 7 September 2011.
* * *
It is very good to be with you this morning.
In the process of deciding a title for this address, I recalled that three years ago I was talking
in public addresses about the times being interesting, perhaps a little too interesting. That still
seems to be the case, hence the title.
As you know, yesterday the Reserve Bank Board met here in Perth. The Board reviewed the
international and local information to hand since its last meeting, and decided once again to
leave the cash rate unchanged.
The reasons for that decision were given in the statement released following the meeting.
More information on the nature of the discussion and considerations the Board took into
account will be published in the minutes of the meeting, two weeks from yesterday. I do not
want to dampen any of your undoubted eager anticipation for what may be contained in
those minutes. What I will do is say a little more about the sequence of decisions the Board
has taken over recent months.
To do that in appropriate context, it is worthwhile first recounting the framework for monetary
policy that has been in operation since the early 1990s and that continues to guide the
decisions of the Board. So I will say something about that. Then I will describe how the flow
of recent events, viewed through that framework, has had a bearing on decisions.
The framework for monetary policy
The framework for monetary policy is a medium-term, flexible inflation target. It seeks to
achieve a rate of increase in the Consumer Price Index of between 2 and 3 per cent, on
average, over time. This arrangement has a fair bit of history now. The Reserve Bank began
to articulate it in the early 1990s and it has been formally agreed between successive
Treasurers and Governors, in published statements, beginning in 1996.1 The "on average"
specification allows the Bank to take account of the fact that it cannot finetune inflation over
short periods, and of the obligation to promote, insofar as monetary policy can, full
employment, which is another of the Bank's charter obligations. Having a numerical goal
takes account of the importance of inflation expectations, and seeks to provide an anchoring
point for them - which is a critical function of any monetary policy regime. It also provides a
focal point and a measuring stick for monetary policy decisions, which recognises that, in the
end, monetary policy is really about the value of money.
We arrived at this framework after a long search - the "search for stability" set out in detail by
Ian Macfarlane in his ABC Boyer Lectures in 2006.2 The current framework is not necessarily
the end of history. But it has worked well for a period not far short of two decades now, with
no obviously superior framework on offer.
Sometimes people ask whether a higher target for inflation might not be better, particularly
when inflation is looking like it will rise and the Bank is running a setting of monetary policy
designed to resist that. The answer ultimately hinges on how prepared we would be to
accept the things that would go with higher inflation. Higher average interest rates would be
among them - there is no reason that savers, any more than wage earners, would be
prepared simply to accept an erosion of their financial position. That is why countries with
higher inflation generally have higher nominal interest rates. Moreover, whatever structural
challenges the economy faces would still have to be faced at higher inflation rates. Higher
inflation wouldn't make those issues go away, nor make them any easier to cope with (as we
know from our own history when inflation was high and structural change still had to occur).
We would simply waste more real resources as everyone sought to protect themselves from
the higher inflation.
In supporting the decision process that puts this framework into practice, the Bank carries out
a great deal of detailed statistical work, tracking several thousand individual data series. It
conducts extensive liaison with businesses and other organisations, usually speaking in
detail to as many as 100 contacts each month. It produces voluminous published analysis of
these data.
The objective of these efforts is, at its heart, fairly simple. We are trying to form an
assessment about the course of overall demand in the economy and how it is travelling in
relation to the economy's supply potential. That assessment in turn informs a judgement as
to whether inflation pressure in the economy is likely to increase, decrease or stay about the
same, and how the likely outcomes compare with the announced objective. That judgement
then informs a decision as to whether monetary policy needs to restrain demand, to support
it or to be "neutral". Of course other factors that affect prices - like exchange rate changes,
changes in the price of oil, and so on - have to be taken into account as well.
Note that the economy's supply potential is a key element in the above framework. This is
not a directly observable thing: there is no time series labelled "potential supply".
Assumptions have to be made about the availability of productive factors - labour and capital
- and about the productivity with which these factors can be used. This is why the current
productivity discussion is so important. Incidentally, the desire for more productivity is not a
call for working harder. Australians already work pretty long hours by international standards.
Productivity per hour, which is what counts, is not improved by adding more hours, but by
finding ways of making the hours that are already being contributed more effective.
The Board's decision each month, and the reasoning behind it, are communicated to the
public. These statements are among the most closely scrutinised documents in the country. I
am often awed by the layers of hidden meaning that people are able to detect in them. But
the main purpose of these statements, and of all the other communication we do, is simply to
try to make the Bank's assessment of the outlook and its actions as understandable as
possible to the many people who need to make long-term decisions, including households
and businesses. Of course, events and new information often change the outlook, as we
have seen recently.
Recent developments
How has the Board evaluated recent developments within the above framework?3
Throughout the past year or so, the forecasts that the Bank's staff have provided to the
Board have suggested that underlying inflation would probably stop falling and then gradually
rise through the three-year forecast period. The backdrop to this view was that the rise in the
terms of trade was expansionary for incomes and investment, which would likely see
demand growth remain pretty strong even as fiscal stimulus spending unwound.
The exchange rate was working to offset a good deal of this expansionary impact, by
restraining some parts of the economy exposed to international trade but not exposed to
mining. Nonetheless, given the size of the terms of trade rise, and the fact that the economy
started from a position of reasonably low unemployment, it was thought that underlying
inflation was more likely to start to go up than to keep falling. On the evidence we have so
far, that's what seems to have been happening.
Faced with that outlook, the Board judged that it was appropriate for monetary policy to exert
a degree of restraint. As of the end of last year, the Board's view was that it had reached that
position. We believed that we were therefore in a position of being able to maintain a steady
setting for a while. The post-Board statements I issued each month at successive meetings
said that the Board viewed the stance of monetary policy as remaining appropriate for the
outlook.
Of course, there are always uncertainties surrounding forecasts, and the Bank's publications
have been careful to articulate possible risks that we could identify - including things such as
the possibility of a serious worsening of the situation in international financial markets, driven
by sovereign debt concerns. Most of these risks do not come to pass, and if they do
eventuate they don't necessarily unfold as we had imagined they might. Still, the Bank
makes considerable efforts to think about how things could turn out differently to the central
forecast.
By the time of the May Board meeting, there was evidence that the pace of underlying
inflation had started to pick up. I myself felt that the Board was still well placed to sit still at
that time. We had already put in place a response in advance of the expected pick-up in
inflation and it is not necessarily always wise to respond to one high (or low) figure.
Nonetheless, the updated forecasts carried a fairly clear message: policy would probably
need to be tightened further, at some point, if things continued to evolve as expected. The
Bank said that - indeed there was no other credible thing we could have said.
In the ensuing months, little has changed about the outlook for resources sector investment.
More large projects have been approved and the pipeline of future investment looks very
large. On all the available information, resources sector investment will probably rise by
another 2 percentage points or more of annual GDP over the next couple of years. Prices for
important commodities remain high and the nation's terms of trade are at an all-time high in
the current quarter.
At the same time, it has become clearer that precautionary behaviour by households and
some firms is exerting restraint on the pace of growth in demand, and that the higher
exchange rate is diverting more demand abroad. This is putting pressure on trade-exposed
sectors. Moreover, the sense that a higher exchange rate might not just be a temporary
phenomenon may be leading to a pick-up in the pace of structural change in the economy.
In net terms, the outlook for the non-resources economy in the near term is weaker than it
looked a few months ago, and the recovery of flood-affected mining in Queensland is taking
longer than earlier thought. At the same time, looking at financial variables, credit growth has
slowed a bit further and asset prices have tended to decline. These factors, along with
ongoing evidence that underlying inflation had turned up, were incorporated in the Bank's
outlook as published early last month.
Meanwhile, the sense of unease about how Europe will manage its problems has increased
over recent months. We also had the anxiety over the US debt ceiling issue, which became
acute early in August. Measures of confidence in both economies declined significantly as all
this occurred. Equity markets fell as investors shifted to the relative safety of bonds issued by
the major countries - even though S&P had announced a downgrade of the US sovereign
credit rating.
It is too soon to see much evidence of a concrete impact of these events on the global
economy. Any assessment we make at present is highly preliminary. Moreover, we have no
way of knowing what events will transpire in financial markets over the months ahead. There
are any number of hurdles in Europe or the United States that could serve as a catalyst for
increased anxiety. This state of affairs is likely to persist for the foreseeable future.
With those caveats, a few preliminary observations can be offered on this episode in
comparison with what we saw in 2008.
First, the focus is more on sovereign creditworthiness as opposed to the state of private bank
balance sheets per se (though in Europe of course the two are intertwined). In a proximate
sense, that is the direct result of the previous crisis and especially the ensuing period of
weak growth that has had a severe impact on government revenues in the affected
countries. But, taking a longer-term perspective, some countries, especially in Europe, have
had fiscal positions that were quite vulnerable to a shock to confidence for some time now.
High debt levels were sustainable while markets thought they were and hence were prepared
to offer financing at low interest rates; if people suddenly doubt sustainability and charge high
interest rates, that same position becomes much less sustainable. So to no small extent, it is
actually a matter of confidence - confidence that there is a sustainable long-run fiscal path,
that policymakers know how to get onto it, and that they have the will to do so. In crafting any
policy response to near-term economic weakness, this is a key point.
Second, there have been pressures in funding markets for some European banks recently, but
at this point not to the same extent as in October 2008. Bank capital levels are improved from
three years ago and leverage is reduced. We have not seen significant funding problems for
US or UK banks recently; their problems at present seem to relate more to the possible size of
legal costs arising from pre-crisis lending standards. Overall, we have not, to this point, seen
the widespread withdrawal of willingness to deal with counterparties that we saw in late 2008.
Third, a key feature of this episode is that confidence in the euro is a more prominent issue
than was the case three years ago. Those countries at the so-called periphery' are paying a
high price as they play their part in keeping the euro together. But the ultimate outcome is
going to hinge on the willingness of "core" euro countries to accept socialisation across the
euro zone of some of the losses associated with countries in trouble. That is really the issue
that is being debated in Europe now.
If there were a major international downturn, an important question would be how
policymakers in major countries would respond. The scope for fiscal policy easing in many
major countries is hotly debated. Some commentators call for further stimulus, citing faltering
recoveries, while others point to medium-term debt paths that look very troubling as a reason
for fiscal consolidation. Both have a point. The question in major countries is whether a
package combining short-term stimulus with a highly credible medium-term path back to
sustainability could be crafted. It certainly does not look easy. As for possible monetary
policy responses, most major countries would be quickly into the realm of "quantitative
methods", if they are not there already. It is hard to gauge the effects of those measures.
In Asia and other parts of the emerging world, however, ample policy ammunition is
available, both fiscal and monetary, should the authorities have a need to use it. To do so
credibly would presumably require confidence that the upward trend in inflation seen over the
past couple of years would be likely to turn down. Of course, a significant weakening of the
global economy would result in lower commodity prices and generally lower underlying
inflation pressures. So far, the decline in major commodity prices has been fairly modest,
though enough to help rates of CPI inflation to moderate a little.
In summary, the environment presents no shortage of challenges, though we should not
assume that this is necessarily 2008 all over again. It is reasonable to conclude, at this point,
that the outlook for global growth is not as strong as it looked three months ago. Forecasters
are generally revising down global growth estimates for 2011 and 2012, mainly as a result of
weaker outcomes for the major countries.
Turning back to the implications for Australia, periods of sudden increases in anxiety within
international financial markets are moments when, if at all possible, it is good to be in a
position to be able to maintain steady settings. In the recent few meetings, the Board has
judged it prudent to sit still, even though we saw data on prices that were, on their face,
concerning. To be in that position of course requires timely decisions to have been made in
earlier periods.
Looking ahead, the task for the Board is to assess what bearing recent information, and recent
international and local events, will have on the medium-term outlook for demand and inflation.
They probably won't have much effect on the large-scale investment plans in the resources
sector, but households and firms watching what is happening may continue their precautionary
behaviour for longer than otherwise. This would presumably dampen demand somewhat
compared with the outlook set out in the Statement on Monetary Policy published in early
August; it may also condition wage bargaining and price setting. If so, that may act to curtail the
upward trend in inflationary pressures that has, up to this point, appeared to be in prospect.
At the same time, significant rises in a range of administered prices are still set to occur over
the period ahead. Moreover, unit costs have been rising quite quickly given the fairly poor
performance of multi-factor productivity growth over recent years. In fact the experience of
the past year, as the Deputy Governor noted recently, is that while growth seems to be
turning out weaker than expected at the end of last year, underlying inflation seems to be
turning out higher. A key question is whether that is just the vagaries of statistical noise and
lags, or whether it is telling us that the combinations of growth and inflation available to us in
the short term are less attractive than they seemed a few years ago. If the latter, the spotlight
will come back on to supply-side issues.
Conclusion
More than at most times in my professional life, Australia's economy faces a very unusual,
and powerful, set of complex forces. Major countries are still coming to terms with the
excesses of earlier years and experiencing what many have learned before, which is that
after a period of financial distress it is usually a long and difficult recovery. Economic growth
has been uneven and patchy, and financial concerns keep recurring, with waves of positive
and negative sentiment sweeping global markets. Australians feel the effects of those swings
in sentiment.
Meanwhile, the emerging world continues to expand, and it is not all due simply to exports to
the rich world, even though the world could still do with some more re-balancing. There is an
epochal change occurring, and Australians are also feeling that. It is overwhelmingly positive
for us in net terms, even if our tendency to dwell on the downside is more prominently on
display at present.
The future is uncertain, but it always is. What we know is that, as we move into that future,
whatever it holds, we do so:
 with our terms of trade at a record high;
 with more jobs in the economy than ever before, and with 95 out of every 100
people seeking work in a job;
 with our banks sound, our financial system stable and our sovereign credit
respected globally; and
 with the capacity for macroeconomic policy to respond sensibly to events,
appropriately guided by well-established frameworks.
We have our problems, but with some good sense and careful judgement we ought to be
able to navigate what lies ahead.