Glenn Stevens: Recent economic and financial developments in
Australia
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the
House of Representatives Standing Committee on Economics, Finance and Public
Administration, Gold Coast, 17 August 2007.
* * *
Mr Chairman, members of the Committee.
Since we last met in Perth, economic conditions in Australia have strengthened. At the same
time, financial markets globally have recently become extremely skittish and there has been
a very sharp re-assessment of risk and a sudden desire for liquidity.
I will come to the financial market turbulence shortly. Before I do, however, it is worth
recounting how the real economy has performed over the past six months. Given the
uncertainty being felt in financial markets at present, it is important to keep a clear sense of
the economic fundamentals.
According to the national income accounts, growth picked up sharply in the December and
March quarters. Over the year to March, real GDP is estimated to have expanded by about
33⁄4 per cent, despite the impact of the drought. The non farm economy was reported as
having grown by about 41⁄2 per cent, equal to its fastest pace for four years.
Gauging the true extent of acceleration is not straightforward given the inevitable noise in the
data over short periods, but a wide range of survey evidence and other indicators also
suggest that conditions picked up in the first half of 2007. Domestic spending is rising, with
robust rises featured among most of the components. The exception is residential
construction, where commencements remain flat at slightly below average levels. Demand
for credit also appears to have firmed, most particularly among businesses. Household
finances, like corporate finances, are generally in strong shape.
Demand for Australian exports is rising too. Success in transporting higher volumes of
resources has been mixed, varying by location and industry and according to disruptions
caused by weather, efforts at adding new capacity, and port and rail delays in some cases.
But the trend is upward and tonnages are set to increase over the next several years as
capacity comes on line. Agricultural exports will benefit from the improved rainfall in some
parts of the country.
Not surprisingly in light of the above, the demand for labour has continued to expand. The
recorded rate of unemployment is at its lowest for a generation. Job vacancies are high and
surveys suggest that many firms see the difficulty of finding additional labour as among the
biggest, or the biggest, impediment to expanding production. As yet, though, the pace of
growth in labour costs overall has remained relatively contained.
In thinking about why growth has picked up somewhat more than had been expected, we
should not overlook the fact that the global economy has surprised, once again, by its
strength. The most recent forecasts for global growth made by the IMF were revised upward
only a few weeks ago, with growth now thought likely to be over 5 per cent in 2007, close to
the 2006 result. The US economy has slowed but greater strength elsewhere has, to date,
more than outweighed the US softening.
Australia's terms of trade have kept rising and stand at a five decade high. This has added
about 11⁄2 per cent of GDP to the annual growth in Australia's national income over the past
couple of years, which is quite an expansionary force. Some of the resulting demand spills
abroad, but there is also a stimulus to spending on non tradeable goods and services arising
from the income gains being experienced. The rise in property prices in Western Australia is
a case in point.
It would be imprudent to assume that this trend will continue indefinitely. Nonetheless, it has
already gone considerably further than most observers anticipated. When we lift our gaze
beyond the conventional forecasting horizon, the big picture is that the emergence of
potentially very large economies like China and India, at such a rapid pace and with such
consistency, is unlike anything we have lived through before. We cannot be confident,
therefore, that the cyclical experience of the past few decades is necessarily a reliable guide
to how things will develop.
In its policy deliberations over several months, the Board has weighed conflicting trends.
When we were last before you, we were observing an apparent moderation in inflation. We
were, as you know, at that time still of the view that there could be a need to tighten
monetary policy further at some stage. But having made three adjustments in 2006, we
believed that the improving short term trend in inflation afforded us time to watch
developments.
Information that came in over the ensuing period suggested stronger than expected demand
in the economy. This meant that the longer term risk of higher inflation was increasing, not
diminishing. Hence, the likelihood that interest rates would need to be increased at some
stage was rising.
Moderate price and wage outcomes continued, however, for some months, suggesting that,
at least temporarily, the supply side of the economy was managing to respond to stronger
demand. It was doubtful that this could continue over an extended period, but taken together,
the weight of evidence suggested that the best course for monetary policy was to maintain
the existing setting for the time being, but to be ready to tighten should signs of a
strengthening of price pressures emerge.
The June quarter CPI data, available for the August meeting, showed some pick up in
inflation. Together with a stronger growth outlook, this information led us to expect a
somewhat higher path for inflation over the horizon of the coming one to two years. The
judgement we reached was that the risk of unnecessarily damaging growth with a modest
rise in interest rates was small, whereas the cost of not responding to a deterioration in the
outlook for inflation could well, in the longer term, be substantial. On straightforward
macroeconomic grounds, therefore, there was a clear case to make an adjustment to
monetary policy.
As our statement on Wednesday of last week set out, the Board considered the recent
events in international credit markets in coming to our decision. Here, Mr Chairman, it is
worth taking a few moments to set out some history.
For some years now, many long term observers, market participants and officials have been
troubled by very narrow pricing for risk. In other words, it has been easier and cheaper than
had been normal in the past for risky borrowers to access funding. Investors were prepared
to take more risk in pursuit of returns in a world of low global interest rates.
Somewhere or other, returns were eventually bound to disappoint someone. As it turned out,
the problems emerged in the US housing sector. Lenders into the so called "sub prime"
market attempted to keep the pace of business up as the US housing sector slowed during
last year. But they could do this only by lowering lending standards. Before long, arrears
began to rise as some borrowers struggled to meet their commitments.
Once this deterioration in underlying asset returns had occurred, those with exposures
inevitably began to see losses. Because this type of lending was via securitised structures
sold into global capital markets, losses have been coming to light right around the world. In
most cases, the losses are embarrassing rather than fatal for the institution concerned. The
exceptions have been where particular funds invested mainly or solely in these types of risky
assets, and especially where leverage was involved. Several hedge funds have borne large
losses, including some in Australia.
All of this created a climate in July and early August in which investors retreated and pricing
of risk started to return to levels that could be regarded as more reasonable based on
historical experience. A number of capital raisings that had sought to take advantage of the
earlier very generous terms were postponed. Volatility in some financial markets increased,
share prices declined somewhat and a general sense of heightened uncertainty was evident.
In considering the implications of all this for our decision on monetary policy, there were two
questions to ask. The first was whether there was information to suggest that financial
developments were likely to make a sufficient difference, over the relevant horizon for policy,
to the global economy, and therefore the Australian economy and the inflation outlook, to
remove the macroeconomic case for a 25 basis point adjustment to cash rates. On balance,
we judged that there was not. Downside risks to the US economy do appear to have
increased over recent months, but in other parts of the world the growth outlook has, if
anything, been marked higher recently.
The second question was whether a rise of 25 basis points in Australian cash rates would, in
itself, be financially destabilising. No credible case could be made for that idea. In fact, it
would probably have been more destabilising to expectations not to have carried out a policy
adjustment that most people could see was needed.
Accordingly, as you know, monetary policy was tightened last week, taking the cash rate to
6.5 per cent.
Subsequently, towards the end of last week there was a period of stress in some major
country money markets. Because the exposures to the mortgage problems in the US are still
coming to light, financial institutions are uncertain over the standing of other market
participants. Objectively, it is extremely unlikely that the sub prime mortgage exposures could
significantly damage the core banking system in any significant country. The exposures are
spread far too widely for that to occur. But precisely because they are spread widely, and
because the associated financial structures are opaque, information on who is exposed and
by how much is incomplete. Hence people remain wary. At times of uncertainty, market
participants naturally get more cautious and want to hang on to cash, rather than lending it in
the interbank market.
In such circumstances, central banks typically respond by being prepared to make additional
cash available, through purchases of high quality assets from market participants, in
sufficient quantities to keep the cash rate at the level required by monetary policy
considerations. Several major central banks made very substantial injections in this way on
Thursday and Friday last week in the face of an abrupt shift in cash market conditions. While
the likelihood of a significant problem of this sort arising in the Australian money market was
low, last Friday the Reserve Bank as part of its normal dealing operations purchased more
assets, hence adding more cash to the system, than it otherwise would have done. The
intent of this was to ensure that the cash rate remained at the target level set by the Board.
The market operated normally and overnight funds were available in the market at 6.50 per
cent, exactly as intended, and this has remained the case subsequently. Of course, the
Reserve Bank remains ready, as always, to ensure there is adequate liquidity for markets to
function normally in the period ahead.
The broader credit market issue is that the losses arising from the US mortgage problems
are still being assessed and absorbed. That is producing a degree of uncertainty that is
affecting financial markets around the world, leading to tougher borrowing conditions for the
moment, and considerable volatility.
The fact that the global economy has been so strong, that core financial institutions after
years of strong profits are well capitalised, and that real sector corporate profitability in most
countries is very sound, will be helpful in coping with tougher credit conditions if they persist.
Indeed, global growth has of late been sufficiently strong that some moderating effect would
be welcome.
An adjustment to investor behaviour needed to occur, and was almost certainly overdue.
Such adjustments often are not entirely smooth, and are frequently triggered, as in this case,
by the realisation that credit terms had been too generous for too long. Sometimes, however,
the ensuing retreat can go too far, resulting in a widespread withdrawal from the provision of
credit that unnecessarily crimps the pace of economic expansion. We will, therefore, have to
continue to watch carefully how this unfolds over the period ahead.
Statement on Monetary Policy
The released a few days ago contains our most recent
assessment of the outlook. It takes account of the change in interest rates as well as the
recent flow of data at home and abroad. There are, of course, various assumptions on which
the outlook is based, and these parameters could shift over time. The credit market
developments add a further degree of uncertainty about the outlook.
Subject to that uncertainty, the picture is one of growth close to trend and the economy
remaining close to full employment. Under such circumstances, inflation is likely to be around
3 per cent over the coming year, and near the top of the target zone in the following year. As
far as risks to that forecast are concerned, the possibility that the world economy might end
up being weaker than assumed, due to a persistence of credit difficulties, is one that
everyone will have in mind at present. At the same time, there is also the possibility that
ongoing strength of demand in a fully employed economy might leave us with inflation
pressure that is harder to manage than expected.
These possibilities, and other things that could come along unexpectedly, will be issues that
the Board will have to assess each month. For now, my colleagues and I are here to respond
to your questions.