I J Macfarlane: Overview of the Australian economy
Opening statement by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to House of
Representatives Standing Committee on Economics, Finance and Public Administration, Brisbane,
8 December 2003.
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Mr Chairman, it is a pleasure to be here today in front of your Committee again, and I am very pleased
that we have been able to meet in Brisbane for the first time. As you know, we take these hearings
very seriously because they enable Parliament, through its representatives on the Committee, to
question the Reserve Bank in depth and in public.
As usual I will make some introductory remarks in which I will focus on three subjects:
• how the situation has changed since the statement I gave to this Committee in June;
• how our forecasts have evolved;
• the background to our monetary policy actions.
1. June and Now
Calendar year 2003 was an unusual one for the world economy. In the first half, prospects for world
growth looked doubtful, with the most extreme uncertainty being concentrated in mid-year. If you
remember, this is when talk of possible deflation in the United States reached its peak, and the US
authorities gave the impression that they needed lower interest rates and a lower US dollar to help
them through. In Europe, economic activity was weakening, and Asia received a temporary
knock-back from the Severe Acute Respiratory Syndrome (SARS) outbreak. At that time, virtually all
the central banks of note - the Federal Reserve Bank of New York (the Fed), the Bank of England, the
European Central Bank (ECB), the Bank of Canada, etc. - reduced interest rates, and I indicated to
this Committee that if things did not improve, we might also have to do so.
In the event, we did not because we witnessed one of the sharpest turnarounds in economic
prospects any of us has seen. While in the June quarter most major countries, including many in Asia,
saw declines in Gross Domestic Product (GDP), by the September quarter they were all growing
strongly. The weakness we had seen in the June quarter turned out to be a 'false signal'. In financial
markets, bond yields rose sharply, share prices continued to rise, and various prices connected with
international trade, such as commodity prices and transport prices, also rose. Talk of deflation ceased
and the short-lived bout of monetary easing stopped. Business and consumer confidence indicators
around the world rose back to levels consistent with reasonable economic growth.
At the same time as perceptions of the world economy were being raised, the general run of economic
indicators in Australia continued to improve, particularly employment, retail sales, construction activity
and business and consumer confidence. Prospects for farm production also picked up sharply
following widespread rain, even though it was not uniform across the country. Economic conditions
here and abroad had returned to something relatively normal and, as a consequence, we judged that
we no longer needed such an expansionary setting of monetary policy: interest rates were raised
accordingly in November and December.
2. Forecasts
At this point, I will follow my usual practice by discussing the forecasts I gave you at the previous
meeting, then adding some new ones for the coming calendar year. When we last met in June, I said
that we expected GDP to grow by 3 per cent in real terms over the course of 2003. With three quarters
of the year behind us, we now expect that the figure will come in a little higher, at about 31⁄2 per cent.
The thing to notice, however, is the big difference between the two halves of the year, with growth in
the first half being at an annual rate of 2 per cent, and growth in the second half expected to be at an
annual rate of around 5 per cent. The other thing to notice is that growth of domestic demand (Gross
National Expenditure - GNE) through 2003, at 5 per cent, is again expected to be well above the figure
of 31⁄2 per cent for GDP.
Over the course of 2004, we expect GDP to grow by 4 per cent. The profile of growth, however, is
unlikely to be smooth. It would not surprise us if the four-quarter-ended growth rate of GDP reached
41⁄2 per cent in mid 2004 due to the effects of the sharp rise in farm GDP, before returning to 4 per cent
by end year. If the world economy continues to surprise on the strong side, as it has in recent months,
our GDP growth could be even higher.
On inflation, we said last time that we expected the CPI to increase by 21⁄2 per cent over calendar
2003. We now think it will be a little lower at 21⁄4 per cent, largely due to the exchange rate being
higher than assumed in our earlier forecast. Over the course of 2004, we expect the CPI to increase
by 2 per cent, but in mid 2004 it could well be below that because the maximum effects of the higher
Australian dollar could be being felt then. As we stated in our quarterly statement, this expectation
implies that the profile of inflation will exhibit a shallow U-shape - falling from its present 21⁄2 per cent to
below 2 per cent in mid 2004, but then rising back to 2 per cent by end 2004, 21⁄2 per cent by mid
2005, and continuing under upward pressure thereafter. Of course, it is difficult to be precise about
these things, especially since future levels of the exchange rate will play a major role. I will say more
about this later.
3. Monetary Policy
As I outlined at the start of these remarks, with growth in the world economy getting back to normal,
and growth in the Australian economy also getting back to normal, or slightly above it, we could no
longer see a justification for Australian interest rates being clearly below normal. That is, the major
reason for the two increases in interest rates this quarter is the same as I gave to this Committee
18 months ago in late May 2002 when talking about the tightening then. Another way of putting this is
to say that if we had maintained the low level of interest rates we had at the beginning of 2002, there
would have been a gradual build-up in inflationary pressures as the growth rates of the world and
Australian economies rose through 2003, 2004 and beyond. Interest rates were just too low for an
economy that was growing that well. As it turned out, this process of returning interest rates to more
normal levels has been a gradual one. Two increases in interest rates were made in mid-2002, then
there was a 16-month gap to the next two increases. I have explained in the previous two meetings of
this Committee why that long gap occurred.
It is clear that, despite our best endeavours to explain ourselves, a number of people think that the
Bank tightened to cool down the property market. In fact, I have more than once received unsolicited
advice that it would be better for us to explain our action in this way because people could more easily
identify with it. The overheated property market is something that people can see around them; it is
much more concrete than such concepts as inflation-targeting or returning interest rates to normal.
However, such an approach would not be consistent with the truth. For a start, signs of overheating in
the housing market were clearly evident through the second half of 2002 and all through 2003, yet the
Bank did not change monetary policy. It was only when it became clear that good economic growth
had returned both globally and domestically that rates were raised. I have often stressed that
monetary policy has to be set taking into account the average of all the parts of the economy, not to
what is happening in one sector. Of course, if a sector is overheated, it may push up the average for
the economy, and in that way exert a disproportionate influence. It is also true that, historically,
borrowing for housing purposes has been one of the more interest-sensitive sectors, and so it may
have been more affected than other sectors by the previous low level of interest rates and it may
respond more than other sectors to the recent increases. But that does not mean we singled it out.
We have also been accused of setting monetary policy in relation to the Sydney and Melbourne
housing markets, and ignoring the rest of the country. This clearly cannot be true in the case of the
recent tightenings, as house prices in Sydney and Melbourne are growing less quickly than in other
states; in fact, housing prices in some parts of these cities are already falling.
In Australia we have conducted monetary policy by using an inflation-targeting regime for about a
decade now. It has been a very successful regime in that it has delivered (along with various other
reforms) the longest period of uninterrupted good economic growth in the post war period, at a rate
exceeding that of all other significant developed economies. It has concentrated our minds at the
Reserve Bank in that we have been very conscious of our need to deliver the results to which we have
committed. Over the 10-year period, inflation has averaged 2.4 per cent. By acting early on monetary
policy to keep inflation in check, we have avoided large swings in interest rates and thereby allowed
the economy to prosper.
As you are aware, our target is a relatively flexible one in that we aim to achieve an average rate of
somewhere between 2 and 3 per cent. It is that average by which we should be judged, or made
accountable. But there are some observers who think that the system should be more prescriptive
than this and there should be some strict rule which should determine our actions.
For example, a few people still think we should aim to keep inflation between 2 and 3 per cent at all
average
times. This is a clear misinterpretation of our system because it fails to realise that it is the we
are interested in. On a number of occasions, inflation has been above 3 per cent and below 2 per
cent. In fact, about 45 per cent of the time it has been outside the 2 to 3 per cent range, and we have
not regarded this as a failure of policy.
Since our objective is to achieve an average inflation rate, there are multiple paths for inflation which
are consistent with meeting our medium-term objective. We wish to choose the one which best
sustainable
satisfies the other obligations contained in our Act, which I summarise as achieving growth
in income and employment. We are not simplistically committed to achieving the minimum possible
variability in the inflation rate, or even hitting the target at some fixed period ahead, such as two years.
Another approach sometimes put to us is to say that we should raise interest rates if, and only if, our
forecast
for inflation is above 3 per cent, and lower them if, and only if, it is below 2 per cent. Again,
this is a misinterpretation of how the system works. It also ignores the complications and uncertainties
involved in economic forecasting. The forecast horizon relevant for policy today is at least two, or even
three, years. We can be relatively confident about forecasts for the first half of that horizon, as much of
what is going to happen over that period is already set in place. But we can be less confident about
the forecasts for the second half. The situation is particularly uncertain when, as is the case at present,
the direction of inflation is expected to change during the forecast period.
Since this type of forecast is so hard to make, we, like a number of other central banks, do not wish to
lead the public to believe we can do this with much precision. In fact, we tend to appeal to the balance
of risks around the central forecast in order to convey our message. In last month's quarterly
statement we said that the balance of risks was shifting to the upside, which was meant to indicate
that inflation was on an upward trajectory through the course of the second year. We also drew
attention to the fact that domestic price pressures were increasing, as shown by the fact that the rate
of increase in the prices of 'non-internationally traded goods and services' had increased from 2 per
cent to 4 per cent over the past few years. That does not mean that inflation will rise to 4 per cent once
the exchange rate effects have worn off, but at least a significant part of the economy will be
influenced by this figure.
In summary, I want to assure the Committee that the Bank remains committed to the inflation targeting
framework and that the decisions taken over the past 18 months have been fully consistent with that
framework. It does not seem plausible to us to argue that the Bank could have been confident of
meeting its inflation commitments if interest rates had been held at 30-year lows in the face of the pick
up in the international and domestic economies that is currently under way.
Finally, let me end by updating you on a few developments in the payments policy reforms. Since we
last met, the challenges brought against the Reserve Bank's reforms to credit card schemes by
MasterCard and Visa were dismissed by the Federal Court. Both schemes subsequently appealed, but
Visa has withdrawn its appeal. The new interchange fees for Bankcard, MasterCard and Visa came
into effect at the end of October, almost halving the fees. The Reserve Bank is monitoring the flow
through of this to merchant service fees. The data are still being gathered, but anecdotal evidence
suggests that merchants are starting to see a reduction in the merchant service fees they pay to
banks.
There have been several developments in other payments streams, and I will be happy to answer
questions on those when they arise, but I am aware that I have already taken a fair amount of your
time, so I will finish at this point.