Mr Macfarlane's overview of monetary policy in Australia
Opening statement by the Governor of the Reserve Bank of Australia, Mr I J Macfarlane, to the House
of Representatives Standing Committee on Economics, Finance and Public Administration, in
Melbourne, Australia on 17 June 1999.
Thank you, Mr Chairman. It is a pleasure to be here in Melbourne again appearing in front of the
Committee.
Like last time, the Semi-Annual Statement on Monetary Policy has already been released a month
before the hearing. On this occasion, it was the Budget that caused the delay in the hearing, but I do
Statement
not think this is a serious matter because the is still relevant. If anything, the advance
Statement
release of the may have been helpful in giving more time to digest the material contained in
it. We have more recently sent to the Committee some new material in the form of a paper on bank
fees.
I would now like to start off in my customary manner by comparing what I told you last time with
what now appears to be the most likely outcome. I do this in the interests of accountability, but I also
think it has the advantage of drawing out the limitations of economic forecasting and the necessity of
seeing policy formulation as an iterative process.
Last time, I indicated our expectation that our growth rate was likely to be lower in 1998/99 and that
there would be some pick-up in inflation (though to a rate consistent with our target). I said that the
current account deficit would expand, and would probably reach 6 per cent of GDP on a quarterly
basis at some stage. I indicated that not much further progress could be expected in reducing
unemployment from the rate of 7.9 per cent which had prevailed in the three months before the
hearing.
It is now well known that growth has not, as yet, declined. In all likelihood, growth for the 1998/99
year has been in excess of 4 per cent, measured either in year average terms or for the four quarters to
June. This makes this expansion, which began in the middle of 1991, the longest continuous upswing
since the 1960s. Nor is there any sign yet that the expansion will come to an end soon.
We are still of the view, however, that some decline in growth is likely, but from a considerably
stronger starting point (and, of course, more delayed) than earlier thought. The outcome for calendar
1999 will, in our judgement, be lower than the growth recorded in 1998 - something between 3 and 4
per cent. This is a fairly mild decline, given the size of the external shock to which we have been
subject.
More importantly, the risks of a sharp slump have lessened considerably since we last met. Last
December, we had just been through a period in which confidence in the prospects for the global
economy, including, of course, the US economy, had reached its lowest point. Behind this were
concerns about extreme instability in global financial markets and the possibility of a "credit crunch".
Since then, the US economy has continued its strong performance and concerns about credit crunches
have disappeared. Indeed, there is now a widespread expectation that the strength of the US economy
means that a tightening of US monetary policy is on the cards. Evidence has also continued to
accumulate of a turn for the better in the countries in East Asia which slumped so sharply during 1997
and 1998.
Inflation in Australia, meanwhile, has risen, but very slightly and considerably more slowly than our
central forecast of six months ago had suggested. A possibility which we flagged in our November
1998 Statement - that competitive pressures in international markets would have a dampening impact
on the rises in prices for imported goods - has in fact turned out to be the case. In our latest
Statement, we have forecast inflation to be about 2 per cent in underlying terms by the end of 1999. In
headline terms, the CPI also is likely to be about 2 per cent. This is a little higher than we suggested in
the Statement, as we have now taken full account of higher international oil prices, which roughly
offset the effect of the health care changes.
The current account deficit has turned out to be something like 51⁄2 per cent of GDP for 1998/99, and
was almost 6 per cent in the March quarter. It is highly likely that a quarterly figure over 6 per cent
will be recorded in the June quarter. It seems to us that numbers something like that might well be
seen over the next few quarters, with the result that the outcome for 1999 as a whole will be about 6
per cent of GDP.
The unemployment rate has fallen further, in line with the stronger than expected growth in the
economy, and over the past three months has averaged 7.5 per cent, its lowest for about a decade.
Given the amount of growth we have had over the past year, some further moderate decline in
unemployment will probably be recorded, in net terms, over the remainder of this calendar year.
Even though the outcome has turned out better than expected, if someone wanted to score a point,
they could say we are not very good forecasters. I would concede that we have been a little
conservative in our forecasts, but it has not led us astray in a policy sense, i.e. it has not jeopardised
the achievement of a good economic outcome.
As someone who has been involved in forecasting and economic policy in the lean years as well as
the good, there is a more interesting question that has to be asked. It is this: How is it that the
Australian economy has been able to grow at 41⁄2 per cent plus per annum in the seventh and eighth
years of an economic expansion without generating significant wage and price pressures? It certainly
was not able to do so in earlier expansions.
I have already given part of the answer to this question in my December testimony, and in a couple of
speeches since. It is that the economy has achieved improved productivity growth as a result of the
micro-economic reforms of the past fifteen years. The main changes have been reductions in tariffs,
privatisations, financial deregulation, competition policy and labour market reforms. Of course,
businesses have also become much leaner and more adaptable as they have responded to increased
competitive pressure. The key piece of evidence for this is the higher growth of multi-factor
productivity in Australia in this expansion compared with previous ones. A lot more could be said
about this subject, but I will leave it to others, and move on to a related subject.
It seems to me to be quite possible to have higher productivity growth and yet to still encounter
macro-economic imbalances which would bring an economic expansion to a halt. In other words,
higher productivity growth can explain why the economy's average growth rate is faster, but I do not
think it can provide an adequate answer for why the expansion will last longer. To do this, I think a
macro-economic explanation is required.
Here I have to come back to low inflation and low inflationary expectations, which have characterised
the 1990s expansion, but were clearly absent from earlier expansions. As the earlier expansions
matured, inflationary pressures built up which simultaneously pushed up prices (requiring a monetary
policy response) and squeezed businesses and business confidence. In the mid-1970s and early 1980s
the expansions came to an end with a wage explosion, while in the late 1980s it was an asset price
boom and bust. This time we have had neither of these.
As I said, a recent history of low inflation has been crucial this time. It certainly has helped the wage
bargaining process. Employees have seen that quite modest nominal wage increases have translated
into decent real wage increases because inflation has been contained. They have not had to build
anticipatory increases into their wage bargains to safeguard themselves against inflation getting away
from them. Increased flexibility in industrial relations arrangements has also helped.
Similarly, low inflation and low interest rates have had a favourable impact on business behaviour.
An important reason for this is that with low interest rates, there is little or no scope for negative
gearing. Most of the reckless schemes of the entrepreneurs of the 1980s were simply negative gearing
writ large. This was the biggest contribution to the boom and bust in asset prices. It was not the only
 
the finance sector also played a role. We could argue about the relative weights of these two factors if
we wish, but the relevant fact for today is that neither of these two factors is present in the current
expansion.
If we do not seem to be developing our usual ailments, as I have argued above, are there some new
ailments that may bring our progress to a halt? A number of possibilities could be identified, but one
that has attracted a fair bit of attention is the fall in the household saving ratio. In contrast to the
business sector, which has become more cautious in the 1990s, the household sector has become less
cautious, as shown by:
• the household saving ratio falling from 12 per cent in the first half of the 1980s to about 1 per
cent at present. This has been a pretty steady trend (see Diagram 1).
• Household borrowing rising as a percentage of annual income.
Household Saving Ratio
% %
12 12
8 8
4 4
0 0
1981 1984 1987 1990 1993 1996 1999
Diagram 1
This less cautious attitude by households is a surprise to many people because it seems to be at odds
with the usual media depiction of a public worrying about its future, anxious about job security and
generally insecure. If we were instead to judge the public by what they actually do, we would
conclude the opposite. Unlike their parents and grandparents, who saw a great need to save for a
rainy day and who had the privations of the Depression still in their minds, the spending and saving
pattern of the current generation indicates a totally different attitude.
Of course, developments on the supply side have made this a lot easier. At today's low interest rates,
it is possible to service a much bigger loan than it was at the start of the decade. Also banks and other
financial intermediaries have found new ways of providing credit based on previously inaccessible
collateral.
The important issue is whether this trend change in household behaviour is going to cause problems
for the economy, particularly whether it is going to endanger the present expansion. I think there are
three possible problems that could arise, so I will discuss each one briefly.
1. The first possible problem is that if inadequate household saving persists, it could mean
inadequate provision for retirement. This, in turn, would put increased demands on future
taxpayers. This is an issue of inter-generational equity. I do not want to suggest that this is not
a problem - it may well be a big one, but the solution to it would be found in improvements to
our policies regarding retirement income.
2. The second possible problem is that any reduction in saving, other things equal, would lead to
an increase in the current account deficit. Has the trend decline in household saving over the
past decade caused the balance of payments to deteriorate? The answer seems to be no: the
current account deficit has shown roughly the same cyclical movement that it has exhibited
over the past twenty years (Diagram 2), but no change in trend. The reason for this is that
there is not a one-for-one relationship between household saving and the current account
deficit. We have to also take into account government sector saving, business sector saving
and, of course, investment before we get to the current account of the balance of payments,
and movements in some of these factors have offset the reduction in household saving.
Current Account Balance*
Per cent of G DP
% %
-2 -2
-3 -3
-4 -4
-5 -5
-6 -6
-7 -7
-8 -8
1981 1984 1987 1990 1993 1996 1999
* Excludes RBA gold transactions.
Diagram 2
3. The third possible problem is that increased indebtedness makes the household sector more
vulnerable when interest rates rise. This is probably true, but the main implication is that to
achieve a given macro-economic effect, interest rates would not have to be raised as much as
formerly was the case. I now want to turn to a totally different subject, but one that will be
very important over the next seven months. I refer, of course, to the issue of the end of
century date change - or Y2K as it is colloquially known.
The main point I want to make is that the Australian financial system is very well prepared for Y2K.
The formal processes of fixing and testing their systems began in the mid-1990s and it has been
under the scrutiny of APRA and the Reserve Bank since early 1997. Financial intermediaries have
devoted over a billion dollars and thousands of staff to checking and updating computer systems.
Where problems have been found, they have been fixed. Outmoded ATMs and EFTPOS machines
have been replaced, computer programs have been rewritten or new software has been installed.
With all this effort, the Australian financial system rightly enjoys a world-class reputation for its
high level of Y2K preparedness.
The Reserve Bank's own computer systems are, of course, Year 2000 ready. In particular, the
systems that the Reserve Bank uses to distribute pensions and other government payments to banks,
building societies and credit unions on behalf of Centrelink have been thoroughly tested. Pension
payments will be made on time.
So much work has now been completed to ensure that the system works, that the big issue facing us
is no longer a technical one - it is instead an issue of public reaction. While I am very confident that
the overwhelming majority of the Australian public will act sensibly, there are no doubt a few who
are inclined to believe doomsday scenarios. With this in mind, there are a few preparations that we
at the Reserve Bank have been putting into place to help reassure the community.
An important step was to talk to the banks, building societies and credit unions to make sure that
they were communicating with their customers in clear language to reassure them that their deposits
were safe. Because the simple fact is that their deposits are safe and their records are not at risk from
Y2K related problems.
All financial institutions have extensive back-up systems to ensure that each night they keep
multiple physical records of all account information. While some members of the public have
expressed concerns for the safety of their deposits because they think records might disappear, there
is no basis for this type of concern. The safest place for people to keep their savings is in the
financial institution that they are already with. Withdrawal and conversion to cash would expose
them to a lot of unnecessary risks.
The vast majority of people, I believe, do not have those concerns, but they probably still have a few
uncertainties. Many will wish to take more cash out to tide them over the New Year period than they
normally do. To this group, I just want to make a few points:
• Do not, for a minute, fear that you need to take out more cash because there may not be enough
to go round. There will be. The Reserve Bank has printed, and is carrying in stock, a lot more
notes than usual so that it can meet any increased demand.
• If you are worried about high-tech systems such as ATMs or EFTPOS letting you down,
remember you are only dependent on them for the first three days of the new year. After that, the
banks, building societies and credit unions open their doors again and you can go back to the
old-fashioned ways of obtaining cash. You are really only dealing with a long weekend.
• Even in those three days, you are not completely dependent on cash - credit cards can, if
necessary, still operate in their traditional paper-based mode and cheques can be used as normal.
Overall, our view is that the system will be able to operate on a "business as usual" basis and the
public should view the new year as just another long weekend. That is what I will be doing. For
those who want a little extra reassurance in the form of extra cash, they can be confident that it will
be readily available.
That is all I wish to say in general terms about Y2K at this stage, but I will be happy to answer any
detailed questions you wish to put to me. I am also conscious that I have been talking for quite a
while, so that I have not left any time to cover the subject of bank fees. But with a copy of our paper
at your disposal, I am sure you will find plenty of material to supply you with questions on that
subject also.