Mr Macfarlane takes the opportunity to expand on the role
of monetary policy in managing an economic expansion
Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the Economic Society of
Australia, Victorian Branch, Melbourne on 11 February 2000.
* * *
It is a great pleasure to be here speaking to the Victorian Branch of the Economic Society. I first spoke
before the Society in 1986 and have been back a few times since. On each occasion I have appreciated
the interest and attention you have afforded me. I hope that what I have to say today will again be of
interest to you.
I want to take the opportunity today to expand a little more on the role of monetary policy in managing
an economic expansion. This is a subject that I have spoken on in the past, but clearly there is more to
be said. On this occasion, I would not only like to restate the Reserve Bank's position, but also deal
with some of the views that have been put forward following our recent raising of interest rates.
The current expansion, as you will all probably be aware, has now lasted longer than its predecessors
in the 1970s and 1980s, and has also reached a higher level relative to its starting point. This is shown
by the accompanying graph, which puts the three expansions on a comparable basis. Another
interesting aspect of our current expansion is how similar it is to the much better known expansion in
the US economy. While the US expansion has been going for 36 quarters compared to 35 for our own
(measured up to the present quarter), our average GDP growth rate of 4.1% is higher than the 3.6%
recorded in the US.1
Diagram 1
Expansions in GDP
Cyclical trough = 100
Index Index
1990s
140 140
1980s
135 135
130 130
125 125
120 120
1970s
115 115
110 110
105 105
100 100
95 95
1 2 3 4 5 6 7 8 9
Years since trough
While it is satisfying to look back and see how far we have come, it is more useful to look ahead and
see what we have to do if we are to continue on this path. For some time now, the task of monetary
policy has been just that - to manage the expansion in such a way as to maximise its length. We do not
want to repeat the experience of earlier expansions which ended so unhappily, and therefore we must
ask ourselves what it is that we have to do this time to avoid that fate. This is the main subject of my
talk today, but before I get into it, I would like to ask your indulgence to detour through the age-old
subject of the business cycle.
The business cycle
Economists have been analysing the business cycle for a century or more. From time to time after a
long expansion, a few feel emboldened enough to suggest that perhaps we have seen the end of the
business cycle. This happened in the very early-1970s, and a few people are canvassing the idea now
as part of the concept known as the "new economy" or "new paradigm". While there is undoubtedly
substance in these ideas, some of you may be disappointed to know that I am not a member of the
school that thinks the business cycle has been banished, although I am happy to recognise that
increased productivity growth in the 1990s has made the task of macro-economic management
somewhat easier than formerly. The most obvious benefit of this from the monetary policy perspective
is that the overall rise in interest rates needed to prevent a potential inflationary situation developing
now seems to be a good deal smaller than previously.
There are two main mechanisms that lie behind the business cycle:
1. A business cycle of some sort may be the inevitable result of interactions involved in a
complex dynamic system such as an economy. We know that cycles are the norm for such
natural phenomena as the weather and animal populations, and some tendency in this
direction is also probably intrinsic to economic behaviour. The first Nobel Prize in
Economics was awarded to Ragnar Frisch for work on how business cycles can be
propagated in simple models of the economy, and others such as Samuelson and Hicks
expanded on this.2 More recently, the Real Business Cycle3 school of economists have taken
this in a new direction by regarding all cycles as being a natural result of changes in the
supply side of the economy. I do not want to take any of this too literally, but I would agree
with one conclusion that comes out of all this work, namely that it is probably unrealistic to
expect a dynamic system like a modern economy to expand in a smooth line; its natural
progression is probably characterised by some element of cyclicality.
2. A business cycle may be viewed as resulting from policy mistakes. In this view, policy is
kept expansionary for too long during the upswing, resulting in the build-up of serious
distortions or imbalances - principally inflation. Eventually something has to be done, but in
order to eliminate the by then well entrenched imbalances, the degree of tightening required
is quite large. As a result, the economy is pushed into recession and unemployment rises
sharply. This explanation essentially sees cycles as the result of a delayed monetary policy
reaction function.
In the popular discussion of economic developments over recent decades, it is the second type of cause
- the tendency for monetary policy to contribute to booms and busts - that has been the focus of
attention. Fortunately, it is also the type that we have most chance of avoiding if we play our cards
right. This would not mean that all cyclical behaviour would be removed, but a significant part of it
could be.
The avoidance of imbalances
The centrepiece of this approach is to act before the imbalances have had time to become entrenched.
If you are seriously aiming to maximise the length of the expansion, the tightening of monetary policy
comes earlier than if you are mainly interested in a high growth rate for the year ahead and less
concerned with the length of the expansion. Of course, this can sometimes make the explanation of
monetary policy moves more difficult, because those opposed to the move may be able to claim that
there was not sufficient hard evidence of imbalances to justify it.
It is instructive to look back over the past few decades to see how imbalances have built up towards
the latter part of economic expansions. No two expansions or their demise have been the same, nor is
it the case that a single imbalance was the cause of the problems. In all cases, there were several
imbalances whose interaction led to the build-up of an unsustainable situation.
Having said that, however, it must be recognised that the pre-eminent imbalance has been inflation. It
is now almost universally acknowledged that the maintenance of low inflation is the sine qua non of a
sustainable expansion. It was the rise of inflation, in one form or another, which spelled the death knell
of our previous expansions.
• In the long expansion which began in the 1960s and ended in 1974, inflation had already
risen to 10% by the September quarter of 1973, which was before the effects of OPEC I had
been felt. Following the rapid wage escalation of 1974, inflation then peaked at 171⁄2% early
the following year.
• We had a rather weak expansion in the 1970s, which received a boost from the rises in
commodity prices associated with OPEC II in 1979. But by 1981 another wage escalation
pushed inflation from a low point of 8% in 1978 to a peak of 121⁄2% in 1982.
• In the strong, but shorter-lived, expansion of the 1980s the story was rather different.
Although the increases in prices and wages were a good deal higher than we have become
accustomed to in the 1990s, there was no sudden acceleration in the latter stages of the
expansion as there had been in earlier episodes. It was a boom in credit-financed asset prices
and the associated speculative activity that did the damage. At some stage the boom was
bound to be followed by a bust, whether of its own accord, or as a result of monetary
tightening. While asset price inflation is conceptually different to CPI inflation, and is further
removed from the ordinary operation of monetary policy, it is nevertheless a classic case of
the type of imbalance that can occur in the latter stage of an expansion and lead to its abrupt
and painful ending.
There are several other types of imbalances that often accompany the latter stages of an expansion and
that can be a warning of danger. One is monetary excess, which is usually manifested as excessive
provision of credit, and which often ends up financing speculative activity. I have already mentioned
this in relation to the 1980s, when the credit expansion was primarily to business and resulted in the
over-leveraging of that sector. It is also possible for the imbalance to show up as over-lending to
households, as happened in the UK in the late-1980s.
Another imbalance that can occur is in physical investment. We are accustomed to thinking of
investment as a good thing and only ever worrying about it if it is too low. But over-investment can
also be a problem at times in that it can lead to the build-up of over-capacity. This in turn can lead to a
subsequent dearth of investment, especially if demand has not been as strong as had been expected by
those who put the investment in place. Part of the severity of the recent Asian recession, and
particularly the Japanese one, is due to the earlier period of over-investment. Some of that effect also
occurred in Australia in the late-1970s/early-1980s during the so-called "resources boom".
Looking back over the post-war years, particularly during the fixed exchange rate period, the
imbalance that often played the decisive role was the current account of the balance of payments. If it
widened markedly, private capital inflow risked being insufficient to cover it, and interest rates would
have to be raised to attract more capital and to reduce the demand for imports. This would be a major
cause of the subsequent contraction, such as the "credit squeeze" of 1961. With a floating exchange
rate, the current account is a less immediate constraint: it only becomes binding if the market begins to
worry about an escalating external debt to GDP ratio, or about the country's capacity to service the
debt.
The current expansion
This brings me to the current expansion. We have now had two policy tightenings involving a net
increase in the overnight cash rate of 3⁄4 of a percentage point. The tightenings were pre-emptive in the
sense that they occurred before imbalances developed - in other words, before there was clear
evidence of the economy generally overheating. As the foregoing discussion makes clear, we regard
these tightenings as an essential component of a strategy which is designed to allow this economic
expansion to continue for as long as possible, and not be overwhelmed by the usual imbalances that
bring an expansion to an end. This approach to monetary policy is not unique to the Reserve Bank of
Australia; one can clearly see the same thinking behind the actions of other central banks. They too
have been bruised by the failures of the 1970s and 1980s and are determined to do better this time.
While I think this approach is generally well understood, there are obviously some who do not support
it. There is nothing like a rise in interest rates to bring out critics of monetary policy who hitherto had
been silent. Of course, everyone has a right to express their views, and I have no trouble with the
recent debate. I can also see why the public expect explanations from bodies that make important
decisions, and we are conscious of the need to meet that requirement. As well as the explanation
contained in the press release that accompanied the monetary policy decision, we will be publishing a
detailed quarterly report on the economy next week, and I appeared in public before a Parliamentary
Committee two days ago. I will also take the opportunity in the remainder of this speech to address
these issues.
We have for some time been in a period characterised by good economic growth, low inflation and
low interest rates. It has been one of the better periods for the Australian economy, especially in light
of the turmoil among many of our trading partners. I think there has been a tendency for some
observers to think this happy state of affairs could continue indefinitely provided we left it alone. A
common theme has been "don't meddle - just leave it alone", or a related one, "are you afraid of
growth?".
These views seem to us to be very short-sighted - in essence, they boil down to the view that the best
way to manage an expansion is to keep interest rates at their low point for as long as possible, and only
raise them when things have gone off-track. We think that if we did this, we would look back in a few
years' time and regret it, even though we might have been more popular in the short run.
We also think that this approach fails to recognise just how expansionary the stance of monetary
policy was in 1999. In either nominal or real terms, interest rates faced by borrowers were very low, as
was shown by their eagerness to borrow.
This expansionary stance of monetary policy was designed to combat a specific set of circumstances
- weak world economy, expected domestic slowdown, and undershooting of the inflation target. When
these circumstances changed, it was only reasonable that monetary policy would also change. We have
tried to encapsulate the two changes taken together as a return to "neutrality" from a position that was
clearly expansionary. Of course, there will always be considerable measurement uncertainties about
the term neutrality - perhaps we should have referred to a return to the "neutral zone". Be that as it
may, if you do not have some idea of the concept of neutrality, you run the dual risk of:
• being late by not changing monetary policy until overheating has actually occurred (or, in the
opposite direction, until a recession is staring you in the face);
• then being forced into a large and abrupt adjustment to recover the situation.
Both of these outcomes effectively describe a "boom and bust" monetary policy, which is the
approach we set out to avoid.
Another variation of the argument that monetary policy should not have been tightened, or not by as
much, is the appeal to US experience. Proponents of this view claim that Chairman Greenspan has
been doing the right thing by letting the US expansion run on, and not being deflected by more
conventional voices calling for monetary restraint to avoid future inflation. I certainly have no qualms
about joining the chorus of praise for Chairman Greenspan's and the Federal Reserve Board's
performance during this expansion, but I would like to make two points. First, we should remember
that the Australian economy has actually grown faster than the US economy during this expansion.
Secondly, the Fed has been prepared to put interest rates up as well as down in its management of the
expansion. Interest rates were raised in 1994, again, although by only a small amount, in 1997, and
again in a third phase in 1999 and 2000. The US experience argues against a policy of leaving interest
rates at their low point for long periods in order to achieve a long expansion.
Diagram 2
US Federal Funds Rate During Current Expansion
%
%
8 8
6 6
4 4
2 2
l l l l l l l l l
0 0
1992 1994 1996 1998 2000
There is another argument I want to address before concluding. For various reasons, a number of
people have been keen to put forward the view that monetary policy was tightened because of the
impending GST. Some have done this for partisan political reasons, and others because they are still
adhering to the view that monetary policy should only be tightened if general overheating is present.
Since it is not present, they assume there must be some ulterior motive that has been hidden and
therefore seize on the GST.
I have said on a number of occasions and will say so again today - monetary policy was not tightened
because of the GST. The tightening would have happened without the impending GST, just as it has in
the United States, the United Kingdom, New Zealand, the Euro Area, Canada, Sweden, etc. We at the
Reserve Bank are still operating on the assumption that the GST will affect prices only on a
one-forone basis, and that wages will not be raised to compensate for the GST. The second assumption
reflects the fact that reductions in income taxes will more than offset the rise in prices due to the GST.
To raise wages as well to cover the GST would be to expect "double compensation". There is no
economic logic for this and, if it were to occur, it would be an example of the type of imbalance that
could threaten the end of the expansion, and therefore threaten the downward trend in unemployment.
Wage surges ended two of the past three expansions - it is important that it does not happen again this
time. I think good sense will prevail, and that anyone who is encouraging "double compensation" will
think again.
Conclusion
I think we have still got a long way to go in this expansion. It is already longer than its predecessors,
and if we as a community are sensible and do not allow short-term thinking to overcome our long-term
interests, it could rival in length the expansions of the 1950s and 1960s. As for monetary policy, we
think it can play a very important part in achieving that end. Inevitably, there will be those who agree
and those who disagree with what we are doing. We think, however, that monetary policy should be
judged, not by any particular movement in interest rates, which will always be surrounded by some
element of controversy, but by its performance over the whole of the expansion.