I J Macfarlane: Statement to House of Representatives Standing Committee on
Economics, Finance and Public Administration
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, Melbourne,
on 22 May 2000.
* * *
It is a pleasure to be here in Melbourne again for our regular half-yearly appearance before the
Committee. I know we met in March and touched upon monetary policy, but that meeting was mainly
about Reform of the International Financial System. On this occasion, we will no doubt have a lot
more time to spend on monetary policy.
I would now like to start this meeting in the traditional way by reviewing the forecasts I gave to the
Committee last November, and then outlining our current views on likely developments over the year
ahead.
Last November, with half a year's data available, I said that we expected GDP growth through 1999 to
be 31⁄2%. In the event, it was 4.3%, which continued our record of expecting a modest slowdown that
did not arrive. I also said that we expected growth to be 4% in the year to June 2000, and on present
indications this still looks likely, even though the rate may well dip below 4% in the year to March. Of
course, it will be more difficult than usual to read the true trends this year, with expenditure being
shifted between quarters because of the GST, and the boost from the Olympics.
Most monthly indicators of economic activity point to a slowing so far in 2000. However, it is too
early to know whether this merely represents the slowdown in domestic demand that we have all been
waiting for, and we have had built into our forecasts for some time, or whether it represents something
bigger - a significant slowing in GDP growth. Our judgment is that we are seeing mainly the former,
namely a change in composition of GDP growth. In other words, the slowing in private domestic
demand, which is undoubtedly occurring, will be largely offset by the boost that we are getting from
net exports and will soon get from fiscal policy.
While we expect some slowdown in GDP in the sense that we do not expect to repeat the 41⁄2%
average that we achieved in 1997, 1998 and 1999, we still see quite solid growth ahead. We have no
quibble with the sort of figures that were contained in the Budget Papers showing growth in GDP of
33⁄4% over 2000/01. Such an outcome would be quite a remarkable achievement compared with the
record of the past three decades, but I will return to that subject later.
On inflation, in November we forecast that the CPI would rise by 2% in the year to December 1999
and by 23⁄4% in the year to June 2000. We got closer to the mark in these forecasts - the outcome for
the year to December 1999 was a little lower, at 1.8%, and we now think that the figure for the year to
June 2000 will be a little higher, at 3%. Some of the increase in the CPI is due to temporary factors, so
that the 3% for the CPI corresponds to about 21⁄2% for underlying inflation. Thus we have finished the
period when inflation was below the bottom of our band - a period that lasted longer than any of us
expected - and we have moved back to where the CPI is near the top of our band, but partly due to
some temporary factors.
Where to from now? This will be particularly hard to judge, given that for at least a year the
yearended figure for the CPI will be obscured by the once-off lift due to the GST, and then the effects of
the abolition of wholesale sales tax.
At present, we feel that the most likely outcome for inflation once all the dust has settled - i.e. once we
are well into 2001/02 - is that it will be in the 2-3% target range, probably in the upper half. As usual,
there is a large margin of uncertainty attached to that forecast, but the adjustments to monetary policy
which have been made over the past six months give us more confidence that inflation should be
contained.
I would now like to move away from the short term and turn to the medium term. Most developments
in monetary policy can only be understood fully in this context although, by necessity, most
commentary concerns short periods such as month to month, in line with our Board Meeting, or even
shorter, such as day to day, reflecting deadlines of the daily press.
I will start by restating the logic of the inflation-targeting framework, which is the underpinning of our
whole medium-term approach. We have an inflation target that says inflation should average
somewhere between 2 and 3% in the medium to long run. We accept that at times it will be outside
this range, but if we think this is going to happen more than briefly it calls for adjustments to monetary
policy which will return inflation to the target and then keep it there.
We have based our monetary policy on this framework not because we only care about inflation, but
because we think it will give us the best result for the whole economy in the long run. In particular, if
applied sensibly, it will enable the economy's average growth rate to reflect its potential growth rate
and therefore deliver the maximum sustainable increase in employment and living standards.
We have already seen nine years of expansion with growth averaging over 4%, a considerably longer
expansion than we were able to achieve in the 1970s and 1980s. And there is every prospect that the
expansion will continue for a good deal longer. For the first time in my working life, Australia in the
1990s has come near the top of the decade growth rates among developed countries. We grew faster
than the United States, and only Ireland, among developed countries, recorded faster growth.
This growth occurred at a time when our inflation rate averaged about 21⁄4%, a good deal lower than in
earlier decades, and comparable with international standards. There was also less variability from year
to year in growth than in earlier expansions, although some variability is inevitable: we have had
annual growth rates at over 5% and at less than 3% during this expansion, yet its fundamental
momentum has remained intact. I think the system has proved itself to be a very good one, and I am
confident that it is the best way to ensure that monetary policy makes sense in the medium term.
It is also worth noting that during the course of the expansion, we have had one complete cycle in
interest rates - rises in 1994, then falls in 1996-98. These played their part in sustaining the expansion.
The increase in official interest rates of 125 basis points that has occurred over the past seven months
has to be seen in this context. For the present expansion to continue as long as possible, monetary
policy has to be adjusted as circumstances change. The economy has been undergoing a shift from a
period when inflation had been below the target to one where it was going to be in the target range.
Without policy adjustment, there was the prospect that it would, in time, rise above the desired range.
Until relatively recently, we were receiving information on economic activity that indicated the
economy could even have been accelerating beyond the 41⁄2% growth that had prevailed over the 1997
to 1999 period. From our perspective, the decisions to raise interest rates were relatively
straightforward.
The situation is not as straightforward now. Signs of a near-term acceleration in growth have gone. As
discussed earlier, there are now signs of slowing domestic demand, some of which may be in response
to the tightenings that have already occurred. Other things being equal, this should be helpful in
containing inflationary pressures. Other developments, principally the lower exchange rate, will act in
an expansionary direction, and potentially put upward pressure on inflation. It will be a difficult time
for reading and forecasting the domestic economy, and all this will take place against the backdrop of
an international economy dominated by the uncertainty of the unfolding events in the United States.
Markets, as always, will be looking for guidance. The more thoughtful will appreciate the complexity
of the situation, the less thoughtful will be expecting to be told the "formula" that we are using.
Unfortunately, there is no "formula" other than the guiding principle of the inflation-targeting regime.
This means that we will be assessing the outlook for inflation as judged by the factors which form the
basis of our forward-looking approach to monetary policy.
Growth in demand and output, and the extent to which that places pressure on the economy's capacity,
are clearly important. We judge this by examining all the available monthly and quarterly time series
data on economic activity, including those which give an impression of intangible factors like
"confidence". We monitor trends in commodity prices, wholesale prices, and wages, as well as the
CPI and the various measures of underlying inflation derived from it. The wages data may be
particularly important in the year ahead, given the difficulties in interpreting price indexes. We have to
allow for structural changes - such as the increased competitive pressure in goods markets. This has
been an important ingredient in maintaining downward pressure on many prices, and should be helpful
in negotiating the introduction of the GST. Inflation expectations are important - since it is the
anticipation of price rises that drives many decisions. We need also to consider the financial side of the
economy - the expansion of credit, trends in asset markets and the extent of risks which may be
building up there.
We then complement this essentially domestic analysis with an appreciation of what is happening in
the international environment in which Australian producers and consumers make their decisions. We
can not afford to ignore the world price level, world interest rates, or the variable which connects both
of them to the Australian economy - the exchange rate. Changes in the price of imports in foreign
currency terms can have a large impact on domestic inflation as the OPEC oil price rises of the 1970s
showed. The recent oil price increases demonstrate the same principle, on a much smaller scale. Rises
in a range of raw materials prices, driven mostly by global trends, are also having an impact on the
cost of producing goods in Australia. In the opposite direction, the subdued world price environment
of 1997 and 1998 helped contain any inflationary fallout from the lower exchange rate we experienced
during the Asian crisis.
Movements in the exchange rate clearly affect inflation and, as such, are an integral part of any
inflation-targeting regime. That is why they are frequently mentioned by central banks which operate
monetary policy in this way. But there is no mechanical relationship between the level of the most
frequently quoted measure of the exchange rate - the rate against the US dollar - and the future
domestic price level. For a start, the price effects are better approximated by the trade-weighted index.
Second, a temporary movement in the exchange rate may have little or no effect on prices and so some
attempt must be made at estimating medium-term developments, or at least market participants'
expectations of medium-term developments. Finally, a change in the exchange rate may have different
implications if it primarily represents international views about our economy and policies, or if it is
because we are being swept along with other countries in an international adjustment process.
All of these factors are relevant and have to be taken into account with due weight. But that is done
under the unifying framework of the inflation-targeting approach to policy. As I have noted above, this
approach has delivered tangible benefits. I am convinced that it will continue to do so.
Mr Chairman, it is a difficult time to be making monetary policy. The world environment is changing.
Most of these changes are for the better - our region is in recovery, as opposed to the severe recession
of two years ago, and global growth is strong. Our terms of trade are improving. Some other changes
in world capital markets, for example - are rather less benign for Australia. Adapting to these changing
circumstances presents a challenge.
At such times, it is important to keep our eye on the main goals - to sustain a long expansion, and to
address early potential imbalances which could impede the expansion's continuation. However, we
cannot assume that we have a choice of outcomes for the Australian economy, in terms of growth and
inflation, which is invariant to what happens in the rest of the world. While we are benefiting from the
stronger world growth compared with recent years, we will also be affected by the contractionary
effects of the lift in world interest rates. As the forecasts I mentioned in the beginning show, the year
ahead will most likely be one of slightly reduced growth, and somewhat higher inflation, compared
with the exceptional outcomes of recent years.
But if we can sustain the economic expansion through a tenth and eleventh year, even if its pace
moderates for a time, and at the same time keep inflation low, we will have achieved something which
has eluded us for three decades. That is a very worthy goal. It is what we aim to do.