Glenn Stevens: Economic conditions and prospects - creating the
upside
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Economic
Society of Australia Luncheon, Brisbane, 10 June 2015.
* * *
I thank Elliott James for research assistance.
Thank you for the invitation to speak in Brisbane once again.
The last time I spoke with this group, in July 2013, the economy was estimated to be growing
at about 21⁄2 per cent.1 Underlying inflation was 21⁄4-21⁄2 per cent, consistent with the target of
2-3 per cent.
Two years on, the economy is growing at just shy of 21⁄2 per cent and underlying inflation is
around 21⁄4-21⁄2 per cent, consistent with the target.
In some respects, then, it might seem that not much has changed. In fact a number of
important developments have occurred during that period, some as anticipated and some
not. Overall, the fact that not much has changed is disappointing: the economy has not
picked up speed as we had hoped.
In this talk, I will make some observations about the global and domestic economies, and try
to give some sense of what we have learned in the past couple of years.
The global economy
Two years ago, we judged Australia's trading partner group to be growing at about its
average pace of around 4 per cent. It was expected that during 2014 and 2015 growth in this
group would pick up a bit, to a pace a little above average. In fact, growth for our trading
partners has remained at about 4 per cent and is expected to stay there over the next couple
of years.
To be sure, 4 per cent growth is faster than growth for the world economy as a whole, which
is more like 31⁄4 per cent. It has been to Australia's advantage that we have a high exposure,
for an advanced country, to the faster-growing Asian region.
As an example, while the euro area is a significant trading partner for Australia, we were
probably less affected than many countries in 2012 and 2013 when Europe lapsed back into
recession. Two years ago, I noted that the economy of the euro area was still smaller than it
was before the financial crisis. Regrettably, that remains true today. Europe is back on a
growth path now, but it is still a fairly modest one, and it seems to require extraordinary
settings of monetary policy to achieve even that.
Growth has recently resumed in Japan after a dip in activity following the enactment of a tax
increase last year. Japanese growth rates remain pretty modest, though since Japan has a
declining population, they look better on a per capita basis. The full implementation of the
socalled "third arrow" of structural reform could be expected, if it occurs, to lift growth per head
further over the long run.
Growth is proceeding at a reasonable clip in the rest of Asia, though as I noted two years
ago, in more than a few countries it has not been possible to restore the pre-crisis growth
rates. And the growth that has been achieved has been accompanied in a number of cases
by a sizeable increase in debt owed by households, firms or both. How big a vulnerability this
will turn out to be under different financial conditions and/or lower growth we cannot yet
know.
While it has been to our advantage to have a lesser exposure to Europe than many other
countries, the flipside is a much greater exposure to China. That means we will be more
sensitive to fluctuations in China's performance than other countries. This is not a new point;
I said as much about five years ago.2 But it is perhaps more concrete now, given that China's
growth has slowed appreciably over the past few years. The moderation in 2014 was more or
less as China's policymakers intended. The further moderation seen over the past six
months or so may have been a little more than intended. Chinese policy has been
responding to that outcome as you would expect: interest rates are declining, and some
selected restraints on credit are being eased.
Stepping back from the ebb and flow of short-run data, the big point is that China's
policymakers are attempting two major transitions. One is towards more consumption-driven
growth, as opposed to investment and export-led growth. This is necessary because a
continental-sized economy such as China cannot rely on the rest of the world absorbing
rapid growth in its output. The second, related transition is towards a more robust financial
structure, which is necessary because the prevailing structure has too many risky aspects.
Both these transitions are necessary, but both remain works in progress. How they will play
out is unavoidably a source of uncertainty.
What does seem fairly clear is that the pace of growth in demand for commodities like iron
ore will be lower in future than in the past five years, even as supply continues to increase.
Thus far much of the additional supply has been Australian ore, though it is apparent that at
least some of the future increase in supply will be from other countries. Perhaps it is not
surprising, then, that Australian discussion of the Chinese economy has been through the
prism of the iron ore price - these days subject to daily monitoring. A few months ago, it
almost seemed as though the price of iron ore might, in terms of attention given, eclipse that
other price on which Australians focus with a passion, namely the price of a house. But of
late house prices seem to have regained their pre-eminent place in our national psyche!
Turning away from China, it is quite significant that there is a good deal more optimism now
in the United States. The rate of unemployment has fallen considerably and growth in wages
has begun to increase. There was a weak March quarter result for growth in output, which
most observers attribute to temporary factors, though it remains to be seen just how robust
the return to growth has been since.
The significance of a healthier US economy is two-fold. One element is that the expectations
of many business people around the world, including in Australia, still tend to take a cue from
the tone of US business. The second is that, at some point, US monetary policy will begin to
adjust to improved conditions. That will be a very gradual process, but at this stage,
indications still seem to be that the US Federal Reserve will begin the process some time this
year.
It is reasonable to hope that this change in course can be accomplished without serious
disruption to financial markets, but we cannot be certain of that. Countries receiving
crossborder capital flows have generally sought to strengthen their economic and financial
fundamentals since the "taper tantrum" of mid 2013. The fact that the Fed has signalled as
clearly as possible the way it thinks about these issues should also help reduce instability.
On the other hand, "guidance" is no guarantee of smooth sailing. Moreover, we stand today
at a highly unusual juncture. We see a combination of remarkably low yields on financial
assets, compressed risk premia and diverging outlooks for monetary policy across the major
jurisdictions. It is a complex picture for both market participants and policymakers.
Recently, we have seen some large and abrupt movements in currencies, commodity prices
and even sovereign bond rates. While to some extent this is a normalisation after a period of
unusually subdued volatility, these movements may also be signalling that a degree of
underlying fragility has built up over the long period of "search for yield". Such dynamics bear
watching.
The Australian economy
In Australia, recent growth in the economy has not been as strong as we want. Of course,
what we are witnessing is not an economy heading along the course of a normal economic
cycle, but a complex and rather lengthy adjustment both to the once-in-a-century cycle in our
terms of trade and an earlier increase in household leverage. During the late 1990s and early
2000s, very confident households spent and borrowed more, and saved less, in the process
extending their balance sheets. That process started to fade in about 2006 and then finished
more abruptly when the financial crisis hit. But by then the run-up in resources prices was
imparting a very large stimulus to the economy and allowed for solid growth to continue at a
time when most other countries were still feeling the aftermath of the financial crisis.
But now most of the capital spending that was needed to lift the output of the mining sector
has been completed, at least for the production of iron ore. Some very large LNG projects
are still underway, but as those projects and others draw to a close, the decline in mining
investment that is already underway will continue (and perhaps accelerate).
The latest edition of the Australian National Accounts, released last week, shows the picture.
The quarterly growth figure was stronger than what had been embodied in our forecasts in
the May Statement on Monetary Policy, though that comes after a weaker-than-expected
outcome in the previous quarter. Some of the strength resulted from unusually high export
shipments of resources, which were less disrupted by weather conditions in the "cyclone
season" than has often been the case in the past. Indications are that this pace of growth
wasn't repeated in the June quarter, when shipments of coal in particular were affected by
weather disruptions on the east coast.
Taking the results over the past four quarters, growth was "below trend". Export volume
growth contributed strongly, while domestic final demand increased by a bit under 1 per cent,
which is quite a weak result. Housing construction rose strongly, and consumer spending
over the year rose by more than real household income (that is, the saving rate fell). Both
these results owe a good deal to low interest rates and rising asset values.
But other components of demand were weak. Business investment fell substantially, with
mining investment falling quickly and, as best we can tell, non-mining capital spending also
weak. Public final spending didn't grow at all. Public investment spending fell by 8 per cent
over the past year.
Overall, these outcomes are weaker than what, two years ago, we expected would be
happening by now. Back then, the two-year-ahead forecast was for annual GDP growth to be
in a range of 21⁄2 to 4 per cent by mid 2015. The width of that range reflected the normal size
of error margins, coupled with the inevitable uncertainty about the timing of when some
components of demand outside of mining might strengthen, and the judgement that if
accommodative monetary policy really was held in place for several years (which was a key
assumption behind those forecasts), activity could at some point start to pick up quite quickly.
It will be three months before we get the national accounts data for the June quarter, but at
this point, with three of the four quarters available for the year to June 2015, it would appear
that the outcome will be either right at the bottom of the range predicted two years ago or,
more likely, a bit below it.
Of course, forecasts are hardly more than educated guesswork and two-year-ahead
forecasts are even less reliable. That there are inevitably forecast errors is neither surprising
nor new, and it is not any more concerning per se now than it always has been. This is far
from the biggest forecast error I've seen over my three decades in this game.
But it is nonetheless useful to see what we can learn from those errors.
The following points are prominent:
• The terms of trade, which two years ago were assumed to fall, have in fact fallen
further - they are about 12 per cent lower than the assumed path. That means
national income is lower, which means spending power is lower.
• The exchange rate, which at that time was above parity against the US dollar, and
was assumed to stay there, is now about 25 per cent lower. It has moved in the
same direction as the terms of trade, which is normal.
• The lower exchange rate has helped to produce a contribution to growth from "net
exports" much greater than earlier forecast, while that from domestic demand has
been much weaker. The latter is mainly spread across non-mining business
investment and weaker government spending, together with softer consumption on
account of lower incomes. One thing which is not very different from the forecast
from two years ago is that mining sector capital spending is falling sharply.
• Because the net effect of the above factors is that GDP growth has been on the
weaker side of expectations, the unemployment rate is about half a percentage point
higher than forecast two years ago. Consistent with that, growth in wages is, as you
would expect, lower than forecast.
Headline inflation is lower than forecast, largely because of the recent fall in oil
•
prices. Underlying inflation is within the 2-3 per cent range that had been forecast.
Again, the depreciation of the exchange rate has been a factor here.
• The cash rate is 75 basis points lower than assumed two years ago, as monetary
policy has used the room provided by contained inflation to try to do more to help
growth. Lending rates have fallen on average by about 100 basis points over that
period. This has produced a stronger result for housing construction than forecast
and will also have contributed to the rise in dwelling prices.
In summary, the economy has in several important respects followed a different track from
the one expected a couple of years ago. That is partly because conditions in the world
economy were different from what had been expected and partly because several domestic
factors were different.
Some in-built responses have been in evidence. For example the decline in the exchange
rate, even if not by as much as we might have expected, has had the effect of supporting
growth and keeping inflation from falling as much as it might have done. And, of course,
monetary policy has also responded to the evolving situation, consistent with the Reserve
Bank's mandate. These responses have had the effect of lessening the extent to which
growth and inflation have differed from the outcomes expected two years ago, but haven't
managed to eliminate those differences entirely, at least in the case of output growth.
The slowing in wage growth in response to soft labour market conditions has also
undoubtedly helped to hold employment up. In fact wage growth appears to be somewhat
lower than previous relationships between wages and unemployment would suggest. This
may be a sign of increased price flexibility in the labour market and could help to explain why
employment recently has looked a little higher relative to estimated GDP than might have
been expected. These hypotheses can be advanced only tentatively, though, until we have
more data.
Looking ahead, the most recent forecasts suggest that growth rates will be similar to those
we have observed recently for a while yet. Residential investment will reach new highs over
the period ahead. Household consumption is expected to record moderate growth. With
national income growth reduced by a falling terms of trade, this requires a modest decline in
the saving rate. It doesn't seem reasonable to expect much more from consumption growth
than that.
Resources sector investment has a good deal further to fall yet over the next two years.
Other areas of investment seem very low and while I would have expected that by now these
would have been showing signs of strengthening, the most recent indications are for, if
anything, a weakening over the year ahead. Public final spending has not been growing and
fiscal consolidation still has some way to run. Under the current macroeconomic conditions, it
would seem inappropriate for governments to seek additional restraint here in the near term.
Inflation is likely to remain low. Growth in labour costs is very low and some of the forces that
were pushing up certain administered prices have started to reverse. So even if the
exchange rate were to fall further, which in my view it needs to, we seem unlikely to have a
problem with excessive inflation.
Putting all that together, as things stand, the economy could do with some more demand
growth over the next couple of years.
Of course, these are forecasts. They might be wrong. In fact, they will be wrong, in some
dimension or other. Our published material goes to some lengths to articulate a range of
"risks". It is easy to think of "downside" ones in the current mood of determined pessimism.
But it is not entirely impossible to think of upside ones as well. A further fall in the exchange
rate, which is not assumed in the forecasts, would add both to growth and prices. If one
thinks that such a decline at some point is likely, that constitutes an "upside" risk. Of course,
the list of countries that would prefer a lower exchange rate is a long one and we can't all
have it.
That being so, we might give some thought to trying to create some upside risks to the
growth outlook through policy initiatives. The Reserve Bank will remain attuned to what it can
do, consistent with the various elements of its mandate - including price stability, full
employment and financial stability. We remain open to the possibility of further policy easing,
if that is, on balance, beneficial for sustainable growth.
The temptation, of course, is to presume outcomes can be fine-tuned by policy settings and
that we can simply dial up more or less demand in short order to avoid deviations from some
ideal path. Reality is inevitably more messy than that and has not always been kind to such
fine-tuning notions. As it is, some observers think monetary policy has done too little, while
others think it already has done way too much. I think it has been about right for the
circumstances.
But the bigger point is that monetary policy alone can't deliver everything we need and
expecting too much from it can lead, in time, too much bigger problems. Much of the effect of
monetary policy comes through the spending, borrowing and saving decisions of households.
There isn't much cause from research, or from current data, to expect a direct impact on
business investment. But of all the three broad sectors - households, government and
corporations - it is households that probably have the least scope to expand their balance
sheets to drive spending. That's because they already did that a decade or more ago. Their
debt burden, while being well serviced and with low arrears rates, is already high. It is for this
reason that I have previously noted some reservations about how much monetary policy can
be expected to do to boost growth with lower and lower interest rates. It is not that monetary
policy is entirely powerless, but its marginal effect may be smaller, and the associated risks
greater, the lower interest rates go from already very low levels. I think everyone can see
that.
If I am correct about this, it really is very important that other policies coalesce around a
narrative for growth. In this regard, I think the Government is on the right track in not seeking
to compensate for lower revenue growth by cutting spending further in the short run. Of
course, some resolution of long-run budget trends is still going to be needed to sustain
confidence and that will not be an easy conversation.
Meanwhile, as often remarked, infrastructure spending has a role to play in sustaining growth
and also in generating confidence. I am doubtful of our capacity to deploy this sort of
spending as a short-term countercyclical device. The evidence of history is that it takes too
long to start and then too long to stop. But it would be confidence-enhancing if there was an
agreed story about a long-term pipeline of infrastructure projects, surrounded by appropriate
governance on project selection, risk-sharing between public and private sectors at varying
stages of production and ownership, and appropriate pricing for use of the finished product.
The suppliers would feel it was worth their while to improve their offering if projects were not
just one-offs. The financial sector would be attracted to the opportunities for financing and
asset ownership. The real economy would benefit from the steady pipeline of construction
work - as opposed to a boom and bust. It would also benefit from confidence about improved
efficiency of logistics over time resulting from the better infrastructure. Amenity would be
improved for millions of ordinary citizens in their daily lives. We could unleash large potential
benefits that at present are not available because of congestion in our transportation
networks.
The impediments to this outcome are not financial. The funding would be available, with long
term interest rates the lowest we have ever seen or are likely to. (And it is perfectly sensible
for some public debt to be used to fund infrastructure that will earn a return. That is not the
same as borrowing to pay pensions or public servants.) The impediments are in our
decisionmaking processes and, it seems, in our inability to find political agreement on how to
proceed.
Physical infrastructure is, of course, only part of what we need. The confidence-enhancing
narrative needs to extend to skills, education, technology, the ability and freedom to respond
to incentives, the ability to adapt and the willingness to take on risk. It is in these areas too,
where there are various initiatives in place or planned, but which often do not get enough
attention, that we need to create a positive dynamic of confidence, innovation and
investment.
That is the upside we need to create.