Mr I J Macfarlane lectures on monetary policy in economic expansions
Speech by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, at the Chris Higgins
Memorial Lecture, held in Canberra on 27 October 1999.
* * *
1. Introduction
It is an honour to be invited to deliver the fifth Chris Higgins Memorial Lecture. I knew Chris from
1970 till his death in 1990. He was, in my opinion, the best Australian applied macroeconomist of his
era and a policymaker of distinction. His views on economics would place him amongst those whom
Alan Blinder1 identified as having hard heads but soft hearts. He could have held a Chair at any
Australian university and many overseas ones of note if that had been his objective; instead, he had an
outstanding career at the OECD and the Australian Treasury, where he rose to become Secretary in
1989. Chris was also an excellent companion - a man of taste, wide reading and wit. It is good to see
so many of his friends in the audience tonight.
Chris' death in 1990 robbed us of a good friend, and Australia of an outstanding public servant and
economist. I also cannot help but think it was a great shame that Chris did not live to see the 1990s
unfold. His professional life was concentrated in the 1970s and 1980s - two periods of relative
turmoil - and he did not see many of the things he stood for bear fruit in the 1990s. I would like to take
this observation as the theme for my lecture tonight.
2. Growth over five decades
I would like to start by looking at economic growth in Australia over the past half-century in terms of
decade averages (Table 1). If we do this, the variation in growth rates is not nearly as great as when we
compare different phases of the cycle. This is largely because each of the decades contained a
recession (or more than one by some estimates2) as well as periods of growth. The 1950s and 1960s
showed the strongest average growth at 4.2% and 5.4% per annum respectively, while the 1970s,
1980s and 1990s showed very similar growth rates in the 3.3% to 3.4% range.
It is disappointing that we could not keep up the 1950s and 1960s performance into the later decades,
but nor could other countries. There was a trend slowdown in growth around the world as the period of
postwar reconstruction passed into history. In fact, the fall-off in growth for OECD countries was
considerably more pronounced than for Australia, so Australia's relative performance improved
towards the end of this 50-year period. While economic growth in Australia was lower than for the
OECD on average over the 1950s and 1960s, it was higher in the 1980s and 1990s, with the biggest
advantage in Australia's favour occurring in the 1990s.
Table 1
Real GDP growth - Average annual rate
1950s 1960s 1970s 1980s 1990s
Australia 4.2 5.4 3.4 3.3 3.3
OECD 5.3 5.2 3.5 2.6 2.1
This is a surprise to some people and one response is to query it on the grounds that our recent
relatively buoyant economic growth could have been mainly the result of our faster population growth.
Table 2 examines this issue by taking out the effect of population growth and looking at real GDP per
capita over the same five decades. On this basis, the recent relative improvement is now more
pronounced than in the earlier Table. The 1990s not only shows a pick-up in Australia's growth of real
GDP per capita compared with the two previous decades, but it is the only decade in which Australian
GDP per capita has grown faster than the OECD area, and by an appreciable amount.
Table 2
Real GDP growth per capita - Average annual rate
1950s 1960s 1970s 1980s 1990s
Australia 1.8 3.3 1.7 1.7 2.1
OECD 3.5 3.9 2.4 1.8 1.3
I do not want to suggest that our recent economic performance means that we have returned to a
golden age such as we had in the immediate postwar period. Nor do I wish to deny that there is still a
backlog of remedial work to be done - our unemployment rate being an obvious example. But, on the
other hand, we must be doing something right. Our expansion so far in the 1990s has outlasted its
predecessors in the 1970s and 1980s, and it is still going strong. We have withstood a difficult external
shock, and should be able to sustain the expansion a good deal longer.
3. Why the improvement?
The fact that the annual growth in GDP per capita has increased in the 1990s, and that it is now faster
than in OECD countries, is a welcome development. The major reason for improvement in GDP per
capita is that a closely-related variable, namely labour productivity, has also shown a clear
improvement in the 1990s. In addition, multi-factor productivity - which is a little further removed
from GDP per capita - has also shown a clear lift compared with earlier decades. Table 3 shows a
comparison of these measures of productivity over the three most recent expansions.
Table 3
Productivity growth in expansion - per cent per annum
1970s 1980s 1990s
Labour productivity 2.2 0.9 2.3
Multi-factor productivity 1.0 0.8 1.8
Note: The expansion periods are: March 1975-June 1982, March 1983-June 1990 and June 1991-June 1999.
The reason for the pronounced rise in productivity is essentially microeconomic. It is because labour
is being used more efficiently, capital is being allocated to areas of the highest productivity and
innovation is occurring more rapidly than before. Partly this may be due to increased managerial
efficiency, but a more likely explanation is to be found in the policy changes designed to make the
economy more flexible and competitive - in other words, policies designed to affect the supply side of
the economy. Among these I include financial market deregulation, tariff reductions, privatisations,
competition policy and decentralisation of the labour market. These have all made a contribution, but
it is probably the interaction between them that is more important; in this sense, the total effect is more
than the sum of the parts. I have talked on this subject on earlier occasions,3 so I will not repeat myself
tonight, other than to observe that these have brought tangible benefits that are often overlooked by the
beneficiaries.
The other distinguishing feature of the 1990s is that the expansion has continued for longer. National
accounts data up to the June quarter of 1999 show eight years of expansion at an average rate of 4%
per annum, already exceeding the length of the previous two expansions. All forecasters are expecting
significant growth in the current financial year, so that, even on the most pessimistic assumptions, the
present economic expansion will be a lot longer than its predecessors in the 1970s and 1980s.
More importantly, in earlier expansions, serious imbalances had built up by this stage. In the early to
mid-1970s and the early 1980s, inflation was in double digits, partly as a result of a surge in wages. In
the late 1980s, asset prices and credit growth were rising to unsustainably high levels, and consumer
price inflation was still excessive. Both the dynamics of the business cycle itself, and the need for
tough anti-inflationary monetary policy, pointed to an abrupt end of the expansion. On this occasion,
the picture is different and no one is expecting an abrupt end.
4. Why has the expansion been steadier and longer this time?
I would now like to make a few comments on why the expansion of the 1990s has been steadier and
longer than its two predecessors. Here I think we have to look for essentially macroeconomic
explanations.
The first explanation is to be found in a comparison of the rates of inflation this time compared with
the two previous expansions. It is curious now to look back to some of the economic debates of the
1960s and 1970s. In those times, there were many people who thought that you had to tolerate "a little
bit of extra inflation" to make sure the economy would grow. Many, if not the majority, thought that
getting inflation down again would not be worth the price, because it would result in permanently
lower growth. The short-term trade-off (the Phillips Curve) was incorrectly interpreted as being a
summary of our medium-term choices.
Now when we look back (Table 4), nothing could be further from the truth. The low inflation
decades - 1950s, 1960s and now the 1990s - are the ones where we did well on growth in absolute
terms, or in relative terms. The high inflation decades - the 1970s and 1980s - were the ones where our
growth performance was at its poorest.
Table 4
Consumer prices - Average annual rate of increase
1950s* 1960s 1970s 1980s 1990s
Australia 6.1 2.5 10.1 8.3 2.2
OECD 2.9 3.2 8.0 5.1 2.7
* If the short-lived Korean War boom is excluded, the average inflation rates in the 1950s would be 2.5% for Australia and
1.7% for OECD.
The most reasonable explanation for the lower inflation and hence steadier and longer expansion in the
1990s is the improvement in macroeconomic policies. By this I mean monetary and fiscal policies, or
what used to be known as demand management policies.
I will not say very much about fiscal policy, other than to note that medium-term considerations now
play a much larger role, something that Chris Higgins consistently argued for. The improvement has
occurred in two stages after the disaster of the 1970s. In the late 1980s, and again in the mid-1990s,
the Budget was brought back into surplus where it remains at present. As a result of this fiscal
consolidation, the medium-term health of the Government's accounts has improved greatly. One
important indicator of this is the stock of government debt to GDP, which is now lower for Australia
than for virtually any other OECD country.
On monetary policy, I will say a little more. A similar realignment towards a medium-term approach
has certainly occurred in the case of monetary policy. The centrepiece of this has been the inflation
target and the Government's reaffirmation of the independence of the Reserve Bank as outlined in our
Act. A similar realignment has occurred in a number of other countries, and a model of this type,
whether explicit or implicit, is now the mainstream international approach to monetary policy.
This approach has been a major factor behind the low inflation of the 1990s, both here and in most
other OECD countries. A central channel through which this approach operates is through maintaining
low inflationary expectations. Wage and price setters no longer need to engage in the defensive
behaviour they formerly used to protect themselves against future rises in inflation. Similarly,
opportunistic tactics aimed at profiting from inflation no longer make sense as a business strategy.
And finally, the assumption by businesses that there is no need to resist increasing costs because they
can simply be passed on to consumers by raising prices has had to be discarded.
While the inflation target has played an important part in maintaining low inflation, there is more to
monetary policy than just setting the target - there also has to be a willingness to act in a timely way.
This is best illustrated by events in the period from 1994 to 1996 (Diagram 1). Around mid-1994, the
economy was growing strongly and there were signs that inflation and wages would soon pick up (this
expectation was reflected in a number of places including the yield curve). The first tightening of
monetary policy occurred in August 1994 and was followed by two others before the end of the
calendar year. It is important to note that at the time the tightening occurred, the current inflation rate
was 2% (four-quarter-ended underlying inflation). Thus the tightening was pre-emptive - it was based
on an assessment of the outlook rather than current experience. In time, inflation did rise and peaked at
3.3% per annum in the year to March 1996.
Diagram 1
Underlying Inflation
Year-ended
% %
5 5
5 5
CPI excluding interest
and health rebate
July 1996
4 4 4 4
3 3 3 3
2 2 2 2
Treasury
underlying CPI
August 1994
1 1 1 1
0 0
0 0
1991 1993 1995 1997 1999
Pressures soon abated as the economy slowed and wage claims moderated. By July 1996, the first of a
series of monetary policy easings occurred. Again this was pre-emptive because the inflation rate at
the time was still above 3%. But, because inflation was forecast to return to the middle of the band, the
period of tighter monetary policy that had prevailed since end-1994 was no longer needed, and so
interest rates could be taken back to more appropriate levels.
The pre-emptive nature of these policy changes, plus the Government's affirmation of the inflation
target and the independence of the Reserve Bank contained in the Statement on the Conduct of
Monetary Policy in August 1996, significantly increased the effectiveness of monetary policy and the
credibility of the Reserve Bank. This put us in a good position later to handle the contractionary
effects of the Asian crisis and the associated period of turbulence in financial markets.
The textbook response to a contractionary external shock such as the Asian crisis is not, in our view, to
tighten monetary policy. But the turmoil in financial markets, such as a plunging exchange rate and
widening bond spreads (both indications of capital flight), can sometimes only be settled by such a
show of forceful action. Most countries in the region, whether developed or emerging markets, chose
to, or were forced to, raise interest rates at some stage during the Asian crisis, with subsequent
detrimental effects on their economic growth and employment. The fact that we were able to withstand
the pressures without doing so (in fact, reducing rates slightly in December last year) is a testimony to
the increased credibility of monetary policy in Australia, and to the higher reputation that the
Australian economy overall commands in the international market place. It is also an illustration of
how timely action, such as in 1994, can ultimately contribute to a longer and more robust expansion.
Before concluding, I would like to make a couple of other observations on this subject. The first is that
pre-emptive monetary policy action only refers to being pre-emptive vis-à-vis actual developments in
the economy; it does not mean being pre-emptive vis-à-vis the financial markets' assessments.
Financial markets are looking at the same data as the Reserve Bank, are making forecasts and
calculating the probabilities of monetary policy action. Interest rates on bills and bonds always move
in anticipation of monetary policy action. To be pre-emptive vis-à-vis the market would be the same as
taking the market by surprise. No one should regard this as a worthwhile objective, although it will
occur from time to time. In the modern world of greater transparency and accountability, such
surprises should be rarer and rarer as the market becomes more aware of the central bank's objectives
and modus operandi.
The other implication of this new world of monetary policy is that policy changes will probably be a
good deal smaller than in the past. Just as the tightening of 1994 was much smaller than its
predecessors in the 1980s, it is reasonable to assume that this trend will continue. The past three years
have hardly been a placid period for the world economy, yet in successful economies the movements
in interest rates have been relatively small (for example, in the United States they have moved through
a range of 3⁄4 of a per cent).
The other thing we are seeing is that financial factors are playing a larger role than before. The biggest
move in US rates over the second half of the decade was the easing in late 1998 as a result of the
"credit crunch" which followed the Russian default and the demise of the hedge fund LTCM. At
present, US monetary policy is, of necessity, partly operating through the medium of the stock market
as that market moves in anticipation of Fed tightenings. Fortunately in Australia we do not have as
highly valued a stock market to contend with, but we cannot ignore these considerations entirely. Our
household sector is now a much larger holder of equities and, at the same time, is more highly
leveraged than in the past. This is bound to affect the transmission mechanism for monetary policy.
My final comment is that whatever monetary policy does, there will be those who disagree with the
decision. This is inevitable and probably healthy. Everyone is entitled to their own view, and has a
right to express it. That will always be the case. What has changed over recent years is that, by and
large, those who disagree with a decision no longer reach for the ready excuse of claiming that it was
"only done for political reasons". This change has been a long time in coming, but now that it has
arrived, it is a huge advance. It makes it easier for monetary policy to do what it judges to be right and
not be inhibited by fears of public misperception - whether that means temporarily higher interest rates
or temporarily lower interest rates - than formerly. In the long run, however, it almost certainly means
on average lower and less variable interest rates for the reasons I have outlined above.