I J Macfarlane: Some recent economic developments in Australia
Opening statement by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to the House of
Representatives Standing Committee on Economics, Finance and Public Administration, Melbourne,
12 August 2005.
* * *
I would like to start by saying how pleased I am to be back in Melbourne in these familiar
surroundings. Since these half-yearly hearings started in May 1997, this is the sixth time we have
appeared in Melbourne, and the seventh time in Victoria - the other time being in Warrnambool in
2002. I hope that the discussions are as fruitful and informative as they have been on the earlier
occasions.
On Monday we released our quarterly Statement on Monetary Policy, and you will not be surprised to
hear that what I have to say today is very similar to it. In fact, what I have to say is also very similar to
a speech I gave on 14 June. The past couple of months or so has been a particularly stable period
and we have not felt the need to change our views much, if at all. Rather than going over all the recent
developments at this time, I will concentrate on a few that I think are important.
The first, as always, is the world economy. It would be possible for someone reading the newspapers
to get the impression that the world economy is in a parlous state - rising oil prices, large US current
account deficit, China on a knife edge, Japan still stagnating, the US dollar about to plunge, etc. You
will be pleased to hear that we are not of that view. In fact, we have for quite a long time been
relatively optimistic about the outlook for the world economy.
When looked at region by region, there is good growth nearly everywhere. Obviously, the United
States, China, India and East Asia are doing well, but the places we tend to overlook are also doing
well - for example, Latin America, the Middle East and the former Soviet Union. Even Africa has
picked up, and so has Japan. The only area that continues to disappoint is continental Europe,
particularly the big three - Germany, France and Italy.
Oil price increases are a source of concern, but their rise is primarily due to strong world demand, not
to supply restriction as was the case in OPEC I and II. They also do not appear to have added to
inflation or inflationary expectations, and so have not required a policy response. Much discussion
recently has focused on the US current account deficit as a source of risk to the world economy. It has
been argued that the United States might encounter difficulty financing its deficit and that this would
put downward pressure on the US dollar and upward pressure on world interest rates. In fact, the US
current account deficit has been financed relatively easily, and the US dollar has risen over the past
year. More importantly, long-term real interest rates around the world have stayed exceptionally low,
which indicates a more-than-adequate supply of world savings, rather than a shortage. Although
China has been cited as a third source of risk to the global expansion, it continues to power ahead,
and the recent changes to its exchange rate regime, although small, will improve its prospects at the
margin.
The most reasonable assumption is that the current world expansion, which has been going for almost
31⁄2 years, will continue for a good while yet. Most private forecasts for global economic growth for the
rest of this year and the next show above-average rates, although not as strong as in 2004.
The second subject I would like to say a few words about is the interaction between developments in
the housing market and household spending and saving. Recent evidence from several countries,
including Australia, shows that during periods where house prices are rising rapidly, households tend
to react to this by increasing their consumption expenditure faster than their income. They can do this
by either reducing discretionary savings, or by borrowing against the equity in their house to finance
non-housing expenditure, a process referred to as 'housing equity withdrawal'. This process occurred
in Australia, particularly in 2002 and 2003.
Over the past eighteen months, during which Australian house prices on average have not risen, this
process seems to have stopped, and so consumption and borrowing have slowed noticeably. In the
eighteen months to the December quarter of 2003, real retail trade rose by 10 per cent, whereas in the
most recent eighteen months it has risen by 41⁄2 per cent. These developments have not been a
concern to us because:
•
The pace of growth in domestic demand had been clearly unsustainable, averaging 6 per
cent per annum in 2002 and 2003. This needed to be brought back to a more sustainable
pace, and this necessarily involved some slowing in consumption.
•
Other parts of the economy are still showing good growth, particularly employment and
investment. The external sector is also exerting an expansionary influence through higher
demand for exports and higher export prices.
•
After periods of rapid borrowing and rising interest servicing costs, a period of consolidation
is welcome. The corporate sector did this in the early 1990s and is now in excellent shape;
the household sector will be in a better position in the long run if it also consolidates its
balance sheet.
Nevertheless, we are taking a great interest in the relationship between housing and household
spending, as it has been and will probably continue to be an important influence on economic
developments. One area where it has been influential has been in explaining the different economic
performance of the different states. We have also recently undertaken a survey of a sample of
households to study the extent to which they have engaged in mortgage equity withdrawal and to see
how the funds were used. We will soon be reporting on the results of that survey.
The third subject I would like to cover is inflation and inflation prospects. This is particularly important
given that our monetary policy is based on inflation targeting. That is, we want to ensure that the rate
of inflation averages somewhere between 2 and 3 percent. We aim for this - not because inflation is
all we care about - but because the maintenance of low inflation is a necessary condition for having a
long economic expansion in output and employment.
Over the past two years, inflation in Australia has been restrained by the appreciation of the Australian
dollar which took place between mid 2001 and the beginning of 2004. However, there have been a
number of influences which have pointed to a rise in inflation further ahead:
•
the fact that after a long expansion we were encountering some capacity constraints;
•
the rising prices of oil and some other important industrial inputs; and
•
the fact that the downward influence on prices from the exchange rate appreciation would
eventually fade away.
The likely extent of the upward pressure has been difficult to assess as the signals have varied quite a
bit. When I was last before you in February, the signals were quite strong. We had received two
quarters of large rises in producer prices at all stages of production and the increase in the CPI in the
fourth quarter of 2004 had exceeded everyone's expectations. There was also some evidence that the
slowdown in credit had run its course and was picking up again. Shortly after we met last time, the
Bank raised the cash rate by 25 basis points.
Since that time we have had more reassuring news on inflation. There is also some evidence that the
monetary policy tightening itself may have had a quicker effect than normal. I do not want to make too
much of this point, but the saturation coverage of the event in the print and electronic media must have
had some dampening effect on expectations, as some surveys have suggested. It would not be
surprising if the household sector had become more sensitive to news about interest rates, given the
increased debt and debt servicing loads that it is now carrying.
To cut a long story short, the next set of producer and consumer price inflation data that we received
was more reassuring. True, it was only one quarter's information and that was not enough to change
our numerical forecast of inflation, but it did lead us to conclude in our May Statement on Monetary
Policy
that there was no longer an upward risk to our inflation forecast. The subsequent set of data
confirmed a similar picture. With two quarterly sets of more reassuring price data now behind us, we
Statement on Monetary Policy
were able in our recently released August to conclude that the CPI
increase will peak at 3 per cent per annum in the second half of next year. As was widely noticed, we
also refrained from making the point we have been making for the past year or so about it 'being
unlikely that there would be no further rises in the course of the expansion'. That does not mean that
further rises could not happen; it only means that in our present estimation there is no longer a more
than 50 per cent possibility of it happening.
This is a pretty comfortable position in which to be. We are not expecting to change monetary policy in
the near term, and when we look further into the future we no longer see a clear probability of it
moving in one direction rather than the other. Importantly, this is also the collective view of the market,
as shown by the yield curve and by economists' forecasts. Of course, individuals do not all share this
view, but on average that is the collective forecast.
I do not intend to say any more about the economy or monetary policy at this stage, but, of course, am
happy to answer any questions that you have on these subjects. I am also happy to answer any
questions on the other important area of the Bank's responsibilities, namely financial system stability.
Within that general area, the subject that has attracted the most recent attention has been the
regulation of the retail payments system by the Bank's Payments System Board. I know that
Committee members have met with the various industry participants, including members of the Bank's
Payments Policy Department, to discuss the main issues, and, of course, I would be happy to address
any questions members have on that subject.