Glenn Stevens: Economic conditions and prospects
Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Australian
Business Economists and the Economic Society of Australia (NSW Branch), Sydney,
17 September 2003.
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Thank you to the Australian Business Economists and the Economic Society for the invitation to speak
to you today. It is a pleasure to renew my association with both groups, which goes back many years.
As the title of my address indicates, I intend to offer an update of our thinking about recent economic
performance and prospects for the period ahead. I'll begin by taking stock of the international scene,
and then move on to the Australian economy. I will then, having set the context, make a few
comments about recent monetary policy issues.
The global economy
The world economy, and particularly the group of large industrial countries, has performed weakly for
the past three years or so.
Much attention has, as always, focussed on the US. The characteristics of this particular episode in
the US are well known: a very large share price boom and bust; a capital investment boom, which then
broke sharply, after views about the likely return on investment changed dramatically; a stabilising role
played by the US household sector, which has been prepared to borrow and spend; and periodic
shocks to confidence resulting from terrorist acts, war and so on. The outcomes might have been
much worse, but for exceptionally large monetary and fiscal policy stimulus applied by the US
authorities, and the fact that holdings of assets whose prices declined were not highly leveraged. In
fact, given the magnitude of the events, the US economy has done well to perform the way it has.
Outcomes for the world economy might have been better, on the other hand, had global demand not
been so dependent on the US. Unfortunately, Japan and Europe also relapsed into weakness in 2001.
In the case of the euro area, performance has been less convincing than that of the US over the past
couple of years. Mainland Europe shared some of the business cycle problems of the US but had
neither the same degree of supply-side dynamism, nor the same scope for expansionary policy action,
to aid recovery. Japan, as we all know, has struggled for some years to deal with financial imbalances,
deflationary pressure, supply-side inflexibility, and political stalemate regarding remedial measures.
China, on the other hand, has increasingly been an important force in the world economy. It is
probably reaching the point of equality with Japan, about now, in terms of its size in international trade.
China's growing economic importance is evident in the data, and also in the way in which the renminbi
exchange rate is becoming an important political issue - just like the yen.
Against that general backdrop, assessments of the near-term outlook for the global economy have
undergone some important changes over the past eighteen months. Through the first half of 2002,
indications of strengthening growth saw hopes rising for better times, only to be disappointed in the
second half of the year. Activity remained sluggish and confidence took a hit from the aftershocks of
the bubble, in the form of, inter alia, accounting and governance scandals (that is, some of the sorts of
things which emerge after every period of excess).
During the first half of 2003, growth and confidence were still at a rather low ebb. Things which did not
help confidence were the anticipation of war in Iraq, and the associated rise in oil prices. The outbreak
of Severe Acute Respiratory Syndrome (SARS) was also very damaging to a part of the international
business scene still struggling with the effects of earlier shocks.
Then there was the spectre of deflation. It's understandable that this would be a concern, since
inflation rates were already below zero in a few countries, and low to very low in most others. A period
of below-par growth was likely, if anything, to push inflation down further. My own views about the way
we should think about deflation were given nearly a year ago. I thought that it was possible that a few
more countries could experience deflation briefly, but that the likelihood of widespread, protracted and
corrosive deflation was low, at least absent a significant policy error. Nonetheless, since prudent
central banks operate on the logic of least regret, some of them had to give attention to the issue, just
in case, and they did so during the past nine months. The US Federal Reserve, in particular, made it
clear that it wanted to err on the side of ease, since even a low probability of inflation falling 'too far'
was something to be resisted, and openly discussed measures that could be employed were interest
rates to reach the zero lower bound.
The Iraq war was over quickly and its direct economic effects have been expansionary for the US
economy in recent months. But all these accumulated worries affected perceptions of the outlook
through to mid year.1 The clearest indication of this was that bond markets pushed down yields to
levels not seen in decades. There were some special factors in operation but, even allowing for those,
the tone of bond markets in May and June can only be described as particularly pessimistic. There
also seemed to be some uncertainty, even if only briefly, about the US Administration's intentions for
the US dollar. Given the rapid rise against the US dollar of the Australian dollar during that period, this
caught our attention.
There was a period, in other words, when it was not that hard to imagine a rather nasty international
outcome - one where the fear of deflation in the US and elsewhere, regardless of how well based it
was, could affect behaviour, and where the US dollar could be moving rapidly downwards, exporting
any deflation pressure to other countries, including Australia. While the probability of this scenario was
still not that high, it seemed to be increasing, to the point where it caused us some discomfort.
Readers of the Governor's 6 June remarks to the House Economics Committee could see quite clearly
the degree of concern at that time.
We can all feel some genuine relief that things have looked better since. After a weak early part of the
year, the US economy is doing much better in the second half. SARS had a big, but temporary, impact
in east Asia, but relatively little impact elsewhere. East Asia is now recovering quickly from that. China
continues to grow rapidly. The US economy, while experiencing very low inflation, has not slipped into
deflation, and some countries which have experienced deflation seem to be experiencing a bit less of
it now (e.g. China). Japan has, I think it is fair to say, surprised most people with solid growth over
recent quarters. The euro area remains the weakest of the major regions, although there are tentative
signs of improving conditions there in some of the most recent survey data.
For the first time in a while, consensus forecasts for world growth are edging higher, not lower.
Financial market pricing also clearly has retreated from the pessimism in May and June: the
exceptionally low bond rates have risen to being simply quite low. Share markets had already turned
somewhat more optimistic earlier, and have remained so. While we could argue about the extent to
which future profits growth in the US is required to validate current pricing, what seems in little doubt is
that actual profits in the US have recovered quite strongly to date. That is testimony to the capacity of
the US corporate sector to respond aggressively to problems, which is ultimately a source of
dynamism for the US economy. Finally, after a very strong upward trend earlier in the year, the
Australian dollar has traded fairly steadily in recent times.
None of this is to say that the world economy is completely out of danger. Things could still go wrong
while ongoing adjustments continue. There could be new shocks. Or the US expansion might wane if
the growth in demand and output does not find some reflection in higher employment, thus starving
the system of some of the fuel for further expansion in demand. Even if things are proceeding well, we
will inevitably see the odd patch of weak data. Once the danger of excessive near-term weakness is
past, moreover, there will be issues to address - like the long-term trend in government finances in a
number of countries.
But these sorts of caveats apply in every cycle, to some degree. The fact remains that things look
better than they did three or four months ago, and noticeably better than we feared, at that time, they
might look by now. That we are now talking about whether the pick-up extends into 2004, rather than
whether it is occurring at all, is welcome progress.
The Australian economy
The Australian economy has been significantly affected by the weakness in the world scene over the
past few years. This is most evident in the trends in exports. In the June quarter of 2003, aggregate
export volumes were about 2 per cent lower than in the middle of 2000 (just before the Olympics
spike). This is a series which in the 1990s grew at an average rate of 71⁄2 per cent per year. If that is a
crude gauge of 'normal' performance, there was an export volume shortfall of over 20 per cent by the
middle of this year. That's over 5 per cent of GDP, which is a much more substantial effect than seen
in the Asian crisis.
Why was the effect bigger on this occasion, even though the Asian crisis had a bigger impact on the
growth rates of our particular trading-partner group? The answer is mainly, I think, because the Asian
crisis was a regional problem which occurred against a backdrop of strength elsewhere (as we now
know, but didn't at the time). So many of Australia's exporters could find other markets. That is
obviously harder to do when the problem lies with the global economy. In addition, of course, there
was the effect of the drought on rural exports, and of the events of 11 September 2001 and SARS on
exports of tourism services, which were over and above the normal effects of global weakness.
How has the economy handled the loss of income? In a world of open capital markets, one would
expect that a temporary reduction in income would in part be reflected in slower growth of spending,
but in part also in a temporary change in our saving behaviour - saving less of our own income,
drawing more on the saving of others. That is, we smooth our living standards in the face of swings in
income. This behaviour means that there is some slowing in GDP growth, but much less than would
be the case, were our spending behaviour to be confined to following much more closely the reduction
in income.
At the same time, as we all know, a long-term adjustment has been under way in the structure of
households' balance sheets, which has been tending to elevate spending relative to income for some
time. It so happens that the direction of this effect has, in the past couple of years, suited what was
needed to adapt to the international conjunctural circumstances.
We can't distinguish from the data what was the result of this structural change and what was due to a
cyclical response to a particular income shock. But the broad effects of the combined forces are fairly
clear in the national income accounts. We have seen domestic final demand rise by over 41⁄2 per cent
over the past year - to be sure, more moderate than the 6-7 per cent pace it was recording a while
back, but still faster than average. Real net exports fell by 31⁄2 per cent of GDP over the latest year,
influenced by the world economy and the drought. Between them, those two factors did most of the
work pegging GDP growth back to a below-average 2 per cent over the year. Over the same period,
the current account deficit has increased by about 3 per cent of GDP. This is smaller than the decline
in real net trade volumes because Australia's terms of trade have continued to improve over the past
year - by nearly 3 per cent, which is worth about 1⁄2 per cent of GDP in additional income.
So the Australian community, by having access to capital markets, and facing macroeconomic policy
settings which remained on the expansionary side, was able to continue to increase its spending at a
very strong pace, even though income growth was impaired by international events. This involved
declining rates of saving out of current income, and some extraction of accumulated equity from the
dwelling stock. Generally speaking, to have that flexibility is a good thing - with the proviso that, as
with all good things, we don't want to over-indulge.
We can anticipate that, over the coming year, the two factors weakening overall performance over the
past year will not recur, and indeed some reversal of these effects is likely. It is widely acknowledged
now that there will be a strong recovery in farm production. The prospect of some continuing
improvement in international conditions means that the downward trend in non-farm exports should
bottom out, and a recovery begin.
At the same time, domestic demand growth should moderate a little. Capital spending by firms will
probably continue to rise, but not as quickly, on current indications, as it has over the past year. Some
decline in dwelling construction activity has occurred, although this looks smaller than earlier thought.
Consumption spending looks likely in the near term to continue to benefit from steady growth in
incomes, high levels of confidence and the higher and more accessible wealth available to
households.
If this outlook is correct, growth in the economy has probably already slowed as much as it is likely to.
The year-ended growth rate of non-farm GDP will decline for another quarter as an earlier very strong
quarter drops out. But the pace of expansion through the second half of 2003 is probably going to be
at least as good as it was in the first. If the global economy continues on its present track, Australian
growth should clearly be picking up by the first half of next year. Inflation will be pushed down a bit by
the earlier exchange rate appreciation for a while, but is still thought likely to be about 21⁄2 per cent in
the medium term, based on the usual assumptions about oil prices, exchange rates and interest rates,
and the above growth outlook.
This picture is much as was described in our Statement on Monetary Policy on 11 August. Since that
document was published, it is fair to say that the downside risks to the global economy have retreated
further. Most recent data on the Australian economy also seem consistent with a moderation in
non-farm growth in the first half of the year, but suggest that it has neither been particularly
pronounced, nor showed signs of being long-lived.
Risks and policy considerations
It has become much better understood in recent years that once a coherent framework for monetary
policy is in place, the regular policy decision is essentially a matter of responding to the changing
balance of risks to the outlook. The RBA's Board certainly has had a busy time over the past year or
more evaluating and deciding how to respond to the evolving balance of international and domestic
risks. It takes a lot more work than you might think to leave rates unchanged for fifteen consecutive
months!
In the middle of last year, it looked as though the international economy was returning to stronger
conditions, and Australian domestic demand was growing very strongly indeed. To foster an inflation
outcome consistent with our medium-term target, we believed that it would be prudent under such
conditions to return interest rates to normal, or 'neutral', from a relatively expansionary setting. Two
initial steps were taken, and the likelihood of further steps clearly signalled. But in the event, the
process did not continue, because the world economy began turning out differently to what we had
assumed. By the end of 2002, it was clear that any thought of near-term tightening could go off the
agenda for a while. The world economy had clearly lost some momentum, and for the time being, this
meant that a steady interest rate structure would probably be associated with achieving our policy
objectives.
That remained the story through to the middle of 2003, as the Iraq war came and went, most
international data looked on the soft side, the drought continued, and financial market sentiment
waxed and waned. The outlook for Australia was for moderate growth - quite a good outcome in the
circumstances - but our feeling was that the risks stemming from international developments were
tilted to the downside. Inflation, if anything, looked a little higher than had been expected, although our
judgement was that in the medium term, it would still turn out to be consistent with the target.
That was a macroeconomic outlook which certainly did not, in my view at least, amount to an obvious
case for monetary policy to be noticeably easier than was already in place. A reasonable case could
be made that policy should be easier than neutral - but it already was, and had been for some time.
Our conviction that the level of interest rates was exerting stimulus to the economy - a conviction
strengthened when we looked at the demand for credit and the behaviour of asset markets - and a
view that the inflation-targeting framework does not call for trying to fine tune outcomes, have both
been important in policy deliberations.
At the same time, it should be obvious that the shifting assessment of the balance of risks to the
outlook (which can occur without there necessarily being major changes to central forecasts) has also
been critical. When, after a period of disappointing international outcomes in the first half of 2003, the
external threats to the economic outlook seemed suddenly to be building up rather dangerously
through May and early June, it looked like a case to ease policy was building.
Throughout this period, the situation was complicated by another type of risk. While views about the
international situation were changing, at home the demand for credit from households, far from
diminishing, seemed to be strengthening. Apart from the fact that this meant that the near-term outlook
for domestic demand might well be stronger than assumed, the Bank had an obligation to consider the
medium-term soundness of the economy in addition to the short-run conjuncture. There is no doubt
that the preparedness of households to borrow has been imparting some strength to demand and
general buoyancy to the economy and asset markets, and that this has been helpful in supporting
growth in the circumstances of the past couple of years. But there cannot be much doubt either that
running up debt today must diminish the scope to do so in future, and that it must also impair, at the
margin, the capacity of some households to cope with adverse shocks which might come along.
There are times when the above is a risk which just has to be incurred because another possible
outcome is even worse. A disastrous international environment, coupled with a soaring exchange rate,
would probably be one such time. That is why, in June, we publicly contemplated the possibility of
easing. But we had to be fairly sure that the alternative was going to be pretty bad before we took
action which we knew would be likely to inflame an asset market and borrowing boom. Monetary
policy might not be able to do much to end an asset price boom without a fair bit of collateral damage -
so, at least, it is commonly claimed. But whatever one's view on that, surely policy should avoid
needlessly adding to the boom. 'First, do no harm' is a good motto here.
We have sought to balance these various concerns over the past several months. Although in early
June a case to ease looked like it was building, it had not strengthened sufficiently by the time of the
July meeting to warrant action. In August the case got weaker, and it got weaker again by early
September. Essentially what happened was that the risks to growth from abroad abated, while those
posed by the rapid rise in debt did not.
This recent experience, and the one a year earlier, is instructive in the discussion about central bank
communication. What it shows is that, while it is natural for market participants and the media to want
central banks to say more and more about their intentions, people need to keep very much in mind
that our assessment of what we might need to do is, of necessity, highly conditional on a view of the
future. And the future often turns up the unexpected - to which we need to respond by revising our
intentions. So it is important that observers not only listen to the central bank's words, but also
continue to look closely at the actual information coming in. I know the majority of you do.
Secondly, because the future cannot be known, and because things can change quickly, people need
some understanding of the principles which guide central bank behaviour. So there is probably more
to be gained by continued efforts at articulating how our framework for policy works, than by providing
ever more frequent commentary on events. Such information hopefully provides interested observers
with a device to filter, in real time, the information becoming available. This, combined with a periodic
account, after the event, of how we filtered it, is the most helpful form of transparency - describing how
we think about things and, within that framework, why we did what we did. The most recent Statement
on Monetary Policy, in fact, goes a good deal further down this track than most of its predecessors.
Conclusion
The world economy is still not entirely in the clear, but is better than it was, and a fair bit better than it
might have been. It is sensible at present to look for further improvement, while keeping in mind the
possibility of regression. If things work out acceptably well abroad, the Australian economy will next
year have a better chance of balanced growth than we have had for a few years. We will continue to
assess the evolving balance of risks and will respond, in a measured fashion, as needed - and we'll do
our best to keep you informed.