Glenn Stevens: Economic conditions and prospects, October 2005
Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the Tasmanian
Chamber of Commerce and Industry Business Dinner, Hobart, 11 October 2005.
* * *
It is nice to be in Hobart and I thank the Tasmanian Chamber of Commerce and Industry for the
invitation. It is now a couple of months since the Bank released its most recent quarterly assessment
of economic conditions, at which time some of our staff paid one of their regular visits to Tasmania to
consult with local businesses.
So I intend to offer a brief instalment in the unfolding narrative of the economy, with the benefit of an
extra couple of months' information. Of course, a few weeks from now we will release our next full
Statement on Monetary Policy. I won't try to preview that in detail, but rather pick on one or two issues
of note. I'll begin with the world economy.
The world economy
Graph 1
The year 2005 is turning out to be another pretty good one for global growth. In its recent World
Economic Outlook released during late September, the IMF estimates growth in 2005 to be about
41⁄4 per cent. That is lower than in the preceding year, but 2004 was exceptional: in that year, we saw
the fastest global growth in three decades. At this point, 2006 is thought likely to be another good
year, though that forecast would be sensitive to events in the next few months.
The US economy continues to expand at a good pace. The recovery from the dot-com-bust recession
of 2001 has been quite strong, notwithstanding periodic talk about 'soft patches'. The US now, once
again, stands pretty close to full employment. The US central bank, having been prepared to lower
short-term interest rates dramatically to alleviate the downturn, is now well advanced in the process of
returning them to normal, as they must if the economic expansion is to continue for an extended
period. Meanwhile, China has continued to grow rapidly, despite fears of a slump at various stages.
Japan - for years a dragging anchor on global growth - has posted some better numbers over the
past year or so, and the debilitating effects of asset price deflation and balance sheet deterioration
may finally be starting to wane. Japan looks more likely to be able to sustain growth now than at any
time in over a decade.
Elsewhere in east Asia, results are a bit mixed but in general show fairly healthy growth, though not at
the pace seen for many years prior to the crisis of the late 1990s. The economy of continental Europe
remains a major disappointment both for its own citizens and policy-makers, and for those elsewhere
looking for the global recovery to be a bit more balanced. Beset by the effects of ageing, high levels of
government debt and great difficulties in achieving structural reform, the old continental European
economies are struggling to keep up with the newer, more dynamic countries joining the European
project from the east.
At the same time, global rates of inflation remain low. Across about 50 significant countries around the
world, the median inflation rate is about 21⁄2 per cent. The scourge of the 1970s and early 1980s has
been well and truly contained in most countries; there are relatively few really high inflation countries
now. At the same time, the incidence of deflation (never that wide) has diminished in the past couple
of years.
Graph 2
There is, of course, the likelihood that the big rise in oil prices will push inflation up over the coming
year, and some commentators are beginning to worry that this could be the start of an undesirable
trend. Much will depend on how economies and policy-makers respond to the rise in oil prices, a
subject to which I shall return shortly. For the moment, what is remarkable is that the rise in raw
material prices over several years has not already pushed inflation rates up more than it has. It is
partly as a result of this general climate of price stability that nominal long-term market interest rates
are at 50-year lows. But even in real terms, long rates are unusually low. Apparently, financial markets
have a very benign view of the risks associated with the medium-term outlook.
Graph 3
Given the prominence of discussion about 'global imbalances' - by which people mean the
dependence of the global expansion on the strength of the US and China, and the rising current
account deficit of the US - it is all the more remarkable that financial markets seem so sanguine. But
as stated by the Governor1 a couple of weeks ago, a more careful analysis of the 'imbalances' shows
that high rates of saving and low rates of investment in Asia have produced a very low cost of capital
for the developed world, to which the US economy has responded, with the US current account deficit
a natural result. While everyone agrees this cannot continue forever, forever is a long time and it may
well continue for a while yet. It has already gone on much longer than many predicted would be
possible, and for it to change, behaviour in Asia, as well as in the US, would need to alter.
All of the above have been part of the scene for some time now, and were part of the state of play as
of early August when we last gave our full views. What has changed of late?
The questions that will naturally be on most people's minds are: what will be the effect on the US and
global economies of Hurricanes Katrina and Rita? And what will be the effect of rising oil prices?
Hurricanes
Clearly these were first and foremost human tragedies on a massive scale, though thankfully, the
death toll looks like it is turning out to be much smaller than was feared early on. As for the economic
effects, clearly business activity has been hampered in the areas directly in the path of the hurricanes,
though the impact of this on the US economy as a whole doesn't seem to have been particularly large.
Longer term, those parts of the US capital stock which were damaged or destroyed need to be
repaired or re-built. This will be expansionary as it adds to the demand for real resources. To give
some perspective, estimates of damage seem to be around US$200 billion. If it took three years2 to do
all the reconstruction, then we would see an addition to the level of demand equivalent to about half of
one per cent of US GDP during that period. This would be in an economy which, just before the
hurricanes hit, was travelling pretty well according to recent data.
Energy prices
A second key aspect of the hurricanes, of course, was that they damaged some very important
infrastructure in the US energy supply chain, which happens to be concentrated along the Gulf coast.
To some extent this has been addressed by the release of oil from stockpiles, and indeed the price of
crude oil is now, if anything, a bit lower than it was immediately before Hurricane Katrina. The bigger
problem is that the Gulf coast area has a large share of US refining capacity, which also suffered
substantial damage. Hence the margin between crude oil prices and wholesale prices for refined
products rose sharply, so Americans (and, for that matter, consumers elsewhere) saw substantial rises
in prices at the pump.
Graph 4
The effect of this, assuming other things equal, is to raise households' cost of living and transportation
costs to businesses. Any number of commentators will remind us that, because it is hard for
consumers rapidly to alter their behaviour away from using gasoline, they will, to some extent, simply
have to pay the higher prices and spend less on other things. This imparts a mild contractionary
impact on aggregate demand. That's true, but over time, consumers can adapt their behaviour
(towards more fuel-efficient cars, for example) to lessen the real income loss. Most importantly in the
US, the impact of the re-building will steadily make its presence felt. So there is a complex set of
forces operating on the US economy, some contractionary but others expansionary.
For those other economies who are net energy importers, the expansionary impact of the re-building is
of course absent, so they are left with the uncomfortable combination of higher prices and slower
growth, at the margin, than would otherwise have occurred.
But it would be a serious mistake, I think, to focus on the effects of the hurricanes on energy prices in
isolation. The fact is that energy prices had been rising for some time, as growing demand stretched
supply capacity, before the hurricanes occurred. It is no secret, either, that Asia has been a major
source of additional demand for oil (though demand in the US has also risen). Of the rise in global
demand since 2000 of over 7 million barrels per day, about 3 million barrels has come from Asia, and
almost 2 million from China alone. Nor is it only energy prices which have been rising. A great many
prices of resource-type commodities have been rising quickly, largely for the same reason as oil
prices: Asian and especially Chinese demand has stretched supply capacity.
Yet this has not derailed the global economic expansion. Unlike the OPEC oil shocks of the 1970s,
when the supply of oil was sharply curtailed, creating significant disruption for economic activity, over
the past few years the supply of oil has been increasing - just not fast enough to accommodate rapidly
rising demand at the old, low price. Far from crippling global growth, the higher price of oil reflects
strong growth. Higher oil prices do reduce growth compared with what might have been possible had
the supply of oil been perfectly elastic, but even with that reduction, the world economy is recording
quite good growth. One illustration of this is that, eighteen months ago, the IMF forecast of global
growth for 2005 was 4.4 per cent, with oil prices assumed to be under US$30. The latest estimate for
2005 is virtually unchanged at 4.3 per cent (with the same again expected in 2006), but with an
average oil price now assumed to be US$54 in 2005, and US$62 in 2006.
Monetary policy and oil prices
How should monetary policy, in particular, respond to rising energy prices?
Traditionally, policy-makers have abstracted from the effects of short-term fluctuations in oil prices.
The case for doing so was that these swings are often driven by temporary supply-side disturbances.
It would not make sense for monetary policy, whose effects take several years to play out, to respond
to price fluctuations which might be reversed within a matter of months. Fluctuations in prices for some
other things affected by supply disturbances - like fresh food - are treated the same way. It is for this
reason that many central banks compute measures of 'core' or 'underlying' inflation - it helps us get a
better idea how overall inflation will look when temporary disturbances have passed from the scene.
one-time
Similarly, in cases where there is a large, permanent but change in the level of energy prices
which occurs because of a change in supply, it is not feasible for monetary policy to offset the
immediate impact on the overall price level. Policy-makers in that situation will focus on ensuring the
on-going rate of change of prices settles back fairly promptly. This means they will typically respond to
signs of second-round effects which might emerge if, say, other prices or wages began to change in
response to the initial oil price effect.
But where there is a persistent trend for some particular price to rise quickly over a longish period
because demand is strong, the case for ignoring that is weak. If oil prices, for example, rise quickly
every year, it isn't really credible to abstract from them every year. Rather, the question is simply one
of whether the combined set of all price movements, whether driven by energy prices or any other
influence, will cause the CPI to rise quickly for an extended period. If the answer is yes, then that is
called inflation, and is prima facie evidence that policy-makers should take action. If the answer is no,
perhaps because non-energy prices are moving in an offsetting way, then price stability is being
maintained, and there is no particular implication for policy.
In recent years, policy-makers in most countries seem generally, thus far, to have felt that rising oil
prices will not threaten medium-term inflation performance. This was partly because there was always
thought to be the possibility of some reversal in the oil price itself, but also because overall inflation
rates in most countries have remained quite low so far, despite energy price rises. While the strong
growth in energy demand in Asia for several years has contributed to inflationary pressure through
higher prices for oil, Asia has also contributed to deflationary pressure via its growing role as a
supplier of manufactures and, increasingly, services. The fact that the overall rate of inflation through
this period has been fairly well behaved, despite strong global economic growth, is distinctly in
contrast to the situation prior to the OPEC episode in 1974. In that instance, inflation in most countries
was already increasing before the rise in oil prices occurred.
At issue, then, is whether that situation could change in the near future. It is doubtful that the
hurricane-related shock per se would make a large difference. The bigger questions are, first, will the
effects of the large cumulative rises in energy prices over several years continue to be accompanied
by moderation in other prices, including international prices for traded manufactures and services, so
keeping overall inflation in check? And second, will hitherto well-anchored inflation expectations - an
important determinant of price and wage behaviour generally - remain that way?
Policy-makers around the world will grapple with these issues in the period ahead. For now, I shall
turn to the Australian economy.
The Australian economy
The terms of trade
The Australian economy, like all other industrial economies, is adjusting to higher energy prices. The
thing we are hearing most about is the negative impact on Australian households as they bear higher
costs for their personal transportation, and the effect on both the goods and services producing
sectors of the economy as they bear another increase in costs of production and distribution. But
unlike many industrialised economies, there is also a major positive side for the Australian economy in
higher prices for energy and raw materials. For those with an income stake in the extraction of these
resources - such as oil, coal, gas, and a number of other commodities which are inputs into global
industrial production - times are very good indeed.
The aggregate summary of this situation is Australia's terms of trade, which have risen by over 20 per
cent in the past two years alone, and stand about 30 per cent above their average of the period 1975-
2000.
Graph 5
This is a very different story to those of most industrialised economies, for whom recent developments
represent a decline in the terms of trade and hence national income.
Terms of Trade
Percentage change
Past Two years
Australia 23.4
Norway 9.3
New Zealand 8.6
Mexico 8.5
Canada 4.2
United Kingdom 0.2
France -3.7
Singapore -4.8
Germany -5.0
United States -7.0
Thailand -9.5
Taiwan -12.6
Sweden -14.3
Japan -16.6
Sources: ABS, Thomson Financial
The trade sector is just over one-fifth of the economy. So a 20-25 per cent gain equates to about
4-5 per cent of GDP - say, $40 billion - in additional annual income that is available. Part of that
income accrues to foreign investors who have ownership stakes in resources enterprises, but a
substantial proportion remains for Australians as shareholders, employees and citizens (via
government taxes).
There can be little doubt that this adds considerable buoyancy to the economy which would not
otherwise be there. The first-round effect is clearest in the regions where resources have the greatest
weight in economic activity. But there are still impacts around the rest of the country - for example,
through the consumption of higher resource-derived incomes, and higher investment by the resource
producers. Indeed, the prospects now appear to be for a significant expansion in capacity in various
resource production areas, judging by the forward-looking indicators of capital expenditure. That will
continue to exert stimulus for a range of other businesses around the country.
Housing market
These income gains have accelerated over the past two years, at a time when the dynamics of the
Australian housing market have changed. From 1996 to 2003, Australian households borrowed at a
rapid pace for the purposes of owning dwellings, either to occupy or to let out. The median price of
dwellings in Australia rose in parallel, by 120 to 150 per cent, depending on the price measure used.3
The peak in prices nationally was about two years ago now, in the last quarter of 2003. Since then,
median prices have risen further in some regions, but have fallen a little in Sydney and Melbourne, to
give a flat performance for the national median price. This has been associated with a slowing in the
pace of borrowing, particularly on the part of investors, though the rate of growth of outstanding credit
remains, if anything, somewhat higher than one would expect to be a sustainable pace in the long run.
This has been associated with a waning of an apparent wealth effect which had been in operation,
where consumer spending rose faster than income for a number of years and household saving rates
declined.4 Some estimates suggest that, in net terms, households actually withdrew some of the
accumulated equity in the dwelling stock during the early years of this decade, a small proportion of
which was probably used for consumption purposes. (The rest appears to have been placed into
financial assets.) But since mid 2004, consumption spending has been proceeding in a more
moderate fashion. At 3 per cent growth over the past year, it has been rising more in line with income.
That is not a particularly weak outcome in any absolute sense, but it is a quite notable slowing from
the earlier 6 per cent pace.
It is quite fortuitous, of course, that this adjustment has coincided with the large income gains from the
terms of trade. A scenario where the housing boom had gone on for two or three more years and then
turned down at the same time as the terms of trade began a cyclical fall would have been much less
attractive.
Petrol prices
I noted earlier that worldwide, rising energy prices over several years did not seem to have pushed up
inflation much, so far, partly because there seemed to have been moderation in other prices. This
same point can be nicely illustrated by Australia's Consumer Price Index. The chart below shows the
change in the CPI, at the sub-group level,5 over the past two years. The figures are up to June 2005;
new data for the September quarter will be published the week after next.
Automotive fuel prices had risen by about 23 per cent over the period. But a number of items which
are affected by strong international competition had fallen in price. These include most electronics
categories, household appliances, clothing and footwear, and furniture. Of course, changes in the
exchange rate, and in particular an appreciating $A in 2003, have had an effect here, as have tariff
reductions, but there is no doubt that competition from abroad has been intense. So while the growth
in demand for energy in China and the rest of Asia has added to petrol costs, the rising production of
manufactures in those countries has reduced other prices. The total CPI rise over the two years was
5 per cent, or 21⁄2 per cent per year, which is exactly in line with the Bank's inflation target.
Graph 6
We will get an update to this picture when the CPI and PPI data for the September quarter are
published. The direct impact of the recent high energy prices will presumably be evident in the result.
Over a somewhat longer horizon, there might be some indirect impacts of the higher energy costs -
through the transport system, for example. Just how big these turn out to be will presumably depend
on, among other things, whether demand conditions allow businesses simply to pass on energy and
transport cost increases, as opposed to absorbing them by finding offsetting cost savings or accepting
narrower profit margins.
Longer term, the question to be asked is whether inflation - be it as a result of rises in energy costs, or
from any other source - is likely to diverge persistently from a rate of 2-3 per cent. Apart from energy
prices per se, factors to consider in assessing the outlook will be trends in international prices, the
likelihood of temporarily higher CPI rises prompting second-round effects via, for example, higher
wage claims or other cost increases, and the strength of aggregate demand in the economy. The
Bank will publish its full updated assessment in its Statement on Monetary Policy on 7 November
2005.
Conclusion
The Australian economy is in its fifteenth year of expansion, having weathered a number of shocks,
both favourable and adverse, during that time. The gradual correction of the housing excesses of the
early part of this decade has gone well so far. It is our good fortune that this is unfolding alongside a
global scene which is quite favourable at present. Even though there is undoubtedly a cyclical element
to the international environment which will wane in time, I suspect that the growing weight of
resource-hungry Asia will mean that our terms of trade will be higher on average in the next decade
than they were in the last quarter of the twentieth century.
The issue before us in the next year or two is whether the world and Australian economies can adapt
to higher energy and resource prices without a significant bout of inflation. If we can, then in a year or
two from now, the TCCI will be hearing about further opportunities for businesses and their
employees, both in Tasmania and around the nation, to create the sustainable prosperity we all seek.