Ric Battellino: Economic developments
Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia,
to the Committee for Economic Development of Australia (Western Australia), Perth,
18 November 2010.
* * *
Introduction
After having held official interest rates steady for five months, the Reserve Bank earlier this
month tightened monetary policy a little further. The background to that decision and the
reasons for it are set out in the quarterly Statement on Monetary Policy and the monetary
policy minutes of the Board meeting that have subsequently been released. My talk today will
focus on that material and outline some of the issues that are likely to shape economic
developments over the next few years.
Global economy
I will start with the global economy because, as always, this forms an important backdrop to
understanding developments here in Australia.
The world economy is quite divided at present. The United States, Europe and Japan are
struggling to recover from the effects of the financial crisis, while emerging Asian economies,
and to a lesser extent Latin America, are growing strongly (Graph 1).
Graph 1
The US economy clearly lost momentum around the middle of the year, with GDP growth
slowing to an annual rate of about 2 per cent over the June and September quarters. This is
below potential. Our reading of more recent data is that they have been a bit stronger, but
nonetheless consumer confidence remains low, the housing and labour markets remain
weak, and the repair of household balance sheets still has quite a way to run.
Basically, the US household sector is in very poor shape.
One of the features of the US economy that has changed over the past 50 years or so is that
households are now bearing more of the brunt of recessions than used to be the case, and
businesses are bearing less. After each downturn, it has taken progressively longer for
employment to regain its peak (Graph 2).
Graph 2
Even after the 2001 downturn, which was relatively mild in terms of GDP, it took about four
years for employment to recover to its earlier peak. The current downturn has been much
more severe, with employment falling by 6 per cent from peak to trough and the recovery in
jobs so far being quite tepid. It is therefore clearly going to be some time yet before
employment regains its pre-crisis levels.
Weak labour market outcomes, of course, mean subdued growth in household income, and
the combination of job losses and low income growth has led to a big rise in mortgage
foreclosures. Almost one in twenty houses that are mortgaged in the United States is in
foreclosure. This is a very high figure (Graph 3).
Graph 3
Household wealth has fallen sharply. Measured relative to household income, it is back to
the levels of the late 1980s, so a large amount of wealth has been wiped out (Graph 4).
Graph 4
At the same time, household gearing has risen sharply, with housing debt now equal to about
55 per cent of the value of the US housing stock.
Understandably, the reaction of households to all this has been to stop borrowing, cut back
on spending and increase savings, all of which means that US households are not going to
be the driving force of the global economy that they were for much of the period since the
mid 1990s.
The US corporate sector, on the other hand, is in pretty good shape.
Profits have recovered strongly and the arrears rate on loans to US corporates has peaked
at a level that is quite moderate by historical standards; it is no higher than in the 2001
recession, which, as I have noted, was quite mild (Graphs 5 and 6).
Graph 5
Graph 6
Also, holdings of cash by US corporations are at record levels - almost US$11⁄2 trillion or
equivalent to over 20 per cent of corporate debt (Graph 7). This means that US corporations
are in a strong position to increase investment when confidence returns.
Graph 7
The US Federal Reserve has been maintaining official interest rates close to zero since late
2008 but, despite this, the economy has remained sluggish. The Fed has therefore tried to
use other instruments to stimulate economic activity.
These measures generally fall under the heading of "quantitative easing". They involve
expanding the Fed's balance sheet through the purchase of securities, with payment for
those securities being made by giving banks extra deposits at the Fed. The Fed has roughly
tripled the size of its balance sheet since the financial crisis began, to over US$2,000 billion.
Earlier this month, it foreshadowed it would be prepared to purchase another US$600 billion
of Treasury securities by next June, if circumstances warranted it (Graph 8).
Graph 8
The objectives of these operations are to put downward pressure on market interest rates, so
as to encourage households and businesses to borrow, and to provide banks with extra
liquidity, so as to encourage them to lend. As noted, however, US households have little
appetite for debt at present, US corporations are flush with cash and have little need to
borrow, and banks appear to be quite happy to leave their extra liquidity on deposit at the
Fed, rather than lend it. US banks are currently holding about 8 per cent of their assets on
deposit with the Fed, while their loans to households and businesses are falling (Graph 9).
Graph 9
These outcomes are typical of what happens in the wake of a financial crisis, as it takes a
long time for households, businesses and banks to repair the damage done to their balance
sheets and regain confidence to borrow or lend again. This often means a prolonged period
of sub-par growth.
In Europe, growth on average has been around trend over the past year, but there is a wide
divergence in the performance of countries. Germany is doing well, benefiting from earlier
economic reforms and Chinese demand for German capital goods, but, at the other extreme,
Greece and Ireland are experiencing very deep recessions. Economic tensions have been
building within the euro area, driven by earlier widening differentials in competitiveness. Unit
labour costs in Greece, for example, have risen by about 25 per cent relative to those in
Germany since the euro came into existence.
Government debt problems are also probably at their most acute in Europe. The facility set
up by European governments in May this year to provide financing to smaller European
countries seemed for a time to lessen market concerns about sovereign debt levels.
However, the situation has deteriorated noticeably again in recent weeks, as markets again
question the capacity of some countries to sustain their current debt levels.
On the other hand, as I mentioned, Asia is a bright spot in the global economy. The region
bounced back very strongly from the global financial crisis and economic activity in all
emerging Asian economies has substantially surpassed pre-crisis levels. Several central
banks in the region have recently been tightening policy settings, but generally policy settings
in Asia are still quite expansionary. Some commentators are concerned that the recent
tightening might lead to excessive slowing in economic growth, particularly in China, but this
seems unlikely while ever policy settings are still on the expansionary side. In fact, economic
activity in China recently appears to have picked up again.
Inflation could become a significant policy issue in Asia if growth remains strong. There are
already early signs of rising inflationary pressures, particularly in food prices. Some Asian
economies are also experiencing very strong rises in house prices, reflecting the favourable
economic and financial climate (Graph 10).
Graph 10
Overall, the outcome for global economic growth over the past year has been strong. When
the figures for 2010 come in, they are likely to show that the world economy grew by around
43⁄4 per cent, a rate that is noticeably above trend (Graph 11). Most forecasters are expecting
that the growth of the global economy over the next couple of years will be slower than in
2010, though probably at a pace that is close to trend.
Graph 11
There are, of course, risks to these outcomes arising from some of the issues I have
mentioned. In the developed economies, the concerns are mainly about downside risks.
What is worrying people is that the capacity of the authorities in most developed economies
to deal with any renewed economic slowdown would be limited, due to the fact that policy
settings are already at extremes. In Asia, on the other hand, it is easier to see risks of
overheating.
Commodity prices
The growth of the world economy that has occurred over the past year has resulted in a
significant lift in the prices of commodities. The prices of the two commodities of most
importance to Australia - iron ore and coal - have been especially strong, and have again
risen in recent weeks (Graph 12).
Graph 12
As a consequence, Australia's terms of trade - the ratio of export prices to import prices -
have surpassed the 2008 peak, and are pretty much at unparalleled levels. The increase in
the terms of trade over the past year has added around $25 billion to the Australian
economy.
The question is: how long will this last? At the Reserve Bank, we have for some time been
forecasting a gradual decline in the terms of trade over the next couple of years, on the
assumption that the supply of commodities will increase and that demand will slow a little, in
line with the assumed slowing in the global economy. This continues to be our projection,
though recent commodity price outcomes have caused us to revise up our forecasts.
Beyond the next couple of years, it is hard to predict what will happen. Both China and India,
however, are going through a phase of their development that is very intensive in the use of
steel. In the past, other countries have taken up to 20 years to move through this phase
(Graph 13). It is likely that China, and more particularly India, will have strong demand for
steel for quite some time yet.
This, of course, would be a very favourable global environment for the Australian economy.
Graph 13
The Australian economy
Let me now turn to the Australian economy.
As you know, our economy recovered relatively quickly from what was a shallow downturn
following the global financial crisis, and over the past year has grown around its trend rate of
31⁄4 per cent (Graph 14).
Graph 14
Domestic demand has grown substantially faster than this - about 51⁄4 per cent - due
importantly to growth in public spending, though this is moderating now.
Consumer spending has grown by a little below trend over the past year. It seems that even
though consumer confidence is high, consumers remain cautious in their spending. The
household saving ratio has picked up noticeably from the low levels it fell to earlier this
decade. As we have said before, a period of consolidation by Australian households, after
10-15 years of fairly robust increases in spending and gearing, is probably no bad thing.
Investment in new dwellings has increased over the past year, though growth in the number
of dwellings is still falling short of growth of the population. As a result, rental markets are
tightening, with vacancy rates falling and rents rising at a solid pace. At the same time,
however, households now seem to be less inclined to increase their gearing in order to trade
up to better housing. Auction clearance rates have fallen back to around long-run average
levels and house prices have been relatively flat over recent months (Graph 15). This is in
keeping with the more financially conservative approach that Australian households have
taken recently. These trends are probably most pronounced here in Perth, which is going
through a period of adjustment after the euphoria of 2006 and 2007.
Graph 15
Business conditions are generally around average levels, although there are clear
differences across sectors. Business investment is at a high level, particularly in the mining
sector, and information published by the Australian Bureau of Statistics, as well as our own
liaison with companies, suggest that it will pick up sharply further over the next couple of
years (Graph 16). In this regard, I would like to acknowledge the vital role played by our
office here in Perth, led by Virginia Christie, in helping us understand what is going on in the
mining industry. And, of course, I would like to thank those many businesses that regularly
make time available to talk to Virginia and her team.
Graph 16
One segment of business investment that remains weak, however, is non-residential
building. Following large increases in gearing and commercial property prices in 2006 and
2007, the commercial property market has since deleveraged and prices have fallen. The
bulk of that adjustment is probably now over, though the availability of finance for commercial
property development remains very tight.
Employment has grown strongly over the past year and the unemployment rate has fallen
back to a range of 5-51⁄2 per cent, which historically has indicated a degree of tightness in
the labour market. Other indicators, however, suggest that the overall labour market may not
be as tight as suggested by the unemployment rate.
The financial side of the economy remains subdued. Household credit is growing at a
moderate pace while business credit remains soft. That softness is largely in relation to large
borrowers; lending to small businesses has increased at an annual rate of about 5 per cent
over the first nine months of 2010 (Graph 17).
Graph 17
We have spent a fair amount of time at the Bank looking at the question of why business
credit is so soft. It is clear that banks had tightened lending standards sharply following the
onset of the global financial crisis, which no doubt contributed to the slowdown in business
lending. This has been most acute in the area of commercial property, where there has been
a sharp cutting back, particularly by foreign-owned banks.
More recently, there are signs that banks are becoming more willing to lend, at least in areas
other than commercial property, but demand for loans, in aggregate, is not very strong. It
seems that the investment that is taking place in Australia, particularly in the case of the
mining sector, is largely being financed outside the banking sector, either from retained
earnings, direct investment from overseas or capital market raisings.
The exchange rate is also clearly having an impact on business conditions. It has risen to
post-float highs recently, although the real effective exchange rate remains below the levels
recorded in the resources boom of the early 1970s (Graph 18).
Graph 18
A rise in the exchange rate is a natural consequence of a resources boom and, at the
aggregate level, is helpful in allowing the economy to adjust. Nonetheless, some sectors of
the economy are adversely affected. A notable example at present is the tourism industry,
where there has been a sharp increase in the number of Australians travelling abroad rather
than taking holidays domestically. This is having a severe effect on traditional holiday
destinations in Queensland, areas which are also suffering from overbuilding in the pre-crisis
years. Given this double impact, it is not surprising that these areas are currently
experiencing among the highest rates of unemployment in the country. The Bank is
monitoring developments in these areas closely.
The outlook
While there are differences between sectors and between regions, the Australian economy
overall is doing well. We expect that the economy will continue to grow at a solid pace over
the next couple of years, with growth picking up to an above-trend rate towards the end of
this period. This will be accompanied by further increases in jobs and falls in unemployment.
With the economy now having grown more or less without interruption for about 20 years, it
is understandable that spare capacity is limited. This means that the economy cannot grow
much above its potential rate without causing a rise in inflation. With a large amount of
money continuing to flow into the country over the next couple of years as a result of the
resources boom, the challenge will be to manage the economy in a way that keeps economic
growth on a sustainable path, with inflation contained. This is what the Bank is trying to do.
At present, inflation is broadly in the middle of the target range (Graph 19). Over the medium
term, though, as growth of the economy picks up, the pressures on inflation are more likely to
be upward than downward. This is reflected in the forecasts the Bank recently published,
which see inflation tending to rise after a period of near-term stability.
Graph 19
For this reason, the Board of the Reserve Bank decided at its meeting earlier this month that
it would be prudent to make an early, modest tightening to guard against such an outcome.
This is consistent with the forward-looking approach to monetary policy that the Bank has
been following for close to 20 years now, and which on balance has helped to keep the
economy on a sustainable path.