I J Macfarlane: Australia's economic situation and implications to monetary
policy
Opening statement by Mr Ian J Macfarlane, Governor of the Reserve Bank of Australia, to the House
of Representatives Standing Committee on Economics, Finance and Public Administration, Canberra,
17 February 2006.
* * *
It is a pleasure to be back here again in front of the Committee, and to be having this hearing in
Canberra for the first time in a number of years. I note that the membership of the Committee has
changed again, particularly on the Government side. That is something that has happened pretty well
continuously in the nearly ten years I have been reporting to it under the current arrangements, but it
has not interfered with the Committee's effectiveness.
As you know, we had our February Board Meeting last week and we issued our quarterly Statement
on Monetary Policy earlier this week. This document spelled out in detail how we see the current
situation in the economy, and why the stance of monetary policy is where it is.
This morning I would like to take the opportunity of looking at the broader trends in Australia's
economic situation and examining the implications they have for the stance of monetary policy going
forward.
I will take as a starting point Australia's current economic expansion. For years I have made the point
that progress in winding back economic slack is made not by high growth in any individual year, but by
maintaining an expansion over a sustained period. Australia's current expansion began in late 1991
and is now in its fifteenth year. This means that it is already significantly longer than its predecessors
in the 1960s, 1970s and 1980s. The expansion has been marked by good growth in GDP, which has
averaged 33⁄4 per cent per annum over this period, one of the best performances in the developed
world.
A consequence of the sustained expansion is that the economic slack generated in the last recession
has been gradually used up. One indicator of this is the unemployment rate, which has trended down
from a peak of 11 per cent in 1993 to be currently just over 5 per cent. Other indicators of the
economy's capacity utilisation are also at cyclically high levels. Business surveys report that
businesses are operating at close to their highest levels of capacity utilisation since the late 1980s.
The surveys have also been reporting high levels of labour scarcity. For the past year or so, many
businesses have been in the unusual position of reporting that scarcity of suitable labour was a bigger
constraint on their activities than their traditional concerns about the adequacy of demand or sales.
Given the maturity of the expansion it should not be surprising if the average growth of the economy is
now less than it was in the earlier stages. As a general principle, it is easier for an economy to grow
quickly when there is a large pool of unused resources to be re-employed, and in Australia's current
position in the cycle, that source of growth is now much more limited. So, in the absence of a
significant lift in trend productivity growth, we should expect to see annual GDP growth rates mainly in
the 2s and 3s, rather than in the 3s and 4s as was typical for most of the expansion. It is not surprising
therefore that growth of the economy over the latest year for which data are available was 2.6 per
cent, or an annualised rate of 3 per cent for the latest half-year.
Business investment has been a major driver of growth in recent years, expanding by 18 per cent over
the past year, and at an average annual rate of 14 per cent over the past three years. The upswing in
business investment is being stimulated by high commodity prices and favourable financial conditions.
With strong investment growth and an expected improvement in exports, our forecast for the economy
overall is that annual GDP growth will pick up modestly during 2006 to about 31⁄4 per cent. While
strong business investment obviously contributes to capacity expansion, the sorts of outcomes
envisaged for GDP growth would imply that the economy will continue to operate close to full capacity.
While the overall growth of the economy during the current expansion has been good, there has been
concern expressed about its composition. In particular, the growth of the economy over the past few
years has been more than fully accounted for by growth in domestic spending, while Australia's export
performance has been disappointing. In consequence, Australia's current account deficit has remained
high at around 6 per cent of GDP recently, despite a strong international environment and rising
commodity prices. Notwithstanding these concerns, it needs to be emphasized that monetary policy
cannot be expected to target a particular composition of growth or current account deficit. Any attempt
to do so (for example, by running a much tighter policy in order to constrain domestic demand) would
be counterproductive and would detract from the Bank's broader macroeconomic goals.
The global business cycle
Australia's economic situation should also be viewed against the backdrop of the global business
cycle. In broad terms, business cycles across various countries have tended to move together, at least
among countries in the developed world. That is, there has been a reasonably high correlation in the
timing of recessions and expansions among developed countries over the past few decades. Most of
the advanced countries experienced recessions in the mid 1970s, the early 1980s and the early
1990s, and many did so in 2001. It is relatively unusual for countries in this group to experience what
might be termed a 'home-grown' recession, that is, a recession not shared by the major industrial
countries. Similarly, it is fairly unusual for countries to skip an international recession, though Australia
and some other countries have recently done so, as did Japan in the early 1980s. This is not to say
that domestic conditions and policies are unimportant. Nevertheless, as a general rule, when the world
economy as a whole is in a sustained expansion, there is a good chance that an expansion will also
be continuing in an economy such as Australia.
Currently the world economy is expanding strongly. The recovery from the global downturn in 2001 is
now well established and, on past experience, the expansion should still have some way to run. While
growth to date has been led mainly by the United States and China, there have been encouraging
signs over the past year that growth is becoming very broadly based, with conditions improving in
Japan as well as in a number of other economies. Assessments of the risks to the global growth
outlook have focused mainly on the effects of higher oil prices and on the possibility that the US
current account imbalance will have a disruptive effect on the world economy. However, there is little
sign that these forces are restricting growth at present. World GDP growth in 2005 is estimated to
have been above average, and most observers expect this to continue in 2006.
This growth performance has been accompanied by generally subdued inflation outcomes. One factor
behind this was the increased focus on inflation control by central banks around the world, after the
high inflation of the 1970s and 1980s. Many central banks have now adopted numerical inflation
targets and others have clearly become more focused on inflation control even without adopting
explicit targets. At the same time, the importance of structural factors, and particularly the
industrialisation of China, should be recognised. The huge pool of low-cost labour that this has
brought into play has put sustained downward pressure on a wide range of prices of internationally
traded goods.
The terms of trade
One consequence of these developments has been a marked upswing in Australia's terms of trade,
defined as the ratio of our export to import prices. Currently Australia is benefiting from the largest
cumulative increase in our terms of trade since the early 1970s. The main factor driving this has been
the rapid growth in global demand for resources, with China in particular contributing strongly. As a
result, world prices for a wide range of resource commodities have been increasing sharply.
Over the past three years Australia's terms of trade have increased by around 30 per cent. This is
estimated to have added 11⁄2-2 percentage points per annum to the growth in national income over
this period, a significant expansionary force for the economy as a whole. The economic effects can be
seen in a number of areas including strong growth in business investment, company profits, share
prices and imports. Increased export prices also tend to boost government revenues through company
taxes and a range of federal and state royalties.
Interest rates and financial markets
Although Australia avoided the recession that engulfed many developed countries at the start of this
decade, it was not totally unaffected by world events, and the Bank found it necessary in 2001 to cut
the cash rate to 4.25 per cent in a series of steps. While that was a new low for Australian official
interest rates - the previous low had been 4.75 per cent in the late 1990s - it was a relatively muted
response compared with the very large cuts in interest rates that occurred elsewhere in the world.
In mid 2002, with both domestic and global economic conditions improving, the Bank began the
process of restoring official interest rates to more normal levels. It did this in five steps over three
years - two in mid 2002, two in late 2003 and one in early 2005 - a more gradual tightening cycle than
normal.
At the current level of 5.5 per cent, the cash rate is in line with its average over the low inflation period
since 1993. There is therefore a sense that the current level is relatively neutral in terms of its impact
on economic activity and inflation. One complication in assessing the level of interest rates, however,
is that competition in the financial sector has seen margins between the cash rate and institutions'
lending rates narrow over recent years, so the interest rates faced by borrowers are still a little below
average.
Australia moved to restore normal interest rates well ahead of other developed economies. All the
major countries had reduced interest rates to unprecedented levels in the early part of this decade - 0
per cent in Japan, 1 per cent in the United States and 2 per cent in the euro area - and they
maintained this position for a prolonged period. Of the major countries, the United States was the first
to raise rates, with the Fed beginning to tighten in mid 2004. The European Central Bank has only just
started the process in recent months and the Bank of Japan is not expected to start lifting rates for
some time yet. Thus, even though the Fed has now restored the funds rate to a relatively normal level
of 4.5 per cent, world policy interest rates on average remain well below normal.
Another unusual aspect of current global interest rates is that long-term rates, which are set by the
demand for and supply of funds in capital markets, have remained quite low in the face of rising official
interest rates. Although various explanations have been put forward for this unusual behaviour, the
ex ante
most likely cause is an excess supply of savings relative to investment around the world, with
Asia accounting for a large part of the excess global savings.
For equity markets, the combination of low interest rates, strong economic growth and low inflation has
proved very beneficial, with global share markets rising solidly in each of the past three years. This
has been underpinned by strong growth in profits so that, notwithstanding the rise in share prices, P/E
ratios have been declining on average.
It is worth noting that the Australian share market has behaved quite differently from the global market
over the past decade. It was affected much less than most markets by the tech bubble and the
subsequent collapse, and in recent years has been rising faster than average. Along with the
Canadian share market, it is the only major market that is currently above earlier peak levels, whereas
in Europe and the United States share markets are still about 20 per cent below their early 2000
peaks.
The Australian dollar has remained in a relatively steady range over the past couple of years, at levels
that are a little above average against the US dollar and about 10 per cent above average in
tradeweighted terms. Some people have found this steadiness puzzling against the background of very
strong rises in commodity prices and the terms of trade, as such episodes in the past have been
associated with strong rises in the currency. A key to understanding the different behaviour on this
occasion is the change in the interest differential with the United States. This has narrowed
appreciably over the past 18 months because the Fed has tightened much more than we have.
Domestic credit and debt
In recent years we have given a lot of attention to the growth of household debt and its possible
effects on the macro economy. I would like to say a little more about it today and will divide the subject
into two aspects: the shorter-term cyclical fluctuations in household credit growth, and the fact that
various debt ratios have trended upwards over time.
Regarding the first of these issues, the most recent cyclical peak in household credit growth occurred
around the end of 2003, when it reached an annual rate of over 20 per cent. Since the bulk of
household borrowing is housing-related, it is not surprising that this phenomenon was closely
associated with a sharp run-up in house prices. Nationwide house prices increased strongly for
several years up to late 2003, reaching a peak growth rate of around 20 per cent in that year. The
increases in credit and house prices were inter-related, with credit availability fuelling the price rises,
while rising house prices meant people had to borrow larger amounts to achieve home ownership.
Much of this behaviour was driven by expectations, particularly in the investor market, of future price
gains - the classic definition of bubble-like behaviour.
In the period since late 2003, both the housing market and the demand for credit have cooled.
Nationwide house prices have been broadly flat over the past two years and prices have fallen in
Sydney. Household credit growth has eased back to an annual rate of around 12 per cent. Although
this might still be regarded as quite high in absolute terms, it is towards the lower end of the range in
which it has fluctuated in the past two decades. While there are some tentative signs that credit and
housing market conditions have firmed a little in recent months, the risks to the economy posed by the
over-heating in housing and credit markets in the period up to late 2003 have eased. Households now
seem to have entered a period of greater financial caution, and this may act as a restraining influence
on the growth of household spending for a while to come.
The second issue is the high average growth rate of household credit over an extended period. This is
a longer-run issue and one on which it is more difficult to make firm judgments. For more than a
decade, household indebtedness has grown at a rate well in excess of the growth in household
incomes. This has meant that the aggregate ratio of household debt to household income has trended
upwards, as has the proportion of household income required to service the debt, and the gearing
ratio (debt to value of household assets).
Simple rules of thumb would suggest that this cannot be sustained indefinitely. Yet there are a number
of reasons why these ratios may rise further. In a low-inflation environment, nominal interest rates are
also low, and households are able to service much higher levels of debt than they could in the past. A
significant proportion of households still carry little or no debt, and in the years ahead might choose to
borrow more. Attitudes towards borrowing appear to be changing, with people becoming more willing
to borrow against assets later in life.
For these and other reasons, it is quite possible that the rise in household debt ratios could go a good
distance further. The risk, of course, is that the process goes too far and that a painful correction
ensues. There has been much debate around the world about the role of monetary policy in these
circumstances, with the consensus being that the best it can do is to continue to pursue the general
objectives of macroeconomic stability and low inflation.
We should also not forget influences on the supply side. Banks and other providers of credit to
households have been competing vigorously to expand or protect their market share. In the process,
lending standards have been progressively eroded so that lenders are now engaging in practices that
would have been regarded as out of the question five or ten years ago. These are matters in which
prudential regulators are taking a strong interest.
While the growth of household borrowing has been relatively high throughout the current expansion,
business borrowing on average has been more restrained. This is the reverse of the pattern that was
observed in the 1980s and, as a result, the business sector generally is in good financial shape with
low levels of debt. In the past two or three years businesses have begun to take advantage of that
position by again expanding their borrowing and lifting the rate of growth in their investment spending.
Business credit has thus strengthened quite markedly, so that it is now growing at a rate of 16 per
cent, well above that for the household sector.
Inflation
Australia's inflation performance over the past decade or so has been consistent with the Bank's
medium-term target. Since 1993, when the 2-3 per cent objective was first articulated, average CPI
inflation (excluding the one-off GST effect) has been 2.5 per cent. Of course, the inflation rate has
inevitably fluctuated quite a bit from year to year, including periods where it has been above 3 and
below 2. But it should be remembered that the Bank's objective is expressed in terms of average
outcomes, and should not be thought of as a rigid commitment to eliminate short-term fluctuations in
inflation. In the latest year, inflation in underlying terms has been close to 21⁄2 per cent, though the
headline CPI figure is higher, principally reflecting the effect of rising fuel prices.
While inflation has remained contained over the past decade it is important, as always, to consider
how inflationary pressures might evolve from here. At the current stage of the expansion there are a
number of factors that might be expected to put upward pressure on inflation. The economy is
operating at a high level of capacity utilisation, the labour market is relatively tight, and there have
been some large increases in raw materials costs. Aggregate wages growth has picked up over the
past year, and businesses generally are reporting difficulty in attracting labour. These conditions
underpin the current forecast of a modest rise in underlying inflation over the year ahead. Based on
the current level of oil prices, this forecast implies that headline CPI inflation would remain close to 3
per cent in the short term.
This outlook is, as usual, subject to significant uncertainty. One area of uncertainty relates to wages
growth, where there is a risk that current labour market tightness will result in higher-than-expected
wage increases. This will be an important area to watch in the months ahead. On the other hand, the
latest CPI figure was a little below expectations, and may indicate that global disinflationary forces are
stronger than had been expected. There are also some tentative signs that conditions in the labour
market are easing. The issue over the period ahead will be whether these latter forces prove sufficient
to contain inflation in an economy operating with little spare capacity.
In these circumstances, the Board at its recent meeting judged the current policy setting to be broadly
consistent with the economy's requirements for the time being. Looking ahead, however, it felt that on
balance, based on the considerations I have outlined here today, it is more likely that the next move in
interest rates would be up rather than down.