decisions are not driven in a mechanical fashion by the forecasts. both the bank staff and the board are very conscious of the limitations of numerical forecasts. predicting exactly which quarter inflation is likely to increase, and at what pace, is inherently difficult. what is often more useful is the analysis and storyline that support the numerical forecasts. it is this analysis, rather than exact numbers, that is rightly the main focus of our internal discussions and our communication with the public. forecasting at the reserve bank i would now like to turn to the actual forecasting process at the rba. as many of you know, we publish a table that sets out our forecasts of inflation and growth each quarter in the statement on monetary policy. we also discuss the broad analysis underlying these forecasts and the main risks. consistent with our general approach, we do this in words, rather than using fan charts showing statistical bands of uncertainty as has become popular in some other countries. the forecasts that are published in the statement on monetary policy are discussed at the board meeting three days earlier and are developed through a series of internal meetings over the preceding month. outside of this quarterly cycle, the forecasts are kept under review by the staff. the actual forecasting process has three key elements. the first is the day - to - day assessment of trends in the economy. the second is the use of formal econometric models. and the third is the information that we obtain from our business liaison program. i would like to touch on each of these. the obvious starting point is to understand what is currently happening in the economy and the financial system and what that means for the future. in our economic analysis department there are around 50 economists continually monitoring the pulse of the domestic and global economies. elsewhere in the bank, staff are analysing developments in the financial system and financial markets. inevitably the data that we look at are subject to measurement error and they are often conflicting. this means that much of our time is spent discussing the data and what they tell us about recent trends, as well as the future. judgement is obviously critical here, with the strong collective memory of the bank staff playing an important role. the judgments that are reached are also anchored by some underlying economic relationships and concepts. as we prepare our forecasts, we are constantly asking ourselves questions such as : how much spare capacity does the economy have ; what constitutes full employment ; what is the neutral real interest rate ; what is the potential growth rate of

the rest of the world. we should not have been surprised that the australian dollar rose over the past three years given its extraordinarily low starting point, the rising terms of trade, the fact that the us dollar was finally weakening and the associated fact that us interest rates were so low. i think this was well understood by the public, including by exporters and manufacturers, even though they saw their margins shrinking and competition increasing. apprehension started to increase, however, when in the relatively short period between early november and mid february, the rate against the us dollar rose from us70 cents to us80 cents ( 14 per cent ) and against the twi from 61 to 66 ( 9 per cent ). this was an uncomfortably fast rate of increase and the prospect of it continuing was clearly a consideration to be taken into account in formulating monetary policy. if there had been a domestic need to tighten earlier this year, as there well could have been, there would have been an extremely difficult decision to make. this is the type of conflict that can arise when the world has such an exceptionally low level of interest rates, but some countries do not need, or would be positively harmed by sharing, the same low interest rate structure. the other risk we faced was that the excessive growth of credit to the household sector would continue, so fuelling further asset price rises, particularly in housing. this risk is diminishing. it now seems likely that the peak in credit demand was reached around october 2003 when monthly loan approvals for housing ( owner - occupation plus investment ) reached over $ 15 billion per month, an increase of 40 per cent over the year earlier. since then, we have had four monthly declines in loan approvals and they are now running at about $ 12 billion per month. some may be inclined to think that a decline of this magnitude - 20 per cent - represents a sharp fall in the provision of housing finance. but $ 12 billion per month is still a rapid rate of lending and, if continued, would be consistent with the stock of housing credit growing at a twelve - month - ended rate of about 18 per cent by end 2004. admittedly, this would be well down on its peak of 23. 6 per cent, but would still be unsustainably high. what we are talking about here is the difference between a flow ( loan approvals ) and a stock ( household credit ). the flow would have to fall quite a lot in order to bring the growth of