philip lowe : some current issues in the australian economy address by mr philip lowe, assistant governor of the reserve bank of australia, to the committee for economic development of australia ( ceda ) - new south wales ( nsw ) economic and political overview 2011, sydney, 17 february 2011. * * * i am very pleased to be able to participate again in ceda ’ s annual economic and political overview. in line with the theme of this morning ’ s conference, i would like to discuss a couple of issues that will have an important bearing on economic developments in australia over the next year or so. the first of these is the performance of the world economy and, in particular, the ongoing strength in global commodity prices. and the second is the continuing evidence of restraint in consumption and borrowing by australian households. i would also like to talk briefly about the rba ’ s forecasts that were published in the latest statement on monetary policy ( smp ). the world economy and commodity prices when i spoke at this conference a year ago, the central forecast for the world economy was that it would grow by around 4 per cent in 2010, with many commentators focussing on the downside risks. now that most of the gdp figures are in for the year, it looks like global growth was quite a bit stronger than this, with global gdp estimated to be up by around 5 per cent in 2010. there have also been upward revisions to forecasts for 2011, with the imf now expecting that growth will continue to be above trend in both this year and next ( graph 1 ). graph 1 bis central bankers ’ speeches while the recent outcomes for the world economy have been better than expected, significant downside risks remain, not least because of the poor state of public finances in many of the advanced economies. these risks clearly cannot be ignored, although the recent more positive data have led to renewed focus on another risk – that is, a rise in global inflationary pressures, particularly as commodity prices have increased significantly over recent months. as an illustration of this increase, the rba ’ s own index of commodity prices is at an all time high and has risen by almost 50 per cent over the past year ( graph 2 ). graph 2 this upward pressure on commodity prices is occurring at a time when conventional measures of the global output gap remain quite large. many of the advanced economies continue to operate well below full capacity and unemployment rates are still very high. these large output gaps mean that there is little upward pressure on

is a smaller degree of " indirect " pressure on domestic inflation because of the smaller output response. 11 the model simulation results are useful in two respects. first, they suggest that under an empirically reasonable specification that seems consistent with the low pass - through to import prices seen in u. s. data, the effects of even a relatively large and sharp 10 percent decline in the dollar on output and inflation are fairly modest. in particular, the output gap peaks at less than 1 / 2 percentage point above baseline, and the inflation rate peaks at only about 1 / 4 percentage point above baseline. thus, there seems to be a substantial disconnect between the exchange rate depreciation and nominal demand. second, a comparison across specifications highlights the importance of adequately modeling the structural features that determine the transmission from exchange rates to import prices. under the specification implying full pass - through, the comparatively large jump in import prices and strong stimulus to activity results in a sizeable surge in inflation, even though long - term inflation expectations remain anchored and agents are assumed to be fully cognizant of the monetary rule. conclusion now let me summarize the lessons from the empirical evidence on exchange rate passthrough. sizeable depreciations of the nominal exchange rate exert fairly small effects on consumer prices across a wide set of industrial countries, and these effects have declined over the past two decades. exchange rate depreciations are thus likely to have less adverse effects on inflation than they have had in the past. the empirical evidence also indicates that pass - through from exchange rates to import prices is low and has declined markedly over the past two decades. this evidence suggests that there may be a weaker relationship between exchange rate fluctuations and nominal demand than prevailed in the past, which may make it easier for monetary policy to stabilize inflation and real activity. nevertheless, exchange rate fluctuations can still have an effect on inflation and economic activity ; hence, monetary policy must continue to take these fluctuations into account to ensure that inflation expectations remain well anchored and that fluctuations in economic activity are minimized. it is useful to note that the responses of both inflation and the output gap under either pass - through specification would be much smaller under an “ optimal ” monetary policy rule derived by minimizing a loss function whose arguments depend on the variability of inflation and the output gap subject to the model ’ s behavioral equations. references atkeson, andrew, and ariel burstein ( 2005 ). " trade costs, pricing - to -