i j macfarlane : the world economy and its implications for australia inaugural di yerbury economic and financial studies lecture by mr i j macfarlane, governor of the reserve bank of australia, sydney, 14 april 2004. * * * it is a great honour to be invited by macquarie university to deliver the inaugural di yerbury economic and financial studies lecture tonight. i also note that this is the 40th anniversary of the establishment of macquarie university. for fourteen of those years professor yerbury has been vice - chancellor - a remarkable achievement by any standard. our paths first crossed in the late 1960s - although neither of us has much recollection of it - when di was a lecturer and i was a tutor in the economics faculty at monash university. since then, of course, professor yerbury has gone on to an illustrious career in academia, government and university administration. the world economy i will speak tonight about recent developments in the world economy and their implications for australia. it is about 18 months since i spoke about the world economy, and a number of things have changed in that time, mainly for the better. despite various hesitations and temporary setbacks, the recovery from the world recession that beset g7 countries in 2001 has consolidated. for the world economy as a whole, gdp growth picked up in 2002, again in 2003, and is forecast to be higher again at a relatively robust 4. 4 per cent in 2004 ( graph 1 ). over the past four quarters, both the united states and japan have reported growth in excess of 4 per cent, and in non - japan asia it has been a lot higher. graph 1 at the same time, inflation in almost all countries has remained low. at the level of final goods prices, as shown by consumer price indices, inflation is low almost everywhere, and few countries report upward pressure. not surprisingly, this reassuring macro - economic picture has led to a return of confidence to financial markets. share markets around the world have risen appreciably from their troughs in early 2003, and in many markets price earnings ratios are well above medium - term averages. a similar return of confidence has occurred in debt markets, where spreads have narrowed to historic lows. borrowers in emerging market economies can obtain finance on very advantageous terms as investors chase yields. a similar process is at work for sub - prime and even sub - investment grade borrowers in developed economies. such a compression of spreads means that providers of capital perceive risks to have been greatly reduced

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