## Mr. Macfarlane reports on monetary policy and financial stability in the
Australian Economy Opening statement by the Governor of the Reserve Bank of Australia Mr. Ian Macfarlane, to the House of Representatives Standing Committee on Financial Insti and Public Administration in Melbourne on 7/5/98 (slightly abridged).
## 1. Introduction
## Mr Chairman,
It is a pleasure to be here in front of your Committee for the third time unde arrangements set out in the Statement on the Conduct of Monetary Policy . I hope this meeting will be as successful as its predecessors in helping to lift the level of understanding of mon financial stability, the Australian economy and, of course, the region more generally. I al have found our Semi-Annual Statement on Monetary Policy a useful source of information and a reasonably clear statement of our views.
It is especially pleasing that we are meeting here in Melbourne for the firs you remember, Mr. Chairman, the attempt to do so last November was foiled by a clash Melbourne Cup week and the attendant shortage of hotel rooms. Fortunately, the Vict Government has not been able to put on a sporting extravaganza to foil our plans this time.
## 2. Review of last time
As on the previous occasion, I would like to start today by recognisin accountability includes being accountable for what was said last time. I will do this by how the past six months have turned out against the background of what I told the Commit were expecting last November. At that time, I summarised our expectations by saying that I 1997 would prove to be a good year for economic growth, with GDP growing by about 4 per that inflation would remain below 2 per cent for a while, but with a tendency to pick up through 1998, and that there was a good chance that unemployment would decline. I said ve about the current account and balance of payments, as the outlook for Asia was still very u
We had only two quarters' data on economic growth in 1997 at the time of previous meeting - now we have all four. The ABS records that GDP grew by 3.6 per cent ov four quarters, and non-farm GDP by 3.8 per cent, slightly less than the 4 per cent t expecting. I do not think there is any point in making much of this small difference.
The other reason that I would not make much of this small difference is th outcome for the labour market turned out to be a bit better than we expected. The unemployment rate in the first half of 1997 was 8¾ per cent. When we met in November, the recent figure we had was 8.6 per cent. The run of numbers we have received over the pa months have been either 8.2 per cent or 8.1 per cent. So if you look across the past 12 think you could see a reduction in the unemployment rate of ½ per cent or so. So over the 1997 a combination of good growth and moderate outcomes on wages made some inroads into o unemployment rate.
On inflation, I have little to add to what I said last time. Underlying inflati 1½ per cent over the past 12 months. We are still expecting that it will rise over the nex largely because falling import prices, which were pushing inflation down, have given increasing import prices. In fact, the fall in the exchange rate has meant that wholesale have risen by 7.7 per cent over the past 12 months, and import prices made their firs contribution at the retail level to the CPI in the March quarter after seven quarters
detracted from it. These changes are not alarming, but they do tend to suggest that we ha the low point in the inflation cycle.
So I feel reasonably comfortable with our earlier assessment, except in one r last time we met, the full extent of the Asian slowdown was still uncertain. In fact, interesting that as recently as six months ago, most discussions treated the ASEAN Four as known extent of the Asian slowdown. We did not know at that stage, although the possibil flagged, that Korea would join them, that Indonesia would deteriorate significantly furthe Japan would suffer a relapse into recession. When we take these developments into accoun clear that a bigger external contractionary effect now has to be factored in. I will r subject in more detail later.
## 3. Prospects for 1998
## (a) General
So much for 1997 - what about 1998? In the absence of the external shock from 1998 was shaping up to be, if anything, a stronger year than 1997. There was nothing in th dynamic of the economy which was pointing to a slowdown, and we had every reason to exp growth of 4 per cent plus. That will no longer be the case, and we are now looking at growt 1998 of something more of the order of 3 per cent. This would probably mean that after a which the unemployment rate came down, we might be looking at a year in which it flattens o
I have already mentioned the outlook for inflation when I reviewed the pre year's results. Broadly speaking, we think that the trough in the inflation rate has passed back again into the 2-3 per cent range, but it is not doing so in an alarming way. We expec that range by the end of this year, and it probably will rise a bit during next year.
## (b) Balance of payments
Another part of the economy which in Australia has always been closely watche the current account of the balance of payments. With domestic demand in Australia growin above trend, but with a number of our major export markets declining, it is an arithmetica that the current account has to widen, as it has. This is not a sign of an economic policy trust markets will treat it accordingly. A number of people, including myself, have made that on this occasion the widening of the current account deficit is not the result of exc in domestic demand, nor is it the result of declining competitiveness because of high inflation, nor is it a counterpart to a large budget deficit. For these reasons, we exp arouse the same excitement as it has in the past, though you can never be sure. At pr expectation is that the current account deficit in 1998 will be about 5½ per cent of GDP, look at the cyclical behaviour of the current account over the last two decades, you could it touching 6 per cent for a time.
Imports are probably slowing from their very high growth rate in the second h last year, but not by much according to the March quarter figures. Over the course of 199 expect them to show their usual behaviour, that is to grow by a few percentage points f domestic demand. Exports, on the other hand, cannot hope to keep up last year's pace of cent, and a small positive figure is probably what we can expect.
Most of our exports - our rural products and metals and minerals - are so worldwide, rather than country-specific, markets. If we cannot sell zinc or copper to Korea to another country: the same goes for our rural exports. It means that for two-thirds of
what we earn is a function of world demand, not of the demand from our specific (largely trading partners. At the end of the day, the prices for these commodities adjust to clear and that has been happening. The prices of Australian commodity exports have fallen by 9 over the past year when measured in terms of a neutral basket of currencies. At the same Australian dollar has fallen against this neutral basket of currencies, so our commodit Australian dollars - what our exporters actually receive - have gone up slightly. Even for exports - coal and iron ore - where prices are renegotiated annually, the Australian doll contracts which commenced in April this year were higher than in the contracts a year earli an example of the market adjusting - in this case, the foreign exchange market - to shield sector (but not the whole economy) from the worst of the Asian downturn.
## 4. Asia
Having made these points, I do not want to give you the impression that downplaying the effects of Asia. To the contrary, the biggest difference between the way our immediate future today and the way we viewed it a year ago is clearly the external have received from Asia. While it is true that the Australian business cycle is always aff world business cycle, the current Asian crisis is the first significant identifiable ext have had for a long time. The last time I can remember something as specific as this was O 1979, but that was on a much bigger scale and affected the whole OECD area more evenly. current Asian crisis is unusual in that Australia has a bigger exposure to it than any country (other than the two who are actually part of the crisis - Japan and Korea).
We have always been very conscious of Australia's vulnerability to a s contraction in Asia. But it has always been our hope, and certainly the guiding princip Australia's policy, that the economic problems in Asia could be minimised by prompt action this awareness of possible danger ahead that lay behind Australia's very quick response t crisis, and the Reserve Bank's willingness to put funds from its balance sheet at the Go disposal to ensure that Australian participation was not delayed. It also explains why Aus only country other than Japan to be a part of all three Asian support packages - those fo Indonesia and Korea.
Australia has done what it can to help minimise the Asian fallout, but clearl have turned out worse than we had hoped for. The crisis has spread further than was at fi likely, it is resulting in larger falls in output and employment in the countries concerne it has been compounded by the relapse of the biggest Asian economy - Japan - into recessio started as a currency crisis in Thailand is leading to widespread suffering in a rang countries.
Of course, those countries have some deep-seated economic policy deficienci weak banking sectors, too much of what is called 'crony capitalism', too much gover direction of investment (including implicit underwriting of loans) and insufficient discl accounting standards, etc. These deficiencies are common to most countries at earlier development than ours, and they have been around for decades. They did not deter massive inflow for most of this decade, and I suppose it must be galling for some of these countri to sermons on their deficiencies delivered by international bankers who, until recently, to ply them with loans. We all have to agree that these countries made policy errors; tha the course. Yet I agree with Paul Krugman who, when commenting on the current situation, 'Yet governments are no more stupid or irresponsible now than they used to be; how com punishment has become so much more severe?'
These countries have had to make a very rapid adjustment to their external po to stop their exchange rates from falling below the extremely low levels they reached lat
They could not rely on a resumption of capital inflow to stop the problem, so the only fe was to return their current accounts to surplus. This has involved very tight policies, a in domestic demand, and very large falls in imports. For the three countries in IMF progra estimate that imports have already fallen by between 30 and 40 per cent. Even though ther been enough time to expand exports in line with their improved competitiveness, their accounts have already moved into surplus. Australia's exports to these countries appear already fallen roughly in line with their falling imports. Thus, we have received the ef trade flows quite early in the piece. In time, when their exports pick up, we should get from this even if their domestic demand remains weak.
## 5. How have we coped?
To date, we have coped quite well, largely because we were in good shape going it with strong domestic demand and low inflation. This was in part due to the fact that we expansionary monetary policy action between July 1996 and July 1997.
The other way in which we have coped well is that our financial markets behaved very sensibly. It is true that our exchange rate has depreciated against the US against major currencies in general, but this is an understandable market reaction to the in our international trading environment. Apart from a minor panic in January, the whole pr been very orderly.
The bond market too has performed very well. International and domestic inves have clearly drawn a distinction between Australia and our Asian neighbours, and we have n any rise in risk premia on Australian bonds. Indeed, we have improved our position over th and Australian borrowers can now borrow in A$ at or below the same rate as equally credi US borrowers can borrow in US dollars. The Australian share market has also risen over the months and, even though it has not performed quite as well as some overseas markets, is hi its former peak in mid-1997.
What is the implication of Asia for the conduct of monetary policy? The si answer is that it makes it more difficult. The Australian economy has suffered an external significant reduction in demand for our exports, which will lead to lower export volumes cases and lower export prices in others. This will show up in some combination of lower gr a widening of the current account of the balance of payments. Because of the fall that has our exchange rate, it will also show up as higher inflation than otherwise. Even if we foresight, we cannot adjust policy in a way which would avoid these outcomes altogether.
The best we can hope for is a combination which minimises the longer-run disru to our economy. Choosing the monetary policy to achieve this is not an easy task. It constantly reviewing our position in the light of changes to the economy, and our forecast events. Importantly, it will be heavily influenced by how the Asian situation develops. I the only reason we are foreseeing any slowdown in growth in 1998 is because of the Asian there was nothing in the domestic economy that pointed in that direction - in fact, it poin growth. I suspect that in the future evolution of our policy, Asia will be the major influe
As you know, the Board of the Reserve Bank met on Tuesday and did not make an change to the setting of monetary policy. There had been some speculation over the precedin that we might ease, but the majority of observers expected no change. Our on-balance vie same as the majority of outside observers: that is, we judged that the present setting is As we see it:
- The present stance of monetary policy provides a low interest r environment which is working to support, rather than restra growth. Credit is readily available, borrowers seem to regard cur interest rates as attractive, financial wealth is rising, as i sector leverage.
- Developments in the exchange rate and interest rates charged financial intermediaries since the last reduction in the cash r July last year have worked to magnify the effects of lower offi rates. The exchange rate has come down against major currencies and competition among banks has reduced interest rates to busine and personal borrowers.
- The most likely outcome over the next 12 months at the presen policy setting is for inflation to return to its target range domestic demand to remain at or above trend growth. With a significant reduction in net exports, GDP will probably grow bel its trend rate, but some growth slowdown in the short run is unavoidable result of the external shock.
- Our measured approach to date has served us well in that it maintained confidence in Australian financial markets. That, course, does not rule out further changes in policy, but it does i a constraint in that it means monetary policy has to be adju credibly. We do not wish to jeopardise Australia's current go international standing or revive memories of when Australia wa regarded as a 'boom and bust' economy. We gain a lot from our current reputation for stability - not only does it reduce our bor costs, but we can raise equity more cheaply, and we have become more attractive place for direct foreign investment.
Of course, we recognise that it would also be a mistake to stick too long to of policy in the name of stability if there were good reasons to move. We have to be consci risks to our current assessment, and constantly review them. The major downside risk which see is the possibility that the effect of the Asian and Japanese situations might prod slowing in the Australian economy than our current expectations, perhaps indirectly by growth substantially in other trading partners or by seriously dampening domestic demand income or confidence effects. Such an outcome is not in our view the most likely one some probability.