Reserve Bank of Australia Annual Report – 1991 The Focus of Policy
The past twelve months have seen major progress in lowering inflation. For the first time in many years Australia's inflation rate fell below the OECD average and inflationary expectations took a large step down. Further steps are still needed but real progress has been made towards establishing an important pre-condition for sustained economic progress in the 1990s.
The gains made over the past year represented the culmination of actions that began with the policy tightening in early 1988. While demand was growing considerably faster than production, the role of monetary policy was unambiguous – to help rein in the excessive growth in spending, which was reflected in surging imports and mounting inflationary pressures. Inflation remained the focus of monetary policy even after the surge in demand had passed. Last year's Report, with its theme of inflation, reflected the Bank's belief that a consistent framework throughout the whole of the economic cycle would be necessary to lower inflation decisively.
In line with this medium-term focus, nominal interest rates have been lowered, since January 1990, in response to the changes in the economic cycle and the inflationary environment. The very high rates which helped to slow the excessive growth of 1988 and 1989 ceased to be necessary as the economy slowed. Short-term interest rates in June 1991 were 7½ percentage points lower than eighteen months earlier.
The pace of this reduction in interest rates was influenced by two main factors. Initially there was the need to guard against any resurgence in demand which might put pressure on productive capacity. Over the year, this concern receded as the extent of the economy's weakness became more apparent. The other major constraint on how quickly interest rates could be moved in response to the weakening economy had to do with inflation. To reduce inflation in a structural, permanent way – as distinct from a temporary, cyclical improvement – requires the prevailing inflation psychology to be fractured. If expectations of future inflation remain high, this will feed into actual price increases and wage costs. Too rapid a reduction in interest rates, therefore, would risk suggesting to a sceptical public that here was another round of “stop/go” policies. In that event, price expectations would not go lower and the opportunity to achieve a lasting reduction in inflation would be lost.
Translating these considerations into day-by-day policies requires fine judgment. There were, as usual, ambiguities in assessing precisely where the economy was in the cycle, and the extent of the weakness. The national accounts provide a basis for historical assessment, but they are released with a considerable lag and do not provide an up-to-date picture of the state of the economy. More specific indicators, such as those for the labour market, are received more quickly but often lag behind current activity. This again proved to be the case; employment declined during the second half of 1990, with a sharper deterioration appearing only in the first half of 1991.
Even before the national accounts and the labour market confirmed the weakness of the economy, it was clear that the slowing in activity was greater than had been expected. Earlier forecasts of a relatively mild downturn had relied on two positive factors: that the world economy was not falling into recession and that domestic wage restraint would soften the labour market contraction. In the event, those assumptions were reasonably close to the mark, although the sluggishness of world industrial output contributed to a significant fall in Australia's commodity prices. At the same time, however, corporate balance sheets were hard pressed by reduced cash flows and declining asset prices, particularly in respect of commercial property. These developments, which had not been widely forecast, led several financial intermediaries (and other repositories of household savings) into difficulties. Business sentiment swung from optimism to pessimism, and new investment dropped off.
Policy did respond to this unfolding picture of the economy, although past experience has made policy-makers wary of attempting to “fine-tune” the economy along some narrow path of desired growth. Policy is able to influence the broad development of the cycle, and it is clear that tight monetary policy did help to slow the excessive pace of spending in 1989. It is equally clear that maintaining such high interest rates after those expansionary pressures had eased would have bitten very deeply into activity. But given the lags between events and the effects of any policy response, even a sharp easing of monetary policy could not have done much to avoid the emerging weakness.
The final assessment of these events and the response of policy requires a longer time perspective than we have now. To this time, however, it is clear that policies have led not only to a fall in recorded inflation but also to a lowering of inflationary expectations. Survey-based measures and financial asset prices which incorporate price expectations both show a marked downward shift. With expectations about inflation shaken from the stubbornly high levels which prevailed for most of the 1980s, we are now in better shape to sustain lower inflation as the economy recovers.
Australia's current inflation rate of about 4 per cent compares favourably with the OECD average, but is still behind the best performers. Securing the recent improvement and doing rather better than the OECD average are now the challenge. While excess demand is unlikely to threaten a resurgence of inflation across the economy in the near term, this and other potential threats will require careful surveillance. Price expectations will remain at low levels only if the public maintains its confidence in the Government's anti-inflationary resolve.
The gains on inflation have not been achieved without significant costs. In particular, unemployment had risen to around 9½ per cent by mid 1991. But living with high rates of inflation, out of concern for the costs of reducing it, is not a credible policy. The longer-term costs of accepting high rates of inflation are substantial. They include the way inflation perverts the taxation system and the pattern and financing of investment, and the way income and wealth are redistributed in favour of those best placed to take advantage of those distortions. Such outcomes make Australians generally poorer than they would otherwise be. For its part, monetary policy can best contribute to growth and equity by maintaining a clear commitment to medium-term price stability.
The substantial reductions in interest rates during 1990 and the first half of 1991 were not accompanied by any sustained fall in the exchange rate. This has been surprising, especially given that Australia's terms of trade deteriorated over the same period. This exchange rate stability has been helpful in achieving lower inflation, in contrast to the large fall of the Australian dollar in 1985/86 which put paid to any prospect of keeping inflation at OECD rates. On the other hand, a somewhat lower exchange rate would provide short-term help in moving towards a lower current account deficit, especially in conditions of relatively weak economic activity and falling inflationary expectations. To this end the Bank acted on a couple of occasions during the year to move the Australian dollar a little lower, effectively seeking to reverse some of the earlier rises that had occurred; at no time, however, were interest rates eased with the specific objective of achieving a lower exchange rate. Monetary policy can best contribute to a sustainable external position in the same way that it can best contribute to overall growth, namely by providing an environment of low inflation.
Interest rates are the main instrument of monetary policy, and experience in 1989 demonstrated how far rates have to be raised on occasions to influence spending in some sectors of the economy. This period witnessed an inevitable collision of strategies based on high gearing and rising asset prices on the one hand, and the arithmetic of high funding costs on the other. Many businesses have been caught up in the aftermath of that collision, together with the associated change in expectations regarding asset prices. It is little comfort to those affected to recognise that this is the way monetary policy has tended to operate in the past.
This outcome has been blamed on the financial deregulation of the 1980s. To the extent that any thorough-going changes require time for adaptation, there is some truth in this view. More vigorous competition, and particularly the prospective arrival of foreign banks, encouraged some financial institutions to put a high priority on increasing market share. At the same time, the strength of the economy, and of asset prices in the late 1980s, no doubt coloured the banks' assessments of the viability of many borrowing proposals.
It is clear that the greater freedom available to the financial sector during the 1980s provided opportunities to fund projects which, with hindsight, were not viable. These and other adjustment costs, however, should be measured against both the ongoing efficiency gains which will flow from deregulation over the medium term, and the mounting costs of the regulated system. The recent improvements in banks' information systems and credit assessment procedures will substantially reduce the risk of similar mistakes being made in the future.
There have been changes too in the supervisory framework. Importantly, the amendment of the Banking Act in late 1989 to give the Bank clear responsibilities for prudential supervision removed any ambiguities that might have existed previously. Other changes have aimed to keep abreast of, and where possible ahead of, developing financial practice. The risk-weighted approach to capital requirements and the refinements to policy on large credit exposures are two past examples; the Bank's proposals on securitisation and funds management vehicles are among current issues being considered.
As it happened, the new financial environment was evolving at the time the economy was experiencing some large shocks, including sharp swings in the terms of trade. On the domestic side, there was real progress in tackling the profit/wages imbalance and the string of large budget deficits of the first half of the 1980s. It was also a period of highly volatile asset prices, most notably in the share market, but also in property prices (not a uniquely Australian phenomenon). More recently, the authorities have been attaching greater priority to reducing inflation, after earlier attempts to slow it had made only limited progress. All these factors, and particularly the sustained high real interest rates needed to reduce inflation, have also helped to change the environment in which businesses operate.
Some of these changes are still working their way through the system but the major adaptations have been made. If, as expected, the result is a more competitive and responsive financial sector compared with a decade ago, the costs of adjustment will have been worthwhile. If, at the same time, a lower level of inflation can be sustained, Australia will be better placed to tackle other necessary structural changes.