Reserve Bank of Australia Annual Report – 1973 Problems and Policies

Monetary policy was eased over the final three quarters of 1971/72. Together with the effects on financial conditions and spending of this easing of policy, there were those produced by a number of expansionary fiscal measures, a growing external trade surplus and a high rate of capital inflow. From around the middle of 1972, and especially after the Budget had been brought down, most forecasts were for an early return to higher levels of activity.

In these early months of 1972/73 some easing in the growth of prices had become apparent. But, despite the fact that rising productivity during the phase of upsurge in activity seemed likely for a time to allow substantial absorption of rising costs, few observers were confident that the slowing of price increases would continue. Many, in fact, felt that it could be reversed; major influences foreseen were higher levels of domestic activity and a speed-up in labour costs following the relief afforded by the delay in the 1971 national wage hearing. Moreover, inflation overseas was tending to worsen and it was therefore a matter of considerable concern that arrangements governing our international transactions meant that the balance of payments would probably continue to fuel the growth in activity and prices for some time to come. Further easing in monetary policy may have made some contribution towards restraining the growth in international reserves but effects would not have been great and, in any case, domestic considerations were beginning to call for a change in the other direction. There were other disquieting features of the rapid build-up in international reserves.

Where exchange rates are less than completely flexible, various considerations affect judgments about the optimal level of international reserves needed to meet fluctuations in international payments and, more generally, to give room for manœuvre. When reserves reach levels that are more than adequate for these purposes, however, the nation can suffer real losses. One possibility is that losses arise from decreased purchasing power of reserves. Such purchasing power declines when earnings on reserves fail to compensate for inflation abroad or when the reserves held are devalued relative to currencies in which payments have to be made. For these kinds of reasons, at least, the situation seemed to call for a lower rather than a higher level of reserves.

The purchase of foreign currencies at rates of exchange higher than necessary to secure amounts needed to make payments overseas was also of concern to the Bank as a matter internal to its own accounts. There was room for doubt about the future value, in Australian currency, of the assets the Bank was acquiring; high on the list of possible measures to check undesired growth in reserves would be variation of the value of the Australian dollar relative to other currencies. The Bank had substantial amounts at risk, not only in respect of existing stocks of foreign currencies but also of amounts to be delivered under forward exchange contracts.

The forward exchange facilities provided by the Australian banking system enable traders to fix in advance the Australian currency equivalent of future transactions in foreign currency. The Reserve Bank has for many years permitted its own net risk position to fluctuate widely in response to the demands of traders. Until 1972 there was a charge which was equivalent to a fixed per annum discount on the buying side and an equal premium on the selling side. Since July 1972 the system has been based on a variable discount for the United States dollar, both buying and selling. Although the discount has varied from 1 per cent per annum to 4 per cent per annum, the Bank has continued to find its forward cover operations greatly one-sided, in the direction of a heavily over-bought position. Further limitation of the Bank's net risk position would require wider variation in the forward discount (or premium), some form of rationing or in some cases allowing the spot rate to move; there is no way in which the Bank can transact the risk away.

Controls on capital flows had some potential as an alternative to exchange rate changes for limiting the growth in reserves. However, experience in other countries suggested that, where incentives to transfer funds persisted over any extended period, such measures had, in many cases and to an increasing extent, proved inadequate to withstand the pressures that built up. Such incentives concerned not only long-term investment opportunities and interest rate differentials, but also possible gains from acquiring claims in currencies which appeared to be cheap. In any case, it seemed that, even if capital inflow into Australia were substantially reduced through direct controls, the rate of domestic inflation compatible with overall balance of payments equilibrium (given the exchange rate then existing) would still be somewhat higher than tolerable. These observations suggested that complete reliance should not be placed on capital controls. In the event, exchange rate adjustments (which crystallised for the Bank substantial losses in foreign exchange dealings) were considered necessary over the following months.

Despite the continuing international uncertainties, there was a rather better prospect for an equilibrium situation for Australia as things stood after the United States devaluation in mid February. Exchange rate changes (both here and abroad), in combination with exchange control measures, gave promise of moving our external accounts nearer to balance and had improved the outlook for prices both directly, through effects on prices of imports and import substitutes, and indirectly, through dampening effects on a resurgence in demand that looked like going too fast and too far. Additionally, the exchange control measures, by effecting to some extent a disconnection of our markets for funds from those in the rest of the world, increased the potential of monetary policy for influencing domestic activity.

Even having regard to the likely restraining influence of the measures aimed primarily at the external situation, however, it seemed, early in 1973, that spending would continue to move up faster than the growth in domestic capacity. This view came briefly into question immediately following the United States devaluation but remained when the initial impact had been substantially absorbed. The Bank therefore has not moved to offset the tightening occurring in domestic financial conditions and, in fact, has considered it appropriate that there should be further modification of the easy conditions prevailing. Accordingly, the Statutory Reserve Deposit ratio for the major trading banks was increased from 6.6 per cent to 7.6 per cent of deposits during April and a further increase of 2 percentage points (accompanied by a release of 0.6 of a percentage point associated with transfers to banks' Term and Farm Development Loan Funds) has since been announced to take effect in August. The tightening in financial conditions has been seen in rising interest rates in the private sector and in the upward moves in government bond yields which have been accepted.

To the various restraining influences mentioned above has recently been added the reduction, by 25 per cent, in the level of Australian tariffs. The overall effects on aggregate activity of this move will not be great and will be reduced as a result of any assistance given to those disadvantaged by the tariff changes; the reduction in tariffs will work in the direction of moderating the rate of growth in prices of imported goods and of prices generally. Over the longer run, the change will tend to enhance efficiency in the Australian economy.

Although imports can be expected to continue to grow strongly, it seems that growth in demand for domestic output will at least match the increase in domestic productive capacity over the next few months. Beyond this, the Budget will have a decisive impact on the balance. As things stand, prospects are that the economy will continue to operate at high levels of activity for some time to come. Both this and tendencies for inflation to remain high or even increase elsewhere in the world point towards continuance of fast growth in prices here. In these circumstances and given the lags in the system, it would be optimistic to expect the measures so far taken to effect an early return to moderate rates of increase in prices. Eventual attainment of this goal will clearly depend also on policies pursued in coming periods.

The community's level of concern about inflation has not been fully matched by sureness of the diagnosis of its origins, and the variety of policies advocated reflects these uncertainties. There are those who see inflation as stemming mainly from nominal incomes being raised faster than productivity as a result of attempts by one or more sectors—wage and salary earners, enterprises or government—to increase access to real resources. This view leads towards adopting direct controls on incomes and/or prices and perhaps towards pressure for restriction of official spending. A number of countries have recently made use of direct controls of incomes and/or prices; their experience suggests that even if efforts by enterprises and workers to increase their incomes appear as proximate causes of inflation, the problem goes deeper and is not to a major extent amenable to policies which act at that level rather than on root causes.

Other insights start by noting the change from the position which obtained some years ago when, with exchange rates relatively rigid and inflation in the world generally rather moderate, an individual small country which sought to maintain fiscal and monetary policies conducive to inflation soon felt a check through weakness of its balance of payments. In contrast, Australia's recent experience has been in the context of a world of fairly easy money and of more rapid inflation externally; in addition, other factors, including mineral deposit development, have tended to improve Australia's competitiveness. In such circumstances, a country can sustain without balance of payments difficulties (although not without other serious harm) a rather higher rate of domestic inflation.

Although the transmission mechanisms are only now beginning to be clearly described, there seems to be a good deal in the view that powerful and pervasive forces have been operating through our external accounts either to permit or to promote domestic inflation, which, of course, if tolerated, would tend eventually to restore external equilibrium; meanwhile, savers are hurt by inflation, capital markets are damaged and inflationary expectations become firmly entrenched, with later need for drastic measures before price stability is re-established. The role of incomes and prices policies, working against such forces, would seem to be at best palliative, and would tend to be associated with evasion, disguised increases in prices, shortages and other forms of non-price rationing. Moreover, any initial success that the controls had in a situation where the main source of the problem is external would subject the controls to even greater pressures.

In short, a country in strong balance of payments surplus in today's external conditions must, if it wishes to minimise inflation, handle firmly and flexibly the instruments of external adjustment—such as the exchange rate and controls of capital movements—while at the same time following fiscal and monetary policies which, while maintaining activity, restrict the pressures on prices from domestic sources.

While there may in such a pattern be scope for a time for policies on incomes and prices to play a part in helping adjust price expectations, the basic need seems to be for a balanced application of complementary external and fiscal/monetary policies to achieve maximum growth and minimum inflation.