Reserve Bank of Australia Annual Report – 1974 Problems of Economic Management

In Australia, as in most other developed countries, inflation was the major problem of economic management during 1973/74. The reasons for concern with inflation are well known. Rising prices tend to disadvantage those on fixed incomes, and to favour those in strong bargaining positions or with substantial real assets. There is encouragement to substitute real for financial assets, and to invest speculatively in assets such as land rather than avenues productive of goods and services. Adverse effects on distribution and resource allocation are especially likely if prices and/or interest rates are relatively constrained in some sectors. Rising prices against a background of excess demand and expanding money supply tend to produce expectations of further increases in prices, which in turn assist those increases to come about. Inflation in Australia at a rate other than that in the rest of the world tends to have a disequilibrating effect on the balance of payments.

It is sometimes argued that many of these problems can be alleviated if those who lose through inflation are properly compensated. However inflation rates are usually irregular and unpredictable, and the circumstances of income recipients in the community differ widely. Consequently satisfactory overall compensation schemes are very difficult to devise and implement, and may have uncertain results. Such experiments have been few, and attention has been given mainly to ways of keeping the rate of inflation itself stable and at low levels.

A common sequence for inflation is excessive growth in the money supply, overly rapid expansion of demand, increasing pressures on resources, and rising prices for goods and labour. If rapid inflation continues, expectations of further price rises become entrenched and serve to support a wage/price spiral which may continue for some time after the excessive demand which initiated that spiral has been removed. In Australia the money supply began to expand more quickly in 1972. Much of the early impetus to this expansion came from a very large net surplus in the balance of payments, as Australia acquired and held, unused, a large volume of liquid claims on real resources from abroad; at the same time the surplus was, by adding excessively to domestic liquidity, a major source of demand stimulation. Given that there was a lag in the response of the Australian exchange rate to this situation, returns from exports and the cost of imports rose, and prices in Australia both of domestically produced goods and services, and of goods traded abroad, were influenced considerably by the rapid growth in prices overseas.

Domestic influences also contributed to growth in money supply and excessive pressures on resources and prices. Policy action in 1972/73 had more to do with ensuring a high level of employment of resources than with the latent potential for inflation, and this affected both fiscal and monetary policies. Australian Government transactions in 1972/73, in sharp contrast to those of immediately preceding years, added considerably to domestic liquidity, and government spending in that year rose by 14 per cent. In 1973/74 official transactions, with receipts made buoyant by strongly rising money incomes, acted to reduce domestic liquidity but the rise of 20 per cent in government spending added to pressures on resources. Higher government spending adds to demand pressures, even if that spending is financed by progressively larger tax receipts flowing from inflated incomes. Further pressure came from the nearly four-fold increase in the rate of growth of bank advances in 1972/73. This credit expansion continued into 1973/74.

Strengthening expectations of inflation also developed in conjunction with the excessive rises in demand for goods and labour, and in prices. With real incomes rising more slowly than the mood of buoyancy seemed to demand, employees sought to maintain or increase their share of product: the presumption that prices would go on rising gave force to the setting of higher targets in an attempt to secure increased real rewards in the future. Employers were more willing to grant increases on the basis that rises in unit labour costs could readily be passed on. Accelerating increases in costs quickly fed through to higher prices and in this way expectations of further inflation served to establish and sustain a severe wage/price spiral.

Policies to reduce inflation need to take account of the sources of pressure on prices, and to devise appropriate complementary settings of domestic and external policies. Most of the early burden of combating inflation rested on external policies, with tighter monetary policies later influencing the situation strongly. Changes in external policies saw the inflow of funds from abroad substantially cease from the end of 1972. At the same time the appreciations (relative to currencies of trading partners) of the Australian currency contributed more directly to dampening the rate of growth of domestic prices. These measures were supported by the further currency appreciation and the tariff cuts of 1973/74. Each of the exchange rate appreciations provided scope for Australian prices, for a time, to rise more gradually than those in overseas countries. In the longer term for prices in Australia to rise more slowly than those overseas implies, in the absence of changes in other factors affecting competitive positions, acceptance of a continuing effective appreciation of the Australian dollar relative to other currencies.

Inflation in Australia will not be lower than that overseas if domestic policies are inappropriate. With this in mind, and in view of the continued growth in domestic activity, monetary policy was tightened progressively during 1973. The measures taken in September substantially altered the financial climate. There seemed to be some easing in the growth of activity in the December quarter; factors in this may have been partly supply shortages, and perhaps some hesitancy in production and spending plans following the September measures. In the event the second half of 1973/74 saw demand remain buoyant in most sectors and supply shortages persist. The strength of official spending continued to put pressure on resources, despite the larger than usual seasonal surplus in the Government's financial transactions. At the same time a downward fluctuation in the average external value of the Australian currency early in this period, and accelerating price rises both at home and abroad, reduced the effectiveness of some aspects of the restrictive monetary and external policies, while expectations of further inflation appeared to become stronger and more firmly entrenched.

The growing external deficit also carried implications for the future course of policies to contain inflation. A balance of payments deficit that makes proper use of existing foreign exchange reserves has the capacity to moderate pressures on resources flowing from domestic expansion, but if such an external policy is not buttressed by appropriate fiscal and monetary actions, inflationary domestic developments can soon overwhelm this capacity and, through adverse trade trends and speculative capital flows, lead to a heavy loss of reserves. Under these circumstances an attempt to restore balance of payments equilibrium by devaluation can, if domestic policies are not tightened sufficiently, do more to fuel inflation than to restore the external account.

Against this background, a further tightening of policy was judged to be necessary if inflation was to be brought under control. The arrival at this judgment was complicated for a time by the acute seasonal tightening in financial conditions in the final months of the year. The private sector found considerable difficulty during this period in financing the growing balance of payments deficit and the heavier than usual seasonal flow of taxes to the Government. One way in which this is normally done is by seasonal sales of short government securities to the Reserve Bank; these were heavier than usual. Given the need to maintain and strengthen the underlying monetary restraint, yields on government securities were raised appreciably in the wake of the sharp increases in private interest rates which accompanied the seasonal financial stringency; bank interest rates were also increased.

Monetary policy could perhaps have been tightened to the point where the prospect of a reduction in inflation was brought about by that means alone. However, the costs could have been severe, in terms of disruption to financial markets, of some enterprises placed in jeopardy on other than efficiency grounds, and of a sharp curtailment of the more interest-sensitive forms of spending financed by borrowing. Accordingly, a tightening of fiscal policy was announced at the Premiers' Conference in June. Slower growth in government spending, and increased charges by public enterprises, were foreshadowed. Together with the prospect that a larger balance of payments deficit, and the repayment of last resort loans made previously by the Reserve Bank, would be draining off some liquidity during the seasonal upswing in early 1974/75, this package of measures was expected to work towards reducing pressures on resources and, with some lag, towards slower growth of prices.

Achieving and maintaining the appropriate mix of stabilisation policies in a situation characterised by excess demand and a well-entrenched wage/price spiral presents severe problems of diagnosis and administration. Externally there has been a clear need to keep the exchange rate for the Australian dollar as highly valued as practicable in order to shield Australia from the effects of accelerating inflation overseas. Internally, yields on monetary claims had to be competitive with those on real assets if financial constraints were to be effective. It is sometimes argued that higher interest rates are in themselves a source of inflation. However, interest rates which are not sufficiently attractive induce asset holders to spend on real goods and services rather than hold financial claims. Attempts to maintain an uncompetitive rate structure oblige the Reserve Bank to buy government securities until money supply has expanded sufficiently to induce the private sector to hold the remaining official paper. Interest payments are a relatively small component of business costs, and the additional spending which flows from a policy of holding down interest rates will have effects on prices far outweighing those which would have stemmed from the added interest costs. The increases in prices which usually accompany a policy of keeping interest rates inappropriately low imply greater welfare losses and inequities than those likely to arise from increased costs arising from higher interest rates.

The achievement of the major objectives of stabilisation policy—acceptable stability in prices with full employment and a viable balance of payments—was by no means assured at the end of 1973/74. The environment in which policy is required to operate is altering rapidly. Externally, the major industrial countries of the world seem to be passing through a period of slower growth coupled with accelerating price rises; activity in world trade and payments is not held automatically at any optimum.

The final outcome of difficulties associated with the oil crisis is not yet clear, nor is the shape a reformed international monetary system may ultimately take. Internally, there are stresses arising from the structural adjustments which are taking place. The extent to which people are demanding additional public goods, and whether there is a corresponding willingness to transfer a greater proportion of real resources to the Government, is not certain. In this changing environment the responses to some of the conventional instruments of policy are not entirely familiar, while other instruments are being used in less traditional ways. Exchange rates and restraints on capital flows have not been used freely in the past, and experience with their likely impact is still being acquired, while monetary policy is operating in a less rigid framework.

In this setting there has been some questioning of the efficacy of conventional policy instruments in achieving the immediate aim of dealing with inflation; overseas experience of other measures such as prices and incomes policies does not provide convincing support for alternatives. It appears that monetary, fiscal and exchange rate measures will remain basic to efforts to check inflation, though the appropriate mix of these three instruments may differ importantly in the shorter and longer terms. In particular, the exchange rate may assume greater importance in the long haul. If the policy measures announced in June prove effective, 1974/75 could see an easing of the hitherto excessive pressures on resources, and subsequently some moderation in inflation. It may be important, once this process is underway, that policy is not redirected too quickly or too single-mindedly towards bolstering activity, with perhaps excessive stimulation once more provided, and a new and more intractable round of price increases set in train.