Reserve Bank of Australia Annual Report – 1983 The Economy and the Bank's Policies

Monetary policy in 1982/83

The Australian economy in 1982/83 suffered a severe shakeout. The conjunction of our high inflation and the prolonged sluggishness of the world economy caused a serious weakening in activity and employment, accompanied by a sharp increase in unemployment. The fall in activity was much deeper than had been expected at the start of the year and contributed to a substantial over-run in the budget deficit. With inflation continuing higher than in other countries the exchange rate fell substantially during the course of the year. There was great volatility in interest rates and external flows – particularly, but not only, in the weeks immediately before and after the Federal elections held in March. The parlous state of the economy kindled a better recognition of its basic flaws by the community and some willingness to face up to them. By the closing months of the year there were indications of a pick-up, albeit patchy, in the economy. These events were closely monitored and claimed much of the Board's attention in 1982/83.

In the preceding couple of years Australia, against the tide of events in other industrial countries, had performed quite strongly. Unfortunately, increases in wage incomes in those years had been based on excessive confidence that Australia's good fortune would continue. With our cost structure uncompetitive, the continued sluggishness in world recovery had a severe impact on Australia in 1982/83. Drought over much of the country added to the difficulties. As production declined and unemployment rose dramatically, the link between wage increases and the level of employment became increasingly apparent. More responsible attitudes to wage demands developed and there was widespread support for the “pause” in wages from about the middle of the year. This contributed to a lessening of inflationary pressure and a slowing in the loss of jobs.

The Commonwealth's Budget for 1982/83 provided for some net fiscal stimulus; but only some of the effects of measures taken would be reflected in the budget deficit for that year. Largely as a result of the unforeseen severity of the recession, the deficit expanded well beyond the initial estimate during 1982/83, adding to public sector borrowing. As activity fell away, growth in the private sector's demand for finance slowed sharply. In this context, and with interest rates declining abroad, domestic interest rates fell during the course of the year.

The current account of the balance of payments registered another sizable, although reduced, deficit; because of heavy capital inflow, the balance of payments was in overall surplus. This surplus, and the large budget deficit, made 1982/83 a year of substantial primary additions to monetary growth.

Like other elements of overall economic policy, monetary policy began the year principally directed at the persistent problem of rapid inflation. Although concerned at the high level of interest rates, the Board sought to conduct policy to maintain a firm grip on monetary conditions and to continue to slow the growth of financial aggregates. The best chance of a sustainable reduction in interest rates would lie in a lower rate of inflation.

At the time the Budget for 1982/83 was being decided, the Board wrote to the then Treasurer about the monetary outlook. While acknowledging that weakness in the economy would tend to increase the budget deficit the Board expressed its concern that, if government borrowing increased much, it would be difficult for expected demand for finance by the private sector to be satisfied without upward pressures on interest rates.

Soon, however, it became clear that the economy was declining more rapidly than had been thought likely. Monetary policy, which had assumed a more robust economy, was reviewed. With economic activity weakening so quickly, there was a case for less restraint in policy. Against this, inflation was still high and out of line with rates in the rest of the world. A looser rein on monetary conditions might well have laid the basis for a pick-up in wage claims and boosted upward pressure on prices. There would have been severe risks in attempting to use monetary policy as a stimulus.

The Board rejected any substantial easing of monetary policy, but it did not favour a more restrictive approach. A lower path for monetary aggregates, perhaps conforming with the reduced level of activity, might have reduced the risks of an excessive expansion of credit at some time in the future. However, given the state of the economy, it was judged inappropriate to tighten the screws on financial conditions and, as it were, chase the economy down.

In the circumstances of late 1982, a tougher approach, intensifying the pressure on the private sector, would have resulted mainly in further cuts in employment and in increases in bankruptcies. It had to be recognised that inflation in 1982/83 had its origins largely in earlier monetary conditions and in past increases in labour costs and government charges. As well as pushing up prices in the near term, these cost increases were leading to a fall in activity which would, in time, help to restrain further inflationary pressure. A significantly tougher monetary policy might have hastened this process and brought inflation down more quickly but it could also have jeopardised the longer-run acceptability of sensible policies.

For these reasons, as 1982 drew to a close it seemed to the Board that monetary policy alone could not do much more to deal with the immediate problems. Accordingly, the Bank sought through the remainder of the financial year to pursue a steady policy which had the aim of maintaining firm financial conditions without bringing about further contraction in the economy.

Although the Bank sought to maintain firm and steady policies there were considerable fluctuations in financial conditions during the year. The most notable was at the time of the Federal elections. With expectations of a devaluation prevalent, a surge in demand for domestic finance to replace foreign borrowings and to make payments abroad compelled the banks to bid strongly for deposits. The following chapter of this Report contains more detail on this episode.

The rates of growth in most measures of borrowing and lending by financial intermediaries fell throughout the year and, for 1982/83 as a whole, were much lower than in the year before. Interest rates were generally at levels which constrained plans for spending but they also discouraged inflationary impulses, including over-generous wage increases.

An important exception to the general slowing in the growth of financial aggregates was the movement in M3 in the second half of the year. While eschewing inflexible adherence to monetary targets, the Board felt that the projected range of growth in M3 of 9–11 per cent for 1982/83 as a whole, as indicated by the then Treasurer in his Budget Speech, would be achievable and consistent with the expected needs of the economy. The Board believes that a difference between the projected range and the outcome in any year should not be regarded as a formal measure of the success or failure of monetary policy. It is, nevertheless, disappointing that the rate of growth in M3 again exceeded the projected range and, more particularly, that growth did not continue to slow in the second half of the financial year. This disappointment is mitigated by the knowledge that the outcome was due largely to very strong growth of one group, the savings banks.

The monetary situation has been affected a good deal by changes in the structure of regulation and the progress of innovation in financial markets. To make a balanced assessment, it is necessary to consider a range of indicators including changes in borrowing and lending by various groups of financial intermediaries, interest rates, movements in credit-sensitive sorts of spending and ultimately the rate of growth in prices. Even so, the Board considers that if monetary conditions need to be indicated by reference to one indicator only, then M3 continues to be the most appropriate measure.

Some difficulties for policy

There were some sharp problems for monetary policy during the year – some peculiar to the year and others of continuing importance.

The growing integration of domestic and foreign financial markets led in 1982/83 to large flows of funds – both inward and outward – in response to changes in relative costs of domestic and foreign borrowing (comprising relative interest rates, the exchange rate and costs of hedging foreign borrowing) and to changing expectations about these individual elements. Several times in 1982/83 (especially in short periods before and after the devaluation early in March) such flows produced sharp fluctuations in domestic liquidity. Short-term rates of interest in Australia were more volatile than in major financial centres abroad.

Such volatility in financial markets increases the difficulty of making confident readings of monetary conditions. It also increases the need, in implementing domestic monetary policy, to take into account conditions abroad and the relationships between these and developments locally.

In addition to the volatility of flows, a further complication for policy was the persistence of private capital inflow, particularly short-term borrowings, which for the year as a whole more than offset the deficit on current account and, consequently, kept adding to the liquid assets of the community. To reduce the growth of liquid assets from external sources, there are two prices which can be relevant, namely the exchange rate and domestic interest rates, particularly short-term rates. The weakness of economic activity, as well as an assessment of the competitiveness of Australian industry, argued against a much higher exchange rate in 1982/83. On the other hand, lower interest rates would have carried some risk of reducing the demand for Government securities and perhaps forming a base for an overall expansion of credit, thus adding unduly to monetary aggregates.

When heavy net inflows occurred around the end of 1982 and the early part of the June quarter of 1983 the Bank did not immediately press sales of securities in order to absorb this additional cash. On both occasions short-term interest rates fell sharply and the pace of net foreign inflows slowed. In the event, sales of Government securities remained buoyant and private demand for credit continued weak. At these times the trade-weighted index of the exchange rate was kept steady or edged upward. This also implied some appreciation – at least short-term – of the Australian dollar against the US dollar.

Early in 1982/83 the Board had to consider closely the appropriate use of the Statutory Reserve Deposits (SRD) of the trading banks.

In his Budget Speech, the then Treasurer said that the Government had decided to ask the Bank to consider making a release of one percentage point from the SRD of the major trading banks for the special purpose of lending for housing. The Board was reluctant to agree to this proposal for several reasons. First, it saw difficulty in reconciling a special release from SRD with the role which it considers those deposits must play in giving effect to monetary policy for the economy as a whole. In the immediate context, an SRD release would not have been in keeping with prevailing monetary policy. More fundamentally, a reserve asset requirement which was perceived to be subject, even in special circumstances, to selective action would very likely lose its effectiveness as an instrument of stabilisation policy.

These views were put to the Government. In the weeks following the Budget Speech, housing finance had continued to become more readily available, partly because of improved flows of deposits to the major home lenders. There were also prospects of this trend continuing. The Board welcomed the Treasurer's announcement in November that the Government had decided to defer its request.

Monetary policy – the future

Late in March, with the rising budgetary deficit confirmed, the Board wrote to the Treasurer of the new Government about the economic outlook and the prospective role for monetary policy.

Noting the current dismal state of the economy, the Board's view was that, even with the whole-hearted collaboration of all branches of industry and labour and of governments, the inflation and unemployment which has plagued the country could not be removed quickly. A solid recovery in real spending by firms and households would be required if there was to be an impact on employment sufficient to reduce the rate of unemployment. This would depend on a renewal of confidence of the private sector. Confidence was low and there was a high degree of uncertainty and nervousness. Inflation was (and remains) very high in relation to inflation in our major trading partners and competitors. Until this situation was resolved, prospects for a sustained revival of private spending appeared remote.

Despite the general gloom, some of the factors contributing to the severity of the recession seemed to be easing. Activity in the United States was starting to increase; this, together with reductions in the price of oil, would contribute to growth elsewhere. Rural conditions in Australia were improving. Restraint in wages offered, among other things, the enhanced prospect of some recovery in profits. In addition, the recent devaluation of the Australian dollar would provide net economic stimulus provided the effects were not eroded by an upsurge of inflation.

The Board noted that fiscal policy had already been moved in a strongly expansionary direction and that this was providing some short-term stimulus to activity. Given the basically private-sector oriented nature of our economy, however, it would not be realistic to rely for recovery solely on fast growth of public spending.

Achieving a broad-based and sustained recovery would require strong efforts to ensure, first, that in the early stages of recovery, when fiscal stimulus was strong and activity weak, the stimulus should not simply lead to more inflation; this would depend importantly on the good sense of the Australian people. Restraint in income claims would provide a basis for enduring benefits, some of which would come in the form of enhanced job prospects. Second, government spending should be of a nature which could be cut back to phase in increased private spending, in particular on housing and other fixed capital. Otherwise, rates of interest would rise to a degree which checked recovery in private spending or there would be a monetary expansion which could not fail to have adverse effects on the plans of investors.

Against this background, the Board considered the range of figures which had been canvassed for a Commonwealth budget deficit in the year ahead. It accepted the virtual inevitability of a major expansion in the deficit in 1983/84. In its view a deficit of around $8 billion, while placing heavy demands on the capital market would be doing so when corporate and household demands for finance were likely to be low. Consequently a deficit of that order might conceivably be financed in 1983/84 without unmanageable financial pressures. In forming this judgment the Board stressed the need to maintain the confidence of the financial community, in Australia and abroad. To this end, it was most important that the Government should show itself to be in control of the economy and that it had realistic plans to reduce its fiscal deficit in subsequent years. The budgetary measures announced in May made a start on this task.

The Board saw firm but not repressive monetary policy as a necessary underpinning of policies to restrain inflation and to rekindle recovery in the economy. In practical terms, the aim would be for gradual but progressive reductions in the growth of various monetary aggregates. At the close of the year, the Board confirmed its intention to adhere to this policy.

The Board believes that such a policy will make a major contribution to a sustainable restoration of Australia's competitiveness. Such a restoration is essential if Australia is to hold or improve its position in the current international trading environment. Otherwise, there can be no guarantee that we will receive much boost from economic recovery abroad.

The National Economic Summit Conference convened by the Government elected in March accepted that income restraint is crucial to the nation's hopes for better times. It is certainly basic to the Bank's assessment of monetary policy. That policy would have to be reconsidered if incomes were again to expand rapidly, for to accommodate excessive income claims would invite a resurgence of inflation and condemn Australia to a further period of poor economic performance and stagnation in living standards. Because it should entail a lower cost in terms of unemployment, income restraint achieved through processes of consultation and sharing of information is much to be preferred to restraint enforced through tough monetary and other policies.

Other issues

A major international concern during 1982/83 was the difficulties which several countries with substantial external debts had in servicing their loans. Debts were rescheduled, extra funds were made available and economic policies reshaped, but the difficulties have not yet been resolved. Australian banks have been expanding their operations internationally over recent years and were not untouched by these developments. However, their international business is widely spread geographically and their exposure to these heightened risks, in aggregate, is relatively small. There is some discussion later in the Report of the Bank's surveillance of the international operations and exposure of the banks.

The foreign involvement of our banks is only one, and perhaps not the most important, element in the growing “internationalisation” of Australian financial activity. The implications of closer linkages between foreign and domestic financial markets for financial conditions in Australia were noted earlier.

The growing links between Australian and foreign financial markets have also been a factor leading to the reorganisation of ownership of a number of intermediaries. Other factors have been a widespread change in view about the effectiveness of consortium-type operations and anticipation of the effects which might flow from the recommendations of the Committee of Inquiry into the Australian Financial System (the Campbell Committee). The Government's foreign investment policy has an important bearing on proposals for reorganisation. The Bank's requirements are also relevant in two important areas, namely banks' associations with merchant banks and the ownership of authorised dealers in the short-term money market, both of which are discussed later in this Report. Reorganisation in accordance with the wishes of the owners should generally lead to more efficient provision of financial services and should be facilitated so far as is consistent with the official policies referred to above.

In last year's Report, the Board expressed support for the general thrust of the recommendations of the Campbell Committee whose final Report was published late in 1981. While welcoming the implementation of changes which were consistent with the Committee's recommendations, the Board believed that further similar steps could usefully be taken, in particular the removal of the remaining controls on banks' interest rates.

The Board's view is that the ceilings applying to these rates of interest are inimical to efficiency and equity in financing and are not fulfilling a useful purpose for monetary policy. The controls can hinder the ability of banks to compete with other intermediaries and in the long run tend to work to the disadvantage of the small borrower. In the Board's view these controls also should be withdrawn.

The Board fully understands the Government's desire for an appraisal of the Campbell Committee's recommendations taking account of the Government's economic and social objectives as well as of the need to improve the efficiency of the financial system. It welcomes the Government's decision to establish a small group under the chairmanship of Mr V.E. Martin to report against that background. The Board hopes that when this review is completed it will be possible to make further changes.