Reserve Bank of Australia Annual Report – 1988 Monetary Management in 1987/88

The economic environment

The first half of 1987/88 — both before and after the October share-market crash — was characterised by an almost universal failure to recognise the underlying strength of world economic growth. As forecasters were starting to raise their estimates, the sharp fall in equity values revived earlier fears of a general economic downturn. In retrospect, the share-market crash seems to have had only a modest and temporary effect on the real economy. Its main impact was on financial markets. By the middle of the March 1988 quarter, it was clear that growth had continued, but even then its momentum was underestimated for a while. Official estimates of growth and of world trade were progressively marked up sharply.

Inflation remained subdued in the major countries during the year. The fall in share prices dampened inflationary expectations but this too was temporary. Upward revisions of the pace of economic growth and the strong recovery in commodity prices rekindled concerns about future price rises. Control of inflation again became an explicit aim of policy in a number of countries.

The year was also marked by improved policy coordination among the major countries. Continuing concern about trade imbalances consequently did not unsettle foreign exchange markets as much as in previous years. In October, when share prices fell sharply around the world, and negotiations for cuts in the U.S. Federal Budget deficit were still in progress, the U.S. dollar came under heavy selling pressure. However, concerted intervention by the major central banks reduced short-term instability and this, together with some emerging evidence of improvement in U.S. trade figures, helped to strengthen the U.S. dollar. Leaders of the major nations meeting in Toronto in June 1988 stressed the desirability of stability in foreign exchange markets and the need for continued correction in the balance of domestic policies.

In Australia, further progress was made in 1987/88 in reducing public sector calls on the nation's savings and resources. The Commonwealth budgeted for a substantial fall in outlays in real terms and total public sector expenditure was expected to make no contribution to growth in output. The public sector borrowing requirement was projected to fall by around one per cent of GDP. In the event, higher than expected tax revenues meant that the Commonwealth budget recorded a substantial surplus and the borrowing requirement was even lower than anticipated. Further cuts in public expenditure and borrowing have been foreshadowed for 1988/89.

Wages policy for the year involved a two-tiered wage settlement; the first tier was for an across the board increase and the second tier provided for further increases to be offset by productivity and efficiency improvements. Real wages fell and productivity rose; real unit labour costs fell to their lowest levels since the late 1960s. New wage-setting arrangements were under negotiation at the end of 1987/88.

In some ways, Australia's economic performance paralleled the rest of the world. Here too, the rate of growth and the strength of domestic demand were underestimated in the early months of the year. The stock-market crash was expected to check the strong rise in demand for goods which by then had become apparent. But it was a brief check. The perceived wealth effects of the fall in asset prices were limited largely to holders of equities. Although the fall in Australian share prices was larger than in most other countries, the earlier rise in Australian share markets had been so sharp that, by and large, expenditure patterns were not greatly affected. An important exception was increased demand for real estate which boosted prices, particularly in Sydney. Some major financial entrepreneurs who had been very active in the share market experienced quite spectacular reversals/adjustments. However, buoyed in part by good news from abroad, consumer and investor confidence recovered quickly. The upward trend in commodity prices accelerated, promising more buoyancy in mineral and resource industries. Very strong growth in private domestic demand, both for consumption and investment, was recorded in the year. Net exports, however, did not contribute to growth.

1 SHARE PRICES

Australia's inflation rate declined in 1987/88 though it continues well above those of our major trading partners. For the first time for several years, Australian prices were not boosted by a fall in the exchange rate. Wage growth was higher than in the previous year, but the level of real wages was little changed.

The share-market fall brought with it a sharp, though temporary, decline in sentiment about the Australian dollar. Before the event, foreigners had found Australian shares and real estate comparatively cheap, boosting their prices sharply. Equity raisings and credit had financed high levels of mergers and acquisitions, raising share-market turnover and prices. Heavy selling of Australian shares by overseas holders was accompanied by sales of Australian currency in the foreign exchange market. As well, there was a belief that world commodity prices would be adversely affected by the share-price crash and a view in many quarters that Australia could be worse hit than countries less dependent on commodity exports. More generally, in the immediate aftermath of the share-price fall, overseas investors sought to hold their funds closer to home and in more familiar assets, even at lower interest rates. Share-market turnover fell sharply over following months but by June 1988 share prices had recovered about a third of their fall in October. Apart from a brief pause, the rapid rise in real estate prices continued. Returning confidence was a factor in the strong upward pressure on the exchange rate over the June quarter. (See also the following Chapter.)

The stock-market collapse led to a flight by investors to assets regarded as safer. The banks were major recipients of investors' funds, particularly the savings banks. These banks were able to replace high-cost with low-cost funds and to boost to very high levels their lending for real estate, mainly housing, where activity rose to boom levels.

Following the collapse of the share market, conditions were conducive to take-overs and other forms of rationalisation of ownership. Equity finance, however, became difficult to raise.

Emphasis turned increasingly to intermediaries for finance. As a result, credit growth picked up strongly. Bank financing in particular rose sharply as borrowers' needs coincided with the switch by investors into more secure financial assets, including bank deposits and bank bills.

External adjustment

Correction of the continuing substantial deficit in the current account of the balance of payments is central to Australia's economic strategy. This calls for sustained improvement in the competitiveness of our industries, a broader productive base of the economy to complement resource industries and progressive transfer of resources into production for export or for import replacement.

Most of the competitiveness gained during the previous couple of years was retained in 1987/88. New investment in export and import-competing industries and the proportion of manufactured products in export totals are rising, though Australia will continue to be highly dependent, in the foreseeable future, on the resources industries.

The current account deficit was smaller both in absolute terms and as a proportion of GDP. However, most of the improvement was due to gains in Australia's terms of trade as a result of the strength of commodity prices. Much of the fall in our terms of trade over the past few years was reversed in 1987/88. Unfortunately, however, the strength of domestic demand contributed to higher import volumes, which grew more rapidly than export volumes. Unlike the two preceding years, net exports did not contribute to growth.

Australia's external debt remained high and net interest payments absorbed about 17 per cent of export receipts in 1987/88 (3 per cent of GDP).

2 TERMS OF TRADE AND CURRENT ACCOUNT

Monetary policy issues

The Bank faced some complexities in formulating and carrying out monetary policy during 1987/88. They arose from changing views of the strength of demand, uncertainty generated by the share-market crash and the very bullish tone of financial and foreign exchange markets for much of the year.

Fiscal tightening and moderate wage growth in prospect in the early part of the year offered hope that past reliance on monetary policy could be lessened. Indeed, given the buoyant tone in financial markets, domestic financial conditions eased over the first few months and interest rates declined, in some cases substantially. Emerging misgivings about whether the general setting of policies may have become too accommodating were put aside by the October share-market crash.

The crash had two effects on immediate policy. The first was a decision to underpin adequate system liquidity to avoid disorder and instability. The second was a preliminary assessment that the size of the market fall would check growth in demand and credit and remove the need for any re-tightening of monetary conditions. That assessment proved to be wrong.

Helped by the Bank's announced undertaking on liquidity support, markets stabilised fairly quickly. Investors sought higher quality havens for their funds, in the process pushing down bank interest rates.

For a time after October, some sluggishness in retail sales and better monthly figures for the current account obscured the underlying strength of the economy. However, as the March quarter advanced, it became increasingly plain that there was a need to dampen demand before it flowed too heavily into import volumes, prices and wages. Capacity constraints were appearing in the building industry and in some other parts of the economy.

Meanwhile, there was continuing strong demand for the Australian dollar which, over the course of the year, rose by about 6 per cent in terms of the trade-weighted index. Investors were attracted by a combination of factors, including rising commodity prices, Australia's relatively high interest rates and confidence that appropriate policy adjustments were continuing. They appeared undeterred by the possibility that the currency might be pushed beyond its longer-run sustainable value. Some other countries with relatively high interest rates had a similar experience.

This presented a problem. Unless matched by further tightening in other policies, falling interest rates (and perhaps a lower exchange rate in consequence) could boost domestic demand unduly, leading to pressures on wages, higher rates of inflation, increased imports and a deterioration in the current account deficit. On the other hand, a combination of relatively high interest rates and a sharply strengthening exchange rate, while imparting a restraining emphasis on the economy could, at the same time, unwind some of the gains in international competitiveness of recent years and discourage much needed new investment. It was not possible for interest rates to be used simultaneously to dampen domestic demand and demand for the Australian dollar.

The easing of monetary conditions was slowed and then halted in the March quarter. As evidence of potential overheating in the economy accumulated, monetary conditions were tightened in the June quarter. At the end of the year most short-term interest rates had returned to levels of a year earlier.

A year ago, it had been hoped that more stable conditions would emerge in the foreign exchange market, allowing the Bank to play a reduced role there. In the event, this was not always practicable in 1987/88.

Perhaps not surprisingly, investors with a short-term focus appear to pay more regard to policy measures themselves (higher interest rates, a strengthening exchange rate) than to the underlying economic problems that policy is addressing. As well, small, open economies are vulnerable to sharp shifts in world sentiment, the more so when, as in Australia's case, the current account deficit is being balanced by basically short-term capital flows. Under these circumstances markets can become very volatile and overshooting a familiar feature.

Foreign exchange market intervention by the authorities does not, of course, deal with the fundamental issues. However, it can smooth the path of an adjustment in the exchange rate and it can provide a breathing space while other policies are coming into effect or are being further adjusted. On both these bases the Bank was again very active in the foreign exchange market at times during 1987/88. In contrast to some earlier periods, strong demand for the Australian dollar predominated in 1987/88 so that the Bank tended to be mostly a seller of Australian dollars. The main exception was in the period following the share-market fall when selling pressure was very heavy and the exchange rate fell sharply. An account of the Bank's actions is given in the following chapter.