Reserve Bank of Australia Annual Report – 1990 The Year in Brief

The economy slowed noticeably over the past year, after a period of excessively strong growth in domestic demand. Monetary policy was adjusted to reflect this slowdown. The Australian dollar was relatively steady throughout 1989/90. By the end of the year, both inflation and the deficit on the current account were showing signs of some improvement, albeit from disappointingly high levels. The end of the year also saw parts of the financial system experiencing serious difficulties.

The combination of sustained monetary tightness and economic slowdown has squeezed profit margins for many businesses. Another important influence has been the fall in asset prices, after several years of appreciating values. While necessary, this reversal has contributed to the recent difficulties of some financial institutions.

A progressive tightening of monetary policy, which commenced in April 1988, pushed interest rates to very high levels; during 1989, interest rates averaged about 10 per cent in real terms, (i.e. after allowing for current inflation). Even so, they took some time to bite into domestic demand. Several factors contributed to the lag. First, the momentum behind spending was extremely strong, underpinned as it was by a long-awaited surge in investment and by buoyant external conditions. On top of that, there was a speculative element based on the attractiveness of geared investments in property and other assets. In addition, there was for a time a belief that the various rises in interest rates would be short-lived.

The sustained monetary tightness, however, made its mark in the second half of 1989. Domestic demand flattened out, with particularly sharp corrections in business investment and housing. Credit from financial intermediaries grew during 1989/90 at roughly half the rate of the preceding year, while prices for commercial property and many other assets declined as the year progressed.

Domestic production also slowed during 1989/90 but less than domestic spending. This reflected continuing growth in export volumes and a fall in import volumes through the year. Given these developments, and continued overall wage restraint, the slowdown in employment has been moderate, at least to this point.

The role of monetary policy in 1989/90 was essentially to help manage the substantial macroeconomic adjustments in the economy. By early 1990 it was clear that the policy was achieving its primary task of eliminating excess domestic demand, and thereby contributing to a lessening of pressures on inflation and the balance of payments. In these circumstances it was no longer necessary or appropriate to maintain the earlier degree of tightness. Short-term interest rates were reduced by three percentage points between mid January and early April, leading to significant reductions in the whole structure of interest rates.

The reductions in official interest rates followed deliberations by the Board and consultations with the Treasurer. They were clearly enunciated at the time by the authorities. This helped to avoid potentially destabilising speculation — particularly in the foreign exchange market — and contributed to the effectiveness of the policy actions.

The major task of monetary policy in recent times has been in eliminating excessive domestic demand pressures. This, in turn, is having a number of consequences. It is reducing pressures in the goods and labour markets and thereby helping to achieve a better inflation outcome than would have resulted had excess demand continued and fed into price and wage decision making. It is also reducing imports and thereby contributing to an improvement in the current account deficit, notwithstanding some partial offset to this through the relatively high exchange rate. The removal of the excess demand component of the current account deficit has been an important objective of monetary policy over recent years. Imports have fallen as the economy has slowed, but the removal of structural — as distinct from cyclical — elements of the current account deficit is dependent largely upon policy measures in other areas.

It is, of course, artificial to view economic developments and economic policies in terms of snippets of discrete twelve-monthly intervals. A much longer timeframe is necessary, both to observe and to assess the processes at work. It is now clear that the crucial adjustments — particularly in terms of reduced inflationary pressures and import demand — are starting to come through. Further advances can be expected on these fronts over the year ahead and, provided policy makers grasp the opportunities inherent in current developments, in the years beyond.

Monetary policy continues to have an important role. Its task is not completed with the removal of excess demand pressures; rather, monetary policy will need to remain relatively tight to help wind down inflation and avoid any early resurgence in demand. Lower inflation will assist in improving Australia's savings and competitiveness but different policies must also attack these and other structural problems if sustained and excessive reliance on interest rates (with all that that implies for business investment and competitiveness, especially in the traded-goods sector) is to be avoided.

At this time, the external environment appears relatively conducive to continuing adjustments in the domestic economy, although export prices have declined in recent months and could drift lower as the world economy slows a little. Any pronounced fall in prices of commodities of major relevance to Australia would reinforce the urgency of further adjustment. Another potentially unhelpful factor is the threat to community confidence that could arise if the difficulties being experienced by some non-bank financial institutions were to spread. These difficulties have diverse sources, including over-exposures to commercial property developments, poor management, and breakdowns in supervisory and other standards, including commercial morality.

The Bank will continue to be substantially involved in managing these problems to minimise the risk that lack of confidence in particular institutions might spill over to well managed and sound institutions, or to the financial system more generally. Fortunately, the Australian financial system is fundamentally very sound and well able to cope with stresses of the kind experienced during the past year. The banking system — which accounts for about 75 per cent of the assets of all financial intermediaries — is particularly solid and will continue to underpin, both directly and indirectly, the essential stability of the system as a whole.

“… there is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

J.M. Keynes
The Economic Consequences of the Peace, 1919