RDP 9212: Changes in the Characteristics of the Australian Business Cycle: Some Lessons for Monetary Policy from the 1980s and Early 1990s 4. Concluding Remarks

Following the liberalisation of Australia's financial markets, there have been important changes in the characteristics of the business cycle and the monetary transmission mechanism. Monetary policy now works primarily through movements in interest rates, which induce wealth and intertemporal substitution effects. But the transition to this market-oriented system from the more liquidity-constrained financial environment that preceded it, was not an entirely smooth process.

During the 1980s, improved fundamentals and financial liberalisation combined to push up asset values and borrowing in a period of buoyant business expectations. The evidence suggests, however, that speculative dynamics characterised by positive feedback and international spillover effects may have pushed the process too far. Two lessons were drawn from this. First, asset prices (and borrowing) may be relatively insensitive to interest rates when speculative dynamics are present. Second, asset values are important in financial intermediaries' lending decisions, regardless of what is driving them. If they overshoot, and then decline, the quality of banks' outstanding loans is undermined, and a period of cautious lending attitudes may follow. Such effects appear to change the usual pattern of the business cycle. Such episodes can complicate the task of monetary policy. During the upswing phase, authorities must choose between raising interest rates higher than otherwise or, alternatively, permitting asset values and borrowing to rise even higher, with prospects for greater financial fragility problems later on.

It was argued, however, that it would be unwise to extrapolate the difficulties of conducting monetary policy in the second half of the 1980s, given the structural changes under way at that time. Policy makers should certainly not over react, by coming to regard asset price changes as unacceptable. Proposals to target asset price inflation in much the same way as goods price inflation come very close to such a judgment. The price of assets relative to prices of goods changes in response to expectations about future activity. Such relative price changes play a key role in business cycle dynamics. In this sense, improved growth of the Australian economy, and elsewhere, may require better fundamentals and an increase in the relative value of assets as a pre-requisite. This need not risk increased goods price inflation, though later in the cycle it will be important to ensure that asset price inflation does not become excessive.

The floating of the $A has also affected the nature of the Australian business cycle, by fundamentally altering the way in which the international business cycle is transmitted to the domestic economy. Real income shocks arising from fluctuations in Australia's terms of trade, which is strongly influenced by the world commodity price cycle, often drove bouts of inflation when the exchange rate was more heavily managed. Since the floating of the exchange rate, this source of pressure on domestic production and (via the Phillips curve) inflation has, for the most part, been eliminated. The counterpart to this, however, has been sharp swings in the nominal (and real) exchange rate. Such swings affect performance in the traded-goods sector, and also lead to direct effects on domestic prices and wages. Both are important considerations in any assessment of Australia's approach to monetary policy.

An intriguing aspect of Australia's recent economic performance, however, is that manufactured exports have performed extraordinarily well in the face of major swings in the exchange rate. The sharp fall in the exchange rate in the middle of the 1980s may have helped to stimulate investment in the non-commodity exporting sector, while also facilitating initial entry into foreign markets. Once “beachheads” were established, the partial reversal of these competitiveness gains in the second half of the 1980s did not have a symmetric adverse impact. In addition, there have been substantial changes in Australia's linkages with the rest of the world. Policies to internationalise the Australian economy through reduced protection and other measures have seen non-commodity exports rise as a share of GDP. This is explained partly by sustained strong growth in the Asia-Pacific region, and partly by Australian manufacturing exporters improving their market share in a number of regions. The apparent importance of these other factors, implies that monetary policy focused on low inflation need not be associated with major resource allocation costs as the exchange rate adjusts to terms-of-trade shocks.

Increased internationalisation has also seen Australian imports rise as a share of GDP. This factor suggests that import prices, and hence the exchange rate, have become more important for domestic inflation and monetary policy considerations.