Reserve Bank of Australia Annual Report – 1992 The Focus of Policy
Progress towards sustained economic recovery and restoration of the banking system proceeded hesitantly over the past year. Monetary and banking policies are continuing to nurse these developments along, while at the same time seeking to consolidate the good progress that has been achieved in lowering inflation.
Monetary Policy: The Transition to Low Inflation
In 1991/92 Australia recorded an underlying inflation rate of less than 3 per cent, the lowest rate for two decades, and lower than in traditionally low-inflation countries. At the same time, economic growth remained well below the rate necessary to employ the labour and other resources available. Monetary policy was eased in several steps during the year in response to both these developments.
Inflation has declined in periods of cyclically weak economic activity in the past. On this occasion, however, there are good grounds for believing that a critical threshold has been breached, and that Australia can sustain a low-inflation environment. This positive outlook mainly reflects the recent pronounced change in inflationary expectations. For nearly two decades, an important part of the inflationary process was the momentum of expectations. As members of the community became accustomed to the idea that prices would go on rising, and adjusted their behaviour accordingly, this helped to perpetuate the inflationary process.
All indicators of inflationary expectations suggest there has been a real breakthrough over the past two years. Surveys of consumers now suggest an expected rate of inflation less than half that in the 1980s. Expectations of businesses about their own price rises are at record lows. Longer-term expectations also have shifted sharply downwards; long-term interest rates have fallen by around 5 percentage points from their levels of two years ago, as investors have lowered their assessments of future inflation. This experience contrasts with the response to the sharp economic contraction of 1982/83, when consumer price expectations and long bond yields changed little.
More generally, strategies which had assumed – indeed, depended on – high inflation are beginning to be rethought. Views about appropriate rates of return on assets and what types of assets to hold, as well as about what borrowing costs and gearing ratios are sustainable, are being recast. This process is still underway and it will be some time yet before the main economic players are fully attuned to low inflation. What is clear, however, is that the inflationary mentality of the past two decades is steadily being broken down in businesses, on factory floors, and in households across the country. As the constituency for price stability develops, so too will the prospects for sustained low inflation economic growth in the 1990s.
The improvement in inflation and attitudes has not come easily. For a time, progress was slow, while over the past couple of years it has been associated with a severe recession, with declining output and investment and high levels of unemployment. Part of this downturn in activity and employment can be seen as an inevitable adjustment to a previously overheated economy. In 1988 and early 1989, a strong world economy and buoyant terms of trade underpinned an excessive rate of domestic spending. The speculative surge in asset prices, driven by an aggressive appetite for debt, added to the excess. Labour costs were held in check by the Accord processes but these alone would not have contained the pressures for long. Monetary policy had to be tightened in response to these pressures and the ensuing economic slowdown and asset price collapse were bound to have some painful consequences.
As the economy turned down, monetary policy could have sought either to minimise the fall in output and employment or maximise the reduction in inflation. In the event, policy sought to avoid either extreme. To have directed policy solely towards minimising the downturn would have let slip the opportunity to make sustained progress on inflation: everyone supports action against inflation in boom periods, but the authorities must also demonstrate their anti-inflation commitment during downturns if they are to influence longer-term price expectations. A clear message was therefore conveyed that lower inflation was an abiding objective of policy, not simply an accidental by-product of economic downturn.
This objective, however, was not pursued to the exclusion of concern about the cyclical downturn and high levels of unemployment. The tight policies adopted earlier to deal with the overheated economy could have been maintained longer if minimising inflation had been the single-minded objective. Instead, policy has been pursued with an eye to the implications for activity and employment, as well as the need to achieve a breakthrough in perceptions about inflation.
Pursuing a balance between inflation and activity objectives imposed a speed limit on policy easings. Domestic considerations dominated here, but an important practical factor at times was the behaviour of the exchange rate. The Bank has not sought to resist well-based, orderly falls in the exchange rate but it has been mindful that attempts to lower interest rates too rapidly could trigger sharp falls in the currency which would be difficult to retrieve. Such falls risked not only jolting confidence in the economy but also limiting the opportunities for sustained interest rate reductions. Similarly, if the reductions had run too far ahead of market expectations, long-term interest rates would probably have risen, thereby also constraining the scope for further reductions in short-term rates.
At times, the reductions in official interest rates did run ahead of public and market opinion. The earlier easings in particular were viewed by some as premature and implying a return to “stop/go” policies and the abandonment of any medium-term price stability objective. Subsequent developments have given the lie to such views.
Three phases in the easing process can be identified. In the initial phase, during 1990, interest rates were reduced relatively quickly. By mid October 1990, five easings of policy had occurred, and cash rates had fallen by 5 percentage points. This was before the extent of the downturn in activity, and the progress being made on inflation, were widely apparent. It was also before the bond market had given any lead; bond yields stayed high through this initial phase.
In the second phase, from late 1990 to mid 1991, cash rates and long-term rates moved down together, as evidence of a structural break in inflation, and a weaker economy, became clearer.
Over the past year – the third phase – short rates moved noticeably below long rates, with the authorities initially more confident about prospects for low inflation than the markets. On a couple of occasions, easings of cash rates were followed by a rise in long rates, but this tended to be short-lived, and over the year the whole structure of interest rates moved down.
The calibration of monetary policy was, as usual, imprecise. Real interest rates as conventionally measured have remained relatively high throughout the downturn, suggesting a firm monetary policy. The shape of the yield curve provided some indication of the shifts in inflationary expectations, but little precise guidance on policy settings. Monetary and credit aggregates can at best provide only a partial picture, although they also suggested that policy was quite firm.
Two unusual factors in the latest downturn made the interpretation of events more difficult. One was the bursting of the asset price bubble, which had a pervasive dampening effect on business. This is clearer in hindsight; at the time it was not obvious, the more so since the 1987 stock market shake-out had had little or no effect on general business confidence.
Secondly, the recession was characterised by disparate performances among the States. The effects of falling asset prices and the associated impacts on financial stability and confidence were concentrated most heavily in those areas which had become most overextended. Victoria (and more lately South Australia) suffered the worst falls on most measures of economic activity, whereas Queensland showed only a relatively small contraction and a more vigorous recovery.
Each cycle has its own peculiarities, and policy has had to rely on judgments: there are no simple rules. Over the past two and a half years, these judgments have resulted in short-term interest rates being cut by over 12 percentage points. During the same time substantial progress has been made in reducing inflation and price expectations but, against that, output and employment have declined.
The policy task now is to consolidate the recent gains on inflation as the economy recovers. Signs of a cyclical upturn in economic activity began to emerge during 1991/92, led by a firmer trend in consumer demand and a pick-up in housing. Compared with earlier cycles, however, the recovery has been modest, hesitant and uneven. In part, this reflects the different conjunction of “external” events; the recovery in the early 1980s, for example, was boosted by the breaking of a major drought in mid 1983, and by a more robust world recovery than has been the case on this occasion.
The slow pace of this recovery also reflects the ongoing adjustments made necessary by the excesses of the late 1980s, which have continued to have their effects on asset prices, balance sheets of financial intermediaries (and other businesses), and confidence. Other structural changes have been occurring throughout the economy as businesses have adjusted their work and management practices in an effort to become more competitive. These adjustments are ongoing but the severity of the recession has forced the pace of change in this area.
The positive side of these adjustments is that important “fundamentals” for the Australian economy are moving in a favourable direction. Despite the difficulties of the past couple of years, business profitability is relatively good for this stage of the cycle and lower interest rates have reduced debt burdens. The financial system, for all its recent problems, remains well capitalised and in a position to respond positively when the demand for funds picks up. Low inflation also will change behaviour in ways which are beneficial for growth. The focus on short-term performance, and particularly the emphasis on capital appreciation which characterised the 1980s, should diminish. In its place we can expect to see investors in both physical and financial capital being more prepared to take longer-term risks. Together with the company tax imputation reforms introduced in the late 1980s, sustained low inflation will lead to changes in the mix of financing between debt and equity. Solidly based investments will be better supported, while poor performances will no longer be masked by inflation.
In short, although overlaid with some immediate difficulties, the Australian economy now is structurally very much stronger than it was when Australia was emerging from the recession of the early 1980s.
An early return to a solid rate of growth is not inconsistent with the maintenance of low underlying inflation. Indeed, employment growth needs to be restored promptly to minimise the atrophy of skills and the onset of social problems which are among the legacies of long-lasting recessions. Reasonable wage outcomes, and sharing of productivity gains with consumers through lower prices, will help both to reinforce a low-inflation culture and to return some of the gains from lower inflation to those who have suffered most in the process of reducing it.
From the perspective of monetary policy, an environment of low inflation and inflationary expectations remains crucial for sustainable growth. Terms of trade or other shocks can push prices off track from time to time in any economy, and inflation can be expected to come under upward pressure again in Australia, even if that prospect seems distant at present. Monetary policy must be ready to respond to that eventuality. Recent experience indicates that monetary policy, in combination with wages and other policies, can check inflationary pressures. Despite the expansionary impetus flowing from a strong world economy, and the lift in the terms of trade in the late 1980s, inflation in Australia actually edged down over that period, in contrast to earlier episodes in Australia, and to the experience in most OECD countries. The capacity to cope with future inflationary shocks will be greatest if the community generally is convinced of the benefits of low inflation.
The Financial System: Consolidation and Adjustment
Good economic performance depends in part on having a financial system which is strong, responsive and enjoys the confidence of the community. These tests have not always been fully met over recent years and financial institutions in Australia, as in many other countries, have had some rebuilding to do.
In any recession, some borrowers – and particularly those dependent on continually growing incomes and cash flows – will have difficulty servicing their debts. Superimposed on this difficulty in the latest cycle has been the sharp fall in property and other asset prices, which has caught out many borrowers who had leveraged themselves in the expectation of capital gains. It has also caught out lenders who had allowed their credit assessment standards to become too lax. One result has been a sharp increase in intermediaries' non-performing loans, and substantial write-downs of assets, particularly property-related loans. The profitability of banks and other intermediaries has suffered as a consequence. The situation has not been helped by the slow pace of economic recovery to date and the generally slow growth of balance sheets; assets on banks' Australian books grew by only 3 per cent over the past year while assets of the main non-bank financial intermediaries fell by 8 per cent.
For all that, the Australian financial system has stood up well to the strains of the economic cycle and the asset price collapse. Despite the recent loan losses, the banking system remains well-capitalised by international standards and retains public confidence, if not public acclaim. Some non-banks have failed but no major systemic problems have arisen. Cost-cutting and rationalisation measures are continuing as players compete for territory on a crowded field.
The structure of the financial system has undergone further changes as the balance sheets of non-banks have contracted, more subsidiary finance company and merchant bank businesses have been absorbed by parent banks, and the largest building society in the country has converted to a bank. Banks now account, in their own right, for almost half of the total assets in the financial system, compared with 40 per cent ten years ago; over the same period, the share of non-banks fell from 30 per cent to under 20 per cent while the share of funds managers rose to over 30 per cent.
Some fund managers, and particularly superannuation funds, have grown more quickly than the banks, and could continue to do so over the 1990s as their inflows are boosted by the new Superannuation Guarantee Charge and the wider availability of retail superannuation products. Banks are planning to respond to this challenge with superannuation products of their own. To the extent that sustained lower inflation causes a shift in funding preferences from debt to equity, and promotes the corporate bond market, there would be added pressure on the balance sheet growth of the banks in the 1990s.
The increased involvement of banks with superannuation and other funds management activities, either in subsidiaries or through alliances with other institutions, raises important supervisory issues. The Bank's primary obligations are to bank depositors. This was reiterated in a new prudential statement issued in February 1992 in which the Bank emphasised the distinction, for prudential purposes, between bank deposits and investment products offered by subsidiaries of banks, and the need for this distinction to be made clear to investors.
Prompted partly by changes in the structure of the financial system and partly by its recent experience, the Bank is pursuing further improvements in its own supervisory practices. To this end, efforts have continued to upgrade the quality of information received from banks on their loan portfolios, and to develop an in-house capacity to undertake limited on-site examinations of banks in certain circumstances. The Bank also reached formal understandings with relevant State Governments to put supervisory arrangements for State banks onto a much firmer footing. A new Council of Financial Supervisors, which will comprise regulators of banks, life insurance and superannuation, the securities industry and the State-based building societies and credit unions, is being established to tackle, inter alia, possible overlaps and unintended gaps in the supervision of the financial sector.
The general task for all supervisors is to improve their craft in ways which avoid the problems of recent years without overreacting and returning to the intrusive regulation of earlier eras. The latter would set back the capacity of the financial system to respond to the vital but changing needs of savers and borrowers. Again it is a matter of striking a balance between objectives – in this context, between providing reasonable assurances to customers of financial institutions and acknowledging the necessity for ongoing financial innovation.