Transcript of Question & Answer Session The Economic Outlook

Mr Stevens, given that the monetary policy of Australia was relatively successful compared to other parts of the world and you are not so inflicted with other monetary areas in the world, do you have an idea how this fiat money in Europe and the US will ever leave the market again?

Will ever leave?

The market again?

I think the – there are two lenses through which you might contemplate that question and I think we have a session this afternoon on some of this. There's the technical lens, how do you go about extracting the – the cash that's in the system when the time comes and I don't really think that's a technical difficulty. I think the Fed being the most advanced will have thought about that and I'd be pretty confident they can accomplish that in an operational sense.

The other lens is the broader sort of political economy overall setting and I think that that will be a difficult challenge for all the central banks that have done so-called unorthodox policies. I think it's always hard to tighten policy. I can tell you, even conventional policy, when the time comes to tighten there's all sorts of people with arguments as to why you shouldn't do it, that's – you know, we know that, that's part of the process and we're accustomed to dealing with it. That will be the case with withdrawing the cash as well and that is why it's imperative I think that the independence of central banks be preserved and that we retain clarity about what the longer-run goals are. If we do that then I think there's a reasonable hope that this can be accomplished reasonably successfully. But there are, you know, conditions we need to remain in place for that to be so.

It's been some time since you've mentioned the FX rate and I'm wondering if the RBA still feels that the Aussie is overvalued and whether 90 is still the unofficial level in the sand if you will.

I'd be very reluctant to draw lines in the sand in the exchange market, but what we've said; it's worth giving some context here. When the currency went very high, when the terms of trade were soaring to easily the biggest episode in – probably since the 1850s, we didn't feel that it was appropriate to try to limit that, given the size of the event. When the terms of trade started to fall and the exchange rate seemed initially unresponsive to that we thought that was odd, probably unhelpful if it persisted and we said that. Happily enough the currency is now well down off its peak.

I would say that from here it really depends on what you think the fundamentals will do. The assumption that we make about the terms of trade, and it's very transparent in our published material, is that they will fall further. We are probably not as pessimistic as some observers but nonetheless we think that commodity prices will be softer on average in the future than they've been in the recent past, our terms of trade will be lower. It would be quite surprising in that world if that comes to pass if the Australian dollar didn't depreciate somewhat along with that. So if you buy our set of assumptions about the future terms of trade I think that draws you to the conclusion that the long-run equilibrium of the exchange rate is probably lower than what we presently observe and we've been quite consistent in saying that.

In regards to the handover from the mining sector to the non-mining sector, is my impression right that the non-mining sector – in order for overall growth to remain the same, the non-mining sector will not just keep its current growth rate but actually the growth rate would have to accelerate with regards to that?

That's right.

And how do you see the risks? Do you think it's a symmetric risk or is it just the risk that non-mining sector won't grow enough to make up?

The premise of your question is correct. The rate of growth of the non-mining sector and you have to – you have to do a bit of number work and make the odd heroic assumption to even put a figure on what the non-mining sector is and what it's growth is, but you know we've done that, and it's growth's been very much sub trend for several years. So if this works out nicely that growth is going to pick up to maybe be a little bit above it's trend pace over the next year or two as mining comes down and the total will be – will be adequate.

The balance of risks, it's – it's hard to say. I think probably up until this point we would have said that waiting for – waiting for business investment to turn up you always wait a long time for that and my memory of previous cycles is we always waited longer than we kind of felt we really should have to wait, but that's the way it is. I think it's pretty clear that some elements of this like the residential construction side, and that's only a modest part of it, but it's pretty clear that's going to turn up very strongly, you know we're going to have a boom in residential construction over the next couple of years. So that's, I would say, very much on track. Consumers, I'd say, largely on track. The non-mining business investment part, it's just too soon to know yet I think there are promising signs but that's all you can say at this point because that's inevitably the way it is. So there remains I guess some risk that that doesn't pick up on cue. Separate question what one can really do about that if that turns out to be the case, to be honest with you, because it's not amenable to fine tuning.

If you look at the components of Australia's CPI over the past decade or so, services inflation has run at around 4 per cent and goods inflation has been close to zero. If you take the assumption that China will export more inflation and deflation verses history and the Australian dollar will weaken at the margin, would you expect that to become a problem in terms of the overall inflation level?

I think – well let's frame that with the current forecast which is on, I think it's on about 89 or 90 for the exchange rate by technical assumption, that's all that is, a technical assumption not a forecast itself. I think we're okay relative to the inflation target there. I think if the exchange rate comes down but that's in the context of terms of trade declining and the contractionary things that that brings then you've got – I guess there's some low level at which it could give us a problem but I don't think that we're in danger of seeing a serious outbreak of inflation over that sort of scenario. And bear in mind that for the non-traded part, the part you're referring to which is mainly services, the degree to which labour costs have slowed quite markedly, you know, the wage price index is recording about its lowest rate of increase at the moment in the history of that survey which is about 15 years. I think you'd have to feel that while ever that's the case we can probably absorb the temporary hits from the exchange rate going down without too much trouble, that's my sense at the moment.

Mr Governor, here, just a question how much consideration do you put into the asset price when you're conducting monetary policy? Take Greenspan's time, obviously we know that they probably not enough attention to the US asset price, particularly housing price I mean. Coming back to Asia we already see that China's property price has started cracking, Hong Kong property price already coming down and probably Australia is only major western country hasn't seen significant adjustment in the property sector. So how much risk do you consider this is going to be? Thank you.

Well there are two questions there and one of them is the extent to which we pay attention to asset values and the answer to that is I think we've always been in the camp for a long time now, where we felt asset prices, and particularly – it's not the asset prices per say or not those alone that's the thing, it's the leverage. So unleveraged asset booms and busts I think are much less damaging, you know if you want to have an asset bubble in rare stamps or works of art I'm not that worried frankly, because the banking system isn't providing the leverage. Houses or commercial property really historically in many countries has been probably the number one source of problems for when banks get into trouble you'll – you know many, many, a very high proportion of the time you'll find its commercial property that's the culprit. And as you say in some countries in the past decade housing values have come to the fore as well because household leverage is much higher. So we've always felt that was important, we've not gone to the point of feeling that you should make a particular level of asset value as a formal objective of policy, I don't think you should do that but I think you ignore asset and credit market dynamics at your peril. So we pay a lot of attention to it.

The second part of the question is what's the extent of the risks and the position that I've had over time is – let me give a few bits to this. There are people who think that Australia has got a bubble. You can never be 100 per cent sure that you haven't, you never say never. My observation simply is that the price-to-income ratio for the household sector as a whole, it's been around four for 10 years, up and down a bit around that mean. That's higher than it used to be but it's been there for about 10 years, so a very long running bubble if it is indeed a bubble; most bubbles don't last that long. The second thing I'd say is that – and we're on record as saying that some increase in housing prices in a cyclical sense that we've had in the past year, it's a bit soon to get on the soap box about that because that's part of the normal cyclical dynamic, that's the second point. The third point is I think it would be unwelcome if we keep getting 10 per cent a year or more particularly if people think that 10 per cent a year is now the norm and there's no risk of a decline. As I said earlier we've had housing values go down twice for a year or so at a time, twice that's happened in the last 10 years. It does happen and people shouldn't assume that it can't. And provided they keep an appropriate sense of the risk and we keep the leverage contained then we'll probably be okay. There's one down here.

Another question on the thorny issue of the handover. So, and this is following up on what was asked earlier, it seems like your assessment of aggregate growth with taking into account the resource dependent sector as well as the domestic sector that is rebounding from sub-trend growth solves for a fairly high number, on aggregate. For example, if we compare to the US, at least what the Fed thinks trend growth is, it seems like you're expecting Australia to do better and even to accelerate over the next couple of years. So my question is for one, why would Australian trend growth be that radically different from the US, in general over a long time because generally speaking these economies in many ways are going to be similar, except the fact that Australia is now dealing with the aftermath of the resource boom. Especially given your assumption about deteriorating terms of trade, obviously historically big deviations from trend growth to the downside during these periods. So it seems like – so two questions; is Australia's trend growth – why is your perception of it so high or it seems to me that it is high and secondly isn't it natural to be below trend for some time?

It is natural to be below trend some of the time we have been for the past 18 months.

That's a very short period of time though, right?

It's long enough – it's long enough to make a difference to things and you know the clearest metric of that is the rate of unemployment has been going up in that time and it's almost certainly I would say – I don't know where the NAIRU is but we're higher than it at present. What's the trend pace of growth? I'd still say that at the moment potential growth is probably about three, the number before the decimal point I'd say is three, the number after isn't a very big number, so it's three, a little bit over three, I don't – I'm not sure what the Fed says about the US, probably two point something.

2.25.

Yeah well I don't think our potential growth is as low as 2.25. If I take historical productivity performance, which I think we're getting back to now having been a bit poorer than that, and I take population growth of one and a halfish for working age population, we've actually got pretty fast population growth for an advanced country. So you're going to get to three at the moment pretty easily. In time, thinking out over you know a five to 10 year horizon there are reasons to think potential growth comes down, to do with demographics and we will get that effect and we'll have to re-calibrate what we think of potential as that – and this is starting but it hasn't gotten very far yet. But right now I think the economy has got ample – ample potential to grow at three, and we've been below that and we're still below that. The short-term forecasts are we stay a little bit below it for a little while yet before we get above.

Hi, this is a follow-on question regards to inflation as well as with the handover from the mining sector to the domestic industries. Now, if as expected you see the handover go very well while the terms of trade is deteriorating it's quite likely that inflation will be raring it's ugly head, while growth may not necessarily be accelerating at a great pace. In your mind which will take a higher importance, control inflation or maintaining growth?

Well I'm not sure that I'd agree that the scenario you paint will lead to serious problems with inflation when historically if the terms of trade are declining, much less income and that's in itself as a shock, it's contractionary for the economy, so you wouldn't expect inflation to rise, exchange rate goes down, that helps offset the contractionary shock and it could give you, you know a one-time lift in the price level but then we'd be looking at what expectations are doing and I think expectations remain well anchored and really that's the key thing. The key thing in dealing with all these shocks from a monetary policy point of view is if you can keep the expectations anchored you've got a much better chance of riding both on the real economy and the price side through successfully. And I think our inflation target is credible, we've been running it for 20-plus years now, we've achieved it, we'll still be achieving it, I think it is highly credible and expectations are well anchored. If that weren't so then I'd be much more worried.

Mr Stevens, so to follow up on the property prices, how concerned are you about the low level of interest rates potentially fuelling part of a bubble and how much do you take that into account when you set monetary policy? Thank you.

Well as I said earlier we pay a lot of attention to asset values. I think I would say that in trying to assess whether policy is having the effect that we would expect, what would you look at? Well one of the things you look at is you look at credit growth, which has remained low so far. You'd look at what are the savers doing with their money, are they behaving in a way that suggests they see a signal to, you know, lighten up on their holdings of very low risk assets where the returns have gone quite low and take a bit more risk. That's part of how monetary policy works, that's what's supposed to happen and it is happening. And the housing prices are part of that dimension as indeed are demand for equities.

So we pay attention to that and in calibrating have we got the setting of the cash rate correct that's one of the things we're looking at, are the things occurring through the spectrum of financial and real assets that should be occurring if we've got an easy setting? I think the answer to that is yes and that's why we've been sitting still. So we pay a good deal of attention to that. The possibility of a bubble is always something that one worries about, that's why we give warnings about don't just assume prices always rise; it's okay for them to rise but don't forget they can fall as well so watch the leverage. That's really the main – the main thing there and we're trying to I guess you know keep the financial stability side of our mandate in view as well as the price stability-full employment side.