Transcript of Question & Answer Session Fundamentals and Flexibility

And here we go. Phil, this one’s to you. How do you expect the gap between growth in income versus growth in output to restore itself in your first chart? Do the lines converge or do we have an extended period where incomes lag output?

The main reason that growth in incomes is lagging growth in output is the decline in the terms of trade. It’s, it’s difficult to predict how they’re going to move in the future. They’ve fall, they’ve already fallen along ways as that chart showed but they’re still high by historical standards. And I think this is one of the big questions for us, what does the long term future commodity crisis look like relative to the price of manufactured goods which is what we essentially import? I, I personally think it unlikely that we go back to the level of the terms of trade we saw in the average of the 1990s. The world demand for commodities has increased a lot and we’ve moved up the global supply curve and so we’re moving into slightly more expensive all bodies around the world. So the costs of production, the marginal cost of production is higher and I think that means that the commodity prices on average are going to be higher relative to manufactured goods than they were in the 1990s. So I expect they’re still be a wedge between those two lines. The more critical issue, is how do we make both lines …

Yeah.

… grow strongly? And I think they’re, they’re some of the issues that I try to touch on.

And just to be clear on that, I guess that’s when you start talking about things outside of commodities. So when you start talking about other exports …

It’s …

… and other high value add.

Well, it’s not just exports. It’s the way we do internal non-traded goods and services as well to become more efficient and more productive as a nation in producing the whole range of goods and services that we do.

Could you comment on the adjustment of the economy as a result of the fall in the Australian dollar? How far has the economic adjustment come and how far is there to go?

Well, it’s a, it’s an extraordinarily large adjustment that we’re going through. In, in other talks I’ve tried to put in context the size of this adjustment and I think without exaggeration, we’ve seen the biggest commodities boom since the Gold Rush in the 1850s. Mining investment nearly went to 8 per cent of GDP. In previous mining booms in Australia in the, in the 20^th century have got to 3 or 4 per cent. So it’s extraordinarily large rise in mining investment. The terms of trade got to the highest level in 150 years. We digested that huge boom without the economy overheating and that was largely because the exchange rate went up, we had higher than average interest rates and the household sector was relatively restrained in its own behaviour. But now mining investments is falling back, the terms of trade are falling back and some of those adjustments that stopped the economy overheating are now unwinding and an important part of that is the lower exchange rate. And you can clearly see this now in our trade figures. There’s been very strong growth in exports of services and imports of services have slowed down as fewer Australians are travelling overseas. So we can see particularly in tourism, but also in a range of services, the lower exchange rate is working to help rebalance the economy. A critical issue that we still are faced is fairly low levels of business investment outside the resources sector. And I’ve talked on previous occasions about why that is, why that’s low. But that’s the thing we really need to see pick up for this transition to work out relatively seamlessly.

Business investment, okay. So we talked about currency. And another question here is, you haven’t mentioned fiscal policy as a fundamental strength and/or source of flexibility in our economy. I guess, what would you like to see from fiscal policy?

What would I like to see from fiscal policy? I think the main issue we have here is making sure that over medium term our fiscal accounts are in good order. We’ve seen in other countries where they got themselves into trouble, where effectively the population was offered something by the political class that ultimately could not be delivered. A whole range of goods and services without the taxing base to, or the willingness to tax people to pay for those goods and services. Fortunately, Australia didn’t have that problem, and we’ve got to make sure that that remains the case. So I think that’s the number one fiscal issue to make sure that the medium term fiscal accounts are sustainable. And then in the short term I think moderate fiscal consolidation along this medium term path makes sense.

We have one question from the floor. Thank you.

Good morning Nicole Chettle from the ABC. There are reports today about predicted declines in house prices about to, or property prices of 7.5 per cent and the broader impact that might have in terms of the economy. What’s your view? Are you concerned?

Well, it looks like that the rate of price growth in Sydney has slowed down a little bit. And in a way that’s not surprising because the supply of new housing is rising and you see this right across the country where the supply of housing increases, the rate of price growth eventually responds. And I, it’s too early to be definitive but I think we’re on the cusp of seeing the supplier response finally kick in moderating price growth. I hope that’s the case because as I’ve said a number of times over the past year, the risk of development in the housing market derailing the economy is increased a little bit. The risk in the housing sector is higher than it was a few years back. I think the measures that APRA have taken here have been sensible. They appear to be having a moderate effect. We’ve seen a tightening of lending standards through the banking sector, a repricing of loans, banks requiring larger deposits. And I think those things are gradually working their way through the system. But people, people do need to be careful here because house prices aren’t going to continue to rise much more quickly than income. Debt levels can’t keep rising faster than income. So people, people need to be careful. But the supply response does seem to be kicking in, and if that’s what’s happening that’s good news.

I suppose it’s interesting, I mean the … Phil, you took us through the falls in the terms of trade. We’re talking about a potential 7½ per cent fall say in residential property. Would the economy, I mean the economy could probably absorb that?

Well, I don’t, I don’t want to endorse that, that particular number. I mean house prices in Sydney, as opposed to a pub, but house prices in Sydney have risen by more than 20 per cent over the past year, and prices are still, are still rising. So I think, that ideally we would now go through a period of quite modest house price growth. I think that would de-risk household balance sheets a little and it would probably be good, good for the economy. So I don’t, that’s not my central scenario, the one that was subject to the newspaper stories this morning.

Okay, thank you. You seem to suggest that interest rates aren’t going to play an important role in improving living standards. Does that mean RBA thinks there is little interest rates can do to boost the economy?

I think interest rates are probably less effective than they, than they used to be. In earlier decades what we found was when interest rates were lower, it didn’t take that much for consumers to respond to borrow either for housing or more fundamentally for household consumption. Now house prices would rise and people would quickly go to the bank when interest rates were lower to extract some of the equity to buy a new car or to go on a holiday or to increase their spending. I think those days are over, or at least they’re over for quite a while. The household sector are really using the lower interest rates not to increase their consumption but to try to pay back their debt a bit more quickly. And so it’s quite a different dynamic than the one we used to be in. It doesn’t mean that monetary policies is not effective. I think we’re clearly seeing the effectiveness of that in the residential construction market. We’re just having a flow through effect so through to consumption, and obviously there are links between the exchange rate and interest rates as well. So interest rates are still working. I don’t think they’re quite as effective as they used to be. But as you prefaced in your question that, that interest rates are not the source of long term growth in living standards. Ideally what we want is a world in which interest rates rise because higher interest rates mean that underlying return on capital in the economy is higher. If underlying return on capital is higher, there’s more investment, there’s more growth. So the low interest rates are symptomatic globally of a lack of investment opportunities and a lack of growth and a return to something more normal I think would serve us all well in time.

No, that’s good to remember. Sorry, did you have another question at the back?

Yes I do. The US Central Bank says …

Can you hold the microphone closer please, it’s hard to hear.

I’m sorry. The US Central Bank says it’s taking a cautious approach in its deliberations over interest rates but there’s talk that they will rise this year. How closely are you watching that and what impact would that have here?

We’re obviously watching that very carefully. When they, when they finally do raise interest rates I think we should welcome that because it would be a sign that the US economy or the Federal Reserve thinks the US economy has enough underlying growth in the medium term to start the process of normalisation. If that’s, if that turns out to be the case I think that’s basically good for the world because a strong US economy helps the rest of the world as well. I think for us when that happens I would expect to see some adjustment in exchange rates, just as we’ve seen in the last couple of weeks, some adjustment the other way as the, as the timing of the markets expected timing of the adjustment been pushed out. I think the other thing that we’ll need to watch very carefully around the world really is, is capital flows as, as the US eventually raises rates some of the capital that’s flown to the emerging market economies will start, to some extent this already happened, will start flowing back to the United States and it’s possible that will create some stresses in capital markets. That’s something that we’ll need to watch carefully. But I think the main point is that we should all hope that the US Federal Reserve feels like it’s in a position before too long to raise interest, start the gradual process of raising interest rates there because that will be a sign that there is enough underlying growth momentum in the United States to start the normalisation process which I think is in all our interests.

We’ll maybe just keep going there. There’s another question here I guess, how do you maintain policy flexibility when the rest of the world is in a desynchronous state?

Well, we feel like we’ve still got quite a lot of flexibility. You know, our exchange rate moves a lot. It wasn’t that long ago that AU$1 would almost buy you $1.10. I think early last week it was buying you 0.69 cents. So the exchange rate, moves a lot and that as I said in my remarks is that the core stabilising influence in our economy. We still have flexibility on interest rates. We’re one of the few advanced economies that has not had to put our interest rates at zero which I think, is a good thing so we still have flexibility there. And because of our long history of um, fiscal prudence we still have flexibility on fiscal policy if we really were to need that. So, I think the Australian economy is, is proven to be remarkably flexible …

So …

… from a macroeconomic point of view, from macro management point of view I think that the more pressing issue is, how flexible we are at the micro level?

So I’ll maybe come back to the micro but just while you’re on that idea, you said currency has been a great release valve for us. You spoke about the importance of China and we’ve also seen, China trying to free up its capital market. What do you think about the exchange rate in China and how quickly should they actually move to a more flexible system on their exchange rate?

Well, this is a huge challenge for them and I’m not going to give them gratuitous advice. It’s been difficult. I mean every country finds this difficult. We found this difficult. It took us two decades and we tried almost every conceivable exchange rate regime. We had a penny against the pound, US dollar, trade against the trade weight of basket, a flexible, I think against the trade of basket and then a floating currency. So, we tried everything and the Chinese are going through a similar process that effectively will link to the US dollar, they didn’t like that as the US dollar rose and then they’ve tried to move to gradually to a more flexible system. Every country finds this difficult and the Chinese are finding it difficult as well. It’s very important ultimately for them and they say very publicly that they want a market determined exchange rate and the process of getting there as we found out and as many others found out can be tricky.

Maybe coming back to the micro again. Does Australia need to have a structural debasing of our total per unit wage costs? If so, how will this happen?

You’re asking whether the level of wages are too high?

Yes.

I don’t think that’s our fundamental problem. I mean, we want to be a high wage, high productivity economy. The solution, our salvation shouldn’t be in just driving wages down to be competitive in kind of mass produced goods, it should be having high wages built on high human capital, good technology, being competitive in global markets and that’s where the things that I’ve talked about are all kind of key. Over the last couple of years, wage growth has been very low, productivity, it’s basically matched productivity. So I think for 3 or 4 years now there’s been no growth in unit labour costs in Australia and that’s actually helping with the short run dynamics of the economy but as I said in my remarks that’s a part of the useful adjustment we’re going through. But just driving wages down to compete, isn’t our solution. Isn’t the solution here, it’s focusing on the structural things.

Okay. We’ve got a few minutes left for a few more questions. Um, this is along the, I suppose with the release of the IMFs revised downward projections of global growth, the Asian infrastructure banks are lower forecast for China GDP, um, and downward revisions I suppose around the world including talk of a recession in Australia, what is the likelihood that we are heading into a recession in your view?

I mean I think that’s a very difficult question. I think it’s, the probability of a recession is low but there is a probability that at some point we will have a downturn. I mean the idea that the Australian economy can just keep growing without having periods of short periods of contraction I think is a mistake. What we should be hoping for is that when those periods inevitably happen that they’re short lived and the economy adjusts quickly to deal with it and as we said in our previous conversation, I think we do have those key elements of flexibility with, still with interest rates, with the exchange rate and ultimately with fiscal policy that’s needed. So this fascination about will we or won’t we have a recession at some point? And I personally think that’s slightly misplaced and the issue is really when those periods happen, how do we best deal with them? And flexibility again is the key.

Live the cycle.

Yeah, there will be a cycle. I mean, we’ve had, as that graph, those graphs that I showed, we had a remarkable 25 years, let’s hope something like that continues but we can’t rule out the possibility again of having a period where the economy contracts. It’s not our central case, we think the economy is on a gradually improving track and the unemployment rate is stabilised, that growth as being 2- 2½ per cent for a while but will gradually pick up so that’s our central base case.

Okay. We have one question from the floor.

You talked earlier about the risk of talking ourselves into too much pessimism and there’s been quite a difference for a while between business confidence and consumer confidence. Just wondering how you see that playing out? What catalyst is there for the consumer to cheer up or otherwise do you think there’s a risk that business gives up and business confidence falls?

It’s quite interesting because many people say business and consumer confidence is kind of incredibly weak and it’s just not correct. I mean consumer confidence at the moment is around average and some parts of the consumer sentiments say they’re actually above average and the latest business survey show at least current business conditions to be a little above average as well. Businesses are clearly happy to hire workers at the moment, employment’s grown by almost 2 per cent over the past year. And as I said in the business surveys that they’re reporting that current conditions are okay. So the issue is at what point does that improvement translate into higher capital spending plans? And that’s something that no one really can give a definitive answer to. Businesses are happy to hire workers, the cost of debt is low, consumers are spending at a reasonable rate. At some point, those factors I think will trip over to, to increased spending on business on capital. At what point are we still waiting for it?

Look Phil there’s probably just one more. It’s an interesting one, should we be using state based stamp duties as a way of, tempering property markets into hot markets?

I’m not quite sure what the … How one would do that. Temporary raising and lowering stamp duties. I’m not going to kind of encourage but the, um, State governments to do that.

Very well answered.

I think that, the main issue to deal with the property market, as I said, in answer to a question earlier on, is supply. Where the supply has come into the market, prices growth has been less. And you clearly see this is the apartment markets in both Sydney and Melbourne, where apartment prices have grown much less quickly than house prices and that’s because the supply has come there. So, the focus on housing really should be a focus on how do we increase the supply and make the supply side of the market more flexible? I think it’s a mistake to think that we can manage this through playing around with various levers that affect demand. It’s supply that needs to be the focus.

It’s all about supply?

It’s all about supply.

So I probably won’t ask, I’ll ask this question but I won’t get you to answer it. It says looking forward to the challenge of being the next RBA Governor but I think it captures …

I think it’s a good place to stop, isn’t it?

It’s a great place to stop the presentation. Phil, really appreciate the candour and questions from the audience which you tackled them. It was a great scene setting for our conference today. Ladies and gentlemen, please thank Phillip Lowe.

Thank you.

Thank you very much Phillip. That was great.