Review of the Reserve Bank of Australia and Payments System Board Annual Reports 2005

Overview of 2005

The rise in the terms of trade has contributed to a highly stimulatory environment for the business sector. The RBA reported that ‘business investment is now undergoing a major upswing, having expanded by 18 per cent over the past year and at an average annual rate of 14 per cent over the past three years.’⁷ This pattern is in contrast to household expenditure. The RBA stated:

…households have moderated the growth of their spending in the past year or two. Previously, households had been expanding their borrowing and spending at rates that could not be sustained, but they now appear to have entered a period of financial adjustments. They are still increasing their levels of debt, but are doing so at a slower pace than they were a couple of years ago. Another moderating influence on the growth of household spending has been the mild downturn in the housing construction cycle. ⁸

Forecasts for 2006

The RBA stated that ‘global economic conditions are continuing to provide a favourable environment for the Australian economy.’ ¹² The RBA Governor, Mr Macfarlane, reported that ‘with strong investment growth and an expected improvement in exports, our forecast for the economy overall is that annual GDP growth will pick up modestly during 2006 to about 3.25 per cent.’ ¹³ Mr Macfarlane noted that ‘given the maturity of the expansion it should not be surprising if the average growth of the economy is now less than it was in the earliest stages.’ ¹⁴ Mr Macfarlane stated:

As a general principle, it is easier for an economy to grow quickly when there is a large pool of unused resources to be re-employed. In Australia ’s current position in the cycle, that source of growth is now much more limited. So, in the absence of a significant lift in trend productivity, we should expect to see GDP growth rates mainly in the twos and threes rather than the threes and fours , as was typical for most of the expansion. ¹⁵

In view of these circumstances, the RBA Board at its most recent meeting

judged: …the current policy setting to be broadly consistent with the economy’s requirements for the time being. Looking ahead, however, it felt that, on balance, based on the considerations I have outlined here today, it is more likely that the next move in interest rates will be up, rather than down. ¹⁹

Mr Macfarlane’s advice that the next move in interests rates ‘will be up, rather than down’ proved to be accurate. On 3 May 2006 the RBA announced that it would increase the cash rate by 25 basis points to 5.75 per cent. The RBA stated:

International developments are continuing to provide stimulus to growth in Australia . The world economy is growing at an above-average pace for the fourth successive year and, significantly, forecasts have recently been revised upwards. Commodity prices have been increasing strongly for some time, and they have risen further in the year to date. This suggests a strengthening in the outlook for Australia ’s export earnings, with consequent expansionary effects on incomes and spending. ²⁰

Inflation targeting and monetary policy

The Second Statement on the Conduct of Monetary Policy between the Treasurer and the Governor of the Reserve Bank sets out the objective of monetary policy and provides an inflation target. The goals of monetary policy as set out in the Reserve Bank Act 1959 requires the Reserve Bank Board to conduct monetary policy in a way that, in the Board’s opinion, will best contribute to:

the stability of the currency of Australia ; . the maintenance of full employment in Australia ; and . the economic prosperity and welfare of the people of Australia. ²¹

In relation to inflation targeting, the 2003 Statement states:

In pursuing the goal of medium term price stability, both the Bank and the Government agree on the objective of keeping consumer price inflation between 2 and 3 percent, on average, over the cycle. This formulation allows for the natural short run variation in inflation over the cycle while preserving a clearly identifiable benchmark performance over time. ²²

Mr Macfarlane cautioned that while inflation has remained contained over the past decade ‘it is important, as always, to consider how inflationary pressures might evolve from here.’ ²⁴ Some of the factors identified that could lead to upward pressure on inflation are the high level of capacity utilisation, the tight labour market, and large increases in costs for some raw materials. Mr Macfarlane stated:

Aggregate wages growth has picked up over the past year, and businesses generally are reporting difficulty in attracting labour. These conditions underpin the current forecast of a modest rise in underlying inflation over the year ahead. Based on the current level of oil prices, this forecast implies that headline CPI would remain close to three per cent over the forecast period . ²⁵

Mr Macfarlane was asked about the impact of tax cuts on inflation and interest rates. He was not overly concerned about this commenting that ‘we can afford some changes to taxes or to expenditure’ concluding that it was ‘simply a matter of what is the right amount.’ ²⁶ Mr Macfarlane stated:

As we go through the year, surprise surprise, taxes are stronger than we thought which is exerting a contractionary influence through the year and then you get to nearly the end of the year and you give it back again. So you have an expansionary impact right at the end of the year. So you really have a within-year seasonal swing in fiscal policy, but from year to year all the years look very similar. From our perspective, it is the fiscal impact, which is the change from year to year, which could potentially cause us difficulties but which has not because the change has been relatively small. Despite the fact that it is talked about frequently in the financial press and amongst economists, it has never figured as an important part of our deliberations on monetary policy.²⁷

During the August 2005 hearing, the committee examined the Reserve Bank’s methodology for forecasting inflation. At the February 2006 hearing, the committee focused on the appropriateness of the bank’s target of keeping inflation between 2 and 3 per cent. Australia ’s mid-point target is 2.5 per cent. Table 2.1 shows the mid-point inflation targets of some leading economies.

Table 2.1 Mid-point inflation targets of some leading economies

Country Mid point target Comments

Source : Erskinomics

Conclusions

Exchange rates and external trade

During the February 2006 hearing, Mr Macfarlane noted that the

Australian currency had remained relatively stable. He stated: The Australian dollar has remained in a relatively steady range over the past couple of years, at levels that are a little bit above average against the US dollar and about 10 per cent above average in trade weighted terms. The currency has been remarkably stable over the last two years. Some people have found this steadiness puzzling against a background of continuing very strong rises in commodity prices and our terms of trade, as such episodes in the past have been associated with strong rises in the currency. ³⁰

The strength of the global economy and recovery from the global downturn of 2001 has resulted in a marked upswing in Australia’s terms of trade, defined as the ratio of our export to import prices. Mr Macfarlane commented that ‘currently Australia is benefiting from the largest cumulative increase in our terms of trade since the early 1970s.’ ³⁵ In particular, there have been sharp rises in the prices of coal, iron ore and a wide range of other minerals. The Governor stated:

Over the past three years, Australia’s terms of trade have increased by 30 per cent. This is estimated to have added 1½ to two percentage points per annum to the growth in national income, or our real income and capacity to spend over this period, which has been a significant expansionary force on the economy. The effect of this can be seen in a number of areas, including strong growth in business investment, company profits, share prices and imports. Increased export prices also tend to boost government revenues through company taxes and a range of federal and state royalties. ³⁶

Earnings from manufactured goods were less favourable. The RBA stated: Earnings from manufactured goods exports increased by around 8 per cent over 2005, with volumes estimated to have grown more strongly than overall exports, albeit at a rate well below that seen during the 1990s. Nonetheless, recent business surveys report a pessimistic outlook for manufactured exports, and the Bank’s liaison with Australian manufacturers reports that producers are finding it difficult to compete with developing economies in Asia. ³⁷

United States , China and the global economy

Interest rates stood at 4.5 per cent which is now ‘closer to neutral levels, although the Federal Reserve’s January policy statement signalled that some further tightening may still be needed.’ ⁴¹ The Federal Reserve at its meeting on 27–28 March 2006 raised the target federal funds rate 25 basis points to 4.75 per cent. The minutes of the meeting stated:

Most members thought that the end of the tightening process was likely to be near, and some expressed concerns about the dangers of tightening too much, given the lags in the effects of policy. However, members also recognized that in current circumstances, checking upside risks to inflation was important to sustaining good economic performance. The need for further policy firming would be determined by the implications of incoming information for future activity and inflation. ⁴²

Mr Macfarlane commented that the industrialisation of China and the ‘huge pool of low-cost labour that this has brought into play has put sustained downward pressure on a wide range of prices of internationally traded goods.’ ⁴⁵ This downward pressure on prices is one of the key forces contributing to disinflationary pressures. Mr Macfarlane stated:

…this business of producing more than you are consuming brings us back, principally, to China and the fact that, as they bring on stream a massive supply of extremely cheap labour and find more and more ways of producing standard products, internationally traded manufactured goods, cheaper and cheaper, this puts downward pressure on everyone’s CPI around the world. That is what we think of as global disinflationary pressure. ⁴⁶

Oil prices

During the February 2006 hearing, the RBA Governor reiterated his views about the impact of oil price increases. Mr Macfarlane stated:

We know the economy has slowed, but I do not think that [oil price increases] was a major player in it. If you look around the world, every economy has had to face this big increase in oil prices and very few of them have slowed. In fact, most of them have chugged along at the same rate as before or have actually picked up. It seems to me that the contractionary effect of the rise in oil prices has been remarkably small in virtually all countries. I think that is the case here too. ⁵⁰

The concern about oil prices must be couched against key points made by the RBA Governor. First, the current growth in oil prices, as opposed to OPEC1 and OPEC2, is due to strong demand and not supply side restrictions. In addition, while there may be some initial inflationary effects, there are competing disinflationary forces. Mr Macfarlane stated:

I think that, in the short term, oil prices had a bigger short-term effect, if you want to measure it over the last year or 18 months. In the medium term, it is the other—the worldwide reduction in the prices of internationally traded manufactured goods, and China is the biggest single reason behind that. ⁵³

Housing and household debt

The RBA focused some of its comments on the implications of the growth of household debt. The RBA Governor summarised key aspects of the most recent cyclical peak, noting that in around 2003 household credit growth reached an annual rate of over 20 per cent. He noted that since the bulk of household debt is housing related it is not surprising that this peak was closely associated with a sharp run-up in house prices. Mr Macfarlane stated:

Nationwide house prices increased strongly for several years up to late 2003, reaching a peak growth rate of around 20 per cent in that year. The increases in credit and house prices were interrelated, with credit availability fuelling price rises, while rising house prices meant people had to borrow larger amounts to achieve home ownership. ⁵⁴

Mr Macfarlane warned that these household debt ratios may rise further. This was because in a low inflation environment, nominal interest rates are also low and ‘households are able to service much higher levels of debt than they could in the past.’ ⁶¹ There were risks for households who were subject to a high debt servicing ratio. Mr Macfarlane stated:

…if the economy does experience some negative shock, the classic one being significant increases in unemployment or even households that lose a high-paying job and have to take a lower paying job, some of those households would be very vulnerable, given the huge amounts of debt servicing. This is a thing we have drawn attention to repeatedly. ⁶²

The RBA noted that growth in household consumption slowed during 2005 with real spending increasing by 2.7 per cent over the year to the September quarter. This is a reduction from an annual growth rate of around 6.5 per cent at the start of 2004. The RBA stated:

Although the saving rate as measured is still negative, the fact that consumption is now growing more slowly than income suggests that households are taking a more cautious approach to their finances. This would be consistent with the further easing in growth in household debt in the September quarter. Nevertheless, the debt-serving ratio increased marginally in the quarter to 10.9 per cent. ⁶⁴

Australian share market

Supply side (capacity) constraints

Labour market shortages including unskilled and skilled labour were discussed. The RBA stated that ‘recent data shows that wages are continuing to grow at a rate above the average of recent years, which is consistent with other indications of tight labour market conditions and shortages of suitable labour.’ ⁷¹ Mr Macfarlane elaborated on the possible consequences of an undersupply of labour:

The ultimate consequence is that some production just does not get done. This is the sort of thing that does happen, not just here but in other countries, when you get to very high levels of capacity utilisation. In our case, not only are we at high levels of capacity utilisation but also we have a skewed demand in that an inordinate amount of the demand is for expansion of resource capacity. That is why it is not surprising that a Western Australian is bringing this question up. The answer is: some things do not get done, which is disappointing. ⁷²

Corporate governance

The RBA Governor acknowledged that the Gerard appointment had revealed a flaw in the process but this should be compared against previous appointments which had proved successful. Mr Macfarlane stated:

I think it did expose a problem—there is not much doubt about that—in that someone was appointed who had engaged in some behaviour such that, had it been known, they would not have been appointed. So I think that that does show up a flaw. I am not quite sure how you overcome that particular thing, given the confidentiality of the tax system. As to whether we should adopt a very different way of making board appointments, it is always up to people to come up with suggestions. I am not totally wedded to this one, but I would point out that, in the time I have been in this position, there have been 20 appointments made to the Reserve Bank board or the Payments System Board, including reappointments. Nineteen of them have been excellent and one caused intense controversy.

Mr Macfarlane, in considering the appointments process, discussed the merits of having parliamentary committee oversight of appointments. Mr Macfarlane stated:

…would it be improved if a committee such as this could interview prospective board members? That is done in the UK , but my understanding is that that committee does not have a right of veto; it just has the capacity to interview people. As far as I am concerned, that is entirely a decision for the government, the parliament or whoever has strong views on that. I would neither support it nor oppose it; I could live with it. ⁷⁵

Conclusions

Mr I McFarlane, Governor of the RBA, Transcript, 17 February 2006 , p. 10. Back

Mr I McFarlane, Governor of the RBA, Transcript, 17 February 2006 , p. 13. Back

The Hon Peter Costello, MP, transcript of doorstop interview, Odyssey House Richmond, Wednesday, 19 April 2006 . Back

The Hon Peter Costello, MP, transcript of doorstop interview, Odyssey House Richmond, Wednesday, 19 April 2006 . Back

Mr I McFarlane, Governor of the RBA, Transcript, 17 February 2006, p. 23. Back