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Dinner address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the BIS Symposium: CIP-RIP?, Basel, 22 May 2017. | Guy Debelle: How I learned to stop worrying and love the basis Dinner address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the BIS Symposium: CIP–RIP?, Basel, 22 May 2017. * * * Thanks to Matt Boge for many educative discussions on the basis over the years. Drawing on the title of this conference, ‘CIP–RIP?’, one possible opening line for my speech tonight is that, unlike Marc Antony, ‘I come to praise the basis, not to bury it’. But instead of a theatrical inspiration, I will resort to a cinematic one and talk about how I learned to stop worrying and love the basis.1 One of the main points that I want to make tonight is that the basis is not something to be always and everywhere feared. It is not a violation of a fundamental principle of global finance that should lead to excessive gnashing of teeth and wringing of hands; most of the time. However, it is useful to ask the question why a non-zero basis exists, that is, why is there a deviation from CIP? When should we worry about it? When shouldn’t we? To answer these questions, it is useful to remember what the basis is. At its simplest, it is a price that clears a market for which there is supply and demand.2 Whenever the words supply, demand and price appear in close proximity, the word ‘identification’ immediately comes to mind. Identification problems have often been ignored in many discussions of the basis over the years. The analysis has often been partial, looking at the basis (the price) and linking it to shifts in demand or supply, but not both. Many factors are often assumed to be exogenous, when in reality they are both endogenous and consequential. We need to better understand what underpins the supply and demand that determines the basis and what causes those two curves to shift. Who are the relevant participants and what, if any, constraints might they have on their behaviour? The CIP assumption of risk-less arbitrage needs to be questioned. The tendency to focus only on banks needs to be broadened. We need to be taking into account the various motivations for the cross-border transactions underpinning the supply and demand. In addition to that, we need to make sure we are measuring the basis correctly. There is no issue with measuring the foreign exchange component. Measuring the relative rates of return in the different currencies is where it gets more complicated. Indeed, even framing the issue in terms of relative rates of return, rather than in terms of funding and investing currencies shifts the focus. The papers at this symposium generally address these issues, coming at them from a variety of perspectives. A common theme across the papers is that banks aren’t the only players and that the arbitrage is not risk free, and perhaps at least as important, the arbitrage is not costless. The manner in which it is not risk free and what and how large the costs are, very much depends on who you are. In my view, there is not complete fungibility across all the various funding sources or the investment opportunities. Not everyone borrows at LIBOR on the one hand, or is willing or able to take on the credit risk of investing in LIBOR on the other side. Moreover, LIBOR aggregates across different credit exposures, not all of which are available to a potential investor with a mandate with credit limits. Beyond that, the composition of LIBOR changes through time as the borrowing needs of global banks change. So there are measurement problems involving LIBOR, which is often the interest rate used to measure the basis. 1/4 BIS central bankers' speeches So, who are the various suppliers and demanders in the market and what are their constraints? A useful taxonomy is the following: banks, hedge funds, corporates and asset managers/real money pools, including central banks. Each of these groups has varying degrees of flexibility to arbitrage the basis. They have varying constraints on how they can use their balance sheets, varying funding sources and varying credit appetites and limits which constrain the investable universe. There is a fundamental difference between a bank (or a hedge fund) that needs to fund itself to arbitrage the basis, compared to a real money investor, which may be naturally long in the funding currency. On the other hand, real money often has restrictions on the ability to take on leverage in the way that a bank doesn’t. Real money can often be constrained in their ability to arbitrage the basis because their mandate doesn’t allow them to. In my experience, one of the fundamental laws of finance is to never underestimate mandate constraints. While the constraints on the various participants in the market vary, so do the potential risks. The risk that concerns me the most is the combination of maturity and currency mismatch; in particular, a bank funding a portfolio of foreign currency assets, by swapping its local currency (for which it has a natural funding base) into the foreign currency with short-dated swaps. The assets are generally long-dated and not particularly liquid. So we have a dangerous cocktail of maturity and currency transformation. If the basis gets too wide, then this can quickly become unprofitable. Even more worryingly, if a quantitative constraint hits the swap market, rather than just experiencing just an increase in the cost of the swap, a bank funding itself with short-dated swaps is quickly going to find itself in the equivalent of a sudden stop. (Note this is quite a different scenario from funding domestic assets with foreign currency swapped back into domestic currency, for which there is ultimately a domestic backstop in the event of liquidity stresses.) A positive basis is often described as indicative of a US dollar shortage. I don’t find that term very helpful at all. ‘Shortage’ very much implies a quantitative constraint, rather than a pricing constraint. But in most circumstances, we are talking about the latter. That is, the supply of dollars might go down, so the price goes up. There is no shortage, there is just more demand than supply, and, as with other markets, the price adjusts to equilibrate the market. The market is functioning effectively and efficiently. The focus of analysis should be on the various factors that affect demand and supply. The papers at this conference highlight the range of factors that need to be taken into account. There are exceptions, most obviously 2008, where there clearly was a dollar shortage. At that time, there was effectively no market-clearing price and rationing was in effect. But that period was the exception, rather than the rule. 2/4 BIS central bankers' speeches Over the past few years, that has not been the state of the world. The basis has gone up and down in response to the shifts in demand and supply. As it has moved around, it has in turn generated behavioural responses from market participants. For example, when the basis got particularly wide a year or so ago, a number of banks which had previously found it uneconomical to arbitrage the market, re-entered as it was profitable to do so, even given the balance sheet costs to them of the trade. In the past, we might have expected wide divergences in money market rates reflected in a large basis to trigger greater use of central bank standing facilities. We would have thought that was appropriate as something must have been going wrong. Now, we’re no longer surprised by these anomalies (be they in FX swaps, repo, etc.) because we are more comfortable with the idea that an increase in the basis is not always a sign of stress and can be consistent with functioning markets (and seemingly have little implication for monetary policy transmission). Nowadays, monitoring markets for signs of stress requires more knowledge of market dynamics than in the past. So most of the time, the basis is not a sign of stress. Understanding what is behind it is a useful exercise and can identify potential vulnerabilities. But I wouldn’t be losing sleep over it in the way that I (literally) lost sleep over it in 2008. Clearly in all of this the speed of equilibration matters. Take the recent US money market reform as an example. Banks that had previously relied on money market funds to source US dollar funding could no longer rely on this to the same extent. How they adjusted in part depended on what those US dollar activities were. If they were simply arbitraging the FDIC deposit levy to intermediate US dollar funding pools to earn the deposit rate at the Fed, then they could let those activities run off. This was easy to do because the assets were short dated. They didn’t need to switch funding to the swap market if it was not profitable to do so. If instead, they were funding US dollar lending, then they did need to raise funding from other sources and we saw both US dollar LIBOR and the basis rise as both of those markets were tapped. Another risk worth contemplating is behaviour that might be induced if the basis gets ‘too’ wide. While that might entice some participants back into the market to keep a lid on the basis, there is a risk that it engenders behaviour that might concern us. It can incentivise people to stop hedging and take on the exchange rate risk. Corporate borrowers or asset managers might decide to run unhedged foreign exchange positions. While some might argue that the price is leading them to make the ‘right’ decision, I would be concerned about the different degrees of sophistication in assessing the risk of unhedged FX positions. Another risk is that it could also incentivise banks/investors to make higher-risk loans/investments to cover the higher cost of hedging. Let me finish by coming back to the title of my talk and explain why I have learned not to worry and love the basis. In the current world of low returns on reserve assets, for conservative asset managers like ourselves at the RBA, the return enhancement offered by the basis is highly beneficial.3 We can still confine ourselves to our conservative investable universe of sovereign assets, but earn the (often quite substantial) return by swapping from the various reserve currencies that we hold into yen (where the basis tends to be the widest). In addition to that, we can also swap Australian dollars, our natural funding currency, into yen for domestic liquidity management purposes. We can manage the risks around these transactions with a well-articulated and conservative counterparty framework, reinforced by ISDA agreements with daily margining. In doing so, we can also take comfort that we are playing a useful role in providing a counterbalancing flow in the market, thereby limiting the rise in the basis and facilitating hedging of cross-border flows. Of course, we don’t want everyone to love the basis as much as we do, otherwise our return enhancement would soon disappear. 3/4 BIS central bankers' speeches So I hope we can all learn not to worry, most of the time, about the basis. But while we are not worrying, we should still spend time understanding the various cross-border flows that underpin the basis. But please can we make sure we look at all the different participants in the market and the different factors that affect them, as the papers presented at this conference generally do. Then, on the hopefully rare occasions when we do need to worry about the basis, we are better placed to respond appropriately. 1 For those who don’t share my cultural heritage, I am referring to Stanley Kubrick’s Dr Strangelove or: How I Learned to Stop Worrying and Love the Bomb. 2 The basis is shorthand for the extent of the deviation from covered interest parity (CIP). It is the difference between the cost of borrowing directly in US dollars (say) and the synthetic cost from borrowing in a foreign currency and swapping the foreign currency into US dollars. Apositive (negative) basis means that the US dollar interest rate is higher (lower) than the foreign interest rate adjusted for the cost of the swap. 3 This is covered in detail in the RBA’s Annual reports/rba/2016/operations-in-financial-markets.html. 4/4 Reports: www.rba.gov.au/publications/annual- BIS central bankers' speeches | reserve bank of australia | 2,017 | 5 |
Opening remarks by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the Launch of the FX Global Code, FX Code Press Conference, London, 25 May 2017. | Guy Debelle: Launch of the FX Global Code Opening remarks by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the Launch of the FX Global Code, FX Code Press Conference, London, 25 May 2017. * * * Today marks the culmination of two years’ effort to develop the FX Global Code and the associated adherence mechanisms. It has involved considerable input from many foreign exchange market participants, both public and private. Today I will reiterate the motivation for the work, highlight the main features of the Code and adherence, summarise how we have developed the Code and outline the way forward. Firstly, why is the work going on? The foreign exchange (FX) industry has been suffering from a lack of trust. This lack of trust is evident both between participants in the market and, at least as importantly, between the public and the market. The market needs to move toward a more favourable and desirable location, and allow participants to have much greater confidence that the market is functioning appropriately. The Code sets out global principles of good practice in the FX market to provide a common set of guidance to the market. This will help to restore confidence and promote the effective functioning of the wholesale FX market. A well-functioning FX market is very much in the interest of all market participants. This clearly includes central banks, both in their own role as market participants but also as the exchange rate is an important channel of monetary policy transmission. In a globalised world, the foreign exchange market is one of the most vital parts of the financial plumbing. One of the guiding principles underpinning our work is that the Code should promote a robust, fair, liquid, open and transparent market. A diverse set of buyers and sellers, supported by resilient infrastructure, should be able to confidently and effectively transact at competitive prices that reflect available market information and in a manner that conforms to acceptable standards of behaviour. The work to develop the Code began two years ago, in May 2015, when the BIS Governors commissioned a working group of the Markets Committee of the BIS (which I chaired until early January this year) to do two things: first, establish a single global code of conduct for the wholesale FX market and second, to come up with mechanisms to promote greater adherence to the Code.1 This work is very much a public sector–private sector partnership. We have been ably and vigorously supported by a group of market participants, chaired by David Puth, CEO of CLS. David’s group contains people from all around the world on the buy side, including corporates and asset managers, and the sell side, along with trading platforms, ECNs and non-bank participants, drawing from the various Foreign Exchange Committees (FXCs) and beyond. All parts of the market have been involved in the drafting of the Code to make sure all perspectives are heard and appropriately reflected. There are two important points worth highlighting: first, it’s a single code for the whole industry and second, it’s a global code. On the first point, the Code is supplanting the existing codes that have been present in the FX market. Importantly, the Code covers all of the wholesale FX industry. This is not a code for just the sell side. It is there for the sell side, the buy side, non-bank participants and the platforms; it reaches around the globe and across the whole industry. The way it is relevant will depend on the nature of the engagement with the FX market. What this means in practice is that the steps 1/4 BIS central bankers' speeches different market participants take to align their activities with the principles of the Code will differ, reflecting the size, complexity, type and extent of their engagement with the FX market. On the second point, our group contained representatives from the central bank and private sector from all the 16 largest FX centres, including both developed and emerging markets. The first phase of the Code was released in May 2016. It covered areas such as ethics, information sharing, aspects of execution and confirmation and settlement. The second phase covers further aspects of execution including e-trading and platforms, prime brokerage, as well as governance, and risk management and compliance. The complete Code comprises 55 principles spanning these issues. The principles are written in plain language and should be easily read and understood by market participants. The principles are supplemented by a suite of examples to illustrate their practical application. Market participants have had a number of opportunities to comment on the Code, in addition to the direct input of the Market Participants Group. Over the past six months, drafts of the full text of the Code have been distributed to market participants for their review, principally through the various FXCs, but also through other industry associations to ensure all perspectives are appropriately reflected in the Code. Through this process, over 10,000 comments were received. The Code reflects our collective judgement as to what constitutes good practice in the market, taking account of the feedback received. I think it is a good outcome of the process that we were able to distil the points of contention down to a small number of issues. Outside of these, the feedback reflected a widely held consensus. Market participants have recognised the Code’s aim of helping move the FX market to a better place. One of our central aims in drafting the Code is for it to be principles-based rather than rulesbased. There are a number of reasons why this is so but, for me, an important reason is that the more prescriptive the Code is, the easier it is to get around. Rules are easier to arbitrage than principles. The more prescriptive and the more precise the code, the less people will think about what they are doing. If it’s principles-based and less prescriptive then market participants will have to think about whether their actions are consistent with the principles of the Code. But we have not written a procedures manual. Rather we have articulated principles that need to be taken into account. Individual firms may then take these principles and reflect them in their own procedures manuals. Our aim in setting out these principles is to provide market participants with the framework in which to think about how they, for example, handle stop-loss orders. The emphasis here is very much on the word ‘think’. The Global Code will not provide the answers to all your questions, but it should help you ask the right questions. Adherence Alongside drafting the Code, we have devoted considerable time and effort to thinking about how to ensure widespread adoption of the Code by market participants. Clearly, that has been an issue with the various existing codes that had been in place in a number of markets. It is evident they were ignored on occasion in the past, wilfully or otherwise. We have worked with the industry to produce a principles-based code rather than a set of prescriptive regulatory standards. It will not impose legal or regulatory obligations on market participants, nor will it supplant existing regulatory standards or expectations. We have developed a blueprint for adherence that has been published alongside the Code today and sets out the key elements we think will be required for the Code to be successful – and the steps that have been taken, and will be taken, to ensure this is the case. 2/4 BIS central bankers' speeches One critical dimension is market-based adherence mechanisms. An important element of discipline should come from the market itself. The adherence to a voluntary code will only come about if firms judge it to be in their interest and take the practical steps to ensure the Code is embedded in their practices. Such practical steps would include training their staff and putting in appropriate policies and procedures. We have provided a draft Statement of Commitment for firms to publicly demonstrate their adherence to the Code. One reason for a public demonstration is that firms are more likely to adhere to the Code if they believe that their peers are doing so too. That is, an important source of pressure to adhere should come from other market participants. To provide visibility around this, there are a number of market-based initiatives to provide public registries where market participants can demonstrate their use of the Statement of Commitment. More broadly, market participants have a vital interest, and a role to play, in promoting and upholding good practices in the market as a whole. This can be partly achieved through leading by example, but can also be supported by having similar expectations of counterparties and other market participants and helping to raise awareness of the Code in their market interactions. In that regard, we have reached out to more than 120 industry associations and key market infrastructure providers globally. Ultimately the success of the Code in promoting integrity and restoring confidence in the wholesale FX market lies in the hands of its participants. Another aspect of market-based adherence comes through the FXCs.2 FXCs have today issued a joint statement of support for the Code. In due course, adherence to the Code is likely to become a requirement of FXC membership. That would ensure the Code is embedded at the core of the FX market, given the extent of coverage of the FXCs. But it is also important that it extends beyond that, and that there is, at the very least, an awareness of it across all market participants. A second dimension of adherence is that the BIS central banks have signalled their commitment by announcing that they themselves will follow the Code, and that they expect that their counterparties will do so too.3 Given that we are only providing the full text of the Code to the market today, there will be a period of time for market participants to adjust their practices where necessary to be in line with the principles in the Code. I would not expect much time should be required to do this. This period of time might potentially be as short as six months, but no more than twelve months for the vast majority of market participants. How much effort this might require will in part depend on the nature and extent of engagement with the FX market. In drafting the Code, we have always kept the principle of proportionality at front of mind. Finally, it is vital that the Code remains up to date and evolves as the market evolves. The Code will be collectively owned, maintained and updated by the Global Foreign Exchange Committee (GFXC) Code, which met for the first time yesterday. This will continue the public sector – private sector partnership which has supported the development of the Code. The GFXC will regularly assess whether new information or market developments warrant updates or additions being made to the Code. As the first example of this, given diversity of views on the use of last look in the market, the GFXC today is requesting feedback on trading in the last look window. On a less frequent basis, the GFXC will oversee a more comprehensive review of the Code. Conclusion This is the culmination of two years of work by a group of people from both the private and public 3/4 BIS central bankers' speeches sectors. The work has reflected a very constructive and cooperative effort between the central banks and market participants. We have all undertaken this work in addition to our regular responsibilities, at all hours of the day and night. This contribution of time and effort reflects the fact that all of us recognise the need to restore the public’s faith in the foreign exchange market. We share the view that the Global Code plays an important role in assisting that process and also in helping improve market functioning and confidence in the market. I would very much like to thank the whole group for their work and commitment, but in particular: David Puth for his tireless effort and support leading the Market Participants Group; Simon Potter for leading the work on the writing of the Code with the enormous support of Jamie Pfeifer and the team at the New York Fed; and Chris Salmon for leading the adherence work, supported by Grigoria Christodoulou and the team at the Bank of England. 1 See www.bis.org/press/p150511.htm. 2 See afxc.rba.gov.au/news/afxc-26052016.html. 3 See <www.bis.org/press/p160526a.htm>. 4/4 BIS central bankers' speeches | reserve bank of australia | 2,017 | 5 |
Address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, to the Thomson Reuters Industry Event "Examining the FX Code of Conduct", Sydney, 15 June 2017. | Guy Debelle: The Global FX Code of Conduct Address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, to the Thomson Reuters Industry Event "Examining the FX Code of Conduct", Sydney, 15 June 2017. * * * The FX Global Code of Conduct was launched just over two weeks ago in London. It is available on the Global Foreign Exchange Committee’s website, www.globalfxc.org. 1 Today I will reiterate the motivation for the work, highlight the main features of the Code and adherence, summarise how we developed the Code and outline the way forward. Firstly, why has this work been necessary? The foreign exchange (FX) industry has been suffering from a lack of trust. This lack of trust is evident both between participants in the market and, at least as importantly, between the public and the market. The market needs to move toward a more favourable and desirable location, and allow participants to have much greater confidence that the market is functioning appropriately. The Code sets out global principles of good practice in the FX market to provide a common set of guidance to the market. This will help to restore confidence and promote the effective functioning of the wholesale FX market. A well-functioning FX market is very much in the interest of all market participants. This clearly includes central banks, both in their own role as market participants but also as the exchange rate is an important channel of monetary policy transmission. In a globalised world, the foreign exchange market is one of the most vital parts of the financial plumbing. One of the guiding principles that has underpinned our work in developing the Code is that the Code should promote a robust, fair, liquid, open and transparent market. A diverse set of buyers and sellers, supported by resilient infrastructure, should be able to confidently and effectively transact at competitive prices that reflect available market information and in a manner that conforms to acceptable standards of behaviour. Note that I am talking about all sections of the FX market: buyers, sellers and infrastructure. The work to develop the Code began two years ago, in May 2015, when the BIS Governors commissioned a working group of the Markets Committee of the BIS (which I chaired until early January this year) to do two things: first, establish a single global code of conduct for the wholesale FX market and second, to come up with mechanisms to promote greater adherence to the Code.2 This work was very much a public sector–private sector partnership. We were ably and vigorously supported by a group of market participants, chaired by David Puth, CEO of CLS. David’s group contained people from all around the world on the buy side, including corporates and asset managers, and the sell side, along with trading platforms, ECNs and non-bank participants, drawing from the various Foreign Exchange Committees (FXCs) and beyond. All parts of the market were involved in the drafting of the Code to make sure all perspectives were heard and appropriately reflected. There are two important points worth highlighting: first, it’s a single code for the whole industry and second, it’s a global code. On the first point, the Code supplants the existing codes that have been present in the FX market. So there is now one single code. Importantly, the Code covers all of the wholesale FX industry. This is not a code for just the sell side. It is there for the sell side, the buy side, non-bank participants and the platforms; it reaches around the globe and across the whole industry. The way it is relevant will depend on the nature of the engagement with the FX market. What this 1/4 BIS central bankers' speeches means in practice is that the steps different market participants take to align their activities with the principles of the Code will differ, reflecting the size, complexity, type and extent of their engagement with the FX market. On the second point, it’s a global code: our group contained representatives from the central bank and private sector from all the 16 largest FX centres, including both developed and emerging markets. The first phase of the Code was released in May 2016. It covered areas such as ethics, information sharing, aspects of execution and confirmation and settlement. The second phase covered further aspects of execution including e-trading and platforms, prime brokerage, as well as governance, and risk management and compliance. The complete Code comprises 55 principles spanning these issues. The principles are written in plain language and should be easily read and understood by market participants. The principles are supplemented by a suite of examples to illustrate their practical application. Market participants had a number of opportunities to comment on the Code, in addition to the direct input of the Market Participants Group. Before its release, drafts of the full text of the Code were distributed to market participants for their review, principally through the various FXCs, but also through other industry associations to ensure all perspectives were appropriately reflected in the Code. Through this process, over 10,000 comments were received. The Code reflects our collective judgement as to what constitutes good practice in the market, taking account of the feedback received. I think it is a good outcome of the process that we were able to distil the points of contention down to a small number of issues. Outside of these, the feedback reflected a widely held consensus as to what is good practice. The degree of consensus and the willingness to contribute to the process reflect the fact that market participants have recognised the Code’s aim of helping move the FX market to a better place. One of our central aims in drafting the Code is for it to be principles-based rather than rulesbased. There are a number of reasons why this is so but, for me, an important reason is that the more prescriptive the Code is, the easier it is to get around. Rules are easier to arbitrage than principles. The more prescriptive and the more precise the code, the less people will think about what they are doing. If it’s principles-based and less prescriptive then market participants will have to think about whether their actions are consistent with the principles of the Code. But we have not written a procedures manual. Rather, we have articulated principles that need to be taken into account. Individual firms may then take these principles and reflect them in their own procedures manuals. Our aim in setting out these principles is to provide market participants with the framework in which to think about how they, for example, handle stop-loss orders. The emphasis here is very much on the word ‘think’. Adherence Alongside drafting the Code, we devoted considerable time and effort to thinking about how to ensure widespread adoption of the Code by market participants. Clearly, that was an issue with the various existing codes that had been in place in a number of markets. It is evident they were ignored on occasion in the past, wilfully or otherwise. We have worked with the industry to produce a principles-based code rather than a set of prescriptive regulatory standards. The Code is not regulation. It will not impose legal or regulatory obligations on market participants, nor will it supplant existing regulatory standards or expectations. We have developed a blueprint for adherence that has been published alongside the Code and 2/4 BIS central bankers' speeches sets out the key elements we think will be required for the Code to be successful – and the steps that have been taken, and will be taken, to ensure this is the case.3 One critical dimension is market-based adherence mechanisms. An important element of discipline should come from the market itself. The adherence to a voluntary code will only come about if firms judge it to be in their interest and take the practical steps to ensure the Code is embedded in their practices. Such practical steps would include training their staff and putting in appropriate policies and procedures. We have provided a draft Statement of Commitment for firms to publicly demonstrate their adherence to the Code.4 One reason for a public demonstration is that firms are more likely to adhere to the Code if they believe that their peers are doing so too. That is, an important source of pressure to adhere should come from other market participants. To provide visibility around this, there are a number of market-based initiatives to provide public registries where market participants can demonstrate their use of the Statement of Commitment. These registries will be in the public domain in the near future. More broadly, market participants have a vital interest, and a role to play, in promoting and upholding good practices in the market as a whole.5 This can be partly achieved through leading by example, but can also be supported by having similar expectations of counterparties and other market participants and helping to raise awareness of the Code in their market interactions. In that regard, we have reached out to more than 120 industry associations and key market infrastructure providers globally. In Australia, that includes AFMA and the Finance and Treasury Association, as well as the NZFMA. Ultimately the success of the Code in promoting integrity and restoring confidence in the wholesale FX market lies in the hands of its participants. Another aspect of market-based adherence comes through the FXCs. In due course, adherence to the Code is likely to become a requirement of FXC membership. In Australia’s case, adherence to the Code will be a requirement of membership of the Australian foreign exchange committee by the end of this year. That would ensure the Code is embedded at the core of the FX market, given the extent of coverage of the FXCs. But it is also important that it extends beyond that, and that there is, at the very least, an awareness of it across all market participants. A second dimension of adherence is that the BIS central banks have signalled their commitment by announcing that they themselves will follow the Code, and that they expect that their counterparties will do so too.6 In the case of the RBA, we will require that our counterparties sign the Statement of Commitment, just as we will ourselves. Given that we provided the full text of the Code to the market only last month, there will be a period of time for market participants to adjust their practices where necessary to be in line with the principles in the Code. I would not expect much time should be required to do this. This period of time might potentially be as short as six months, but no more than twelve months for the vast majority of market participants. How much effort this might require will in part depend on the nature and extent of engagement with the FX market. In drafting the Code, we have always kept the principle of proportionality at front of mind. Finally, it is vital that the Code remains up to date and evolves as the market evolves. The Code will be collectively owned, maintained and updated by the Global Foreign Exchange Committee (GFXC), which met for the first time in London in May. This will continue the public sector – private sector partnership which has supported the development of the Code. The GFXC will regularly assess whether new information or market developments warrant updates or additions being made to the Code. As the first example of this, given diversity of views on the use of last look in the market, the GFXC is currently requesting feedback on trading in the 3/4 BIS central bankers' speeches last look window. 7 On a less frequent basis, the GFXC will oversee a more comprehensive review of the Code. Conclusion The Global Code is the culmination of two years of work by a group of people from both the private and public sectors. The work reflected a very constructive and cooperative effort between the central banks and market participants. We all undertook this work in addition to our regular responsibilities, at all hours of the day and night. This contribution of time and effort reflected the fact that all of us recognise the need to restore the public’s faith in the foreign exchange market. We share the view that the Global Code plays an important role in assisting that process and also in helping improve market functioning and confidence in the market. 1 An app version has also been made available by an external party: app.policystore.ch/C/FXCode/. 2 See <www.bis.org/press/p150511.htm>. 3 www.globalfxc.org/adopting_the_global_code.htm 4 The Statement of Commitment is in Annex 3 of the Code. 5 The Banking and Finance Oath has a very similar motivation www.thebfo.org/home. 6 See www.bis.org/press/p170525.htm. 7 See www.globalfxc.org/consultative_process.htm 4/4 BIS central bankers' speeches | reserve bank of australia | 2,017 | 6 |
Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, on a Panel at the Australian National University's Crawford Australian Leadership Forum, Canberra, 19 June 2017. | Philip Lowe: Remarks on a Panel at the Australian National University's Crawford Australian Leadership Forum Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, on a Panel at the Australian National University's Crawford Australian Leadership Forum, Canberra, 19 June 2017. * * * Thank you for the invitation to be part of this panel at the Crawford Australian Leadership Forum. The central issue is: where does the future growth in the global and Australian economy come from? There are four points that I would like to make. 1. For a while, growth can come from a cyclical upswing in the global economy. Over 2017, the global economy has improved. It is not just a story in one or two countries, but one that is broad based. After nearly a decade, the healing process after the financial crisis is well advanced, although there is still plenty of scar tissue. The Chinese economy has continued to grow, although there are some fault lines. And in Europe, it has been a few years now since the underlying problems last erupted. Globally, monetary policy remains accommodative, there has been a lot of financial system repair and fiscal policy is no longer contractionary. This is all helping. So we are in a better position than we have been for some time. To be clear, we are not talking about a boom and there are still plenty of risks out there. But globally things are better. Animal spirits have been missing for quite a while and they might just be starting to come back. 2. At some point, the cyclical upswing will run its course. Beyond that, much depends upon demographics and technology. Here there are reasons for pessimism and for optimism. Many developed economies, as well as China and Korea, face big demographic challenges. Populations are stagnant or declining. They are also ageing. Older societies want to save, rather than invest, especially so when there will be fewer people tomorrow than there are today. And older societies are likely to be more risk averse. So this is a major issue. On technology, I am more optimistic. There are great advances being made in science: in the material sciences, in power generation and storage, in genetics and the health sciences, and in computing and artificial intelligence. It is hard to be sure how these will all play out, but advances in these areas open up possibilities that few of us can imagine. They can transform our economies and form the basis for a new wave of global investment and higher living standards. We can’t be sure though: time will tell. But a clear lesson from history is that advances in technology form the backbone upon which higher living standards are built. An obvious question is how to create and seize these opportunities that technology offers. There will be those in the audience better informed than me on how to do this. I do, though, find it hard to escape the conclusion that the starting point must be heavy investment in human capital and the creation of a culture that promotes innovation. A related challenge is dealing with the distributional effects of technological progress. The sheer scale of global markets means that the potential gains to innovators who can tap into these markets can be huge. At the same time, new technologies and globalisation create some losers. At the moment, our societies are struggling in dealing with this tension. We have a strong interest in working out how to manage this better. If we don’t do this, 1/2 BIS central bankers' speeches technological progress and globalisation could come to be seen as bad things, not the good things they are. That would surely harm prospects for long-run global growth. 3. In Australia, it is likely that growth over the next couple of years will be a bit stronger than it has been recently. The pick-up in the global economy is helping us. The return of mining investment to more normal levels is almost complete. Monetary policy continues to provide support and surveybased measures of business conditions have improved noticeably. Employment growth has also strengthened over recent months. These are all positive developments. We do, though, continue to face some headwinds. Households are gradually coming to grips with slower growth in their real incomes. Growth in wages is unusually low, average hours worked have declined and the nature of employment is changing. So there is a recalibration of expectations going on. Many households are also coming to grips with higher debt levels and, in our largest cities, high housing prices. We need to watch these issues carefully. 4. Australia’s longer-term prospects remain positive, but we need to keep working to keep them that way. Over the past couple of weeks there has been much discussion of Australia’s record run of 26 years without a technical recession. This is a significant achievement. We have done better than most countries over a long period. But just in case we are inclined to celebrate too much, we should remember that over those 26 years we have had three periods of rising unemployment. Our strong population growth has also flattered our headline growth figures. As things currently stand, it looks likely that average growth in per capita incomes over the next quarter of a century will be lower than over the past quarter of a century. We should, though, be capable of stronger growth than we have seen over the past few years. But we can’t take this for granted. It is important that we have a sharp focus on the reforms that can make a real difference to our living standards. If we don’t do this, we will fall behind. The positive news is that there is no shortage of good ideas here. The not-so-positive news is that there is a shortage of good ideas that can successfully navigate the political process. As we search for the reforms that will make a difference, we need to be aware that the drivers of growth in our economy are changing. Natural resources remain our main export earner, but Australians are increasingly employed in service industries. Right across the spectrum, competitive advantage is increasingly built on technology and management capability. This trend is not going to go away and we need to capitalise on it. There is no magic solution. But, as I said before, the central ingredient lies in investment in human capital. If we are to grow strongly in the future, then that growth will be built just as much on the quality of our ideas as it is on the quality of our natural resources. Thank you and I look forward to participating in the panel. 2/2 BIS central bankers' speeches | reserve bank of australia | 2,017 | 6 |
Speech by Ms Michele Bullock, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Economic and Social Outlook Conference, Melbourne, 21 July 2017. | Michele Bullock: Big banks and financial stability Speech by Ms Michele Bullock, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Economic and Social Outlook Conference, Melbourne, 21 July 2017. * * * Thanks to David Orsmond, Penny Smith, David Norman and Dilhan Perera for assistance with this speech. Good afternoon and thank you to the Melbourne Institute for the invitation to speak at this interesting conference. The theme of new directions in an uncertain world certainly has resonance at the moment in any manner of ways – political, economic, social and environmental. Many of these themes have been examined during the course of the conference. The theme of this session is: are the banks too big? What I will attempt to do in the next 20 or so minutes is take the banking system structure as given and talk about the implications of this for the stability of the Australian financial system. First, a bit of background. Australia has always had a fairly concentrated banking system. Through the 1960s and 1970s, the major banking groups, of which there were up to eight, accounted for around 80 per cent of banking assets in Australia (Graph 1). This share declined to around 65 per cent following deregulation and the entry of foreign banks in the mid 1980s. It remained around this level until the global financial crisis when the share of the major banks, of which there were now only four, rose back to around 80 per cent. The concentration of the banking system in Australia is not unique internationally but it is at the high end. There are other countries that have similar levels of concentration to Australia, even a 1/9 BIS central bankers' speeches bit higher, including Canada and Sweden (Graph 2). But there are many countries that have much lower levels of concentration including the United States, the United Kingdom and a number of European countries. Aside from the concentration, there are a couple of features of the Australian banking system that are worth highlighting. First, if we look at cost-to-income ratios, Australian banks seem to be fairly efficient (Graph 3). On average, the four major Australian banks have a cost-to-income ratio of around 40 per cent, at the lower end of cost-to-income ratios for a selection of banks in other countries. It’s likely that this reflects, in part, differences in the business models of the banks. Banks like the Australian banks, with a greater emphasis on traditional lending activity, tend to have lower cost-to-income ratios than banks with a greater focus on other activities, such as investment banking and wealth management. 2/9 BIS central bankers' speeches Second, the major Australian banks are very profitable (Graph 4). Apart from a brief period after the global financial crisis, returns on equity for the major Australian banks have consistently been around 15 per cent and even higher in some years. Their performance has been helped by a long run of consistent economic growth in Australia – we haven’t had a recession in over 25 years. So our banks haven’t had to deal with substantial credit losses that have impinged so heavily on the profits of many overseas banks following the global financial crisis. This profitability has also meant that the banks have found it relatively easy to build capital in response to international moves to improve the resilience of the banking system worldwide. 3/9 BIS central bankers' speeches So while we have a concentrated banking system, the major banks appear relatively efficient and strong. What, then, can we say about the implications of this structure for financial stability? Does having a relatively concentrated banking system promote financial stability? Or does it make the system more susceptible to shocks? The answer to this question is not straightforward. One view is that a concentrated banking system promotes financial stability in a number of ways. It is sometimes argued, for example, that if a concentrated banking system implies less competition, the large banks will be more profitable and able to generate capital organically, increasing their resilience. This argument therefore suggests that a concentrated banking system will promote financial stability. Having a few large banks might also promote financial stability in other ways. Larger banks might be more diversified in the risks they take on and have more sophisticated risk management systems. It could also be argued that it is easier for our prudential regulator, the Australian Prudential Regulation Authority (APRA), to supervise and regulate a small number of large banks. On the other hand, an alternative view is that a concentrated banking system results in large banks that are too big to fail. According to this argument, this is not good for financial stability if this implicit guarantee encourages the banks to take on excessive risk in the knowledge that they will not be allowed to fail. Furthermore, if the large banks all have very similar business models, as they do in Australia, problems in one bank might portend problems in the others and hence a large systemic issue. If anything, the major Australian banks’ business models have become more similar over the years since the global financial crisis. They are all now more focussed on housing lending and some are pulling back from wealth management and international operations. Finally, it could also be argued that a large bank is, by its nature, more complex and hence more difficult to supervise than a set of smaller banks. The academic literature doesn’t provide much guidance on which of these views is likely to be of 4/9 BIS central bankers' speeches more relevance for Australia. But is there anything we can say from experience over the past couple of decades since deregulation? Has increasing competition from new entrants had an impact on financial stability? Has the concentration of the system resulted in concerns about financial stability? I will take both these issues in turn. The issue of competition in Australia’s banking system has generated a lot of interest. There have been a myriad of reviews and inquiries over the years. Indeed, another inquiry into competition in the financial system, undertaken by the Productivity Commission, has just kicked off. And the Australian Competition and Consumer Commission has recently been tasked with keeping a watching brief on competition in the financial system. The Bank supports the Productivity Commission’s work on competition. But in the context of what competition might mean for financial stability, it is worth making three points. First, concentration of itself does not necessarily imply a lack of competition. Indeed, indicators of market structure such as measures of concentration are not regarded as a very accurate measure of competition. In principle, four large banks could still compete very actively among themselves. So if you have a concern that competition could lead to financial instability, having a concentrated system will not necessarily address the issue. Second, competition tends to be pro-cyclical. Competition on the lending side tends to hot up during the good times. Lending for housing, for example, has been pretty competitive over the past few years. In tougher times, however, competition for some types of funding, particularly more stable types, tends to increase. Post-crisis, for example, banks looked to increase the amount of deposit funding relative to wholesale funding, increasing competition for deposits, and in particular, term deposits. Regulators therefore need to be aware of this and take it into account when considering financial stability. Third, at least some sectors of the market do appear to be contestable, as demonstrated by the impact that new entrants have periodically had on the competitive landscape. The arrival of the mortgage originators in the 1990s, for example, resulted in more competition in the housing lending space. And foreign bank branches have utilised intragroup funding and wholesale deposits to compete in areas such as institutional lending. Despite the dominance of the four major banks in the market for deposits, competition has increased in this space as well. Foreign banks have introduced innovative online saving accounts, allowing them to compete for deposits without having a large physical presence. More recently, financial technology brings the possibility of even more contestability in the financial system. Competition and innovation are to be encouraged. Regulators nevertheless need to be alert to developments and any potential implications for financial stability. There is, consequently, a great deal of interest internationally on whether developments in financial technology will have implications for financial stability. While competition can, at times, pose challenges for stability of the financial system it is also true that large banks pose particular risks. A strong framework of prudential regulation and proactive supervision are therefore necessary regardless of the specific structure of the system. The actions taken on housing lending in Australia over the past few years are an example of how active supervision can address risks that might arise in an environment of heightened competition. Over the past few years, the regulators had observed very strong growth in lending to investors for housing. Furthermore, a large share of that lending was interest only for the first 5–10 years of the loan – that is, the loans were not being amortised for a very long time. And this behaviour was being fuelled by competition between the banks. Individual banks were reluctant to pull back because if they did so, the business would go to their competitors. This raised concerns about the financial stability implications if this behaviour continued. So in late 2014, with the support of the Council of Financial Regulators, APRA introduced a 10 per cent ‘speed limit’ on growth in investor housing credit as well as tighter lending standards. The Australian Securities and Investments Commission supported this with work on responsible 5/9 BIS central bankers' speeches lending. This was followed up in March this year with a limit on the share of interest-only loans and further guidance on lending standards. As Wayne Byres (the Chairman of APRA) recently highlighted, the concerns that prompted action were not about competition on interest rates or customer service standards. Rather, the concern was that competition was manifesting itself in an erosion of lending standards. Not only were the banks taking on more risk, but households were carrying a higher level of debt that they would have to service, which could be particularly concerning in the event of a shock. In other words, it was a financial stability issue not only because of its potential impact on banks’ balance sheets, but also because it was increasing the vulnerability of the household sector. The importance of the major banks for financial stability is also explicitly recognised in the regulatory framework. Since the financial crisis there has been a major international effort to increase the resilience of the global financial system, and Australia has been an active participant both in the policy debate and in implementation. There have been a number of elements to this work – raising capital levels, increasing liquidity buffers, identifying and regulating systemically important financial institutions and addressing the issue of ‘too big to fail’. The implementation of capital requirements in Australia has been driven by the international move to higher capital ratios as well as a desire to ensure that the Australian banks are ‘unquestionably strong’. The Financial System Inquiry (FSI) set out the rationale for Australian banks to achieve this. It noted that the concentrated nature of the system and the similar business models of the major banks could exacerbate contagion if one major bank experienced difficulties. With capital levels increasing around the world, the FSI therefore concluded that it was important that the Australian regulatory framework continued to evolve to ensure confidence in the Australian banks. It also suggested that higher capital ratios would help to reduce the value of any implicit government guarantees. Australian banks’ capital levels have therefore risen substantially in recent years, both relative to the past and in relation to international peers (Graph 5). Furthermore, consistent with the Basel framework for domestic systemically important banks (D-SIBS), APRA has determined that due to their size, interconnectedness, substitutability and complexity, the major banks should be required to hold more capital against their risk-weighted assets than smaller financial intuitions. Specifically, they are required to hold an additional 1 per cent of their risk-weighted assets as common equity Tier 1 (CET1) capital, bringing the minimum CET1 capital requirement for the major banks to 8 per cent (Graph 6). All of the major banks are currently comfortably above this minimum. But APRA’s announcement earlier this week on unquestionably strong capital ratios means that the larger banks, in particular, will need to build their capital a little further over coming years. As D-SIBS, the major banks are also subject to more intense supervision by APRA. 6/9 BIS central bankers' speeches 7/9 BIS central bankers' speeches The higher capital levels and greater intensity of supervision provide confidence that, notwithstanding the systemic importance of the major banks, the Australian financial system is more resilient to shocks than it was in the past. But there is still a need to consider what might happen in the event of a bank failure. Global initiatives in this area have focused on developing appropriate resolution frameworks and on addressing too big to fail. The centrepieces of this work are the Financial Stability Board’s Key Attributes of Effective Resolution Regimes for Financial Institutions (Key Attributes) and total loss absorbing capacity (TLAC) for global systemically important financial institutions (G-SIFIs). The intention is that the relevant authorities should be able to resolve failing global financial institutions in an orderly manner without taxpayer exposure to loss from solvency support. TLAC helps to operationalise the Key Attributes for G-SIFIs, by ensuring that there are sufficient resources to recapitalise a failing institution. This includes securities that could be ‘bailed in’ in the event that losses were large enough to reduce the capital below certain minimum levels. It is still too early to determine how effective the new arrangements for resolution are likely to be. Most countries are developing their frameworks for resolution, although if the institution being resolved is a large, interconnected, international bank, the process will be complex and difficult regardless, especially given the cross-border issues associated with resolution. Most countries are also still to finalise their TLAC regimes, so how this might work in practice is not clear at this stage. But many financial institutions are issuing securities with TLAC-like features and there have been recent examples in Europe where these types of securities have played a role in resolving troubled banks. In Australia, we are working on improvements to our resolution framework in line with the Key Attributes and legislation is being drafted to give APRA stronger crisis management powers. But the issue of an appropriate regime to enhance banks’ loss absorption and recapitalisation capacity, as recommended by the FSI, is still being considered. We will be watching developments overseas on this issue closely to determine the most appropriate regime for Australia. In conclusion, I want to reiterate that the concentration of the banking system in four major banks in Australia does not necessarily provide financial stability benefits. Nor is it necessarily detrimental to financial stability. But the systemic importance of the four major banks in Australia does mean that they need to have a proportionately greater supervisory focus. The strengthening of capital and liquidity standards post crisis, and the use of proactive and intensive supervision, has certainly improved the resilience of the major banks in Australia, and the financial system more broadly. The success of other global initiatives to address the issues that arise when a bank fails, however, remain to be seen. Thank you. References RBA (Reserve Bank of Australia) (2014), ‘Submission to the Financial System Inquiry’, Submission to the Financial System Inquiry, 2 April. Davis K (2007), ‘Banking Concentration, Financial Stability and Public Policy’, in Kent C and J Lawson (ed), The Structure and Resilience of the Financial System, Proceedings of a Conference, Reserve Bank of Australia, Sydney, pp 255–284. Byres W (2017), ‘Opening Statement’, Opening Statement at the Roundtable Hearing for the Productivity Commission Inquiry into the State of Competition in the Australian Financial System', 29 June. Byres W (2017), ‘Fortis, Fortuna, Adiuvat: Fortune Favours the Strong’, Keynote address at the 8/9 BIS central bankers' speeches AFR Banking and Wealth Summit 2017, 5 April. FSB (Financial Stability Board) (2014), Key Attributes of Effective Resolution Regimes for Financial Institutions, October. 9/9 BIS central bankers' speeches | reserve bank of australia | 2,017 | 8 |
Address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, to the Committee for Economic Development of Australia (CEDA) Mid-Year Economic Update, Adelaide, 21 July 2017. | Guy Debelle: Global influences on domestic monetary policy Address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, to the Committee for Economic Development of Australia (CEDA) Mid-Year Economic Update, Adelaide, 21 July 2017. * * * Thanks to Dan Rees and Rachael McCririck for their work on the neutral rate, which this draws directly on. There are a large number of factors that the Reserve Bank Board takes into consideration in making its interest rate decision each month, both domestic and global. Today I would like to talk about some of the global influences on domestic monetary policy. As you are well aware, the Australian economy doesn’t operate in isolation from the rest of the world. This is also true when it comes to monetary policy. While the goals of monetary policy are very much domestic, in terms of inflation and employment, the influences on the achievement of these goals are both domestic and global. In talking about the global influences on the setting of monetary policy, I will make the probably obvious point that the policy rate here in Australia is at a historic low, in no small part because policy rates elsewhere in the world are also around historic lows. Why are global policy rates as low as they are? Part of the explanation is that to meet their policy goals, central banks in other advanced economies have had expansionary policy settings since the start of the global financial crisis. Moreover, in the largest advanced economies, policymakers have provided further monetary stimulus through large asset purchase programs, which have seen central bank balance sheets increase significantly. Another part of the explanation is that the neutral level of the policy rate has declined in most countries, including here in Australia. That is, the level of the policy rate where monetary policy is neither providing stimulus nor restraint is lower than it used to be. Central banks have had to set their policy rates even lower than that already lower neutral policy rate to provide the appropriate stimulus to their economies. I will start by talking about four common global factors that have led to the expansionary monetary policy settings seen in most advanced economies for almost a decade. These four factors are present in Australia to varying degrees. I will then discuss the neutral policy rate and its decline over the past decade. I will finish with some comments on the influence of global financial factors on domestic monetary policy considerations. Four Common Global Factors The first and most obvious factor influencing monetary policy settings globally is the financial crisis and its aftermath. The large and rapid decline in policy rate settings in most advanced economies occurred in 2007 and 2008. Over this period, many policy rates were reduced to close to zero and subsequently, in some cases, even below zero. The collapse in global output and trade at the end of 2008 was sharp and significant. The severity of the episode was increased by the fact that it was synchronised across the global economy. It is now ten years since the onset of the crisis, and nearly nine years since its nadir in the last quarter of 2008, yet we still see policy rates at their post-crisis lows. The Federal Reserve in the US has raised its policy rate in recent times, but even then only four times in quarter point increments, so that the policy rate has only just reached 1 per cent. That said, broader measures of financial conditions in the US suggest that financial conditions there aren’t tighter since the Fed 1 / 11 BIS central bankers' speeches started increasing its policy rate: longer-term government bond yields and the US dollar exchange rate are both no higher than when the Fed first increased its policy rate. Corporate bond yields remain near historic lows and US equity prices are higher. The effects of the financial crisis on most parts of the advanced world have been very longlasting. Global economic growth has mostly fallen a little short of expectations for the past decade. As a result, even with the expansionary monetary policy settings, aggregate global growth has been average over this time, but not better than average, which would be desirable given the large loss of output in 2008/09. As I’m sure you all know, Australia did not suffer from the same decline in output that many other advanced economies underwent. The level of GDP in Australia is 27 per cent higher than it was in 2007. In comparison, in the US, it is 13 per cent; in the UK, 10 per cent; while in the euro area, the pre-crisis level of GDP was only regained in 2015. It is only quite recently that forecasts for the global economy have been revised higher for the first time in many years. This has reflected an upswing in industrial production and exports across a broad swathe of the global economy. A critical question is whether this upswing will be sustained. One of the reasons that global growth after the financial crisis has been only moderate is the second common factor I’d like to highlight: the low level of corporate investment over the past decade.1 Many of the preconditions that historically led to a pick-up in business investment have been in place: low policy interest rates, low borrowing costs for business, strong corporate debt markets. Something has clearly been missing that has prevented these positive preconditions from generating an upswing in business investment. One obvious candidate is uncertainty about future demand or, as it is often referred to, animal spirits. To some extent, this lack of animal spirits is self-fulfilling. If businesses are not confident about whether there will be enough demand in the future to justify more investment, they hold off spending on investment, which means that, indeed, there isn’t enough demand in the future. As the global economy has become more integrated, there seems to be a more important common global element in animal spirits. One driver of this may well be multinational firms making investment decisions across a number of economies. In Australia, the investment dynamics have been clearly different. In marked contrast to the rest of the world, business investment in Australia has been at historic highs in recent years, largely as a result of investment in the resources sector. But now resource investment has fallen most of the way back to its pre-boom levels. Investment outside the resources sector in Australia has remained at a low level, as in other countries, though it has grown modestly in the past couple of years. In recent months, there have been some positive signs on investment spending in a number of countries. If this is sustained, then it is possible animal spirits switch from being self-fulfillingly negative to self-fulfillingly positive. As we see signs of investment picking up this year in some other countries, there is an increased chance this will be reflected in Australia. A gradual pick-up in investment is embodied in the RBA’s growth forecast. The third common global element is low wage growth (Graph 1). This is occurring despite very low unemployment rates in countries such as the US, Germany, Japan and the UK. The unemployment rates in these countries are at levels that have historically been associated with an acceleration in wage growth. The Governor talked about this in a speech late last year. 2 Andy Haldane at the Bank of England recently discussed some of the possible explanations for this stubbornly low wage growth and concluded that, in the end, we don’t yet have a particularly persuasive explanation.3 That said, we know that the labour supply curve ultimately does slope upwards. So if unemployment rates continue to decline in these countries, we must get closer to 2 / 11 BIS central bankers' speeches the point where wage pressures materialise. Wage growth in Australia is subdued, as it is elsewhere. One noteworthy difference in Australia is that labour productivity growth has generally been higher than it has been in other countries over recent years. As a result, there has been no growth in unit labour costs (that is, wages adjusted for productivity) in Australia for five years, whereas in other countries, unit labour cost growth has been quite a bit higher. The fourth and last common factor is the sustained low inflation that has been evident globally for the past decade (Graph 2). This is a direct consequence of the three previous factors I have just talked about. In addition to those influences, there has been a continuation of the disinflationary pressure resulting from the integration of China into the global economy. There are signs that this latter force might be waning, with producer prices in China actually growing, following many years of continual, often quite substantial, declines. Throughout the past decade, expectations about future inflation have remained broadly anchored, which, at times, has helped stave off a shift towards deflation, but currently may be dampening the prospects of a sustained pick-up in global inflation. 3 / 11 BIS central bankers' speeches These four factors – the subdued global recovery, low investment, subdued wages growth despite low unemployment rates and low inflation – are the primary explanation for the very stimulatory policy settings in place globally (Graph 3). The fact that they are at such low levels has a material influence on why the policy interest rate in Australia is also at a historically low level. 4 / 11 BIS central bankers' speeches Beyond these factors that I have just discussed, another significant factor contributing to the low level of policy rates globally is that the neutral policy rate in many countries has declined over the past decade. The Neutral Interest Rate The neutral interest rate provides a benchmark for assessing the current stance of monetary policy. If the real policy rate – that is, the cash rate less inflation expectations – is below the neutral rate, then monetary policy is exerting an expansionary influence on the economy. If the real policy rate is above the neutral rate, then monetary policy is exerting a contractionary influence on the economy. The neutral rate is often associated with the turn of the 20th century Swedish economist Knut Wicksell and was picked up by Keynes.4 The previous Governor Glenn Stevens discussed the neutral rate in the Australian context more than a decade ago.5 There was a discussion of the neutral rate at the most recent Board meeting, as detailed in the minutes of the meeting released earlier this week. No significance should be read into the fact the neutral rate was discussed at this particular meeting. Most meetings, the Board allocates some time to discussing a policy-relevant issue in more detail, and on this occasion it was the neutral rate. The neutral interest rate aligns the amount of saving and investment in the economy at a level that is consistent with full employment and stable inflation. That is, the neutral rate is where the policy rate would settle down in the medium term when the goals of monetary policy are being achieved. Accordingly, most explanations of the neutral interest rate start with the factors that influence saving or investment. Developments that increase saving will tend to lower the neutral interest rate; developments that increase investment will tend to raise the neutral interest rate. There are three main factors that, in my view, affect the neutral rate in Australia: 5 / 11 BIS central bankers' speeches the economy’s potential growth rate the degree of risk aversion international factors. One of the major determinants of the neutral interest rate is the economy’s potential growth rate. In an economy with a high potential growth rate, because it has strong productivity or population growth, the expectation of increased future demand provides a strong incentive for firms to invest and the prospect of higher real incomes reduces the incentives of households to save. Both of these forces will tend to raise the neutral interest rate. The economy’s potential growth rate tends to evolve quite slowly, and hence we should expect the neutral interest rate also to change only very gradually as a result of this influence. Another influence on the neutral rate is the risk appetite of firms and households and the way risk has been priced into market interest rates. This influence can move rapidly. When risk aversion rises, firms require more compensation to make long-term investments with an uncertain return. At the same time, the increased risk aversion will cause households to save more. This lowers the neutral interest rate, as any given level of the policy rate is less expansionary because of the increased risk aversion. If there is an increase in risk aversion, it is also likely that there will be a widening in the spreads between the policy rate and market interest rates that determine the behaviour of households and firms. A given market interest rate will correspond to a lower policy rate if spreads widen. This will further lower the neutral interest rate. Finally, in an open economy, where capital can move reasonably freely across borders, global interest rates will also influence domestic interest rates. This means that trends in overseas productivity growth, demographics and risk appetite will affect the neutral interest rate in Australia. So how do we calculate the neutral interest rate? It is not directly observable. There are a number of different ways of estimating it from the behaviour of market interest rates and other economic variables6. The shaded area in Graph 4 shows a range of plausible estimates for the neutral real interest rate obtained using a number of different approaches. As you can see, there is a reasonable amount of uncertainty about the exact level of the neutral rate. Graph 4 also shows the (ex post) real cash rate calculated by deducting the trimmed mean inflation rate from the cash rate.7 When the real cash rate is above the neutral rate, the monetary policy stance is contractionary. When it is below, the stance is expansionary. As you look at the graph, you can see that this lines up with most assessments of the stance of monetary policy over the past 25 years. It suggests that monetary policy was clearly expansionary in the early 2000s, in 2008 and for the past five years or so. 6 / 11 BIS central bankers' speeches The estimates of the neutral rate suggest that it was fairly stable for much of the 1990s up until 2007. In Glenn Stevens’ speech that I mentioned earlier, he noted that the neutral real cash rate at the time (2004) was probably somewhere between 2½ per cent and 3¾ per cent. This is consistent with the estimates shown here. The graph shows a clear step down in all the estimates of the neutral rate in 2007/08 and that it has probably drifted lower since. It suggests that Australia’s neutral interest rate is currently around 150 basis points lower now than in 2007. This decline can largely be accounted for by a slowdown in potential growth and an increase in risk aversion. The Bank estimates that Australia’s long-run potential growth rate has declined by around ½ percentage point from the mid 1990s.8 Part of the decline reflects slower labour force growth. The rest of the decline reflects a slowdown in trend productivity growth, which is common to many advanced economies. This slowdown in potential growth has probably translated about one-for-one into a decline in the neutral rate, though the decline has been gradual. The sharper decline in the neutral rate in 2007/08 can be most easily related to the sharp increase in risk aversion with the onset of the financial crisis. This increased risk aversion probably accounts for most of the large fall in estimated neutral interest rates in Australia and abroad that occurred at this time. This heightened risk aversion has also contributed to an increase in spreads between the cash rate and market interest rates, which should have a roughly one-for-one effect on the neutral interest rate.9 At the same time, increased risk aversion means that companies are investing less than one would expect given financing conditions and the economic outlook. Households are less willing than in the past to borrow in order to fund consumption. Although these effects are hard to quantify, they would both lower the neutral interest rate. To return to a global perspective, Graph 5 compares the average estimate of the neutral interest 7 / 11 BIS central bankers' speeches rate for Australia to a range of international estimates. On average, the neutral interest rate estimates for Australia are similar to those of the United Kingdom and Canada, but higher than those for the United States and the euro area. As is the case for Australia, estimates of neutral interest rates in other developed economies were fairly stable until around the mid 2000s and have fallen since then. The decline in the neutral rate was particularly sharp in 2007/08 and, again, most likely reflects the increase in risk aversion at the onset of the financial crisis. Because trends in determinants of the neutral interest rate, such as productivity growth and risk appetite, tend to be highly correlated across advanced economies, it is hard to distinguish between international influences and domestic influences. But it is very likely that global factors have contributed to a decline in Australia’s neutral policy rate. So in short, the policy rate in Australia is low because the neutral rate is lower than it used to be as a result of both international and domestic developments. This means that the current (nominal) cash rate setting of 1½ per cent today is not as expansionary as a cash rate of 1½ per cent would have been in the 1990s or the first half of the 2000s. Looking ahead, the neutral policy rate both here in Australia as well as in other advanced economies is likely to remain lower than it was in the past. It is plausible that the degree of risk aversion might abate in time, which would see the neutral rate rise from its current low level. But other developments contributing to the lower neutral rates, particularly lower potential growth rates, could be more permanent. Global Financial Influences 8 / 11 BIS central bankers' speeches In addition to the neutral rate declining, policy rates in other countries have been set even lower to provide the appropriate stimulus. On top of that, in a number of the major economies, policy is more expansionary than indicated by just the level of the policy interest rate. Central bank balance sheets have expanded considerably as the central banks have purchased assets, in large part government debt (Graph 6). This program of asset purchases has finished in the US and the UK, but is still ongoing in the euro area and Japan. The fact that monetary policy settings are more expansionary in the rest of the world than in Australia, both through lower policy rates and balance sheet expansion, puts upward pressure on the Australian dollar. Capital is attracted by the higher rates of returns on offer here, which is likely to lead to an appreciation of the exchange rate. So, while an easier monetary policy elsewhere in the world should lead to faster growth in the world economy, which is good for the Australian economy, an appreciating exchange rate works against this. To put it in economic terms, there are offsetting income and substitution effects for the Australian economy. Whether this is positive or negative in net terms for Australia is an empirical issue. 10 Generally, the evidence suggests that widening interest rate differentials do lead to an appreciation of the Australian dollar. So that does counteract the benefit to the Australian economy of faster global growth. It is conceivable that unconventional monetary policy may have a larger financial impact than movements in interest rates.11 That is, the effect of unconventional policy through the exchange rate channel may be larger while the effect in terms of higher output may be smaller. Again, it is an empirical issue. Central bank asset purchases generate cross-border capital flows from investors seeking higher returns. Some of that we see directly in a higher Australian dollar exchange rate. But some of those cross-border flows are not quite so obvious. Investors often tend to hedge their exchange 9 / 11 BIS central bankers' speeches rate exposures to protect their offshore investments from exchange rate movements. As these investments increase there is more demand for such hedges, which causes the cost of hedging to increase. A direct measure of this is the cross-currency basis, which I spoke about recently.12 For example, the relatively wide yen basis in part reflects the increased capital flows out of Japan.13 If fewer of these investments were hedged, we would see more of these capital flows reflected in the exchange rate. If there was less hedging in the example I just used, the yen may well have depreciated further and currencies where Japanese investors have placed their funds, such as the Australian dollar, would have appreciated by more. So hedging, which is reflected in the wider cross-currency basis, has served as something of a shock absorber for these cross-border flows. But this aside, the expansionary settings of monetary policy globally clearly have had a material influence on domestic policy settings through the impact of capital flows on the exchange rate. Hélène Rey has recently described this state of affairs as a monetary dilemma: ‘Independent monetary policies are possible if and only if the capital account is managed…’14 That is, we can only set the monetary policy we want if we impose controls on the flow of capital in and out of the country. I don’t think the situation is quite as stark as that. There is still a substantial degree of flexibility to set domestic monetary policy appropriately for domestic conditions. But I would certainly agree that the monetary policy decisions of other central banks are a significant factor to be taken into account in our monetary policy deliberations.15 Another way of stating this is that we don’t have the independence to set the neutral rate, which is significantly influenced by global forces, but we do have the independence as to where we set our policy rate relative to the neutral rate. Conclusion To conclude, I have outlined today a number of the channels of influence that global developments have on domestic monetary policy settings. Some of these global forces are transmitted through the real economy, some through financial channels. The effects of these global influences on the Australian economy have been material. The global economic environment and global policy settings that have been in place for the past decade have contributed significantly to the monetary policy settings in Australia that we have today and will likely continue to do so for the foreseeable future. Currently, financial markets don’t expect any further lowering of policy rates in the major economies, nor any further expansion in policy settings. Hence the downward pressure on domestic policy settings from this source does not look like it will intensify in the foreseeable future. But the four common factors that are highlighted in the first half of my speech are still present. While there are some tentative signs that they are abating, the evidence is inconclusive at this stage. As I said earlier, the Federal Reserve has raised its policy rate very gradually four times over the past two years. And last week the Bank of Canada increased its policy rate to 0.75 per cent. Just as the policy rate in Australia did not need to decline to the very low levels seen in other parts of the world, the fact that other central banks increase their policy rates does not automatically mean that the policy rate here needs to increase. The policy rates in both the US and Canada still remain below that in Australia. Ultimately, in Australia as is the case elsewhere, policy rates are set at the level assessed to be appropriate to achieve the domestic policy objectives. While global influences, including monetary policy settings in other economies, have a significant impact on that assessment, they 10 / 11 BIS central bankers' speeches are, in the end, only one of a number of considerations to be taken into account. 1 See also Carney M (2017), ‘Investment and Growth in Advanced Economies’, Remarks at 2017 ECB Forum on Central Banking, Sintra, June. Available <www.bankofengland.co.uk/publications/Documents/speeches/2017/speech986.pdf>. at 2 Lowe P (2016), ‘Inflation and Monetary Policy’, Address to Citi’s 8th Annual Australian & New Zealand Investment Conference, Sydney, 18 October. 3 Haldane A (2017), ‘Work, Wages and Monetary Policy’, Speech at the National Science and Media Museum, Bradford, June. Available <www.bankofengland.co.uk/publications/Documents/speeches/2017/speech984.pdf>. at 4 Given I am speaking in Adelaide, it is appropriate to thank my former macro/money professor at Adelaide University, Colin Rogers, for getting me to read Wicksell’s Interest and Prices in my honours year. 5 Stevens G (2004), ‘Recent Issues for the Conduct of Monetary Policy’, Address to the Australian Business Economists and the Economic Society (NSW Branch), Sydney, 17 February. 6 See Laubach T and J Williams (2016), ‘Measuring the Natural Rate of Interest Redux’, Finance and Economics Discussion Series 2016–011. Washington: Board of Governors of the Federal Reserve System, <dx.doi.org/10.17016/FEDS.2016.011>. 7 Note that is an ex post measure of the real cash rate as I am using actual inflation rather than expected inflation. 8 The Treasury has very similar estimates in the Commonwealth Budget. 9 The Bank has noted on many occasions over the past decade that it has taken account of this widening in spreads in the setting of monetary policy. 10 Adler G and CO Buitron (2017), ‘Tipping the Scale? The Workings of Monetary Policy through Trade’ IMF Working Paper 17/142. Available at <www.imf.org/~/media/Files/Publications/WP/2017/wp17142.ashx>. 11 Ferrari M, J Kearns and A Schrimpf (2017), ‘Monetary Policy’s Rising FX Impact in the Era of Ultra-low Rates’, BIS Working paper No 626, April. Available at <www.bis.org/publ/work626.pdf>. 12 Debelle G (2017), ‘How I Learned to Stop Worrying and Love the Basis’, Dinner Address at the BIS Symposium: CIP–RIP? Basel, 22 May. 13 The yen basis refers to the cost for a Japanese investor of hedging a US dollar or Australian dollar investment, say, back into yen. 14 Rey H (2013), ‘Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence’, Proceedings of a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 23–24 August, pp 285–333. Available at <www.kansascityfed.org/publicat/sympos/2013/2013rey.pdf>. 15 See also Obstfeld M and A Taylor (2017), ‘International Monetary Relations: Taking Finance Seriously’, NBER Working paper No 23440. Available at <www.nber.org/papers/w23440>. 11 / 11 BIS central bankers' speeches | reserve bank of australia | 2,017 | 8 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Anika Foundation Luncheon, Sydney, 26 July 2017. | 7/26/2017 The Labour Market and Monetary Policy | Speeches | RBA Speech The Labour Market and Monetary Policy Philip Lowe [ * ] Governor Address to the Anika Foundation Luncheon Sydney – 26 July 2017 Summary → It is a great pleasure to be able to support the Anika Foundation by speaking today. I was delighted when Adrian asked me to continue the RBA's support of the Foundation. In the early 1990s, when I first returned from studying overseas, Adrian had just taken up the position of Head of Economic Research at the RBA and he was a great mentor to me. More importantly, the Anika Foundation is undertaking really important work in helping improve the mental health of our children. Thank you all for coming out today to support this work. I would particularly like to thank NAB for its support as the new sponsor of this lunch. Over the past few months I have participated in a lot of international meetings: the IMF, the G20, the BIS, the Financial Stability Board and meetings of Asian central bank governors. Two points, in particular, have struck me. The first is that conditions in the global economy have improved. The pessimism of earlier years has given way to cautious optimism. Forecasts of future growth are being revised up, not down. So the discussions are quite different from those that were taking place a year ago. The second point is the commonality of the questions being asked about labour markets. Employment growth has generally surprised on the upside and, in a number of countries, the unemployment rate is at, or below, the rate conventionally associated with full employment. Yet at the same time, growth in wages remains subdued, even in countries with low unemployment rates. So a common question being asked is: why are the stronger labour markets not generating more upward pressure on wages? A related question is what does this mean for the outlook for inflation and monetary policy? https://www.rba.gov.au/speeches/2017/sp-gov-2017-07-26.html 1/13 7/26/2017 The Labour Market and Monetary Policy | Speeches | RBA In today's remarks, I would like to talk about these labour market issues in an Australian context. My remarks will be in three parts. I will first talk about trends in employment in Australia. I will then discuss recent wage outcomes. And finally, the implications for monetary policy. Trends in Employment On a number of measures the Australian labour market has performed well over recent times. Over the past decade and a half, the unemployment rate has moved up and down within a narrow range of around 2 percentage points and its average level has been considerably below that in the previous 30 years (Graph 1). Most other countries have seen considerably larger swings in their unemployment rates over recent times. The relative stability in Australia's unemployment rate is despite us experiencing the biggest terms of trade and mining investment booms in a century. It is a considerable achievement and a testament to the flexibility of the Australian economy. Graph 1 If we look at just the past few months, there has been a welcome pick-up in employment growth right across the country, after a period of softness. The forward-looking indicators suggest that employment growth will continue. Job ads, job vacancies and hiring intentions have all lifted. Businesses are also reporting better conditions than they have for some years. This is good news, particularly given that the https://www.rba.gov.au/speeches/2017/sp-gov-2017-07-26.html 2/13 7/26/2017 The Labour Market and Monetary Policy | Speeches | RBA unemployment rate is still around ½ a percentage point above estimates of full employment in Australia. Notwithstanding these outcomes, there are other labour market developments that are causing concern in the community. There is a degree of underemployment, wage growth is slow and job security is an issue for more people. The nature of work is also changing, in both the way we work and the industries in which we work. Over the medium term, two trends in particular stand out. The first is the growth of part-time employment. And the second is the growth of employment in the services sector. The number of Australians working part time has grown rapidly (Graph 2). Since the 1960s, the share of part-time workers has increased threefold to nearly one-third of total employment, with the pace of this shift picking up over recent years. Since 2013, growth in part-time employment has averaged 3 per cent per year, while growth in full-time employment has averaged less than 1 per cent. Graph 2 This shift in working patterns reflects both supply and demand factors. https://www.rba.gov.au/speeches/2017/sp-gov-2017-07-26.html 3/13 7/26/2017 The Labour Market and Monetary Policy | Speeches | RBA On the supply side, many people want to work part time. Indeed, in many workplaces, employees have long been asking for greater flexibility, including the ability to work fewer hours. Part-time work leaves time for other activities, including education, caring for others and leisure. Some insight into why people work part time can be gained from the HILDA Survey, which asks people for the main reason that they work part time (Graph 3). The most common response is that they are studying. Other frequent responses are that they are caring for children or that they simply prefer parttime work. For many people, part-time work is what they want. The fact that we have been able to accommodate this desire is a positive feature of our labour market. Graph 3 There are demand factors at work as well. Many businesses benefit from having employees who work part time. But there is an element to the demand side that is not so positive. Some people are working part-time because they can't find a full-time job and others are working part-time because of job requirements. While most part-time workers are not seeking full-time employment, around one-quarter want to work more hours than they currently do. On average, they are looking to work an additional 14 hours per week, although many are not taking active steps to secure those additional hours. https://www.rba.gov.au/speeches/2017/sp-gov-2017-07-26.html 4/13 7/26/2017 The Labour Market and Monetary Policy | Speeches | RBA So many people want to work part time, but some of these would like more hours than they currently have. This represents an additional source of unused capacity in our labour market that is not reflected in the unemployment rate. Given this, as part-time employment has grown, the RBA has paid additional attention to alternative measures of labour market slack. One measure that has conceptual appeal is an hours-based underutilisation rate, which measures the additional hours sought by workers (including those currently unemployed) relative to the total number of hours that workers would like to work. This measure shows the same general pattern as the unemployment rate, although the gap has tended to widen gradually over time (Graph 4). Graph 4 Now turning to the second longer-term trend shift we have seen in our labour market – the shift to employment in the services sector (Graph 5). https://www.rba.gov.au/speeches/2017/sp-gov-2017-07-26.html 5/13 7/26/2017 The Labour Market and Monetary Policy | Speeches | RBA Graph 5 Today, almost 80 per cent of Australians work in service industries, broadly defined. By way of contrast, in the 1950s only around 50 per cent of employed Australians worked in the services sector. In the past, it was common to have a full-time job producing goods. In our more modern economy, this is no longer the case. In an effort to better understand the growth in services-sector employment, one of the exercises that we have done at the RBA is to classify around 300 individual service-sector occupations into jobs that pay hourly wages that are below average, around average and above average. [3] We have then tracked employment growth for each of these three groups since 2000 (Graph 6). https://www.rba.gov.au/speeches/2017/sp-gov-2017-07-26.html 6/13 7/26/2017 The Labour Market and Monetary Policy | Speeches | RBA Graph 6 The picture is pretty clear. The growth in service-sector employment has been strongest in those occupations with above-average rates of pay. Since 2000, over a million new higher-paying jobs have been created in the services sector. Some of the occupations where there have been large gains in employment are: medical professionals, IT managers, project administrators and sales managers. There has also been strong employment growth in occupations with lower rates of pay. We have also conducted the same analysis for the business services and household services sectors separately (Graph 7). The growth of higher-paying jobs has been much more pronounced in business services, than it has been in household services. For the household services sector, the growth has been strongest in jobs with below-average wages. Some of the occupations where there has been a big increase in employment here include: baristas and waiters, childcare workers and aged-care workers. So it's a mixed picture. https://www.rba.gov.au/speeches/2017/sp-gov-2017-07-26.html 7/13 7/26/2017 The Labour Market and Monetary Policy | Speeches | RBA Graph 7 I am often asked where future jobs growth will come from. The short answer is that it will come mainly from where it has come from in the recent past – from the myriad of occupations in the services sector. Some of these jobs will attract relatively low rates of pay, but, if our experience is a useful guide, more of these jobs will be higher-paying high-skill jobs. With most of us working in the services sector, it's in our national interest to lift productivity growth in these industries and to develop more higher-paid high-skill jobs. Technology is important here but so too is investment in human capital. It seems probable that the next wave of growth in Australia will be driven by us building on our expertise in services. This requires investment, including in human capital. Growth in Wages I would now like to turn to another element of the labour market story – the slow growth in wages. Over the past year, the Wage Price Index has increased by 1.9 per cent. This is the slowest rate of increase since this series commenced in 1997. The same picture is evident in the broader measure of average hourly earnings from the national accounts. To help see the longer-term trends, Graph 8 shows average annual growth in hourly earnings over a rolling four-year period. The most recent observation is the lowest for many decades. From the mid 1990s until a few years ago, Australians got used to https://www.rba.gov.au/speeches/2017/sp-gov-2017-07-26.html 8/13 7/26/2017 The Labour Market and Monetary Policy | Speeches | RBA average hourly earnings increasing by around 4 per cent a year. Over recent years, growth has been a bit less than half of this. Graph 8 These lower wage increases have persisted for some time now. One consequence of this is that there has been a decline in expectations of future income growth. This decline is seen as more than just temporary. It is one of the factors that has been weighing on consumption growth over recent times. As households have revised down their expectations of future income growth, they have adjusted their spending too. A downward revision to expectations of income growth also means debt obligations stay higher for longer than was originally expected. Why is this happening, both here and elsewhere in the world? There is no single answer. Part of the story in Australia is that our labour market has some spare capacity and we are unwinding some of the effects on wages of the mining investment boom. But this isn't the whole story, and neither spare capacity nor a mining boom explain low wages growth in some other advanced economies. Another part of the story, particularly overseas, is slower productivity growth. In the United States, for example, low growth in wages is being matched with low productivity growth. In Australia, productivity https://www.rba.gov.au/speeches/2017/sp-gov-2017-07-26.html 9/13 7/26/2017 The Labour Market and Monetary Policy | Speeches | RBA growth has also slowed somewhat. Here, however, the slowing in earnings growth has been more pronounced than that in productivity. The result has been a decline in labour's share of national income. None of these reasons alone appears sufficient to explain the weakness in wage growth. This suggests that there is something else going on, and that it has a global dimension. Many workers in advanced economies feel like they face more competition. A basic principle of economics is that when you face more competition, you are less inclined to put your price, or as a worker, your wage, up. This perception of greater competition is coming from two sources. The first is globalisation. One of the positives of globalisation is that it increases the size of market that a firm can tap. At the same time, though, globalisation increases the number of competitors that can tap your market; it increases competition. The second source is changes in technology. In some industries, advances in technology have led workers to worry about the competition from robots. At the same time, advances in technology have made more areas of the economy subject to international competition; there are fewer truly nontraded industries any more. Perhaps as a consequence of this extra competition – or perhaps as a consequence of other forces within our societies – many workers in advanced economies feel that the world is less secure – less secure economically and less secure politically. This means that security is valued more highly. With a greater premium on security, it's plausible that workers are less inclined to take a risk by seeking larger wage increases. One related aspect of the current labour market is a decline in job mobility. Data published by the ABS suggest that the share of employed people changing employers is around the lowest in recent decades (Graph 9). It is likely that in an environment of less job security, fewer people are inclined to switch employers. There is also a demand-side effect, with fewer firms attempting to attract workers from other firms. This is consistent with subdued wage growth. https://www.rba.gov.au/speeches/2017/sp-gov-2017-07-26.html 10/13 7/26/2017 The Labour Market and Monetary Policy | Speeches | RBA Graph 9 When I spoke about this set of issues in a recent panel at the Crawford School at ANU, I made the point that some pick-up in aggregate wage growth over time would be a welcome development. Some commentators saw this as the Reserve Bank Governor making a rather unusual call to arms: a call for workers to demand larger wage increases from their employers. My intention was less dramatic. It was simply to make the point that a gradual pick-up in aggregate wages growth would be a positive development. The best outcome for both workers and firms is for any pick-up to be underpinned by a lift in productivity growth and more high-skill jobs. But even the current rate of productivity growth could sustain some increase in wages growth over time. Indeed, some pick-up is incorporated into the Bank's forecasts for the economy. A gradual lift in wage growth is a central element in our forecast for inflation to return to around the mid-point of the medium-term target range. Policy Implications I would now like to turn to some of the implications for monetary policy, both globally and in Australia. The persistent slow growth in wages is creating a challenge for central banks. It is contributing to an extended period of inflation below target. In years gone by, the more standard challenge was to keep wage growth in check, so as to stop upward pressure on inflation, which could lead to restrictive monetary policy. No advanced economy faces this challenge at present. https://www.rba.gov.au/speeches/2017/sp-gov-2017-07-26.html 11/13 7/26/2017 The Labour Market and Monetary Policy | Speeches | RBA It is possible that things could change in the not too distant future, particularly in those countries at, or near, full employment. It may be that the lags are just a bit longer than usual. If so, we could hit a point at which workers, having had only modest pay increases for a run of years, decide that it is time for a catch-up. If such a tipping point were reached, inflation pressures could emerge quite quickly. In this scenario we could see a period of turbulence in financial markets, given that markets are pricing in little risk of future inflation. This scenario can't be completely discounted. It would seem, though, to have a fairly low probability in Australia, especially in light of the continuing spare capacity in our labour market. The more likely case here is that wage growth picks up gradually as the demand for labour strengthens. Globally, an alternative scenario is that the period of slow wage growth turns out to be much more persistent, partly for the reasons that I discussed earlier. In this scenario, wages growth eventually picks up, but it takes quite a while longer. If so, inflation stays low for longer, although there are other factors that could push inflation higher. This scenario is one in which the Phillips Curve is flatter than it once was. It is one in which inflation is harder to generate. We can't yet tell though whether the Phillips Curve in Australia has become flatter, given that we have experienced relatively little variation in the unemployment rate over recent times. The combination of a flatter Phillips Curve and inflation below target raises a challenge for central banks: how hard to press to get inflation up? For a central bank with a single objective of inflation, the answer is relatively straightforward. Inflation is too low, so you do what you can to get inflation up. If inflation doesn't increase, you need more monetary stimulus. This approach does carry risks, though. A flatter Phillips Curve means that the monetary stimulus has relatively little effect on inflation, at least for a while. At the same time, however, the monetary stimulus is likely to push asset prices higher and encourage more borrowing. Faced with low inflation, low unemployment and low interest rates, investors are likely to find it attractive to borrow money to buy assets. This poses a medium-term risk to financial stability. Australia's monetary policy framework is better placed to deal with this world than some others. We have a flexible medium-term inflation target that allows financial stability considerations to be taken into account in the setting of monetary policy. Over recent times you would have noticed that we have been paying close attention to the risks in household balance sheets. Household debt is high and rising faster than the unusually slow growth in incomes. These developments have had a bearing on the setting of monetary policy. We have not sought to stimulate a rapid lift in inflation. The fact that the labour market has been generating sufficient jobs to keep the unemployment rate broadly steady has allowed us to be patient. Our judgement has been that seeking a more rapid pick-up in inflation through yet further monetary stimulus was likely to add to the https://www.rba.gov.au/speeches/2017/sp-gov-2017-07-26.html 12/13 7/26/2017 The Labour Market and Monetary Policy | Speeches | RBA medium-term risks. Our central scenario remains for underlying inflation to pick up gradually as the economy strengthens. Elsewhere in the world, some central banks are now starting to increase interest rates and others are considering when to withdraw some of the monetary stimulus that has been put in place. This has no automatic implications for monetary policy in Australia. These central banks lowered their interest rates to zero and also expanded their balance sheets greatly. We did not go down this route. Just as we did not move in lockstep with other central banks when the monetary stimulus was being delivered, we don't need to move in lockstep as some of this stimulus is removed. Our decisions will continue to be made within the framework of our medium-term inflation target. We are intent on delivering Australians an average rate of inflation over time of between 2 and 3 per cent. We are seeking to do this in a way that supports sustainable growth in the economy and that best serves the public interest. To do this we need to understand developments in Australia's labour market and to take account of our decisions on balance sheets in the economy. Thank you for listening. I look forward to your questions. Endnotes [*] I would like to thank Natasha Cassidy and James Foster for assistance in the preparation of this talk. See Cusbert, T (2017), Estimating the NAIRU and the Unemployment Gap PDF , RBA This measure includes all part-time workers seeking additional hours, regardless of whether they are taking active steps to obtain the additional hours. See RBA (2017), ‘Box B: Underemployment and Labour Market Spare Capacity’, February, pp 38–40. Bulletin, June, pp 13-22 Statement of Monetary Policy, Occupations in the business and household services sectors have been included in this analysis. Related Information HILDA Disclaimer Notice © Reserve Bank of Australia, 2001–2017. All rights reserved. https://www.rba.gov.au/speeches/2017/sp-gov-2017-07-26.html 13/13 | reserve bank of australia | 2,017 | 8 |
The Bloomberg Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, Sydney, 9 August 2017. | 8/9/2017 Fixed Income Markets and the Economy | Speeches | RBA Speech Fixed Income Markets and the Economy Christopher Kent [ * ] Assistant Governor (Financial Markets) The Bloomberg Address Sydney – 9 August 2017 Introduction Thank you to Bloomberg for kindly playing host this morning. I was here just over a year ago discussing the economy's transition following the end of the mining boom. That was in my capacity as the Bank's chief economist. For the past few quarters I've been through my own transition. I now oversee the Bank's Financial Markets Group. This move has provided me the chance to reflect upon the interactions between finance and the broader economy. I wish to share some observations about those interactions today, focusing on the fixed income market. Fixed Income Markets Like many other financial markets, the fixed income market matches those who have a demand for funds to those who can supply them. The market is an important means by which governments and businesses can raise funds by issuing bonds to a wide range of investors in order to build new capital, purchase existing assets or cover other expenses. But defining the boundaries of what constitutes the ‘Australian’ bond market is not entirely straight forward. Does it mean bonds on issue in Australia or bonds on issue by Australian entities, which includes overseas issuance? Or is it a combination of both? What about Australian dollardenominated bonds issued overseas by foreign businesses? Should they be counted? Today, I'm taking a broad view. I want to discuss the way the fixed income market as a whole interacts with the Australian economy, so I'm going with the broadest definition of the Australian fixed income market: all issuance by Australian residents, onshore and offshore; and all issuance denominated in Australian dollars, including by foreign entities. One way we can cut the data is to look at issuance by government versus issuance by the private sector and other non-government entities (Graph 1). Prior to the global financial crisis, the stock of https://www.rba.gov.au/speeches/2017/sp-ag-2017-08-09.html 1/16 8/9/2017 Fixed Income Markets and the Economy | Speeches | RBA government debt on issue in Australia was quite low, and private sector bonds on issue accounted for the vast majority of paper outstanding. Government debt outstanding had been little changed over those years. Indeed, it was actually a bit lower than the levels reached in the 1990s. After the financial crisis, government debt began to increase. Federal government debt has continued to do so, although state government debt has stabilised over the past couple of years, a feature which I will discuss later. Private sector issuance has evolved somewhat differently. It grew quite rapidly from low levels in the lead up to the financial crisis, but growth has been more modest since then. Both demand and supply factors influenced that change. Demand for private sector securities waned in the midst of the crisis in response to a general reduction in risk-taking, although that weakness in demand really has only been persistent in the case of asset-backed securities. Supply was also affected by regulatory requirements that sought to place banks on a sounder footing and reduce their exposure to wholesale markets. How important is the private bond market compared with alternative sources of finance? Currently, the value of private bonds outstanding is around $1.1 trillion. This includes issuance by financial and non-financial corporations. That stock is equivalent to around two-thirds of the value of companies on the Australian stock exchange. So the bond market is an important source of finance. listed Graph 1 https://www.rba.gov.au/speeches/2017/sp-ag-2017-08-09.html 2/16 8/9/2017 Fixed Income Markets and the Economy | Speeches | RBA Even so, it's also worth noting that a large share of finance in Australia is intermediated via banks and other financial institutions. [1] So, it is not surprising that about half of private sector bonds have been issued by financial entities, mostly banks (Graph 2). The value of funds raised by nonfinancial corporations through fixed income markets is much less than the $1.1 trillion I previously mentioned. In contrast, total bank credit amounts to about $2.6 trillion. Graph 2 We can also view this through the funding composition of non-financial corporations in the National Accounts, published by the Australian Bureau of Statistics (ABS) (Graph 3). Intermediated debt is much greater than non-intermediated debt for that part of the economy. https://www.rba.gov.au/speeches/2017/sp-ag-2017-08-09.html 3/16 8/9/2017 Fixed Income Markets and the Economy | Speeches | RBA Graph 3 Another way to cut the data is to compare bonds issued domestically with those issued offshore. Offshore issuance is attractive for a number of reasons. The deep, liquid markets that exist in the United States, for example, offer attractive issuance opportunities for those seeking large amounts of funding (Graph 4). As a result, most of the issuance by Australian residents is offshore. The exception is for asset-backed securities, most of which are now issued domestically (although those can still be purchased by non-residents). https://www.rba.gov.au/speeches/2017/sp-ag-2017-08-09.html 4/16 8/9/2017 Fixed Income Markets and the Economy | Speeches | RBA Graph 4 Interestingly, the international dimension of the Australian fixed income market is not limited to Australian residents issuing overseas. Non-residents also issue in Australia, and issue Australian dollar debt overseas. These types of issuance have been increasing steadily since the financial crisis (Graph 2). It may surprise some that non-resident issuers account for just as much bond issuance as domestic non-financial corporations. (Of non-resident issuance, supranational, sovereign or quasisovereign agency entities account for a large share of the market. [2] ) So far, my discussion has been based on volumes. By itself, it might give the impression that finance from fixed income markets has been a bit harder to come by than before the financial crisis (at least for a range of non-government issuers). While there may be an element of truth to this, in large part the slower growth of funding from this source reflects low demand (by issuers to raise funds) and the availability of other sources of funds. To understand that point, it's also important to have a look at prices. They suggest that funding is readily available. Starting with the Australian government market, we see what should be a familiar story to many people here: a downward trend in yields since the global financial crisis (Graph 5). We have seen a slight uptick since the latter part of 2016. That uptick has been part of a global shift in yields. In many respects it is welcome because it reflects better prospects for global growth and inflation. Even so, that pick-up in rates is quite modest and only takes yields back to levels of a year or so ago. Hence, rates remain close to historical lows. As I mentioned, funding is available at favourable rates. https://www.rba.gov.au/speeches/2017/sp-ag-2017-08-09.html 5/16 8/9/2017 Fixed Income Markets and the Economy | Speeches | RBA Graph 5 A similar pattern can be seen in private sector yields (Graph 6). We see the modest uptick lately, following a long run downward trend. However, the experience during the crisis was different from that of government debt. Naturally, interest rates faced by the private sector spiked up (particularly for lower-rated debt) as the appetite for risk contracted sharply. https://www.rba.gov.au/speeches/2017/sp-ag-2017-08-09.html 6/16 8/9/2017 Fixed Income Markets and the Economy | Speeches | RBA Graph 6 The differences between what happened with private sector and government yields can be seen clearly by examining spreads (Graph 7). The spike in spreads during the crisis is obvious. But they have come back from those levels. And even though they are higher than the levels prior to the financial crisis, spreads are still at low levels. Again, funding from these markets is available on favourable terms. https://www.rba.gov.au/speeches/2017/sp-ag-2017-08-09.html 7/16 8/9/2017 Fixed Income Markets and the Economy | Speeches | RBA Graph 7 Links from the ‘Real’ Economy to Financial Markets and Back Again So far I've given you a standard run-down of securities markets. This would be familiar ground for many. Now I would like to turn my attention to the links that some of these developments have to the wider economy. These links can be profound. We saw this spectacularly during the global financial crisis. What happened then is well known and I will not retell that story now. However, it is worth remembering that developments in the slicing and dicing of American mortgages had tangible effects that went well beyond the US economy. Australia, fortunately, weathered the global financial crisis without the sort of pain seen elsewhere in the world. But its effects were clearly evident across the economy, including in fixed income markets, as I have already mentioned. Developments in the market for wholesale debt can affect the costs of funds for banks, and thus have implications for the wider economy. Indeed, a material change in the cost of funds for banks would, by itself, contribute to a change in financial conditions. In this context, the spikes in spreads associated with the global financial crisis, and then later during the European debt problems in 2012, are notable (Graph 7). In the light of recent increases in long-term government bond yields across a range of advanced economies, it is worth highlighting some key points about the cost of banks' funding. The first point to reiterate is that yields on longer-term government debt are still quite low; monetary policy remains very accommodative across advanced economies and inflation remains low. Moreover, given https://www.rba.gov.au/speeches/2017/sp-ag-2017-08-09.html 8/16 8/9/2017 Fixed Income Markets and the Economy | Speeches | RBA the decline in bank bond spreads since mid 2016, the same is true of the costs of banks' funding in longer-term wholesale debt markets (Graph 8). Funding costs in short-term debt markets are also low. Graph 8 Second, banks' use of wholesale debt markets (both short-term and long-term) is much less than it was a few years ago. Since the financial crisis, a much larger share of funding is obtained via deposits; the fall in the share of short-term debt over the past decade has been quite stark. Third, our estimate of the average outstanding funding rate for banks has declined by close to 10 basis points since late last year, and the marginal rates of funding are currently a little below the average outstanding rates. The market for bank wholesale debt has played an important role in facilitating capital flows to and from Australia. Net inflows of debt attributable to Australian financial institutions (more specifically, authorised deposit-taking institutions (ADIs)) were significant prior to the financial crisis (Graph 9). However, that has not been the case since then. Indeed, in some years the financial sector has experienced net outflows of debt. In part, this probably owes to the behaviour of the non-mining private sector, as savings from that part of the economy went up and investment remained lacklustre. As a result, banks – which are important intermediaries between the private non-mining sector and the rest of the world – didn't need to issue as much wholesale debt and they were able to https://www.rba.gov.au/speeches/2017/sp-ag-2017-08-09.html 9/16 8/9/2017 Fixed Income Markets and the Economy | Speeches | RBA make use of deposits for a greater share of their funding. Instead, since the crisis the net capital inflows to Australia – which are the mirror of our current account deficit – have been dominated by the government and the mining sector. Graph 9 Australian federal government issuance rose after the financial crisis as the federal budget went into deficit (Graph 1). This was, in part, an automatic consequence of the slowing economy we had at the time. However, there were some added stimulatory fiscal measures introduced to support economic activity, which is well known. Perhaps less appreciated is the fiscal position of the state governments. They too experienced larger deficits, but that upward trajectory in their bonds outstanding had generally stopped a few years ago. Why has this happened? For a clue we can look at bonds outstanding by state (Graph 10). We see that New South Wales has seen the largest decline of outstanding bonds, while the mining state of Western Australia has headed in the opposite direction. These patterns are not so surprising. The Western Australian economy has experienced a bumpy road following the commodities boom. On the other hand, New South Wales is faring relatively well; revenues associated with the strong property market, in conjunction with asset sales, has provided the opportunity to reduce the value of bonds https://www.rba.gov.au/speeches/2017/sp-ag-2017-08-09.html 10/16 8/9/2017 Fixed Income Markets and the Economy | Speeches | RBA on issue. The message is that state debt has been affected by state specific economic developments, which in the case of New South Wales has helped to bring down debt. Graph 10 We also see the imprint of developments in the real economy quite clearly in the market for nonfinancial corporate debt. Moreover, there is some evidence of conditions in debt markets influencing the behaviour of firms in the mining sector. The mining boom required significant financing. As we have observed previously, much of that finance was raised internally. [4] However, mining companies also accessed external finance. Some of that came from banks, but a large share came from the bond market (Graph 11). Resource and resource-related companies increased their bonds on issue by three-fold from 2008 to 2015, encouraged by strong growth in commodity prices, favourable interest rates on debt, and the need to fund a large rise in investment. https://www.rba.gov.au/speeches/2017/sp-ag-2017-08-09.html 11/16 8/9/2017 Fixed Income Markets and the Economy | Speeches | RBA Graph 11 A broader measure of debt that captures other sources of funding, including from banks, is gearing (which is the ratio of net debt to the book value of equity). Up to 2013, the gearing ratio of the major miners had increased significantly, and for some companies it was at quite high levels (Graph 12). https://www.rba.gov.au/speeches/2017/sp-ag-2017-08-09.html 12/16 8/9/2017 Fixed Income Markets and the Economy | Speeches | RBA Graph 12 The larger-than-expected declines in commodity prices (since 2012) had a marked effect on pricing in the bond markets and on the behaviour of resource companies. The sharp rise in bond spreads on resource company debt from 2015 into early 2016, in response to the large declines in commodity prices, signalled the concerns in these markets about the health of some resource companies (Graph 13). https://www.rba.gov.au/speeches/2017/sp-ag-2017-08-09.html 13/16 8/9/2017 Fixed Income Markets and the Economy | Speeches | RBA Graph 13 Not surprisingly, mining companies responded to those signals in commodity and bond markets by reining in their costs significantly (Graph 14). Part of that may well have come from gains in efficiency that followed from earlier investment in capacity. But much of it was driven by a reduction in expenditure on a wide range of things. Indeed, cutbacks across the resources sector, in addition to the planned reductions in mining investment, had a very noticeable effect on aggregate demand in Western Australia and Queensland over recent years. The associated reductions in spending allowed the mining companies to reduce the extent of their debt, and repayment of bonds has played an important role in that process. https://www.rba.gov.au/speeches/2017/sp-ag-2017-08-09.html 14/16 8/9/2017 Fixed Income Markets and the Economy | Speeches | RBA Graph 14 Conclusion This has been quite a tour of fixed income markets. They constitute a non-trivial share of financing, not just for governments, but also for businesses. For the private sector, though, growth in this source of funds has remained less than it was prior to the financial crisis. For the banks, that represents a shift to other sources of funds, notably deposits. Moreover, it has also been reflected in the banks no longer being a conduit for capital flows into Australia, in contrast to their key role before the financial crisis. For the mining sector, plenty of funding was obtained from fixed income markets, although, following the sharp fall in commodity prices, resource companies have reduced their debts. Non-mining corporations haven't stepped in to fill that breach as their investment demand remains modest. However, as is the case across a range of funding sources, finance appears to be readily available to credit-worthy firms in fixed income markets at favourable prices. Endnotes [*] I thank Leon Berkelmans for invaluable assistance in preparing these remarks. This is typical of many economies, though not for the United States. See Ellis L (2016), ‘Financial Stability and the Banking Sector’, Address to the Sydney Banking and Financial Stability Conference, 12 July. Bergmann M and A Nitscke (2016), ‘The Kangaroo Bond Market’, RBA https://www.rba.gov.au/speeches/2017/sp-ag-2017-08-09.html Bulletin, September, pp 47–52. 15/16 8/9/2017 Fixed Income Markets and the Economy | Speeches | RBA Australian Financial Review Banking Debelle G (2017), ‘Recent Trends in Australian Capital Flows’, Address to the and Wealth Summit, 6 April. Arsov I, B Shanahan and T Williams (2013), ‘Funding the Australian Resources Investment Boom’, RBA March, pp 51–61. Bulletin, © Reserve Bank of Australia, 2001–2017. All rights reserved. https://www.rba.gov.au/speeches/2017/sp-ag-2017-08-09.html 16/16 | reserve bank of australia | 2,017 | 8 |
Speech by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at Moody's Analytics Australia Conference 2017, Sydney, 14 August 2017. | Christopher Kent: Innovative mortgage data Speech by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at Moody's Analytics Australia Conference 2017, Sydney, 14 August 2017. * * * I thank Michael Tran and Michelle Bergmann for invaluable assistance in preparing these remarks. Introduction I’d like to thank Moody’s for the invitation to speak to you at this conference on innovation in banking and risk management. My discussion is relevant to both of these issues. The Reserve Bank has always emphasised the value of using a wide range of data to better understand economic developments. One relatively new source of data for us is what we refer to as the Securitisation Dataset. Today, I’ll briefly describe this dataset and then I want to tell you a few of the interesting things we are learning from it.1 The Bank collects data on asset-backed securities. Currently, the dataset covers about 280 ‘pools’ of securitised assets. We require these data to ensure that the securities are of sufficient quality to be eligible as collateral in our domestic market operations. The vast bulk of the assets underlying these securities are residential mortgages (other assets, such as commercial property mortgages and car loans, constitute only about 2 per cent of the pools). Some of these are ‘marketed securities’ that have been sold to external investors. There are also securities that banks have ‘self-securitised’.2 Self-securitisations are primarily used by participating banks for the Committed Liquidity Facility (CLF) in order to meet their regulatory requirements.3 The size of the CLF across the banking system is currently $217 billion. Self-securitisations are also used to cover payment settlements that occur outside business hours via ‘open repo’ transactions with the RBA. The Bank has required the securitisation data to be made available to permitted data users (such as those who intend to use the data for investment, professional or academic research). This has helped to enhance the transparency of the market. Much of that has been achieved by requiring data that is comparable across different pools of securities. Another benefit of the Securitisation Dataset is that it provides a useful source of information to help us better understand developments in the market for housing loans. The dataset covers information on 1.6 million individual mortgages with a total value of around $400 billion. Currently, this accounts for about one-quarter of the total value of home loans outstanding in Australia. Nature of the data Let me make a few brief remarks about the nature of the data. For each housing loan, we collect (de-identified) data on around 100 fields including: loan characteristics, such as balances, interest rates, loan type (e.g. principal-and-interest (P&I), interest-only), loan purpose (e.g. owner-occupier, investor) and arrears status; borrower characteristics, such as income and the type of employment (e.g. pay as you go (PAYG), self-employed); details on the collateral underpinning the mortgage, such as the type of property (e.g. house or apartment), its location (postcode) and its valuation.4 1 / 13 BIS central bankers' speeches The dataset is updated each month with a lag of just one month. The frequency and timeliness of the data allow us to observe changes in interest rates, progress on repayments (i.e. the current loan balance) and the extent of any redraw or offset balances (just to name a few) without much delay. I should note that, while the dataset covers a significant share of the market for housing loans, it may not be entirely representative across all its dimensions. In particular, the choice of assets in the collateral pool may be influenced by the way that credit ratings agencies assign ratings and by investor preferences. Also, in practice it may take quite a while until new loans enter a securitised pool. I’ll mention one important example of this later. Now let’s look at some interesting things we have learnt from this dataset. 1. Interest rates In the years prior to 2015, banks would generally advertise only one standard variable reference rate for housing loans.5 There was no distinction, at least in advertised rates, between investors and owner-occupiers, or between principal-and-interest and interest-only loans. That changed when the banks responded to requirements by the Australian Prudential Regulation Authority (APRA) to tighten lending standards, with a particular focus on investor loans. Then, earlier this year, APRA and the Australian Securities and Investments Commission (ASIC) further tightened lending standards: this time the focus was on interest-only lending. A key concern has been that interest-only loans are potentially more risky than principal-and-interest loans. This is because with a principal-and-interest loan the borrower is required to regularly pay down the loan and build up equity. Also, interest-only borrowers can face a marked step-up in their required repayments once they come off the interest-only period (after the first few years of the loan term). Among other things, the banks have responded to these regulatory actions by increasing interest rates on investor and interest-only loans. There are now four different advertised reference rates, one for each of the key types of loans (Graph 1). While the data in Graph 1 provide a useful guide to interest rate developments, they only cover advertised or reference rates for variable loans applicable to the major banks. Actual rates paid on outstanding loans differ from these for a few reasons. Borrowers are typically offered discounts on reference rates, which can vary according to the characteristics of the borrower and the loan. Discounts offered may vary across institutions, reflecting factors such as funding costs and market segmentation. (For example, non-bank lenders typically compete for different borrowers than the major banks.) The level of the discounts has also varied over time. Furthermore, there are fixed-rate loans, for which rates depend on the vintage of the loan. 2 / 13 BIS central bankers' speeches The Securitisation Dataset provides us with a timely and detailed source of information on the actual interest rates paid by households on their outstanding loans. Graph 2 shows rates paid on specific types of loans and by different types of borrowers.6 3 / 13 BIS central bankers' speeches The first thing to note is that rates on owner-occupier loans and investor loans used to be similar, but investor loans became relatively more expensive from the latter part of 2015. Again, this followed regulatory measures to impose a ‘benchmark’ on the pace of growth of investor credit, which had picked up noticeably. The second development I’d draw your attention to is the variation in housing loan interest rates over time. There were declines in 2016 following the reduction in the cash rate when the Reserve Bank eased monetary policy in May and then August. More recently, rates have increased for investor loans and interest-only loans, with a premium built into the latter as lenders have responded to the tightening in prudential guidance earlier this year. As part of that guidance, lenders will be required to limit the share of new mortgages that are interest-only to 30 per cent. Meanwhile, interest rates on principal-and-interest loans to owner-occupiers are little changed and remain at very low levels. Pulling this all together, the average interest rate paid on all outstanding loans has increased since late last year, but only by about 10 basis points. A third and subtle point relates to the differences in the level of interest rates actually paid on different loan products (Graph 2) when compared with reference rates (Graph 1). The reference rates suggest that any given borrower would expect to pay a higher rate on an interest-only loan than on a principal-and-interest loan. That makes sense for two reasons. First, because the principal is paid down in the case of principal-and-interest loans, those loans are likely to be less risky for the banks; other things equal, you would expect them to attract a lower interest rate. Second, the banks have added a premium to interest-only loans of late to encourage customers to take on principal-and-interest loans and constrain the growth of interest-only lending. But Graph 2 (based on securitised loans) suggests that, up until most recently, actual rates paid on interest-only loans have been lower than those on principal-and-interest loans. This doesn’t necessarily imply a mispricing of risk. Rather, it appears to reflect differences in the nature of loans and borrowers across the two types of loan products. In particular, borrowers with an interest-only loan tend to have larger loan balances (of around $85 000–100 000) and higher incomes (of about $30 000–40 000 per annum).7 4 / 13 BIS central bankers' speeches We can control for some of these differences between loan characteristics (such as loan size, loan-to-valuation ratio (LVR) and documentation type). When we do that, we find that rates have been much more similar across the two loan types in the past; although, a wedge has opened up more recently as we’d expect (Graph 3). This highlights the value of examining loan-level data. We find that interest rates are lower for borrowers that are likely to pose less risk (as indicated, for example, by lower loan-to-value ratios and full documentation). Borrowers with larger loans – who typically have higher income levels – also tend to attract lower interest rates. In relation to loan size, this suggests that borrowers with larger loans may have somewhat greater bargaining power. 2. Loan-to-valuation ratios and offset balances The Securitisation Dataset provides us with a measure of the LVR, based on the current loan balance.8 We refer to this here as the ‘current LVR’. This is one indicator of the riskiness of a loan. Other things equal, higher LVRs tend to be associated with a greater risk of default (and greater loss for the lender in the case of default).9 Graph 4 shows current LVRs for owner-occupiers and investor loans, split into interest-only and principal-and-interest loans. I should emphasise again that the Securitisation Dataset may not be entirely representative of the set of all mortgages, particularly when it comes to LVRs. That is because high LVR loans may be less likely to be added to a pool of securitised assets in order to ensure that the securitisation achieves a sufficiently high credit rating.10 With that caveat in mind, we see that there is a large share of both owner-occupier and investor loans with current LVRs between 75 and 80 per cent. That is consistent with banks limiting the share of loans with LVRs (at origination) above 80 per cent. Also, borrowers have an incentive to avoid the cost of mortgage insurance, which is typically required for loans with LVRs (at 5 / 13 BIS central bankers' speeches origination) above 80 per cent. Comparing investor loans with owner-occupier loans, we can see that investors have a larger share of outstanding loans with current LVRs of 75 per cent or higher. 11 That’s most obvious in the case of interest-only loans, but is also true for principal-and-interest loans. This reflects the investor’s financial incentive to maximise the amount of funds borrowed (without breaching the banks’ threshold above which they require lenders mortgage insurance). That can be more easily achieved with an interest-only loan. And, even in the case of principal-and-interest loans, investors don’t have the same incentives as owner-occupiers to get ahead of their scheduled repayments. But what I’ve just shown doesn’t account for offset accounts. These have grown rapidly over recent years and are now an important feature of the Australian mortgage market (Graph 5). Funds held in these accounts are ‘offset’ against the loan balance, reducing the interest payable on the loan. In that way they are similar to a principal repayment. But, unlike the scheduled principal repayment, offset (and redraw) balances can be moved in and out freely by the borrower. 6 / 13 BIS central bankers' speeches Part of the strong growth in offset balances up to 2015 appears to have been related to the rise in the share of interest-only loans, with the two being offered as a package. Interestingly, we saw a significant slowing in growth in offset balances around the same time as growth in interest-only housing loans started to decline. Graph 6 highlights how the distribution of current LVRs is altered if we deduct funds held in offset accounts from the balance owing. This suggests that for owner-occupier loans, interest-only borrowers are behaving somewhat like those with principal-and-interest loans. That is, many of those borrowers have built up significant balances in offset accounts. If needed in times of financial stress – such as a period of unemployment – borrowers could use those balances to service their mortgages. 7 / 13 BIS central bankers' speeches However, I would caution against any suggestion that this similarity regarding the build-up of financial buffers means that the tightening of lending standards for interest-only loans was not warranted – far from it. What matters when it comes to financial stability is not what the average borrowers are doing, but what the more marginal borrowers are doing. There are two important points to make on this issue. First, for investor loans, even after accounting for offset balances, there is still a noticeable share of loans with current LVRs of between 75 and 80 per cent. And for both investor and owneroccupier loans, adjusting for offset balances leads to only a small change in the share of loans with current LVRs greater than 80 per cent. This suggests that borrowers with high current LVRs have limited repayment buffers. The second point is that more marginal borrowers are now more likely to take on a principal-andinterest loan than in the past. One reason is that there is a premium on the interest rates charged on an interest-only loan (for any given borrower, compared with an owner-occupier loan). Another reason is that banks, at APRA’s direction, have also tightened their lending standards for interestonly loans, most notably by reducing the share of new interest-only loans with high LVRs at origination.12 3. Arrears by region Banks’ non-performing housing loans have increased a little over recent years (Graph 7). However, at around ¾ of one per cent as a share of all housing loans, non-performing loans remain low and below the levels reached following the global financial crisis. 8 / 13 BIS central bankers' speeches Using the Securitisation Dataset we can assess how loans are performing across different parts of the country by examining arrears rates. Like non-performing loans, the arrears rates have increased a little but remain low. 13 Arrears have risen more in regions experiencing weak economic conditions over recent years. In particular, there has been a more noticeable pick-up in arrears rates in Western Australia, South Australia and Queensland since late 2015 (Graph 8). 9 / 13 BIS central bankers' speeches The Securitisation Dataset allows us to drill down even further to examine some relationships between arears and other factors. A key factor contributing to a borrower entering into arrears is a reduction in income, most obviously via a period of unemployment. We find that there is a positive relationship between arrears rates and the unemployment rate across regions (Graph 9).14 However, the relationship is not especially strong, which suggests that other factors are at play. For example, arrears rates are higher in mining-exposed regions, which have generally experienced a sharp fall in demand following the end of the mining investment boom. One indicator of that has been the pronounced fall in the demand for housing in those parts of the country as indicated by a decline in housing prices (Graph 10). 10 / 13 BIS central bankers' speeches 11 / 13 BIS central bankers' speeches Conclusion The Securitisation Dataset plays a crucial role in allowing the Reserve Bank to accept assetbacked securities as collateral in our domestic market operations. The development of this database and its availability to investors has also helped to enhance the transparency of the securitisation market. A useful additional benefit of this database is that it provides us with a range of timely insights into the market for housing loans. I’ve discussed how things like actual interest rates paid, loan balances and arrears vary over time and across different types of mortgages and borrowers. Although variable interest rates for investor loans and interest-only loans have risen noticeably over recent months, the average interest rate paid on all outstanding loans has increased by only about 10 basis points since late last year. Also, many borrowers on interest-only loans have built up sizeable offset balances. But even after taking those into account, it appears that current loanto-valuation ratios still tend to be larger than in the case of principal-and-interest loans. Finally, while mortgage arrears rates have increased slightly over recent years, they have increased more noticeably in regions exposed to the downturn in commodity prices and mining investment. 1 For more detail, see Aylmer C (2016), ‘Towards a More Transparent Securitisation Market’, Address to Australian Securitisation Conference, Sydney, 22 November. 2 I use the term banks here to refer to all authorised deposit-taking institutions (ADIs), namely banks, building societies and credit unions. 3 The RBA provides a Committed Liquidity Facility (CLF) to participating ADIs required by APRA to maintain a liquidity coverage ratio (LCR) at or above 100 per cent. 12 / 13 BIS central bankers' speeches 4 For more details, see reporting templates on the Securitisations Industry Forum website. The valuation is typically from the time of origination. 5 An exception was a period during the 1990s, when banks advertised distinct rates for owner-occupier and investor loans. 6 Modernised reporting forms that are collected by APRA on behalf of the RBA and the Australian Bureau of Statistics will significantly improve the aggregate and institution-level data that are currently collected from ADIs and registered financial corporations (RFCs). While the new data will have less granularity than the Securitisation Dataset, they will have much greater coverage. 7 The figure for income is the average of all borrowers for each loan. That is, a given loan may be in the name of more than one borrower; on average, there are 1.7 borrowers per loan. 8 The balance of a loan is reduced via scheduled repayments of the principal and by any repayments ahead of schedule. The latter may be accessible through a redraw facility. 9 Read, Stewart and La Cava (2014), ‘Mortgage-related Financial Difficulties: Evidence from Australian Micro-level Data’, RBA Research Discussion Paper No 2014–13. 10 Some analysis we have conducted on the representativeness of the Securitisation Dataset suggests that it has fewer high LVR loans than the broader population of loans. There is also a tendency to include loans in securitisation pools only after they have aged somewhat (i.e. become more ‘seasoned’). 11 The share of new investor loans with very high LVRs (above 90 per cent) at the time of origination has been declining for a few years and is below that for owner-occupier loans (Reserve Bank of Australia (2017), Financial Stability Review, April). This feature is not apparent in the data I’ve shown here, which is based on the current LVR for the stock of outstanding securitised loans, including those that are well advanced in age. 12 APRA have instructed lenders to implement stricter underwriting standards for interest-only loans with LVRs greater than 80 per cent (see: ). 13 The 90+ days arrears rate refers to the share of loans that have been behind the required payment schedule or missed payments for 90 days or more but not yet foreclosed. 14 These regions are defined in terms of the ABS’s Statistical Areas Level 4 (SA4s), which are geographic boundaries defined for the Labour Force Survey. The boundaries for most SA4s cover at least 100 000 persons. The Securitisation Dataset identifies loans according to the location of the mortgaged property. 13 / 13 BIS central bankers' speeches | reserve bank of australia | 2,017 | 8 |
Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Reserve Bank of Australia's Board Dinner, Brisbane, 5 September 2017. | Philip Lowe: Remarks at Reserve Bank Board Dinner Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Reserve Bank of Australia's Board Dinner, Brisbane, 5 September 2017. * * * Good evening. On behalf of the Reserve Bank Board I would like to warmly welcome you all to this community dinner. Thank you for your interest in the RBA and for joining us this evening. As you are probably aware the Reserve Bank Board had its monthly meeting here in Brisbane today, at our offices on Creek St. I would like to take the opportunity of this dinner to welcome Mark Barnaba to the Reserve Bank Board. This was Mark’s first Board meeting and he brings a wealth of experience in the resources and banking sectors to the table. Mark replaces John Akehurst who retired from the Board last week after a decade of public service in this role. Over those 10 years, John made an outstanding contribution to our deliberations. It’s fair to say that he served through interesting times, perhaps a little too interesting: a global financial crisis, the biggest mining investment boom in over a century, and central banks worrying that inflation was too low, not too high. All that, in just 10 years. Mark, I hope your time on the Board is not quite as interesting! At our meeting today we had the usual review of the global and Australian economic and financial data, as well as a thorough discussion of recent developments in Queensland. We know that the Queensland economy has gone through a difficult period following the wind-down of the mining investment boom, and that the pain has been concentrated in some regional communities. We are also watching the Brisbane property market carefully, particularly the effect on prices of the large increase in the supply of new apartments. More broadly, a range of indicators, including employment and retail trade, suggest that there has been a recent improvement in economic conditions in Queensland. The lower exchange rate is helping, particularly in the tourism, education and rural industries. An appreciating exchange rate would not be helpful from this perspective. You have probably heard that the Board decided today to leave the cash rate unchanged at 1.5 per cent. This is unlikely to have come as a surprise to many people; the cash rate has been at 1.5 per cent since August last year and financial market pricing suggests market participants expect it to remain there for some time yet. As usual, the reasons for the decision were released shortly after the meeting. For some time, the Board has been seeking to balance the benefits of stimulatory monetary policy with the medium-term risks associated with high and rising levels of household debt. The current low level of interest rates is helping the Australian economy. It is supporting employment growth and a return of inflation to around its average level. Encouragingly, growth in the number of Australians with jobs has picked up over recent months and the unemployment rate has come down a bit. The investment outlook has also brightened. Inflation has troughed and it is likely to increase gradually over the next couple of years. These are positive developments. Even so, it will be some time before we are at what could be considered full employment in Australia and before underlying inflation is at the mid-point of the medium-term target range. This means that stimulatory monetary policy continues to be appropriate. The Board has been conscious that attempting to achieve faster progress on unemployment and inflation through yet lower interest rates would have added to the risks in household balance sheets. Lower rates would have encouraged faster growth in household borrowing and added to the medium-term risks facing the economy. Our judgement has been that it was not in the public 1/4 BIS central bankers' speeches interest to encourage an already highly indebted household sector to borrow even more. More borrowing might have helped today, but it could come at a future cost. So the Board has been prepared to be patient and has not sought to overly engineer or fine-tune things. In our view, the balance we have struck is appropriate and it is likely that the economy will pick up from here as the drag from declining mining investment comes to an end. Our central scenario is for growth of around 3 per cent over the next couple of years and for the unemployment rate to move lower gradually. In striking the appropriate balance in our policy setting, we have paid close attention to trends in household borrowing, given the already high levels of debt. Over the past four years, household borrowing has increased at an average rate of 6½ per cent, while household income has increased at an average rate of just 3½ per cent. Given this, the RBA has worked closely with APRA to ensure that lending practices remain sound. Rightly, APRA has had a strong focus on loan serviceability calculations. In some cases, loans were being made where the borrower had only the slimmest of spare income. APRA has also introduced restrictions on growth of investor loans and restrictions on interest-only lending. This has been the right thing to do. One might ask why lenders themselves did not do more to constrain their activities in these areas, given the earlier trends were adding to risk in the overall system. When everything is going well, it appears that any single institution has difficulty pulling back. Each worries about their competitive position and about the market reaction. Individual institutions are also more likely to focus on their own risks, rather than the risks to the system as a whole. This means that supervisory measures can be useful in helping the whole system pull back. Ideally, such measures would not be needed, with instead the appropriate level of restraint coming out of lenders’ holistic risk assessments. But when this does not occur, supervisory measures can play a constructive role. Most lenders are now operating comfortably within the new restrictions and these measures are not unduly restraining the supply of overall housing credit. One of the factors that has a bearing on current discussions of household debt is the slow growth in household incomes. Over the past four years, nominal average hourly earnings have grown at the slowest rate in many decades. This means that borrowers haven’t been able to rely on rising incomes to reduce the real value of the debt repayments in the way they used to; debtservice ratios will stay higher for longer. This is something that both lenders and borrowers need to take into account. The slow growth in wages is a common experience across most advanced economies today. It lies behind the sense of dissatisfaction that is being felt in many communities. The reasons for this slow growth in wages are complex. Part of the explanation is a perception of greater competition from both globalisation and technology. An increased sense of uncertainty among workers is also likely to be playing a role, as is a change in the bargaining environment. The slow growth in wages is contributing to low inflation outcomes globally. My expectation is that this is going to continue for a while yet, given that the structural factors at work are likely to persist. But I am optimistic enough that I don’t see it as a permanent state of affairs. It is likely that, as our economy strengthens and the demand for labour picks up, growth in wages will pick up too. The laws of supply and demand still work. Even at the moment, we see some evidence through our liaison program that in those pockets where the demand for labour is strong, wages are increasing a bit more quickly than they have for some time. The Reserve Bank’s central scenario is that, over time, this will become a more general story. On another matter, over the past few months there has been quite a lot of interest in the regular special papers considered by the Board. This followed the release of the minutes of the July meeting, which recorded that the Board had held a discussion of the neutral interest rate (that is, the rate at which monetary policy is neither expansionary nor contractionary). 2/4 BIS central bankers' speeches The main conclusion from that discussion was that, in future, it was likely that the average level of the cash rate would be lower than it was before the financial crisis. This reflects slower trend growth in the economy and a shift in the balance between savings and investment. When people want to save more and invest less, the return on the risk-free asset is lower. These same forces are at work around the world, so that the average level of interest rates globally is likely to be lower than before the financial crisis. A second conclusion from our discussion was that the cash rate is around 2 percentage points below our current estimate of the neutral rate. As we make further progress on both unemployment and inflation, we could expect the cash rate to move towards this neutral rate over time. It is worth repeating that the Board’s consideration of these issues carries no particular message about the short-term outlook for monetary policy. The discussion was part of our regular in-depth reviews of important issues. As is appropriate, these discussions are reflected in our minutes. I hope that you see Australia’s central bank as transparent, analytical, rational and independent. We seek to look at issues in detail and from different angles and to explain our thinking to the public. While not everybody agrees with our decisions, we do our best to explain those decisions and the framework we use to make them. This month’s special discussion was on the Chinese economy. One focus was on the difficult trade-off facing the Chinese authorities. There is a clear need to, and a desire by the authorities to, address the high and rising levels of debt in China. At the same time, though, the authorities are committed to achieving growth targets that are still quite high. It remains an open question as to whether both of these objectives can be achieved. Here in Australia, we have a strong interest in the right balance being achieved. Another focus of our discussions was the Chinese authorities’ progress in implementing the structural reforms announced in 2013 at the Third Plenum. The one-child policy has been relaxed and the government has expanded funding for social security and health care. The value-added tax has been broadened and there has been some deregulation of interest rates. So there has been progress on a number of fronts. But, on the other hand, there is still some way to go to meet the goal of allowing market forces to play a decisive role in resource allocation. Reform of state-owned enterprises has been slower than many had hoped for and the state, rather than market prices, still has a strong influence in allocating resources in parts of the economy. Looking forward, the pace and nature of future reform in these areas are likely to be influenced by the outcomes of the 19th Congress of the Chinese Communist Party later this year. On one final matter, I would like to take this opportunity to remind you that our new $10 note will be issued in just a couple of weeks, on 20 September. The new note contains the same worldleading security features as the new $5 note that we issued last September, including the clear top-to-bottom window, and the tactile feature so that it can be recognised by vision-impaired members of our community. For me personally, the new $10 note will be a particularly special note, as it is the first note with my signature. We have printed a couple of hundred million of these notes, so it has been a busy time for John Fraser and me recently! The new note will continue to feature Mary Gilmore and Banjo Paterson, two of Australia’s most famous writers. Both grew up in southern New South Wales. Indeed, Mary Gilmore spent time at schools in both Cootamundra and Wagga Wagga, just as I did. Both of these writers also have a connection to Queensland. For many years, Mary Gilmore’s husband ran a farm near Cloncurry in northern Queensland. And of course, Banjo Paterson is said to have written the words to Waltzing Matilda during a trip to Dagworth station near Winton. We are proud to have these two great Australian writers on our banknotes. Again, thank you for your attendance tonight. I hope you enjoy your dinner and the conversation. 3/4 BIS central bankers' speeches 4/4 BIS central bankers' speeches | reserve bank of australia | 2,017 | 9 |
Address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the FINSIA Signature Event "The Regulators", Sydney, 8 September 2017. | 08/09/2017 Interest Rate Benchmarks | Speeches | RBA Speech Interest Rate Benchmarks Guy Debelle [ * ] Deputy Governor FINSIA Signature Event: The Regulators Sydney – 8 September 2017 Today I am going to talk again about interest rate benchmarks, as recently there have been some important developments internationally and in Australia. [1] These benchmarks are at the heart of the plumbing of the financial system. They are widely referenced in financial contracts. Corporate borrowing rates are often priced as a spread to an interest rate benchmark. Many derivative contracts are based on them, as are most asset-backed securities. In light of the issues around the London Inter-Bank Offered Rate (LIBOR) and other benchmarks that have arisen over the past decade, there has been an ongoing global reform effort to improve the functioning of interest rate benchmarks. I will focus on the recent announcement by the UK Financial Conduct Authority (FCA) on the future of LIBOR, and the implications of this for Australian financial markets. I will then summarise the current state of play in Australia, particularly for the major interest rate benchmark, the bank bill swap rate (BBSW). Our aim is to ensure that BBSW remains a robust benchmark for the long term. I will also discuss the important role for ‘risk-free’ interest rates as an alternative to credit-based benchmarks such as BBSW and LIBOR. The Future of LIBOR and the Implications for Australia LIBOR is the key interest rate benchmark for several major currencies, including the US dollar and British pound. Just over a month ago, Andrew Bailey, who heads the FCA which regulates LIBOR, raised some serious questions about the sustainability of LIBOR. [2] The key problem he identified is that there are not enough transactions in the short-term wholesale funding market for banks to anchor the benchmark. The banks that make the submissions used to calculate LIBOR are uncomfortable about continuing to do this, as they have to rely mainly on their ‘expert judgment’ in determining where LIBOR should be rather than on actual transactions. To prevent LIBOR from abruptly ceasing to exist, the FCA has received assurances from the current banks on the LIBOR panel that they will continue to submit their estimates to sustain LIBOR until the end of 2021. But http://www.rba.gov.au/speeches/2017/sp-dg-2017-09-08.html 1/5 08/09/2017 Interest Rate Benchmarks | Speeches | RBA beyond that point, there is no guarantee that LIBOR will continue to exist. The FCA will not compel banks to provide submissions and the panel banks may not voluntarily continue to do so. This four year notice period should give market participants enough time to transition away from LIBOR, but the process will not be easy. Market participants that use LIBOR, including those in Australia, need to work on transitioning their contracts to alternative reference rates. This is a significant issue, since LIBOR is referenced in around US$350 trillion worth of contracts globally. While a large share of these contracts have short durations, often three months or less, a very sizeable share of current contracts extend beyond 2021, with some lasting as long as 100 years. This is also an issue in Australia, where we estimate that financial institutions have around $5 trillion in contracts referencing LIBOR. Finding a replacement for LIBOR is not straightforward. Regulators around the world have been working closely with the industry to identify alternative risk-free rates that can be used instead of LIBOR, and to strengthen the fall-back provisions that would apply in contracts if LIBOR was to be discontinued. The transition will involve a substantial amount of work for users of LIBOR, both to amend contracts and update systems. Ensuring BBSW Remains a Robust Benchmark The equivalent interest rate benchmark for the Australian dollar is BBSW, and the Council of Financial Regulators (CFR) is working closely with industry to ensure that it remains a robust financial benchmark. BBSW is currently calculated from executable bids and offers for bills issued by the major banks. [3] A major concern over recent years has been the low trading volumes at the time of day that BBSW is measured (around 10 am). There are two key steps that are being taken to support BBSW: first, the BBSW methodology is being strengthened to enable the benchmark to be calculated directly from a wider set of market transactions; and second, a new regulatory framework for financial benchmarks is being introduced. The work on strengthening the BBSW methodology is progressing well. The ASX, the Administrator of BBSW, has been working closely with market participants and the regulators on finalising the details of the new methodology. This will involve calculating BBSW as the volume weighted average price (VWAP) of bank bill transactions. It will cover a wider range of institutions during a longer trading window. The ASX has also been consulting market participants on a new set of trading guidelines for BBSW, and this process has the strong support of the CFR. The new arrangements will not only anchor BBSW to a larger set of transactions, but will improve the infrastructure in the bank bill market, encouraging more electronic trading and straight-through processing of transactions. The critical difference between BBSW and LIBOR is that there enough transactions in the local bank bill market each day relative to the size of our financial system to calculate a robust benchmark. are For the new BBSW methodology to be implemented successfully, the institutions that participate in the bank bill market will need to start trading bills at outright yields rather than the current practice of agreeing to the transaction at the yet-to-be-determined BBSW rate. This change of behaviour needs to occur at the banks that issue the bank bills, as well as those that buy them including the investment funds and state treasury corporations. The RBA is also playing its part. Market http://www.rba.gov.au/speeches/2017/sp-dg-2017-09-08.html 2/5 08/09/2017 Interest Rate Benchmarks | Speeches | RBA participants have asked us to move our open market operations to an earlier time to support liquidity in the bank bill market during the trading window, and we have agreed to do this. While we all have to make some changes to systems and practices to support the new methodology, the investment in a more robust BBSW will be well worth it. The alternative of rewriting a very large number of contracts and re-engineering systems should BBSW cease to exist would be considerably more painful. The new regulatory framework for financial benchmarks that the government is in the process of introducing should provide market participants with more certainty. Treasury recently completed a consultation on draft legislation that sets out how financial benchmarks will be regulated, and the bill has just been introduced into Parliament. [4] In addition, ASIC recently released more detail about how the regulatory regime would be implemented. [5] This should help to address the uncertainty that financial institutions participating in the BBSW rate setting process have been facing. It should also support the continued use of BBSW in the European Union, where new regulations will soon come into force that require benchmarks used in the EU to be subject to a robust regulatory framework. Risk-free Rates as Alternative Benchmarks While the new VWAP methodology will help ensure that BBSW remains a robust benchmark, it is important for market participants to ask whether BBSW is the most appropriate benchmark for the financial contract. For some financial products, it can make sense to reference a risk-free rate instead of a credit-based reference rate. For instance, floating rate notes (FRNs) issued by governments, non-financial corporations and securitisation trusts, which are currently priced at a spread to BBSW, could instead tie their coupon payments to the cash rate. However, for other products, it makes sense to continue referencing a credit-based benchmark that measures banks' short-term wholesale funding costs. This is particularly the case for products issued by banks, such as FRNs and corporate loans. The counterparties to these products would still need derivatives that reference BBSW so that they can hedge their interest rate exposures. It is also prudent for users of any benchmark to have planned for a scenario where the benchmark no longer exists. The general approach that is being taken internationally to address the risk of benchmarks such as LIBOR being discontinued, is to develop risk-free benchmark rates. A number of jurisdictions including the UK and the US have recently announced their preferred risk-free rates. One issue yet to be resolved is that most of these rates are overnight rates. A term market for these products is yet to be developed, although one could expect that to occur through time. Another complication is that the risk-free rates are not equivalent across jurisdictions. Some reference an unsecured rate (including Australia and the UK) while others reference a secured rate like the repo rate in the US. http://www.rba.gov.au/speeches/2017/sp-dg-2017-09-08.html 3/5 08/09/2017 Interest Rate Benchmarks | Speeches | RBA As the RBA's operational target for monetary policy and the reference rate for OIS (overnight index swap) and other financial contracts, the cash rate is the risk-free interest rate benchmark for the Australian dollar. The RBA measures the cash rate directly from transactions in the interbank overnight cash market, and we have ensured that our methodology is in line with the IOSCO benchmark principles. [6] However, the cash rate is not a perfect substitute for BBSW, as it is an overnight rate rather than a term rate, and doesn't incorporate a significant bank credit risk premium. Conclusion There are three main points I would like you to take away with you concerning interest rate benchmarks. First, the longevity of LIBOR cannot be assumed, and you should start considering might mean for any contracts you have that reference LIBOR. today what that Second, in contrast, we are well advanced in changes to enhance the longevity of BBSW. While these changes entail some costs, the cost of not doing so would be considerably larger. Third, you should think hard whether risk-free benchmarks are more appropriate rates for your financial contracts than credit-based benchmarks such as LIBOR and BBSW. Endnotes [*] Thanks to Ellis Connolly for his work on interest rate benchmarks and in preparing this speech. I have talked about this issue previously: <https://www.rba.gov.au/speeches/2016/sp-ag-2016-02-22.html> and <https://www.rba.gov.au/speeches/2015/sp-ag-2015-11-18.html>. For Andrew Bailey's speech, see: <https://www.fca.org.uk/news/speeches/the-future-of-libor>. These are typically negotiable certificates of deposit (NCDs). See: <https://treasury.gov.au/consultation/c2017-t188618/> and <http://www.aph.gov.au/Parliamentary_Business/Bills_Legislation/Bills_Search_Results/Result?bId=r5962>. See: <http://www.asic.gov.au/about-asic/media-centre/find-a-media-release/2017-releases/17-237mr-asic-consultson-proposed-financial-benchmark-regulatory-regime/>. For more details about the methodology for the cash rate, see: <https://www.rba.gov.au/mktoperations/resources/cash-rate-methodology/>. The RBA has also conducted a self-assessment against the IOSCO benchmark principles: <https://www.rba.gov.au/mkt-operations/resources/cash-ratemethodology/compliance.html>. © Reserve Bank of Australia, 2001–2017. All rights reserved. http://www.rba.gov.au/speeches/2017/sp-dg-2017-09-08.html 4/5 08/09/2017 http://www.rba.gov.au/speeches/2017/sp-dg-2017-09-08.html Interest Rate Benchmarks | Speeches | RBA 5/5 | reserve bank of australia | 2,017 | 9 |
Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Bank of China Sydney Branch's 75th Anniversary Celebration Dinner, Sydney, 8 September 2017. | 9/8/2017 Remarks at the Bank of China Sydney Branch's 75th Anniversary Celebration Dinner | Speeches | RBA Speech Remarks at the Bank of China Sydney Branch's 75th Anniversary Celebration Dinner Philip Lowe Governor Sydney – 8 September 2017 [Acknowledgement of special guests and hosts] It is an honour to be here this evening to celebrate the 75th anniversary of the opening of the Bank of China's first branch in Australia. On behalf of the Reserve Bank of Australia, I would like to pass on our warmest congratulations. The story of how the Bank of China came to establish a branch in Australia in 1942 is a story of resilience and friendship. Over recent weeks I have had the opportunity to read about this story through the yellowed pages of the Reserve Bank's archives. When conflict came to Singapore in 1942, Mr Parkane Hwang from the Bank of China's Singapore branch decamped to what was then known as Batavia. From there, he sought a visa to travel to Australia to establish a branch of the Bank of China in Sydney. It must have been a difficult and stressful time. True to Australia's welcoming nature, especially to those in need, the visa was granted. By midyear, the branch was in operation, with Mr Hwang's deputy from the Singapore branch, Mr S.C. Lu, as its representative. In those days it was quicker to get a banking licence than it is today! It is clear from our archives that the granting of this licence was a significant sign of friendship by Australia towards China. It was very unusual at the time to grant such licences. Upon the licence being granted, one of my predecessors as Governor – Governor H.T. Armitage of the Commonwealth Bank of Australia, which at the time carried out central banking functions – wrote to Mr Lu to congratulate the Bank of China on the new branch. I would like to read from that letter, as 75 years later I could not have put it better myself. Governor Armitage wrote: http://www.rba.gov.au/speeches/2017/sp-gov-2017-09-08.html 1/3 9/8/2017 Remarks at the Bank of China Sydney Branch's 75th Anniversary Celebration Dinner | Speeches | RBA ‘I feel sure that the entry of your Bank into the Australian Banking System will not only be of inestimable value in facilitating business relationships between China and Australia, but will also help to foster the increasing bond of friendship between our respective countries.’ Seventy-five years on, this sentiment remains just as valid as it was in 1942, despite the tremendous change in both our countries since. Our files show that it was some years before the Bank of China's branch in Australia was able to turn a profit – a problem that has now been fixed. When the branch was first established, it was very restricted in its operations. It was limited to operating accounts for the Chinese Government and officials and for Chinese nationals visiting Australia. Notwithstanding these restrictions, it quickly established a presence in Australia. In May 1944, less than two years after operations began, Governor Armitage wrote to the Secretary to the Treasury stating: ‘The Bank of China has proved to be a useful adjunct to the banking system in Australia, particularly in regard to facilitating the handling of remittances on behalf of Chinese citizens. They have faithfully observed the conditions under which they are allowed to operate.’ Today, of course, the Bank of China continues to facilitate currency exchange between China and Australia, but it is on a much larger scale. In 2014, the Bank of China was appointed the official RMB clearing bank for Australia, affording it more direct access to China's onshore financial markets and hence the ability to provide RMB liquidity in the Australian market. The establishment of the clearing bank has promoted the role of the RMB in trade among Australian companies and the development of the pool of local RMB deposits. This is an important development. The Bank of China is also providing an important source of finance for Chinese companies operating in Australia as well as for Australian companies. It is making trade easier between our two countries by providing trade finance. It is also helping on the investment side, with securities and investment banking services. The growth of Bank of China's operations from currency exchange to facilitating trade and now, more recently, to facilitating investment is mirrored in the deepening relationship between China and Australia. On the trade side, in 1942 there was negligible trade between our two countries. Today, we are important trading partners. The deepening of the financial relationship is a more recent development and still has some way to go. China is an important source of direct investment in Australia and there are an increasing number of investment channels available to Australian entities looking to invest in Chinese financial markets. As one example of this, the RBA holds around 5 per cent of our foreign reserves in China. I expect that, as the Chinese capital account is liberalised, the financial relationship between our two countries will deepen further. As we know from our own experience in Australia, the journey of financial liberalisation is a difficult one, but it is one that is well worth undertaking. As I have said on a number of previous occasions, the internationalisation of the RMB and the associated capital http://www.rba.gov.au/speeches/2017/sp-gov-2017-09-08.html 2/3 9/8/2017 Remarks at the Bank of China Sydney Branch's 75th Anniversary Celebration Dinner | Speeches | RBA account liberalisation in China is likely to be one of the biggest forces shaping the global financial system over the next decade or so. The Bank of China will help Australia be part of that. Finally, again, I would like to congratulate the Bank of China on the occasion of the 75th anniversary of establishing a branch in Australia. The story of how the branch was established is one of resilience and friendship. In 1942 there was a hope that granting the Bank of China a banking licence would help build ties between our two countries. This hope has been realised. Our hope today is that the same will be true for the next 75 years. Thank you. © Reserve Bank of Australia, 2001–2017. All rights reserved. http://www.rba.gov.au/speeches/2017/sp-gov-2017-09-08.html 3/3 | reserve bank of australia | 2,017 | 9 |
Speech by Ms Luci Ellis, Assistant Governor (Economic) of the Reserve Bank of Australia, at the Australian Business Economists (ABE) Lunchtime Briefing, Sydney, 20 September 2017. | Luci Ellis: The current global expansion Speech by Ms Luci Ellis, Assistant Governor (Economic) of the Reserve Bank of Australia, at the Australian Business Economists (ABE) Lunchtime Briefing, Sydney, 20 September 2017. * * * Thanks to Peter Rickards and Rochelle Guttmann for assistance in preparing this speech. I’d like to thank the organisers of today’s event, the Australian Business Economists, for giving me the opportunity to speak to you today. It really is a pleasure. Today I’d like to talk about an important driver of future prospects for the Australian economy: the pick-up in global economic activity that began in the second half of last year. How did we pick up that this was happening? And how might conditions evolve over the period ahead? An apparently gloomy starting point During 2015 and early 2016, the tone of commentary about the global economy was quite negative. Yes, there had been a slowing evident in the data, particularly from China. Yet this alone would not explain it. Things seemed fragile. Growth forecasts were revised down. Experience suggested that the mood should have been more buoyant. Policy was accommodating the recovery from the global and European financial crises. There was a fall in commodity prices, particularly oil prices (Graph 1). Declines in oil prices are typically seen as expansionary, because they often imply that supply has increased, and this was precisely what OPEC was doing. Lower oil prices also often support growth. Most of Australia’s major trading partners are net oil importers and are better off if the price of oil declines relative to other prices.1 1 / 10 BIS central bankers' speeches But rather than being a catalyst for growth, lower oil prices were an indicator of weakening global demand. This in turn spurred an unusually large pull-back in energy-related business investment in some economies and this exacerbated the downturn in global activity. For commodity-exporting emerging markets, growth was impeded by lower commodity prices, on top of any domestic factors driving growth (Graph 2). Previously, the negative effects of lower oil prices on producers would have been outweighed by the positive effects on spending by net oil-importing countries. This time around, the opposite occurred: the net effect was negative. Commodity exporters’ demand for traded goods produced elsewhere declined noticeably over 2015 and early 2016. This had spillover effects on other economies highly exposed to global trade, particularly in Asia. The Asian region was also affected by concerns circulating about risks in China. It’s worth contrasting the experience of these commodity exporters with Australia, or with an economy more exposed than Australia to oil prices, such as Canada. Falling commodity prices reduced Australia’s terms of trade, and thus our income. There was a debate about whether the Australian dollar had depreciated by enough to offset that effect. But the net effect of lower commodity prices and the exchange rate was smaller than in some other economies. The lower exchange rate had gone some of the way to cushioning the income effects of the lower terms of trade. It also contributed to helping some parts of the non-mining economy pick up. The 2016 turnaround Late last year, the negative sentiment and rhetoric around the global economy started to turn around. Clearly there was a recovery in the data, but the recovery in the accompanying rhetoric was even more marked. To the extent that perception affects people’s expectations, this had the potential to influence actual outcomes. 2 / 10 BIS central bankers' speeches Perhaps one way to show this is to look at the text from reports by key economic agencies. If you contrast the words most frequently used in the first chapter of the April 2016 IMF World Economic Outlook, with the same chapter in the issue from a year later, you can see how the tone has changed.2 Another way to characterise this change in tone is that in the April 2016 edition, around 6 per cent of the key words coded as positive and 10 per cent as negative. A year later, more than 13 per cent of the words were considered positive, compared with about 5 per cent negative. At first, the turnaround seemed to be only in ‘soft’ indicators of sentiment, such as business surveys and financial market prices. The global Purchasing Managers Indices – a commonly used measure of surveyed business conditions – hit bottom and started to turn around in late 2016 (Graph 3). Commodity prices also started to lift. Over time, however, clearer signals started to emerge that this was more than just people feeling optimistic. There was something real happening as well. Growth in global merchandise exports was the next to pick up. Soon afterwards, it became clear that growth in industrial production was also increasing (Graph 3). It should be noted that throughout this period, the swings in the actual data were never very large, certainly not relative to the crisis period. 3 / 10 BIS central bankers' speeches By the time we reached early 2017, there were further signs that the pick-up in trade and other high-frequency indicators were flowing through various countries’ national accounts. Particularly welcome was the recovery in investment growth, which can now be seen in a range of major economies and regions (Graph 4). 4 / 10 BIS central bankers' speeches As well as broadening across different measures of activity, the expansion also broadened across countries and regions. In the latest Statement on Monetary Policy, the Reserve Bank emphasised the broad-based nature of the pick-up, across both sources of exports and destinations of imports. The boost to incomes from rising commodity prices has also helped economic prospects of commodity exporters. Some of them have emerged from recessions and are now increasing their demand for production from the rest of the world. How people saw it happening The sequence of events that I have just described is a turning point. As any economic forecaster could tell you, a turning point is essentially impossible to predict. But it does seem that many observers, including the Bank, managed to notice that turning point in near real-time. In the Overview of the November 2016 Statement on Monetary Policy, the first sentence read: ‘Growth in Australia’s major trading partners remains a bit below average and is expected to decline a little over the forecast period, reflecting a further moderate easing in growth in China.' Shortly after its publication, markets rallied following the US election outcome. It wasn’t clear that the policies of the incoming Administration would be expansionary overall. The expected fiscal stimulus would have been, but the announced trade policies were rightly seen as likely to harm global growth. Many observers thought the election outcome would be negative for financial market pricing. So it was understandable to downplay reactions when markets instead rose. Then, over the southern hemisphere summer, it became clear that this was more than a financial market reaction to political events in one country. The outlook had become more positive. The first sentence of the February 2017 SMP Overview read: 5 / 10 BIS central bankers' speeches ‘The global economy entered 2017 with more momentum than earlier expected.’ The facts had changed, and we had changed our minds. The nature and pattern of the pick-up in the data convinced us. The first aspect of the shift that helped convince us was the broadening of the pick-up from sentiment indicators (including financial market pricing) to measures of physical activity. Growth in global trade was the first place this became apparent. Industrial production data in a range of countries followed soon afterwards. The second aspect was the broad-based spread of the pickup across countries and regions. If it had just been one country – say, China – demanding all the extra imports, there would have been less reason to revise the outlook. To identify a turning point as it happens, you need to have a sound analytical framework for thinking about how the economy works, and how all the various indicators fit together. One thing to bear in mind is that trade is often – though not always – highly leveraged to global activity (RBA 2017). When global activity picks up, trade picks up by more (Graph 5). This is partly because demand for traded merchandise tends to be a bit more cyclical than the services sector, where much output is not traded across borders. It is also a result of the structure of global supply chains. You can imagine a situation where final-stage production increases by one unit, but almost all of the value-added crosses three borders before reaching its destination. Global exports (or imports) would then pick up by close to three units. It is also reasonable to expect that in the first instance, an unexpected increase in demand for goods and materials might be met on global markets, because often not every product or input is produced in every country. 6 / 10 BIS central bankers' speeches Another point to bear in mind is that in recent upswings, investment has usually come later. This wasn’t always the way. But in recent times, businesses have tended to wait until they see evidence of increased demand before they invest in expanding capacity. They are even less likely to invest to expand when there is plenty of spare capacity, a legacy of the crisis. We also know that businesses are more likely to invest in things that boost labour productivity when the labour market is tight, not when there is considerable slack. So in the current environment, we would not expect business investment to be at the leading edge of a pick-up in economic activity. And we have to be willing to call the pick-up before we see it in business investment. A third point to be mindful of is that data are noisy and can be revised. So we need to triangulate multiple data sources against each other. Survey measures of sentiment and other supposed leading indicators are not the whole story. They tell you something, but shouldn’t be taken as gospel on their own. But neither should you wait until you see the whites of the national accounts’ eyes before you change your view. All data are noisy, including the national accounts. By the time you have seen something in the national accounts and are sure it isn’t just noise, several quarters will have passed. If you wait that long, you will be well behind the curve in catching a change in economic momentum. Portents for the future Now that we’ve seen this pick-up in global activity, we must then ask: what next? Will the 7 / 10 BIS central bankers' speeches expansion continue at its current rate, pick up further, or peter out? Part of the question here is whether expansions can continue unabated or whether something forces them to ‘die of old age’. While one could argue that this is a relatively new upswing, many economies have in fact been expanding ever since the end of the Global Financial Crisis, and are now quite close to being at full capacity. Countries such as the United States and Japan are generally regarded as being already at full employment. Does this mean that they can’t keep going like this for much longer? The academic literature, at least, seems to suggest that long-lived expansions are no more likely to end than shorter ones, at least beyond some point (Rudebusch 2016). I think we can take some comfort from that. We should then ask whether we would expect the current expansion to be any different from past expansions. A common pattern is that expansions end because they came together with an unsustainable build-up in leverage. Globally, leverage does not seem to have increased much this time around. At least, it hasn’t increased to the extent seen in the leadup to the Global Financial Crisis. Of course there are some areas where debt has increased rapidly, in ways that deserve further investigation. Whether credit expansions pose a problem isn’t always clear-cut, except in hindsight. So we should be cautious when we see them, and should factor them into our assessments of how long an expansion might last. In thinking about how long and how strong the global expansion could be, a lot will depend on productivity growth. This isn’t the place to dwell on the ‘secular stagnation’ debate in detail. But I will note that productivity itself can be cyclical. Productivity growth has been weak in some major advanced economies. It’s not clear that this will continue once spare capacity in these economies has been fully absorbed. I also note that some of the pessimism about productivity is happening alongside great optimism in some quarters about a new Industrial Revolution built on better algorithms. The truth may well lie somewhere in the middle. It might also take a while to assert itself. Those of us who remember the 1990s would recall that there have been previous episodes where considerable innovation seemed to be happening, but this took a while to be evident in the productivity data. This is because firms take a long time to adapt their business models and processes to the new technologies. And the greatest spur to change is capacity constraints. Tight economies spur process innovation. When there is plenty of spare capacity, not even strong competition necessarily induces higher rates of adoption of new technologies. Risks to the outlook Taking all that into consideration, there seems a reasonable prospect that – as long as nothing really bad happens – this global expansion could continue for a while. This is especially so if the technology optimists are right about the implications of recent innovations. But of course there are risk scenarios that have the potential to derail the current economic momentum. Foremost of these at present would be geopolitical risks. These are particularly difficult risks to integrate into a macroeconomic analytical framework. We aren’t political analysts. And I question whether anyone can truly know what the odds of certain events occurring might be. But we can at least think about what those risks might be and whether they might be increasing or receding. I think it is fair to say that geopolitical risks in Europe and specifically the euro area have receded. While it remains to be seen how Brexit will play out from a practical perspective, an existential crisis for the euro area and the EU more broadly no longer seems so close. Against that, geopolitical risks in Asia have increased. These are the low probability, high-impact events that can only ever be a risk to one’s forecasts. Until something actually happens, they do not and should not affect the central scenario. Even if you knew for sure that an event happened, the economic effects are often difficult to predict. Financial risks will also be ever-present as risks to a macroeconomic outlook, and they are almost as hard as geopolitical risks to quantify. One that seems to be becoming less pertinent at 8 / 10 BIS central bankers' speeches the moment is the international risk posed by ongoing low interest rates and the resulting search for yield by investors. Now that policy interest rates globally are starting to rise, if only slowly, the urgency of the search for yield surely becomes less pressing. On the domestic front, the Bank has repeatedly pointed to the issues associated with household sector balance sheets. These are probably best regarded as a potential exacerbating factor. That is, if some other shock should come along, debt would make it worse. Of itself, the level of indebtedness is unlikely to be a triggering factor that sparks a negative outcome. But it is an important consideration in the context of other triggers. The risk profile of recently originated debt has improved as a result of various actions by the regulators, the evolving risk environment and the lenders’ responses. The level of debt owed matters most when the borrower is facing a large negative shock. Strong lending standards mitigate the effects of moderate shocks, and can help prevent a shock turning into a default event. But in the face of a large, economy-wide shock, even the best lending standards might not be enough to protect borrowers and lenders. At that point, the absolute amount of debt owed becomes the binding consideration. A final risk to mention is the global monetary policy environment, together with the economic and market reactions to it. Expansionary monetary policy and less contractionary fiscal policy have supported economic recoveries. Some economies are now thought to be close to full employment and productive capacity. Yet so far, growth in both prices and wages has remained quite low. We believe that, ultimately, the forces of supply and demand do assert themselves. Wage growth and inflation should therefore pick up in these economies at some point. However, it could take a while. If productivity growth is indeed cyclical, it will start to pick up over time in these economies. So it will take longer to hit the capacity constraints that induce price rises. On the other hand, stronger potential growth is clearly a positive for economic welfare more broadly. If this scenario happens, and inflation stays low despite reasonable growth in a range of economies, policymakers will face a challenge. In that scenario, policy still needs to remain appropriately expansionary while avoiding further build-up of leverage and financial risk. Calibrating the pace of withdrawal of stimulus will be no easy task. Policy will therefore need to adapt to the evolving momentum in national and global economies. Concluding remarks To sum up, the global economy is looking better than it did a year ago. The turning point was around the end of last year. While it doesn’t seem to have picked up further recently, neither is this expansion a flash in the pan. That is positive news for the Australian economy, too. Noticing that change in momentum required economic forecasters to be alert to the right indicators, and have the right framework for thinking about the signals these indicators send. Nothing is ever clear-cut. There are always uncertainties about the data. There are times when you have to be willing to make a call, because waiting until you are 100 per cent sure things have changed means waiting too long. And that means taking a view and being willing to evolve that view as new data come in, just as we always have done. Thank you for your time. Bibliography RBA (2015), ‘Box C: The Effects of the Fall in Oil Prices February, pp 46–48. ’, Statement on Monetary Policy, RBA (2017), ‘The Recent Pick-up in Global Merchandise Trade Policy, August, pp 13–14. 9 / 10 ’ , Statement on Monetary BIS central bankers' speeches Rudebusch G (2016), ‘Will the Economic Recovery Die of Old Age’, Federal Reserve Bank of San Francisco. 1 A sentence along these lines was included in several of the Bank’s Statements on Monetary Policy over this period. See also RBA (2015). 2 The colouring of the words as red for negative and blue for positive has been done manually, based on the consensus of a number of colleagues. Standard packages for sentiment analysis do not handle the nuanced communications of central banks and international agencies particularly well. It should also be noted that some nouns that are coded as positive (such as ‘growth’ or ‘investment’) can sometimes be mentioned in negative contexts, for example with verbs such as ‘slowed’ or ‘declined’. That is certainly the case in the April 2016 issue. The cited proportions of words coded positive or negative does not include common ‘stop words’ such as ‘the’, ‘and’ and ‘with’. 10 / 10 BIS central bankers' speeches | reserve bank of australia | 2,017 | 9 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the American Chamber of Commerce in Australia (AMCHAM), Perth, 21 September 2017. | Philip Lowe: The next chapter Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the American Chamber of Commerce in Australia (AMCHAM), Perth, 21 September 2017. * * * I would like to thank Andrea Brischetto for assistance in the preparation of this talk. I would like to thank the American Chamber of Commerce in Australia for the invitation to speak today. It is a pleasure to be in Perth again. This lunch is being held at a time when one chapter in Australia’s economic history is drawing to a close and another is about to start. A main theme in the chapter that is about to come to an end is the mining investment boom. That boom, and its unwinding, has been central to the story of the Australian and Western Australian economies for more than a decade now. The new chapter will, almost certainly, have a different central theme. Today, I would like to provide a sketch of some of the likely plot lines of the next chapter. Before doing that, though, I will reflect on the current chapter. The current chapter The storyline of the current chapter is well known. It has had two main plot lines. The first was a troubled global economy. A decade ago we had the global financial crisis and the worst recession in many advanced economies since the 1930s. A gradual recovery then took place, but it was painfully slow. Recently, things have improved noticeably and unemployment rates in some advanced economies are now at the lowest levels in many decades. Throughout this chapter, central banks have mostly worried that inflation rates might turn out to be too low, not too high. Interest rates have been at record lows. And workers in advanced economies have experienced low growth in their nominal wages. So it’s been a challenging international backdrop. The second plot line was the resources boom. Strong growth in China saw strong growth in demand for resources. Prices rose in response, with Australia’s terms of trade reaching the highest level in at least 150 years (Graph 1). Then an investment boom took place in response to the higher prices, with investment in the resources sector reaching its highest level as a share of GDP in over a century. And now we are seeing the dividends of this, with large increases in Australia’s resource exports. 1 / 11 BIS central bankers' speeches Overall, it has been a reasonably successful chapter in Australia’s economic history. Real income per person is around 20 per cent higher than it was in the mid 2000s and real wealth per person is 40 per cent higher. Australia is one of the few advanced economies that avoided a recession in 2008. And the biggest mining boom in a century did not end in a crash, as previous booms did. Our interest rates remained positive, unlike those in many other advanced economies. Since the mid 2000s, the unemployment rate has averaged 5¼ per cent, a better outcome than in the previous three decades. Inflation has averaged 2½ per cent. And over this period, GDP growth has averaged 2¾ per cent, higher than in most other advanced economies. So, taking the period as a whole, it is a positive picture. At the same time, though, as the chapter draws to a close, we do face some issues. I would like to highlight three of these. The first is the recent slow growth in real per capita income. For much of the past two decades, real national income per person grew very strongly in Australia (Graph 2). We benefited from strong productivity growth, higher commodity prices and more of the population working. In contrast, since 2011 there has been little net growth in real per capita incomes. This change in trend is proving to be a difficult adjustment. The solutions are strong productivity growth and increased labour force participation. 2 / 11 BIS central bankers' speeches A second issue is the unusually slow growth in nominal and real wages. Over the past four years, the increase in average hourly earnings has been the slowest since at least the mid 1960s (Graph 3). This is partly a consequence of the unwinding of the mining boom but there are structural factors at work as well. The slow growth in wages is putting a strain on household budgets and contributing to low rates of inflation. 3 / 11 BIS central bankers' speeches A third issue is the high level of household debt and housing prices. Over recent times, Australians have borrowed a lot to purchase housing. This has added to the upward pressure on housing prices, especially in our two largest cities, where structural factors are also at work. Australians are coping well with the higher level of debt, but as debt levels have increased relative to our incomes so too have the medium-term risks. The very high levels of housing prices in our largest cities are also making it difficult for those on low and middle incomes to buy their own home. So as we turn the final pages of this chapter, these are some of the issues we face. But as we turn these pages, we also see improvements on a number of fronts. Business conditions, as reported in surveys, are at the highest level in almost 10 years. There are also growing signs that private investment outside the resources sector is picking up. We have been waiting for this for some time. For a number of years, animal spirits had been missing, with many firms preferring to put off making decisions about capital spending. It appears that some of this reluctance to invest is now passing. According to the June quarter national accounts, private non-mining business investment increased strongly over the first half 2017, to be around 10 per cent above the level at the start of 2016. Non-residential building approvals have increased to be above the levels of recent years and there is a large pipeline of public infrastructure investment to be completed (Graph 4). The decline in mining investment has also largely run its course. 4 / 11 BIS central bankers' speeches There has also been positive news on the employment front. Over the past year, the number of people with jobs has increased by more than 2½ per cent, a positive outcome given that the working-age population is increasing at around 1½ per cent a year. Growth in full time employment has been particularly strong. The various forward-looking indicators suggest that labour market conditions will remain positive in the period immediately ahead. Here in Western Australia, there are also some signs of improvement after what has been a difficult few years. The drag from declining mining investment is diminishing. Businesses are feeling more positive than they were a year ago and employment has been rising after a period of decline. At the same time though, conditions in the housing market remain difficult, with housing prices and rents continuing to fall in Perth. Weak residential construction has also weighed on aggregate demand over the first half of this year, although building approvals and liaison reports point to some stabilisation in the period ahead (Graph 5). 5 / 11 BIS central bankers' speeches For Australia as a whole, the recent national accounts – which showed a healthy increase in output of 0.8 per cent in the June quarter – were in line with the Bank’s expectations. These, and other recent data, are consistent with the Reserve Bank’s central scenario for GDP growth averaging around the 3 per cent mark over the next couple of years. This is a bit faster than our current estimate of trend growth in the Australian economy, so we expect to see a gradual decline in the unemployment rate. This should lead to some pick-up in wage growth, although we expect this to be a gradual process given the structural factors at work that I have spoken about on previous occasions. We can also expect to see a gradual increase in inflation back towards the middle of the 2 to 3 per cent medium-term target range. There are clearly risks around this central scenario. We would like to see the improvement in business investment consolidate and a continuation of job growth at a rate at least sufficient to absorb the increase in Australia’s workforce. Some pick-up in wage growth in response to the tighter labour market would also be a welcome development. So these are some areas to watch. But as things stand, the economy does look to be improving. The next chapter I would now like to lift my gaze a little and turn to the next chapter in our economic story. I would like to sketch out four of the possible plot lines, acknowledging that, as in all good stories, there are likely to be plenty of surprises along the way. Shifts in the global economy A first likely plot line, as it has been in previous chapters, is the ongoing shift in the global economy. Here, changes in technology and further growth in Asia are likely to be prominent themes. 6 / 11 BIS central bankers' speeches In some quarters there is pessimism about future prospects for the global economy. The pessimists cite demographic trends, high debt levels, increasing regulatory burdens that stifle innovation and political issues. They see a future of low productivity growth and only modest increases in average living standards. It’s right to be concerned about the issues that the pessimists focus on, but I am more optimistic about the ability of technological progress to propel growth in the global economy, just as it has done in the past. We are still learning how to take advantage of recent advances in technology, including the advances in the tools of science. In time we will do this and new industries and methods of production will evolve, some of which are hard to even imagine today. So there is still plenty of upside. The challenge we face is to make sure that the benefits of technological progress are widely shared. How well we do this could have a major bearing on the next chapter. Beyond this broad theme, it is appropriate to recognise the important leadership role that the United States plays in the global economy. If the US economy does well, so does most of the rest of the world. The United States has long been a strong supporter of open markets and a rules-based international system. It has been the breeding ground for much of the progress in technology. And it has been a safe place for people to invest and an important source of financial capital for other countries. It is in our interests that the United States continues to play this important role. A retreat would make our lives more complicated. Another important influence on the next chapter is how things play out in China. While growth in China is trending lower, the share of global output produced in China will continue to rise, as per capita incomes converge towards those in the more advanced economies (Graph 6). As this convergence takes place, the structure of the Chinese economy will change and so too will China’s economic relationship with Australia. Exports of resources will continue to be an important part of that relationship, but increasingly trade in services and other high value-added activities, including food, will become more important. Notwithstanding this, there are risks on the horizon, with the Chinese economy going through some difficult adjustments. One of these is the switch from a growth model based on industrial expansion to one based more on services. Another is managing an increasingly large and complex financial system. Australia has a strong interest in China successfully managing these challenges. 7 / 11 BIS central bankers' speeches Another shift in the global economy that could shape the next chapter is the growth of other economies in Asia. Developments in India and Indonesia bear especially close watching. Both of these countries, especially India, have very large populations, and per capita incomes are still quite low. In time, the effects of economic progress in these countries and others in the region could be expected to have a substantial effect on the Australian economy, just as the development of China has. Normalisation of monetary conditions A second likely plot line of the next chapter is a return to more normal monetary conditions globally. Since the financial crisis we have been through an extraordinary period in monetary history. Interest rates have been very low and even negative in some countries. Central banks have greatly expanded their balance sheets in order to buy assets from the private sector (Graph 7). This period of monetary expansion is now drawing to a close. 8 / 11 BIS central bankers' speeches Some normalisation of monetary conditions globally should be seen as a positive development, although it does carry risks. It is a sign that economic growth in the advanced economies has become self-sustaining, rather than just being dependent on monetary stimulus. It would also lift the return to many savers who have been receiving very low returns on interest-bearing assets for a decade now. On the other side of the ledger, periods of rising interest rates globally have, historically, exposed over-borrowing somewhere in the global system. Investment strategies that looked sensible when interest rates were very low tend not to look so good when interest rates are higher. We can take some comfort from the major efforts over the past decade to improve the resilience of the global financial system. But at the same time, investors have increasingly been prepared to take more risk in the search for yield. Many continue to expect a continuation of low rates of inflation and low interest rates, despite quite low unemployment rates in a number of countries. So this is an area that is worth watching. If higher interest rates are the result of a surprise increase in inflation, financial markets could be in for a difficult adjustment. A rise in global interest rates has no automatic implications for us here in Australia. Notwithstanding this, an increase in global interest rates would, over time, be expected to flow through to us, just as the lower interest rates have. Our flexible exchange rate though gives us considerable independence regarding the timing as to when this might happen. Higher levels of debt This brings me to a third plot line: that is, how we deal with the higher level of household debt and higher housing prices, especially in a world of more normal interest rates. It is likely that higher levels of household debt change household spending patterns. Having increased their borrowing, households are less inclined to let consumption growth run ahead of 9 / 11 BIS central bankers' speeches growth in incomes for too long. Higher levels of debt also mean that household spending could be quite sensitive to increases in interest rates, something the Reserve Bank will be paying close attention to. To date, households have been coping reasonably well with the higher debt levels. The aggregate debt-to-income ratio has trended higher, but the ratio of interest payments to income is not particularly high, given the low level of interest rates (Graph 8). Housing loan arrears remain low, although they have increased a little recently, especially here in Western Australia. Over recent times, one issue that the Reserve Bank has focused on is the build-up of mediumterm risks from growth in household debt persistently outpacing that in household income. Our concern has been that, in this environment, a small shock could turn into a more serious correction as households seek to repair their balance sheets. We have been working with APRA through the Council of Financial Regulators to address this risk. The various measures are having a positive impact in improving the resilience of household balance sheets. A broadening of the drivers of growth The fourth likely plot line is a broadening of the drivers of growth in the Australian economy. How the next chapter in our economic history turns out depends partly on our ability to lift productivity growth across a wide range of industries. The resources sector will, no doubt, continue to make an important contribution to the Australian economy, but it is unlikely that it will shape the next chapter in our economic history as it did the current chapter. With another major upswing in the terms of trade unlikely and the working-age share of our population having peaked as the population ages, improving productivity will be key to growth in our national income. The drivers of growth are changing: they increasingly depend on our ability to produce innovative 10 / 11 BIS central bankers' speeches goods and services in a rapidly changing world. In this world, it is difficult to make precise predictions about where the jobs and growth in our economy are going to come from in the future. But it seems clear that we will be best placed to take advantage of whatever possibilities arise if businesses and our workforce are innovative and adaptable. Australia is fortunate to have a natural resource base that provides an important source of national income, and this will remain the case. But in this next chapter we will need to look more directly to the skills of our workers and our businesses to drive economic growth. If we are to take advantage of the opportunities that are offered by technology and growth in Asia, we need a flexible workforce with strong skills in the areas of problem solving, critical thinking and communication. Investment in human capital will be one of the keys to success. We also need a competitive business environment that encourages innovation. How well the next chapter turns out will depend on how we do in these areas. So, in summary these are some of the themes we might expect to see in the next chapter – the impact of technology and the growth of Asia; the normalisation of monetary conditions; the effects of higher levels of household debt; and the capability of our workforce and businesses to be flexible, innovative and adaptable. This is, obviously, not a complete list. There are clearly other factors that could have a major influence on the storyline, including how geopolitical tensions are resolved and how we adjust to climate change. And no doubt there will be surprises as well. But overall, I remain optimistic about how this next chapter might unfold. While we have our challenges, some of which I have talked about, we also have some advantages. We have a strong institutional and policy framework, a skilled, growing and diverse population and a wealth of mineral and agricultural resources. We have strong links to Asia, the fastest growing part of the global economy. We also have a flexible economy with a demonstrated capacity to adjust to a changing world. These factors should give us confidence about our future. But we can’t rest on this and there are a number of significant risks. The world is a competitive place and the global economy is continuing to go through some challenging adjustments. If we are to do well in this world, we need to keep investing in both physical and human capital. We also need to keep investing in policy reform. Finally, I have said relatively little about monetary policy today. This is partly because there are other forces that are likely to be more important in shaping the next chapter of the Australian economy. Monetary policy has an important role to play in supporting the economy as it goes through the current period of adjustment. It can also help stabilise the economy when it is hit by future shocks. Monetary policy can make for a more predictable investment climate by keeping inflation low and stable. Having a competent, analytical, transparent and independent central bank can also be a source of confidence in the country. But beyond these effects, monetary policy has little influence on the economy’s potential growth rate. Over recent times, the Reserve Bank Board has not sought to overly fine-tune things. We have provided support and allowed time for the economy to adjust to the new circumstances. In its decisions, the Board has been careful to balance the benefit of providing this support with the risks that can come from rising household debt. As things currently stand, we look to be on course to make further progress in reducing unemployment and moving towards the midpoint of the medium-term inflation target. This would be a good outcome. Thank you for listening and I look forward to answering your questions. 11 / 11 BIS central bankers' speeches | reserve bank of australia | 2,017 | 9 |
Address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the Bank of England "Independence - 20 years on" Conference, London, 28 September 2017. | Speech Central Bank Independence in Retrospect Guy Debelle [ * ] Deputy Governor Address at Bank of England Independence: 20 Years On Conference London – 28 September 2017 It is a pleasure to be here today to celebrate 20 years of central bank independence for the Bank of England. I have been tasked with discussing central bank independence in retrospect. In part, this is because a little more than two decades ago, Stan Fischer and I wrote about central bank independence in prospect and posed the question: How Independent Should a Central Bank Be? When we asked that question in 1994, central bank independence was all the rage. I wrote my PhD dissertation at MIT on it, under Stan's expert tutelage. A bit further up Mass Ave, Adam Posen was writing his PhD dissertation at Harvard on the very same issue. In New Zealand, the government had established a new framework for independence for the Reserve Bank of New Zealand (RBNZ) in 1989, which granted the RBNZ significant independence, including making the Governor directly accountable for any failure to achieve the price stability objective. The framework for the European Central Bank (ECB) had just been established, which legislated a very high degree of central bank independence. Looking back, that may have been the high-water mark for central bank independence. Though, of course, the Bank of England's independence was still to come, so perhaps that was the apogee! Fast forward to today and central bank independence is no longer in the ascendancy. Its legitimacy and effectiveness are under scrutiny. Is this ‘the end of the era of central bank independence’? The answer to that question is no, in my opinion. The reason why has a lot to do with the answer that Stan and I proposed in answering the question of how independent should a central bank be. We made the important distinction between goal and instrument independence, arguing that central banks should be goal dependent but have instrument independence. That is, the goal(s) that the central bank is pursuing should be determined by the political process. But, once given the goal, the central bank should be able to pursue the goal as it sees fit, with appropriate accountability. That distinction we drew between the two aspects of independence stands up to scrutiny twenty years on. If anything, I would argue that the experience of the past two decades serves to reinforce our conclusion, with the Bank of England's own experience being a prime example. In my remarks today, I will first revisit the motivation for central bank independence. I will then ask whether those justifications are still relevant today. Or is central bank independence a solution to yesterday's problems? I will then discuss why central bank independence is under more threat today and ask whether modifications to the model of central bank independence are required. Three Foundations of Central Bank Independence First, I would like to revisit the three foundations of the arguments supporting our conclusions on goal dependence and instrument independence. The first foundation was the performance of the Bundesbank. We questioned how effective the Bundesbank had been, in the sense that recessions were at least as costly (in terms of lost output) in Germany than they had been in other countries with less independence. That is, the sacrifice ratio in Germany was not lower, which would have been expected if there had been a material credibility benefit from the Bundesbank's independence. We cautioned against the cult of central bank independence, that is, the need to avoid excessive concentration on inflation avoidance. Hence the conclusion that a central bank should have goal dependence. Second, there was the academic literature. Stan and I noted that much of the academic literature focused on rules versus discretion in the context of dynamic inconsistency. [4] Dynamic inconsistency doesn't have any particular implication for central bank independence. A rules-based monetary policy can be implemented mechanically by an agency with neither goal nor instrument independence. The argument won out in favour of discretion; if not in all of the theoretical literature then absolutely in practice. But both in practice and to a large extent in theory, the solution was in the form of ‘constrained discretion’. [5] The constraint on discretion is the goal for the central bank set by the government. The central bank has complete discretion as to how best to achieve that goal. Given discretion, what then is the best institutional framework? Stan and I also noted that Ken Rogoff's conservative central banker could be too inflation averse to be socially optimal. [6] The optimal degree of central bank independence was ‘chosen by trading off the reduction in mean inflation secured by conservatism against the less than optimal trade-off between inflation and output variability produced by that same conservatism’. [7] Carl Walsh took up this point in designing a socially optimal incentive contract for central bank governors, and the New Zealanders went a fair way towards operationalising it. Third there was the empirical evidence of Alex Cukierman, Alesina and Summers, and Grilli, Masciandaro and Tabellini. [9] Those papers showed a clear negative correlation between average inflation and central bank independence, and this result was influential in the changes to central bank independence that occurred around this time. Stan and I drilled down empirically into what particular aspects of central bank independence underpinned this correlation and concluded that inflation performance is likely to be better if there is goal dependence and instrument independence. Before discussing how these foundations stand up to scrutiny two decades later, I will spend some time talking about the overlap between central bank independence and inflation targeting. The issue of goal dependence raises the question about what are the appropriate goals for a central bank. At the same time as central bank independence was coming to the fore, inflation targeting was in its nascence. Indeed, I attended a conference here at the Bank of England in 1995, organised by Andy (Haldane), on the brand-new topic of inflation targeting. [10] The New Zealanders had adopted the first formal inflation target in 1992. The Canadians and Swedes followed. The UK had just adopted an inflation target. It is noteworthy that this was a couple of years before the Bank of England received its independence. Andy wasn't sure whether to invite the RBA as we had put in place a ‘soft’ version of inflation targeting around 1993, in marked contrast to the (then) hair-shirted framework of the New Zealanders and the Canadians. Graciously he erred on the side of inclusiveness in inviting Glenn Stevens and me to talk about the Australian model. That model now looks very much like the standard flexible inflation-targeting framework that is practiced here in the UK and elsewhere, including both NZ and Canada. Inflation targeting and central bank independence are sometimes conflated given their similar birth dates in a number of countries. In part this is because both can been seen as a response to the inflation experience of the 1970s and 1980s. The problem at hand was how best to establish and maintain a low inflation environment while delivering the desired macroeconomic outcomes. But the nature of the underlying issue that the two were intended to address was quite different. The political business cycle was one of the primary motivations for central bank independence. The temptation to run the economy too hot in the lead-up to an election argued for the allocation of monetary policy management of the economic cycle to an agency insulated from the political cycle. While one might argue that the political business cycle is less of a consideration today in many countries, its current abeyance should not be assumed to be a permanent state of affairs. Moreover, it still very much remains a live issue in a number of emerging markets. In contrast, inflation targeting arose in part because other monetary frameworks had seemingly proven unable to deliver the appropriate degree of inflation control. As Governor Bouey of the Bank of Canada famously said, ‘We didn’t abandon monetary targets, they abandoned us'. In that regard, Mervyn King describes inflation targeting as a coping strategy, [11] coping with the inability of other monetary policy frameworks to deliver the required outcomes. Central banks in many cases didn't have a lot of public credibility in terms of macroeconomic policymaking. In the Bank of England's case, it wasn't the monetary policy decision-maker, so the institution itself didn't have any track record of monetary policymaking. So in the UK, as in NZ, Canada and Australia, there was a need to build that track record. A track record requires a track. Inflation targeting provided that track. Here was a goal over which the central bank believes it has a sizeable degree of influence. The inflation-targeting framework provides a benchmark against which the central bank can be held to account in close to real time. If successful, then credibility is likely to build through time. The Foundations for Central Bank Independence in Retrospect Ultimately the proof of the central bank independence pudding is in the eating. Has central bank independence delivered? The subsequent two decades have clearly seen low inflation. Somewhat ironically, the problem today is that inflation is too low, which has contributed to the claim that central bank independence, and particularly inflation targeting, is the solution to yesterday's problem. Certainly, up until 2007, the low inflation outcomes did not come at the cost of inferior outcomes in terms of output or employment. This was Mervyn's ‘nice’ decade. But were these ‘nice’ outcomes causation or correlation? It is difficult to disentangle from other influences, including the emergence of inflation targeting as the operating framework for many central banks. There is also the integration of the Chinese economy into the global economy and the significant disinflationary impulse that came with that. Ed Balls and his co-authors have revisited the empirical findings of Stan's and my paper and show that they stand up with the addition of 20 years of data. [12] They demonstrate that the negative correlation remains between the instrument independence of the central bank and inflation. There is also a strong test case in the recent experience in the UK. The period between mid 2010 and mid 2012 saw a prolonged period of inflation above target. Yet inflation expectations remained well anchored. This was reflected in subdued wage outcomes, leading to a significant decline in real wages. This event seems to me to demonstrate that the credibility of the Bank of England in terms of inflation control was well entrenched. Could such a conjuncture have been achieved in earlier periods in the UK? The experience of earlier decades suggests that it is highly likely that inflation expectations would have gone up with inflation. How much this can be attributable to central bank independence or the inflation target is difficult to disentangle. But the fact that the Bank of England had the independence to pursue the inflation target set by the Chancellor must count for something. The fact that the target was not adjusted upward to accommodate the rise in inflation is also consequential. The Bank of England did not have a political incentive to achieve surprise inflation, Barro-Gordon style. That's the good news. The economic outcomes of the 1990s and 2000s in terms of low inflation, low unemployment and lower economic volatility are at least partly attributable to central bank independence. The political business cycle has been largely absent from discussions for some time now, particularly in the advanced economies. In the end, though, this assessment mostly relies on assertion, rather than empirical proof, particularly for the advanced economies. The unknowable counterfactual as to what would have happened in a world of less central bank independence remains just that, unknowable. The emerging economies provide a more fertile ground for empirical validation, although China stands as a very large counterexample. Central Bank Independence under Threat? But there is also the bad news. Why is central bank independence under pressure today? In summarising the economic outcomes over the past two decades, I stopped short of the financial crisis and its consequences. Clearly the output performance since the crisis has been inferior (labour market outcomes less so), although inflation has generally been low and stable. In some cases, the concern has been that inflation has been too low. The UK is not obviously one of these cases, given that the average inflation rate over the past decade in the UK has been 2¼ per cent, slightly above the middle of the inflation target. Similarly, in Australia the average inflation rate has been 2.4 per cent, again right around the middle of the inflation target. How much these outcomes can be attributed to monetary policy settings, both before and after the onset of the financial crisis, is a hotly contested debate. I will not add to that debate here, but simply note that the unsatisfactory post-crisis growth experience is a significant contributor to the current scrutiny of central banks and their independence. In this regard, I am concerned that along with insulating the setting of monetary policy from the political business cycle through central bank independence came a belief that monetary policy was the only game in town for demand management. This belief was reinforced by the success of the macroeconomic management after the 1990s recessions up until 2007. After the onset of the crisis, with a rare exception in 2008-2009, demand management continued to be the sole purview of central banks. Fiscal policy was not much in the mix. This put additional pressure on central banks. Given their mandate, as long as there was something that could be done to achieve the goals given to the central bank, however small the impact, then that something had to be done. Otherwise there was a serious risk of undermining the legitimacy of the central bank's independence. As we know, that took a number of central banks into the territory of the zero lower bound, and beyond in some cases. In some respects, monetary policy around the zero lower bound, particularly in the form of quantitative easing, starts to morph into elements of fiscal policy. In the framework that Stan and I used to examine the appropriate degree of central bank independence, government spending or fiscal policy more generally had a central role to play that the central bank needed to take account of. There were different outcomes depending on the nature of the interaction between the central bank and the government (in game theoretic terms, it depended on which was the Stackelberg leader or whether it was a Nash solution). But fiscal policy did play an important role in demand management. Monetary policy was not the only game in town. Central bank independence does not imply the complete delegation of demand management to the central bank. The achievement of the output and inflation goals of the central bank is very much a function of the fiscal response too. There is a risk that the cult of central bank independence has placed excessive pressure on the central bank to always do more. Stan and I examined the issue of instrument independence in a ‘normal’ macroeconomic world, where changes in interest rates within standard historic ranges were sufficient to achieve the desired macroeconomic outcomes. Again, that is not the environment that a number of economies have experienced over the past decade, where policy settings have moved into ‘unconventional territory’. Unconventional monetary policy has the possibility to undermine the support for instrument independence because of the interaction between the central bank's asset purchases and the government's debt management strategy. Mervyn King noted that ‘inflation targeting as a practical definition of price stability is separable from our understanding of the economy, which can evolve’. [13] I would make the same argument about central bank independence as an overarching framework for monetary policymaking. My view is that inflation targeting and central bank independence are being blamed for economic outcomes that are not a consequence of either of them, but rather of our understanding of the way the economy operates. Legitimate criticisms of central banks' understanding of the economy can be made, but that does not delegitimise the overall operating framework. But a great strength of central bank independence and inflation targeting is that one's view of the transmission mechanism can evolve over time while the basic architecture of the policy framework remains unchanged. Besides that, a new threat to central bank independence comes from the greater focus currently on the distributional consequences of monetary policy. Monetary policy has always had distributional consequences. The primary transmission of monetary policy decisions is through two relative prices: the interest rate and the exchange rate. The interest rate is the intertemporal price of substitution, which has distributional consequences between savers and investors, as well as across generations, as indeed does inflation itself. The exchange rate has distributional consequences between the traded and non-traded sectors of the economy as well as cross-border distributional implications. It is also important to note that unemployment has larger, first order consequences for income distribution than either the interest rate or the exchange rate. But these distributional effects of monetary policy have always been present. Why is this so much more of a threat to central bank independence today? One plausible explanation is the lower level of nominal growth, and particularly wage growth. The concerns around income distribution are much starker (though not necessarily any less), when nominal wages are stagnant for a significant share of the population. Another possible explanation is that if a primary transmission channel of unconventional monetary policy is through asset prices (including house prices), then the wealth channel may be playing a disproportionately larger role than in the past. The distributional impact of the wealth channel may well be larger than that of other channels of monetary policy transmission. If the distributional impact of monetary policy channels is larger now than it was in the past, this can compromise the legitimacy of instrument independence. Financial Stability and Independence Stan and I also addressed the question about goal dependence coming from the standard macroeconomic perspective of the day. One aspect that has changed post-crisis is the heightened focus on the financial stability goal of central banks. The Bank of England is a prime example of this. One question that arises is how the financial stability goal interacts with the inflation target. Is it a separate goal for the central bank that sets up potential trade-offs or is it aligned with the inflationtargeting goal? If it is separate, should the central bank have independence in how it defines the goal of financial stability? Should it have complete instrument independence as to how it pursues that goal? The goal of financial stability has generally been left vague. To some extent, it has been defined only in the negative. That is, we can all agree that financial instability was present in 2008 and that was not a good state of affairs. But it is much harder to get agreement on what are the important elements of financial stability and how central banks should go about achieving them. The longlasting, and still very active, debate about whether the central bank should lean against the wind is the best example of this. It brings to the fore a number of issues: is there a trade-off between the inflation target goal and the financial stability goal? Does the goal of financial stability need to be better defined than it is at the moment? If so, by whom? Should the central bank have complete independence to pursue its goal of financial stability with whatever instruments it so chooses, including when the distributional implications of some of those instruments are much starker? The questions do not have a straightforward answer. I would hope they would be a hot topic for PhD students today in the way that central bank independence was when Adam Posen and I were PhD students. Accountability One of the points that Stan and I were at pains to stress was the importance of central bank accountability. It is the very bedrock of central bank independence in a democratic society. It alleviates the criticism that central bank independence is inappropriate because macroeconomic policy decisions are being taken by unelected bureaucrats. I find this criticism misplaced. There are many instances where the goals of public policy have been set by the political process but are then implemented by (unelected) public servants. That is, the bureaucracy has instrument independence in many different areas. This set-up is not unique to central banks. But it does underscore the argument for goal dependence. The central bank is accountable to the political process in achieving the goals given to it. Over the past two decades, accountability has changed substantially. Again the Bank of England is a good example. There are regular appearances before the Treasury Select Committee. The volume and content of central bank publications is considerably larger and more detailed than twenty years ago. The number of speeches is dramatically higher and the messaging more transparent. No longer is it the case that a Governor would say: if you understood what I said, I must have misspoken. So with independence has come the accountability. The accountability is to the politicians and the population at large, not a small group of central banking aficionados, nor the financial markets. That means that, unlike the Delphic Oracle, it is important that the utterances of central banks are understandable. Another important distinction, in my view, between the Delphic Oracle and central banks is that the accountability is confined to the goals given to the central bank. The central bank should not be regarded as a font of all wisdom. To do so risks comprising the independence in the areas that matter. Conclusion Central bank independence was in the ascendancy twenty years ago when the Bank of England was given its independence to pursue its inflation-targeting goal with complete instrument independence. The framework adopted in the UK was very much along the lines that Stan and I envisioned when we wrote on this topic a few years earlier, namely that a central bank should have goal dependence and instrument independence and should be held accountable for its decisions through the political process. The subsequent economic performance of the UK economy validates that choice of regime. The macroeconomic outcomes through the remainder of the 1990s until 2007 certainly do. Whatever failings led to the financial crisis and its long-lived consequences, I am not convinced that central bank independence was a contributing factor. Indeed, I think the experience of the UK economy through the past decade underlines the value of the independence given to it. I do not regard central bank independence as fighting yesterday's war. The theoretical and empirical underpinnings of central bank independence remain as valid today as they did twenty years ago. The links between monetary policy, fiscal policy and financial stability policy may be more prominent now than they were two decades ago. One can question the central bank's understanding of the functioning of the macroeconomy and the monetary policy transmission process, but that is a separable issue from the validity of independence. That said, the questioning of the framework itself is a vital quid pro quo for independence. The accountability of central banks to the political process and the public more generally is critical. To be able to take independent decisions about the appropriate stance of monetary policy, a central bank has to appropriately justify them. While the combination of goal dependence and instrument independence in terms of monetary policy has stood the test of time, the equivalence in terms of financial stability is more an open question. Both the goal of financial stability and the instruments are much less clearly defined at present. While central bank independence in terms of monetary policy was all the rage in the first part of the 1990s, a similar focus in terms of financial stability today is warranted. Endnotes [*] Thanks to Stan Fischer for his education, example, guidance and support over many years. Thanks to Ed Balls and Bruce Preston for helpful discussions. Ed Balls and his co-authors have recently written a paper covering many of the same issues. Debelle G and S Fischer (1994), ‘How Independent Should a Central Bank be?’ in Jeffrey C Fuhrer (ed), Goals, Guidelines, and Constraints Facing Monetary Policymakers, Federal Reserve Bank of Boston Conference Series no.38, North Falmouth, Massachusetts, pp 195–221. Munchau M (2016), ‘The End of the Era of Central Bank Independence’, FT.com site, 14 November. Available at <https://www.ft.com/content/8d52615e-a82a-11e6-8898-79a99e2a4de6>. See also W den Haan, M Ellison, E Ilzetski, M McMahon and R Reis (2017), ‘The Future of Central Bank Independence: Results of the CFM-CEPR Survey’, 10 January and Fels J (2016), ‘The Downside of Central Bank Independence’, PIMCO Macro Perspectives, May. Adam Posen reached the same conclusion in his PhD thesis. See Posen A (1995), ‘Central Bank Independence and Disinflationary Credibility: A Missing Link?’ Federal Reserve Bank of New York Staff Reports no 1, May. Barro R and D Gordon (1983), ‘A Positive Theory of Monetary Policy in a Natural Rate Model’, Journal of Political Economy, 91(4), pp 589–610. Bernanke B, T Laubach, R Mishkin and A Posen (1999), Inflation Targeting, Princeton University Press. Rogoff K (1985), ‘The Optimal Degree of Commitment to an Intermediate Target’, Quarterly Journal of Economics, 100(4), pp 1169–89. Debelle and Fischer (op cit) p 198. Walsh C (1995), ‘Optimal Contracts for Central Bankers’, American Economic Review, 85(1), March, pp 150–167. Cukierman A (1992), Central Bank Strategy, Credibility and Independence: Theory and Evidence, MIT Press; Grilli V, D Masciandaro and G Tabellini (1991), ‘Political and Monetary Institutions and Public Financial Policies in Industrial Countries,’ Economic Policy, 13 (October), pp 341–392; Alesina A and L Summers (1993), ‘Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence’, Journal of Money, Credit and Banking, 25(2), pp 151–162. [10] Haldane A (ed) (1995), Inflation Targeting, Proceedings of a Conference, Bank of England, London. [11] King M (2016), The End of Alchemy, Little Brown. [12] Balls E, J Howat and A Stansbury (2016), ‘Central Bank Independence Revisited: After the financial crisis, what should a modern central bank look like? M-RBCG Associate Working Paper Series, No 67, Harvard Kennedy School. [13] King M (2016), op cit. [14] See Haldane A (2017), ‘A Little More Conversation, A Little Less Action’, available at <http://www.bankofengland.co.uk/publications/Documents/speeches/2017/speech971.pdf>, Federal Reserve Bank of San Francisco, Macroeconomics and Monetary Policy Conference, 31 March. [15] That said, the opacity of the Delphic Oracle is a matter of some historical contention. © Reserve Bank of Australia, 2001–2017. All rights reserved. | reserve bank of australia | 2,017 | 9 |
Text of the 7th Warren Hogan Memorial Lecture by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, Sydney, 26 October 2017. | 27/10/2017 Uncertainty | Speeches | RBA Speech Uncertainty Guy Debelle [ * ] Deputy Governor 7th Warren Hogan Memorial Lecture Sydney – 26 October 2017 Uncertainty is one of the few certainties in monetary policy decision-making. It enters at nearly every stage of the process – from understanding where the economy is at the moment to knowing where it will be in the future. Tonight, I will discuss some of the main ways that uncertainty affects things. In doing so, I will draw on the ‘Superforecasting’ template described by Philip Tetlock. [1] I will also discuss the monetary policy reaction function, which is one area where we can try to minimise uncertainty. In describing these various manifestations of uncertainty, I will outline some forthcoming changes to the way uncertainty is presented in the RBA's . The intention of these changes is to portray uncertainty in a form that is usable and understandable. I would also like to Statement on Monetary Policy discourage an excessive focus on false precision. 1. Uncertainty about Where We Are I will start by discussing the uncertainty about the present. It is obviously important to have a good idea of where you are, in order to know where you are going. We do have some sense of where the economy is, albeit imperfect. Most of the time, the uncertainty about where exactly we are is not consequential to the setting of monetary policy, but at times it can be. Some of the uncertainty relates to the frequency of data releases and the time it takes for data to be collected and published. Take the case of output and inflation, two of the most important summary statistics on the economy. It is now late October. But we won't receive an official read on GDP in the current quarter until the December quarter national accounts are released in early March of next year. That's more than four months away. This is by no means intended as any criticism of the ABS. It just highlights the challenges of compiling such statistics for an entity as large and complex as the Australian economy. http://www.rba.gov.au/speeches/2017/sp-dg-2017-10-26.html 1/16 27/10/2017 Uncertainty | Speeches | RBA For inflation – which is also published quarterly in Australia – we won't get an official read on the current rate until the December quarter Consumer Price Index (CPI) is released in late January, three months from now. In most other countries, the CPI is published monthly, so the wait to get an assessment on current inflation is not so long elsewhere. More timely and more frequent estimates of output and inflation are not unambiguously desirable. There is clearly a trade-off between timeliness and accuracy. But, in the case of inflation, a more frequent estimate would help to identify changes in the trend in inflation sooner; it probably comes with more noise, but we have ways to deal with that. Any reading on inflation always contains varying degrees of signal and noise about the ‘true’ inflation process. At the moment, we need to wait three more months to gain a better understanding as to whether any particular read on inflation is signalling a possible change in trend or is just noise. That is one of the reasons why the RBA has long advocated a shift to monthly calculation of the CPI. That said, we do not depend solely on GDP and the CPI to assess the current state of the economy. We spend a lot of time and effort piecing together information from a large number of other sources. These include higher frequency and more timely data, including from the ABS, but also from a wide range of other data providers. The information we obtain from talking to people, particularly through our business liaison program, is also invaluable. The question then arises as to how we can filter the information we receive from all these different sources to gain an overall picture about inflation and the state of the overall economy. Take GDP as an example. Some of the data released before the national accounts, such as monthly retail sales and international trade, feed directly into the calculation of GDP. So we have a direct read on those. We ‘nowcast’ other components of GDP using data that are more timely. Let me illustrate for household consumption. We get a good measurement of consumption of goods by looking at monthly retail sales and sales of motor vehicles and fuel. But there is very little timely information on household consumption of services, so the nowcast of this component relies more on statistical relationships. Some of these relationships are pretty weak, so we also supplement this with information on sales from our regular discussions with our business liaison contacts. This then gives us an estimate of consumption for the quarter. To get a preliminary nowcast for GDP growth for the quarter, we aggregate our best estimate for each of the relevant components. We then ask ourselves whether this estimate is consistent with other information that we have, such as the monthly labour market data, as well as predictions from our macro forecasting models. The nowcast can be then updated with new information as it comes to hand. That said, my observation from a couple of decades of forecasting is that your first estimate of GDP (three months out) is often the best, and that additional information is often noise rather than signal. Measurement uncertainty Aside from when data are published, uncertainty about the present also arises from how things are measured. This takes two forms. First, there is the methodology used to actually measure the variable in question. Second, there are the revisions to data after they were first published. http://www.rba.gov.au/speeches/2017/sp-dg-2017-10-26.html 2/16 27/10/2017 Uncertainty | Speeches | RBA On the first, a good example is the CPI. The CPI measures prices for a large number of items purchased by households. When aggregating these to calculate the overall consumer price index, each item is assigned a weight based on its average share of household expenditure. That is, the aim is to weight each price by the amount households spend on it, on average, in the period in question. Obviously, these weights can change through time. But the weights used in the CPI are only updated each time the ABS conducts a Household Expenditure Survey, which, in recent times, has been every five or six years. In between each household expenditure survey, a number of things can happen. First of all, some new goods and services can come along that weren't there before. One example you might think of is a mobile phone. Though it's not quite that straightforward, as before mobile phones, households spent money on landline phone bills and on cameras. So often these ‘new’ goods are providing similar services to something that was there before. Nevertheless, the ABS needs to take account of these new goods coming in, as well as some old items dropping out. Secondly, households adjust their spending in response to movements in prices and income. In practice, households tend to substitute towards items that have become relatively less expensive, and substitute away from items that have become relatively more expensive. But the expenditure weights in the CPI are only updated every five or six years. Over time, the effective expenditure weights in the CPI become less representative of actual household expenditure patterns. That is, they are putting more weight on items whose prices are rising than households are actually spending on them. This introduces a bias in the measured CPI – known as substitution bias – which only is addressed when the expenditure weights are updated. Because households tend to shift expenditure towards relatively cheaper items, infrequent updating of weights tends to overstate measured CPI inflation. The ABS will very shortly update the expenditure weights in the CPI. Because of substitution bias, history suggests that measured CPI inflation has been overstated by an average of ¼ percentage point in the period between expenditure share updates. While we are aware of this bias, we are not able to be precise about its magnitude until the new expenditure shares are published, because past re-weightings are not necessarily a good guide. It is also not straightforward to account for this in forecasts of inflation. However, from a policy point of view, the inflation target is sufficiently flexible to accommodate the bias, given its relatively small size. Going forward, the ABS will update the expenditure shares annually, rather than every five or six years. This will reduce substitution bias in the measured CPI. Another form of uncertainty about where we are, and sometimes also where we've been, comes from revisions to data after they were first published. [3] I will illustrate this point with a couple of recent examples. In the annual national accounts for 2015/16 released in October last year, there was a sizeable reappraisal of the allocation of total investment between the mining and non-mining sectors of the economy (Graph 1). There were upward revisions to the level of mining investment throughout the past decade, which was offset by downward revisions to the level of non-mining investment. http://www.rba.gov.au/speeches/2017/sp-dg-2017-10-26.html 3/16 27/10/2017 Uncertainty | Speeches | RBA Why is this important? In analysing investment over the course of the past decade, it has been very useful to separately analyse investment in the mining sector and investment in the rest of the economy because of the markedly different drivers of the two and the differing sources of information we have. More recently, in the June quarter national accounts, the data on non-mining business investment were revised upwards. The effect of both of these two revisions has significantly changed the profile of recent years to show more substantive growth in non-mining business investment than had been recorded earlier. This is very much welcome news for the economic outlook. A rebound in investment outside the mining sector has been a core part of the RBA's forecast for a while. So in this case, the revisions resulted in a reassessment both of where we are now, but also, of where we have come from. Graph 1 Another example concerns the household saving ratio, which is useful in gauging current and prospective developments in household consumption. Revisions can have a material effect on the profile of the household saving ratio. At times, these have been substantial (in both directions), which can change our understanding of what was going on at any particular point in time. It also can complicate the estimation of economic relationships if the historical data change. http://www.rba.gov.au/speeches/2017/sp-dg-2017-10-26.html 4/16 27/10/2017 Uncertainty | Speeches | RBA The annual national accounts, where the ABS ‘confronts’ the data and takes account of possible inconsistencies, as well as incorporates new information sources, is due out tomorrow, and might again change our understanding of where the economy is at currently in some key areas. Note that again this is not at all a criticism of the ABS. The process of collecting the data before publication is time consuming and very challenging, both practically and conceptually. Many of the issues I have raised here, and more, apply to data in other economies. I am just seeking to highlight the uncertainties that enter the assessment of where we are. Uncertain economic concepts In addition to these uncertainties about where we are, there are also uncertainties that arise from important economic concepts that we can't measure directly. One of these is the neutral policy rate, which I talked about recently. Another is the degree of spare capacity in the labour market, which, like the neutral rate, is fundamentally important to a central bank tasked with achieving price stability and full employment. But, like the neutral rate, it is difficult to measure spare capacity directly. (The output gap is the GDP equivalent, with similar measurement challenges). A useful benchmark for assessing the degree of spare capacity in the labour market and inflationary pressures is the NAIRU, or non-accelerating inflation rate of unemployment. When the actual unemployment rate is above the NAIRU, there is spare capacity in the labour market, which would typically exert downward pressure on wage growth and inflation. The NAIRU is not observable, but it can be estimated. [5] Indeed, I have spent part of my economic life doing just that. The NAIRU can only be estimated, rather than directly measured like GDP or inflation. As we get new data on unemployment, wages and inflation, we can update our estimates of the NAIRU. Graph 2 shows various vintages of estimates of the NAIRU. That is, the NAIRU is estimated using data up to the end of the period shown, so, for example, the 2001 estimate uses the data up to end of 2001, while the 2017 estimate uses the data up to the current period. As we get a set of outcomes for inflation and unemployment that are different from what our previous model of the NAIRU suggested, we can apportion that difference to either the residual in the estimated equation or to a change in our estimate of the NAIRU. http://www.rba.gov.au/speeches/2017/sp-dg-2017-10-26.html 5/16 27/10/2017 Uncertainty | Speeches | RBA Graph 2 The graph shows that, most of the time, our current estimate of the NAIRU is not much different from our earlier estimates. [7] There are a few noteworthy divergences between different vintages of the NAIRU. Most of these divergences occur around sharp movements in the unemployment rate where, in real time, it is difficult to disentangle how much of these movements are structural versus cyclical. Note that in these circumstances, the sign of the unemployment gap is not changing, just the size of it. Graph 3 shows the confidence intervals around the estimates of the NAIRU. As can be seen in the graph, the current estimate of the NAIRU from this model is around 5 per cent. The 70 per cent confidence interval around this estimate is ±1 percentage point. That is, we can be fairly sure that the NAIRU lies between 4 and 6 per cent. http://www.rba.gov.au/speeches/2017/sp-dg-2017-10-26.html 6/16 27/10/2017 Uncertainty | Speeches | RBA Graph 3 But what does this uncertainty about the NAIRU mean from a monetary policy point of view? How much of a problem is it that it is difficult to pin down the estimate of spare capacity in the labour market that precisely? The estimates suggest that the NAIRU is slow moving most of the time. Changes in the actual unemployment rate generally give you a pretty good gauge as to what is going on in terms of the general direction and extent of change in spare capacity in the labour market. We can then see how outcomes in terms of wage and price growth evolve in subsequent periods to assess whether we need to revise our estimates of spare capacity, but most of the time we are unlikely to revise those estimates materially. That is why I find the unemployment rate to be a particularly useful guide to the current state of the economy. We can bring other pieces of information to bear to confirm the assessment of the current state of spare capacity in the labour market, including information from business surveys. Measures of underemployment are also helpful. Of particular benefit is our business liaison program, which can give us an indication of whether wage and price pressures are starting to emerge in particular parts of the economy. That said, there are periods where this ability to rely on the gradual evolution of estimates of spare capacity breaks down, most notably the 1970s. So we always need to be alert to these possible regime shifts. http://www.rba.gov.au/speeches/2017/sp-dg-2017-10-26.html 7/16 27/10/2017 Uncertainty | Speeches | RBA Most recently, this has been an issue (to some extent a pleasant issue) for a number of central banks. The unemployment rate has approached and gone below previous estimates of the NAIRU in the US, Germany and Japan, yet wage and price inflation has remained subdued. As a consequence, estimates of the NAIRU in those countries have continued to be revised lower. This can, presumably, only go on for so long, as eventually the laws of supply and demand mean that as new workers become increasingly hard to find, companies will actually have to pay higher wages to fill jobs. Here in Australia, our assessment is that there still remains a sizeable degree of spare capacity in the labour market. Our forecast is that spare capacity will be gradually reduced in the period ahead. But, as it is reduced, we will be alert to the possibility that these developments we see in other labour markets, in terms of subdued inflation in the face of minimal spare capacity, occur here too. 2. Uncertainty about the Future Having talked about uncertainty about the present (and the past), I will now turn to discuss uncertainty about the future. As I said in a speech on uncertainty almost a decade ago, the late Jim Morrison put it best: ‘the future's uncertain and the end is always near’. Monetary policy affects the economy with a lag. Changes in interest rates affect output, employment and inflation over a period of time. In Australia, we estimate that a change in the policy interest rate today has its peak impact on aggregate demand in about 12 to 18 months. The peak impact on inflation is closer to two years. So, in thinking about the appropriate stance of monetary policy today, we need to make an assessment about the likely state of the economy over the next couple of years. We need to make forecasts. How much output will be produced in the economy in 18 months' time? How fast will prices be rising in two years' time? How would changing the level of interest rates now affect these outcomes? These questions are difficult to answer with any degree of precision. The inaccuracy of economic forecasts is well documented and often much maligned. As Glenn Stevens noted when speaking on forecasting a few years ago, ‘one big difference in economics is that some decisions based on forecasts may alter the outcomes – as in the case of economic policy decisions, or spending decisions by businesses and households’. [9] He went on to observe that this is one advantage weather forecasters have over the economics profession. Human behaviour doesn't change the weather, at least over short horizons. Economics has to deal with the vagaries of human behaviour, which seem to be more difficult to predict and are more consequential than the vagaries of the weather. The economics profession has developed a range of methods to deal with forecast uncertainty. Rather than try and summarise that work, I would like to discuss some of the ways we deal with forecast uncertainty at the RBA. Before I do that, it will be useful for me to outline how RBA staff generate forecasts for key variables like output growth, inflation and the unemployment rate. http://www.rba.gov.au/speeches/2017/sp-dg-2017-10-26.html 8/16 27/10/2017 Uncertainty | Speeches | RBA As I alluded to above, we begin with very careful analysis of the data; trying to understand where things are at now. It is always useful to have some idea of where you are, before working out where you are going! We monitor thousands of variables relating to the domestic and global economies and financial markets. And we try to understand the relationships between these variables. We also try and gain a better understanding of developments in the economy by talking to people – firms, unions and employee groups, financial market participants, other public institutions and government departments, academics, think tanks. Much of this occurs through the RBA's liaison program. We also talk to our colleagues at other central banks, and participate in a range of international forums to try and understand global economic developments and how they might affect Australia. The forecasts for key variables are generated using a combination of econometric models and our judgement. We try and take an eclectic approach to this. For any given variable, we don't know what the ‘true’ model is, or the true data-generating process is, if you would like to take a more atheoretical approach. There is rarely one single model that outperforms all the rest. Or, even if we thought we knew what that model was today, structural changes in the economy means that it mightn't be the true model tomorrow. So we typically estimate a range of different models for each of the key variables that we are interested in. To some extent, this is utilising the wisdom of crowds. To illustrate, consider the models we use to forecast inflation. One approach is an extension of the Phillips Curve, that I was discussing above when talking about the NAIRU, where inflation is a function of spare capacity in the labour market, import prices and inflation expectations. Another approach is to model inflation as a mark-up over input costs, such as growth in labour costs and import prices. ‘Bottom-up’ approaches are also used; for example, forecasting non-tradable and tradable inflation separately, and aggregating those to get a forecast for overall inflation. We can also use time series techniques to estimate the data-generating process only using the inflation data itself. These give us a range of forecasts for inflation. They highlight the issue of model uncertainty, that is, we are not sure which model is the right model for inflation. It poses the difficult challenge of how to process/weight the different forecasts that we have. This is where the art of forecasting comes in, though science can help us with this challenge too. Here it is important, in my view, to be flexible and eclectic rather than rigid and dogmatic. In addition to single-equation models, we also have a number of macroeconomic and multi-equation models that are used to cross-check the forecasts. These models have the advantage of incorporating feedback effects. For example, higher wage growth increases firm's input costs and could lead to higher inflation. That, in turn, could increase inflation expectations and encourage workers to push for higher wage growth. The macro models also impose internal consistency, so we can have greater confidence that forecasts for individual variables are consistent with each other. It is also useful to check that adding up constraints aren't being violated! Often we use our judgement to augment the forecasts generated by the econometric models. Applying judgement is appropriate for a number of reasons. http://www.rba.gov.au/speeches/2017/sp-dg-2017-10-26.html 9/16 27/10/2017 Uncertainty | Speeches | RBA We do not have a fully articulated behavioural model of the economy where we are confident about the evolution of all the parameters. Hence we estimate models that are the average outcomes over the time period over which they are estimated. The model fits the data, on average, with some degree of imprecision. At any point in time there are residuals. That is, at any point in time, the current outcome is not likely to be exactly where the model expects it to be. We can bring judgement to bear on those residuals and their possible evolution. There is likely to be information about the current state of the variable in question that is not easily incorporated in the model. For example, over the past decade, the information we have gained from our liaison program from talking to the large resource companies has been very informative and, most importantly, quite accurate about the profile of investment in the resources sector. But this information was difficult to incorporate directly into standard models of business investment. The nature of these idiosyncratic residuals or shocks may have some degree of predictability to them, which, again, we can utilise in the forecasts. We may have some reason to believe the residuals are likely to be correlated in the immediate future, if we have some understanding as to what underpins them today. At other times, we may have reason to believe that the econometric model has broken down. Behavioural parameters may change through time, particularly in the face of policy changes. In the words of the standard investment disclaimer: past behaviour may not be a good guide to future performance. Although judgement is necessary, we are also mindful of its dangers. It can lead to biases, for example, the tendency to see persistent patterns in random data. And it can be harder to explain, replicate and refine than quantitative models. As elsewhere, a balance is needed. So, we must always ask the question: how relevant is the past for forecasting the future? Does history repeat, rhyme or is it bunk? Dealing with forecast uncertainty Despite these efforts, the history of economic forecasting tells us that our central forecast will almost certainly be wrong. But there are things we can do to manage this uncertainty. The methodology in Philip Tetlock's again. Superforecasting is very helpful: try, fail, analyse, adjust, try It is essential to ask, after the fact, what did cause our forecasts to be wrong? Evaluating forecasts ex post is as important as generating the forecasts. This can be described in three stages: Where were we wrong? For which variables were our forecast misses the largest? Why were we wrong? There are a number of possible reasons. Was it because the model was the wrong model? Has the model changed? Was our judgemental adjustment wrong? Was our forecast for an explanatory variable wrong? Was there an economic event or ‘shock’ that we didn't anticipate? http://www.rba.gov.au/speeches/2017/sp-dg-2017-10-26.html 10/16 27/10/2017 Uncertainty | Speeches | RBA Having attempted to answer these questions, we can then ask what can we learn? What, if anything, do we need to adjust in our forecasting framework? To understand forecast misses, it is important to ask whether there were any unanticipated economic events or ‘shocks’. It is just as important to understand the source of these shocks; not only can that help us understand the forecast misses, but it can also help us understand economic developments more generally. That said, it is important to be mindful of hindsight bias. Hindsight is always the best forecaster. So it is important to differentiate between what we should have known have learnt . ex post ex ante and what we can only I will illustrate the issue arising from forecast uncertainty by showing the forecast misses for underlying inflation and the unemployment rate since 1993 (Graph 4). Graph 4 Not surprisingly, forecast misses are more common than not, as I have already noted. The inflation misses (the vertical axis) are centred on zero; they have been unbiased. But the unemployment misses (the horizontal axis) have been negative more often than positive. That is, on average over this period, the unemployment rate has been lower than we had forecast. That's a good economic outcome. But, as a forecaster, this bias is something we would hope to avoid. http://www.rba.gov.au/speeches/2017/sp-dg-2017-10-26.html 11/16 27/10/2017 Uncertainty | Speeches | RBA I have labelled on the graph some of our biggest misses. The cluster on the left represents the financial crisis, which we thought was going to deliver much lower growth and higher unemployment in 2010 than it did. Again, from an economic outcomes point of view, it is better that it turned out this way. If we ask ourselves, why did things turn out to be better than feared in this instance, a large part of the explanation was the unexpectedly large fiscal stimulus in China in 2008-09, which was particularly beneficial for the Australian economy. There was also the beneficial effect of fiscal actions in Australia and the labour market turned out to be more flexible than we had expected. Finally, there was the domestic monetary policy response and the depreciation of the exchange rate, the extent of which were not forecast. Most of these fall into the category of were difficult to foresee ex ante. ex post events, which The cluster at the top represents the increase in underlying inflation in 2008, which we did not fully anticipate. In the bottom left is 1999, when both unemployment and inflation turned out surprisingly well. But these outliers are unusual, with most of our errors clustered around the centre. To reinforce that point, I have drawn ellipses – under certain assumptions we would expect 70 per cent and 90 per cent of our forecast errors to fall within these ellipses, respectively. A feature of the chart is how featureless it is. It is tempting to assume that forecast misses for unemployment and inflation would be negatively correlated; if unemployment is surprisingly low, then inflation would be surprisingly high. This would be consistent with demand shocks. But, in reality, there is not much correlation. Supply shocks – where, for example, both unemployment and inflation were surprisingly low – have been about as common as demand shocks. How consequential are these forecast errors for the actual setting of monetary policy? To a large extent, that is the acid test. The answer to that question is dependent on whether the forecast misses ex ante ex post were foreseeable and . It also depends on what the monetary policy response has been between when the forecast was made and when the outcome is actually realised. As I noted earlier, one challenging dynamic in forecasting the economy is that we are all participants in the process and can have an impact on the actual outcomes with our future actions. How we communicate uncertainty So far I have discussed how we think about forecast uncertainty and some of the approaches we use to make our forecasts as robust as possible. Statement on Monetary But how do we communicate forecast uncertainty? In the RBA's quarterly , our approach is to show graphically confidence intervals around the central forecasts. Policy The following graph from the August http://www.rba.gov.au/speeches/2017/sp-dg-2017-10-26.html Statement shows this for year-ended GDP growth (Graph 5). 12/16 27/10/2017 Uncertainty | Speeches | RBA Graph 5 The black line shows actual GDP growth up to the latest data point, and then the central forecast. This is the modal forecast; the outcome we consider most likely. The dark blue area is the 70 per cent confidence interval around the central forecast, based on our forecasts errors since 1993. Roughly speaking, it says that – if we make similar forecast errors to those in the past – there is a 70 per cent chance that GDP growth in two years' time will be between 2 and 4½ per cent. [14] The light blue area is the 90 per cent confidence interval. These intervals show that there is considerable uncertainty around the forecasts for GDP. This is true for other forecasters, as well as GDP forecasts for other economies. In the Statement on Monetary Policy, we have also published a table of forecasts for key variables. Recently these forecasts have been published as ranges, for example, 2–3 per cent for inflation. In the next Statement, these ranges will be replaced by the central forecasts to the nearest quarter point. Anything more precise than that is false precision in my view. This evolution in the approach to portraying the forecasts and the uncertainty around them is because the technology has improved. We are making the change because we think that we can provide more useful information about the central forecast and the degree of uncertainty around the forecast. Given the uncertainty around the central forecasts, I would strongly encourage you not to place too much significance on small changes from quarter to quarter. That is, avoid falling into the trap of http://www.rba.gov.au/speeches/2017/sp-dg-2017-10-26.html 13/16 27/10/2017 Uncertainty | Speeches | RBA false precision. The exact estimates are, in the end, not that important. The sense of central tendency conveyed by the graphs is more important and the accompanying text will continue to provide our assessment as to whether the changes are material or not. The monetary policy reaction is more likely to be affected by where the actual outcomes for inflation and growth fall within those intervals in the graph than whether or not the forecast in the table is actually achieved. Similarly, focussing on how exactly the point estimates in the table change from quarter to quarter is likely to be less informative than the evolution of the information in the graphs. We will also continue to supplement this information with a discussion of some of the uncertainties around the forecast. This gives some sense as to what are some of the forces that could cause the outcome to depart from the modal forecast. That is, they may be low probability events, but, if realised, they would be highly consequential for the Australian economy. The discussion of these different scenarios comes from asking ourselves the question: ex ante, what things could cause our central forecast to be wrong? What would our forecasts look like (say) if the exchange rate was 10 per cent lower than we assumed? Or if Chinese GDP growth slowed sharply? Or if households save less income than we assumed? These scenarios involve changing a key assumption or central forecast for a particular variable, and then evaluating the outcome relative to the central forecasts. The scenario effectively picks out a different point in the distribution of possible forecast outcomes. Macro models are an effective tool for scenario analysis. At the RBA, we have several macro models we can use, depending on the scenario we want to evaluate. Over the period ahead, we will be conveying the potential outcomes of such scenario analysis in the Statement on Monetary Policy. Monetary Policy and Uncertainty At various times throughout this speech, I have raised the issue of how consequential these various sources of uncertainty are for the monetary policy decision-making process. Most of the time, the uncertainties, while needing to be acknowledged, have to be taken for what they are. That is, we can assume that they will probably evolve only slowly, in a way that gives time for monetary policy to respond appropriately as they are realised. Another way of putting this is that monetary policy responds to the modal forecast, the most likely outcome. If an uncertainty is realised that changes that modal outcome, then monetary policy responds appropriately when that information becomes available. It does not respond to the weighted average of the likelihood of all the various uncertainties. In part, this is because it is impossible to articulate all the uncertainties and/or assign probabilities to them. It is also because if we were to set policy in response to the mean, rather than the modal, forecast, we would almost certainly have the wrong policy setting in whatever future state of the world is realised. This approach is very much in keeping with Brainard's gradualism in policymaking under uncertainty. At times, there is a need for a decisive policy response as particularly large shocks away from the modal path come to pass. The financial crisis is a particularly good example of this. But such events tend to be the exception rather than the rule. http://www.rba.gov.au/speeches/2017/sp-dg-2017-10-26.html 14/16 27/10/2017 Uncertainty | Speeches | RBA Whatever the circumstances, though, it is important that there is a good understanding of what the monetary policy reaction is likely to be. That is, it is important that people have a good understanding of what the reaction function is. Then they can have reasonable surety about how the central bank will respond given the outcomes for inflation, unemployment and output that actually come to pass. They can have some confidence in saying: if I think this is my most likely forecast for the economy, then it is likely that monetary policy will be adjusted in this way. At the same time, it is important to note that the monetary policy decision is ‘not rigidly and mechanically linked to forecasts’, not least because of all the uncertainties I have just been discussing. Another way of putting this is that we can try and make the monetary policy decision-making system as robust as possible to the inherent uncertainty that we have no choice but to deal with. Conclusion Most (all?) decisions in life are taken under some degree of uncertainty. This is because decisions are about something that will happen in the future, which is uncertain. Policymaking under uncertainty is similarly a fact of life. As Tetlock puts it, ‘it is one thing to recognise the limits on predictability and quite another to dismiss all prediction as an exercise in futility.’ In this speech, I have tried to articulate a number of ways in which uncertainty enters the monetary policy decision-making process. There is uncertainty about both where we are and where we are going. But not all these sources of uncertainty are above the materiality threshold that impinges on the actual monetary policy decision or on other economic decision-making. We need to avoid false precision in both our assessment of outcomes and forecasts and in our policy response to them. In that regard, I have noted a change to the way we will present our forecasts to try and encourage a shift of focus to the central tendencies for the future paths of key economic variables. We will continue to assess how our forecasts turn out and adjust our framework and methodology where and when appropriate. We will try and understand the sources of forecast misses and question whether they were knowable ex ante or ex post. In doing so, we continue to aspire to have ‘perpetual beta’, recognising the need to be cautious, pragmatic, self-reflective, analytical and thoughtful updaters. Endnotes [*] Thanks to Mick Plumb for his help. Tetlock P and D Gardner (2015), Stevens G and G Debelle (1995), ‘Monetary Policy Goals for Inflation in Australia’, RBA Research Discussion Paper No 9503. See Bishop J, T Gill and D Lancaster (2013), ‘GDP Revisions: Measurement and Implications’, RBA 11–22. Superforecasting: The Art and Science of Prediction, Crown Publishing, New York. http://www.rba.gov.au/speeches/2017/sp-dg-2017-10-26.html Bulletin, March, pp 15/16 27/10/2017 Uncertainty | Speeches | RBA Debelle G (2017), ‘Global Influences on Domestic Monetary Policy’, Speech at the Committee for Economic Development of Australia (CEDA) Mid-Year Economic Update, Adelaide, 21 July. Cusbert T (2017), ‘Estimating the NAIRU and the Unemployment Gap’, RBA Debelle G and J Vickery (1998), ‘Is the Phillips Curve a Curve? Some Evidence and Implications for Australia’ , 74, pp 384–398; Debelle G and D Laxton (1997), ‘Is the Phillips Curve Really a Curve? Some Evidence from Canada, the United Kingdom and the United States’, IMF Staff Papers, 44 (2), pp 249–282. Note that the model to estimate the NAIRU here is not changing through time, just the sample period. There would likely be additional variation if different models were used through time. Debelle G (2010), ‘On Risk and Uncertainty’, Address to the Risk Australia Conference, Sydney, 31 August. Stevens G (2011), ‘On the Use of Forecasts’, Address to the Australian Business Economists Annual Dinner, Sydney, 24 November. Bulletin, June, pp 13–22. Economic Record [10] Lowe P (2010), ‘Forecasting in an Uncertain World’, Address to the Australian Business Economists Annual Forecasting Conference Dinner, Sydney, 8 December and Kent C (2016), ‘Economic Forecasting at the Reserve Bank of Australia’, Address to the Economic Society of Australia (Hobart), Hobart, 6 April. [11] See Tetlock and Gardner (2015), p 177. [12] See Tulip P and S Wallace (2012), ‘Estimates of Uncertainty around the RBA's Forecasts’, RBA Research Discussion Paper No 2012-07. Thanks very much to Peter Tulip for generating this graph. [13] See Tulip and Wallace (2012). [14] This is an intuitive interpretation, not the technical definition of a confidence interval. [15] Brainard W (1967), ‘Uncertainty and the Effectiveness of Policy’, American Economic Review, 57, pp 411–425. [16] Stevens G (2011), ‘On the Use of Forecasts’, Address to the Australian Business Economists Annual Dinner, Sydney, 24 November. [17] See Tetlock and Gardner (2015), p 10. [18] See Tetlock and Gardner (2015), pp 190–192. © Reserve Bank of Australia, 2001–2017. All rights reserved. http://www.rba.gov.au/speeches/2017/sp-dg-2017-10-26.html 16/16 | reserve bank of australia | 2,017 | 10 |
Address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the UBS Australasia Conference 2017, Sydney, 13 November 2017. | 13/11/2017 Business Investment in Australia | Speeches | RBA Speech Business Investment in Australia Guy Debelle [ * ] Deputy Governor UBS Australasia Conference 2017 Sydney – 13 November 2017 One of the ongoing themes in the global economy since the financial crisis has been the long-lasting paucity of business investment spending. This has been despite conditions that, in the past, have been very favourable for investment spending, such as low borrowing rates, strong corporate balance sheets and solid profitability. In Australia, the story has been quite different. Investment spending here has been at a historically high level over much of the past decade. This has been primarily due to the strength of investment in the resources sector, which reached its highest share of activity in more than a century. So, unlike in other countries, there has been a significant addition to the capital stock in Australia over the past decade. We are seeing the fruits of that investment in the strong growth in resource exports. Today I would like to compare and contrast the investment experience in Australia with that of other countries. I will also compare and contrast investment in the resources sector in Australia with investment in the rest of the economy, where the experience is more similar to that elsewhere in the world. As we are almost at the end of the resource investment cycle, stronger growth in investment in other sectors is important for future additions to the capital stock in Australia. I will spend some time discussing the recent history of investment in this part of the economy, drawing insights from a recently available dataset that provides highly disaggregated information on the business sector. Mining Investment In Australia, investment spending as a share of the economy rose to a multi-decade high around 2012–13 (Graph 1). This stands in stark contrast to the experience in nearly every other advanced economy as well as most emerging economies, with China being a noteworthy exception (Graph 2). http://www.rba.gov.au/speeches/2017/sp-dg-2017-11-13.html 1/13 13/11/2017 Business Investment in Australia | Speeches | RBA Graph 1 Graph 2 http://www.rba.gov.au/speeches/2017/sp-dg-2017-11-13.html 2/13 13/11/2017 Business Investment in Australia | Speeches | RBA Much of that outcome was clearly a result of the record level of investment spending in the mining sector. Investment spending in the mining sector rose from around 2 per cent of GDP in the early 2000s, where it had been for much of the previous five decades to peak at around 9 per cent of GDP in 2012/13. Or, to put that in dollar terms, investment spending in the mining sector in 2006/07 totalled $41 billion and rose to a peak of $136 billion in 2012/13. The reasons for the huge rise in investment spending in the mining sector have been well documented. In the case of iron ore and coal, it was a response to the large rise in commodity prices through the 2000s, predominantly driven by the emergence and strong resource-intensive growth of China. Investment spending to increase capacity in the iron ore and coal industries accounts for around 40 per cent of the spending over the past decade (Graph 3). A larger share has been spent in the liquefied natural gas (LNG) sector, which is not only a China story, with a large part of LNG exports also destined for Japan and Korea. Graph 3 Many of these investment decisions, particularly in iron ore and coal, took place well before commodity prices peaked. These projects are large with very long lead times; LNG projects often take more than five years to complete. The investment decisions were predicated on prices much lower than those subsequently seen through the height of the commodity price boom. Prices for iron ore and coal in Australian dollar terms today still compare favourably with the level assumed when commissioning these projects. http://www.rba.gov.au/speeches/2017/sp-dg-2017-11-13.html 3/13 13/11/2017 Business Investment in Australia | Speeches | RBA Since the peak in 2012/13, investment spending in the resource sector has declined as projects have been completed. As they have been completed, production has been ramped up and we are now seeing the benefits of that with large increases in resource exports. Since 2007, iron ore export volumes have more than doubled and coal export volumes have increased by 70 per cent (Graph 4). The Bank's assessment is that the vast bulk of the increase in production for these commodities is now behind us, with only a project or two still to be completed. LNG is in a much earlier stage of the process. LNG exports have risen by 75 per cent over the past couple of years and our expectation is that, over the next couple of years, exports are likely to increase by a further one-third. At the end of that, LNG exports are likely to be two-thirds of the value of iron ore exports, and account for around 15 per cent of total exports from Australia. Graph 4 With the increase in productive capacity of the resources sector, and hence supply both here and in other parts of the world, naturally enough, prices have declined from their extremely high levels earlier this decade. It is interesting to think about the commodity price dynamics going forward. Through much of the 2000s, the growth in demand vastly outstripped the growth in supply, causing the extraordinarily large price increases. Then, over much of the past five years or so, the growth in supply has considerably outstripped the growth in demand, and prices have fallen considerably. But, looking forward, most obviously in the case of iron ore, there is not so much supply to come on to the market, so the commodity price dynamics are very much dependent on the demand side of the market. In the near term, the prices of coal and iron ore are primarily affected by Chinese demand. There is analysis on this issue in a box in the recently published . It is Statement on Monetary Policy worth keeping in mind the simple point that maintaining the level of demand around current levels http://www.rba.gov.au/speeches/2017/sp-dg-2017-11-13.html 4/13 13/11/2017 Business Investment in Australia | Speeches | RBA will support prices if there is no material change in supply. If demand declines then prices will fall, but, if it grows, then prices are likely to rise again. Following the significant addition to productive capacity from these large projects over the past decade, there has been a notable lack of exploration spending in recent years. This means there is not much prospect of any material increase in investment spending in the period ahead. As a result, our expectation is that investment spending in the resources sector will bottom out just above 2 per cent of GDP and stay at roughly that level for quite a while. That is, companies will primarily just be undertaking replacement spending to maintain existing production capacity. This outlook is also very much consistent with the information we get from the Bank's business liaison program, and is also evident in the Australian Bureau of Statistics (ABS) capital expenditure survey. So what is the primary explanation for why investment in the mining sector has been so much stronger than in the non-mining sector and so much stronger than investment in other advanced economies? Fairly obviously, it is because mining companies expected that demand in the future was going to be strong. The other factors affecting these investment decisions were generally comparable with those in other parts of the economy. Funding was as cheap and readily available; uncertainty was not obviously any more or less. Indeed, the long horizons for these projects meant that uncertainty was at least as large as in other sectors. Non-mining Business Investment Now I will turn to investment in the non-mining sector. The sharp contraction in business investment during the financial crisis, and the subsequent weak recovery, has primarily been a phenomenon of advanced economies. [1] A large body of literature has attempted to explain the underwhelming pick-up in investment and has attributed it to a range of factors, which I will spend some time discussing. Australian non-mining investment (in real terms) is currently around 17 per cent higher than it was at Q1 2008. By way of comparison, investment spending in the US has increased by about the same amount, while in the UK it has risen by 13 per cent, by 3 per cent in Japan but in the euro area it is still 4 per cent lower than in 2008. In all of these cases, this is a disappointingly low level of investment spending. What has been holding investment back? There are a number of possible explanations, some of which I will discuss here. [2] In doing so, in a number of cases I will use evidence from a new database from the ABS called BLADE (Business Longitudinal Analytical Data Environment). The BLADE database contains matched administrative and ABS survey data for (almost) all Australian firms with data available from 2002 to 2015. It includes annual data on capital purchases, sales, capital stock, wages and a number of other variables. The data on capital purchases are well aligned with investment spending in the national accounts and coverage is considerably larger than that in the ABS capital expenditure survey (Graph 5). http://www.rba.gov.au/speeches/2017/sp-dg-2017-11-13.html 5/13 13/11/2017 Business Investment in Australia | Speeches | RBA Graph 5 Weak economic growth An obvious candidate to explain the post-crisis behaviour of investment is weak aggregate demand. Research finds that much of the weakness in global investment since the crisis can be explained by slower economic growth. [5] However, when we look at this in Australia, while the explanation clearly has a lot of attraction, there is less clear-cut evidence for non-mining business investment. Investment spending in the non-mining sector has been even weaker than predicted by our standard aggregate model. Similarly, we have examined firm-level data and found that corporate investment has been consistently weaker than would be predicted based on past relationships with Tobin's Q (a forward-looking measure of investment opportunities). These results could mask heterogeneity across firms of different sizes (Graph 6). For example, while the post-crisis weakness in non-mining investment has been broad based across large and small businesses, our analysis using BLADE data shows that, for large firms, this can be mainly explained by weakness in demand. In contrast, investment by small firms has been unusually weak since the crisis, relative to current demand. http://www.rba.gov.au/speeches/2017/sp-dg-2017-11-13.html 6/13 13/11/2017 Business Investment in Australia | Speeches | RBA Graph 6 Expectations of weak future conditions are plausibly restraining business investment even more than current conditions. Until recently, Bank liaison pointed to businesses being reluctant to invest until they saw a sustained pick-up in demand. Similarly, we have some evidence that weaker corporate sentiment is holding back investment for both US and Australian companies, using estimates of corporate sentiment based on the share of ‘negative’ words in each company's annual report. More recently, though, investment intentions in business surveys and the Bank's liaison contacts have increased alongside improved expectations for demand. This is true in Australia, but particularly so in other countries, most prominently in the US. There may be a cross-border aspect to the weakness of global investment over the past decade. Investment decisions taken by multinationals may be influenced by their assessment of conditions in their home market, particularly to the extent that imposes funding constraints on their global operations. One theme that has been present in our business liaison is that, notwithstanding the relative strength of the Australian economy, a number of multinationals were making investment decisions on a global basis rather than a local basis. Again, there are signs that the generalised improvement in business sentiment is leading to a global reassessment of investment decisions and a synchronised global upswing in investment spending. Headwinds from the mining investment boom http://www.rba.gov.au/speeches/2017/sp-dg-2017-11-13.html 7/13 13/11/2017 Business Investment in Australia | Speeches | RBA While the mining investment boom was in progress, there were very apparent positive spillovers to non-mining business investment in Western Australia and Queensland. At the same time, this was creating headwinds to investment in the rest of the country, particularly New South Wales and Victoria, not least because of the very elevated level of the exchange rate at the peak of the commodity boom. [6] One area of the economy where the negative effect of the high exchange rate on investment was evident was tourism. Our liaison with the tourism sector highlights that the low level of investment while the exchange rate was at its peak is having an impact on the industry now that tourism demand has increased with the lower Australian dollar. As these forces have reversed, non-mining investment in Queensland and Western Australia has declined along with the decline in mining investment, while it has risen noticeably in New South Wales and Victoria. These spillovers are evident in the BLADE database. The data show that investment by firms in mining-exposed industries in Queensland and Western Australia has declined sharply since 2012, whereas investment by firms in other industries has remained broadly unchanged. That is, the effect of the mining investment rise and fall has been larger than we initially anticipated because of the spillovers to other parts of the local economies. Firms' and shareholders' reduced appetite for (and assessment of) risk Investment could be held back if firms have become more risk averse or if they have reassessed the likelihood of bad outcomes. While it is difficult to differentiate between these two, there are some signs that suggest that one or both have changed post-crisis. Liaison suggests some managers are less willing to take risks, and have tightened investment criteria since the crisis. Companies have reduced their gearing and increased their cash holdings, and hurdle rates remain relatively high despite falls in borrowing rates. Related to the latter point is that there are some indications that the stock market is rewarding cost reduction rather than investment spending where the payoffs are multi-year rather than immediate. That is, the risk aversion may be coming more from shareholders than a company's executive or board. There appears to be a desire to have ‘excess’ capital returned to shareholders through buybacks and dividends, rather than utilising that capital for investment with uncertain returns (Graph 7). http://www.rba.gov.au/speeches/2017/sp-dg-2017-11-13.html 8/13 13/11/2017 Business Investment in Australia | Speeches | RBA Graph 7 Note that cost reduction does not necessarily imply lower investment. Achieving greater automation or process efficiencies is quite likely to require some amount of capital spending. Heightened uncertainty Several studies suggest that heightened uncertainty has weighed on investment in a number of countries. [9] Indeed, construction of measures of uncertainty has become something of a cottage industry. Our own work has found some evidence of a negative relationship between uncertainty and investment but most measures of uncertainty for Australia have been at relatively low levels in recent years. [10] That said, uncertainty is not observable, and different uncertainty measures may have different statistical relationships with investment. Tighter financial conditions Financing constraints have been found to play a role in explaining weak investment outcomes in a number of countries. [11] However, liaison with larger businesses suggests that the cost and availability of finance is generally not weighing on investment in Australia. Moreover, aggregate indicators of borrowing costs are at low levels. http://www.rba.gov.au/speeches/2017/sp-dg-2017-11-13.html 9/13 13/11/2017 Business Investment in Australia | Speeches | RBA However, aggregate indicators of the availability of finance and borrowing costs hide a great degree of heterogeneity (Graph 8). [12] While finance is readily available for large companies, either through the banking system or through capital markets, our liaison with smaller enterprises indicates that the availability of finance is a much more binding constraint. My colleague Chris Kent will talk about this in more detail next month. Graph 8 Changes in the composition of output Another possible explanation is that non-mining investment is lower because the steady-state investment-to-GDP ratio is lower than in the past. (The steady-state ratio is the ratio that the economy should converge to once all cyclical factors have dissipated.) These arguments can broadly be split into two categories: a structural shift in the economy towards services (and other less capitalintensive sectors); and changes in other economic factors that determine the steady-state investment ratio. The main challenge for these theories is to explain why structural factors only emerged as important in restraining investment in the post-crisis period. If relatively less capital-intensive sectors become a larger share of the economy, the steady-state level of investment ratio is likely to be lower. However, our analysis suggests that the capital intensity of http://www.rba.gov.au/speeches/2017/sp-dg-2017-11-13.html 10/13 13/11/2017 Business Investment in Australia | Speeches | RBA industries varies substantially within each of the goods and services sectors. That is, the decline in the investment share of output is largely due to changes in investment changes in the sectoral composition of output. within industries, rather than The Current Conjuncture That said, of late, there have been signs of life in investment spending outside the resources sector. In particular, following some data revisions that I referred to recently, it now appears that there has been a solid upward trajectory in non-mining business investment over the past couple of years. Where has the growth been? The annual national accounts data indicate that much of the growth in business investment in recent years has been in the services sector, including industries such as health, information, media and telecommunications (Graph 9). Service industries are not necessarily less capital intensive. Graph 9 The services sector does not have good coverage in the ABS capital expenditure survey, particularly health and education. The capital expenditure survey covers only around half of investment spending in the non-mining sectors. So it is not a particularly comprehensive guide to either the current level or outlook for aggregate non-mining investment. http://www.rba.gov.au/speeches/2017/sp-dg-2017-11-13.html 11/13 13/11/2017 Business Investment in Australia | Speeches | RBA The other area of investment that has been robust of late has been in those parts of the economy associated with infrastructure spending. There has been a pick-up in growth of public investment in recent years. A share of these projects have been completed by the private sector on behalf of the public sector, some of which have been recorded as private investment in the national accounts as the work occurs. [14] This has boosted investment growth, both as a direct consequence of the infrastructure spending and, increasingly, in spillovers to other parts of the economy. Conclusion A common global theme in the post-crisis environment has been the lack of investment. I have presented three points around that in the Australian context. First, there has not been a lack of investment in Australia over the past decade. Indeed, it has been close to the opposite, with investment reaching a multi-decade peak. Second, the strength of investment spending in Australia has been clearly associated with the mining industry and the spillovers (both positive and negative) of that to investment in other parts of the economy have been greater than we thought ex ante. Third, in reviewing possible explanations for why investment in the non-mining sector in Australia has been weak, the most powerful reason boils down to firms' expectations of future demand, otherwise known as animal spirits. Mining investment was strong because expectations for future demand were high and there wasn't that much uncertainty around that expectation. Expectations of demand elsewhere have not been strong. We are now seeing signs of that dynamic changing around the world and in Australia. With any luck, it will be sustained. This will be timely for the Australian economy as the mining investment story draws to its close. Endnotes [*] Thanks to Gianni La Cava and Jonathan Hambur for their assistance. IMF (International Monetary Fund) (2015), ‘Private Investment: What's the Holdup?’, World Economic Outlook: Uneven Growth – Short- and Long-term Factors', Chapter 4, April, pp 111–143. See also Gutiérrez G and T Philippon (2016), for an examination of the relative weakness in non-mining investment in the United States <http://pages.stern.nyu.edu/~tphilipp/papers/QNIK.pdf>. A recent intergovernmental review explores some of the factors influencing investment in the non-mining sector in recent years. For more information, see <http://research.treasury.gov.au/external-paper/intergovernmental-reviewof-business-investment/>. For more information on the BLADE database, see <https://industry.gov.au/Office-of-the-ChiefEconomist/Data/Pages/Business-Longitudinal-Analysis-Data-Environment.aspx>. The results of these studies are based, in part, on ABR data supplied by the Registrar to the ABS under and tax data supplied by the ATO to the ABS under the These require that such data are only used for the purpose of carrying out functions of the ABS. No individual information collected under the is provided back to the Registrar or System (Australian Business Number) Act 1999 Administration Act 1953. http://www.rba.gov.au/speeches/2017/sp-dg-2017-11-13.html A New Tax Taxation Census and Statistics Act 1905 12/13 13/11/2017 Business Investment in Australia | Speeches | RBA ATO for administrative or regulatory purposes. Any discussion of data limitations or weaknesses is in the context of using the data for statistical purposes, and is not related to the ability of the data to support the ABR or ATO's core operational requirements. Legislative requirements to ensure privacy and secrecy of this data have been followed. Only people authorised under the have been allowed to view data about any particular firm in conducting these analyses. In accordance with the Census and Statistics Act 1905, results have been confidentialised to ensure that they are not likely to enable identification of a particular person or organisation. Australian Bureau of Statistics Act 1975 See for example IMF (2015). Though it is worth noting that a higher exchange rate makes imported investment goods cheaper. Kent C (2014), ‘Non-mining Business Investment – Where to from here?’, Address to the Bloomberg Economics Summit, Sydney, 16 September. Lane K and T Rosewall (2015), ‘Firms' Investment Decisions and Interest Rates’, RBA , June, pp 1–8. Bulletin Bulletin, March, pp 47–56. See Bergmann M (2016), ‘The Rise in Dividend Payments’, RBA Banerjee R, J Kearns and M Lombardi (2015), ‘(Why) Is Investment Weak’, available at <https://www.bis.org/publ/qtrpdf/r_qt1503g.htm>, March. Fay R, J Guenette, M Leduc and L Morel (2017), ‘Why is Global Business Investment so Weak? Some Insights from Advanced Economies’, available at <http://www.bankofcanada.ca/wp-content/uploads/2017/05/boc-review-spring17-fay.pdf>, Spring. BIS Quarterly Review, Bank of Canada Review, [10] Moore A (2016), ‘Measuring Economic Uncertainty and Its Effects’, RBA Research Discussion Paper No 2016-01. [11] See Fay et al (2017). [12] Hambur J and G La Cava (forthcoming), ‘Firming Up Our Understanding: Firm-level Interest Rates and Corporate Investment’, RBA Research Discussion Paper. [13] Debelle G (2017), ‘Uncertainty’, Speech at the 7th Warren Hogan Memorial Lecture, Sydney, 26 October. [14] Once the work is complete there can be a transfer of ownership recorded between the private and public sector. © Reserve Bank of Australia, 2001–2017. All rights reserved. http://www.rba.gov.au/speeches/2017/sp-dg-2017-11-13.html 13/13 | reserve bank of australia | 2,017 | 11 |
Text of the Stan Kelly Lecture by Ms Luci Ellis, Assistant Governor (Economic) of the Reserve Bank of Australia, Melbourne, 15 November 2017. | 16/11/2017 Where is the Growth Going to Come From? | Speeches | RBA Speech Where is the Growth Going to Come From? Luci Ellis [ * ] Assistant Governor (Economic) Stan Kelly Lecture Melbourne – 15 November 2017 I'd like to thank the Economic Society of Victoria and the organisers of this event. It truly is an honour to be included in the list of presenters of the Stan Kelly Lecture. This lecture was established forty years ago by the former member of parliament and commentator Bert Kelly in the name of his father, Stan. Both men were great servants to the people of Australia and advocates of free trade and an open economy. I'm not old enough to be able to claim to have known either man, but as a teenager I was certainly aware of Bert's columns in my parents' copies of the magazine. And, of course, the issues Bert championed in them – free trade and less regulation – were central to the policy conversation in the 1980s, when I was an undergraduate here at the University of Melbourne. Bulletin A Different World When Bert entered Federal Parliament in 1958, Australia was a very different place. The industrial structure was very different. Manufacturing accounted for around 25 per cent of output and 26 per cent of employment compared with 6 per cent and 7 per cent now. Living standards were lower. Real household disposable income per household was a little more than half the level it is now. [1] Even that figure does not truly capture the difference in people's experience. In the late 1950s, the average household spent 20 per cent of its post-tax income on food consumed in the home, compared with 9 per cent now. And the basket of goods and services used to calculate real incomes did not then include overseas holidays, internet connections or the array of electronic goods that it does today. Australia's economy was also organised very differently then. Almost all wages were set by a judicial process. High tariff and other barriers restricted manufactured imports. Agricultural production was protected and managed through marketing boards and other government agencies. The financial sector was highly regulated and restricted in the kinds of business it could do. http://www.rba.gov.au/speeches/2017/sp-ag-2017-11-15.html 1/16 16/11/2017 Where is the Growth Going to Come From? | Speeches | RBA Because of this regulatory structure, by the time Bert retired from parliament in 1977, Australia was a poorly performing, inward-looking economy. Economic growth and living standards were lagging other industrialised economies. Inflation remained higher as well. Productivity growth seemed lacklustre and there was a general sense that the Australian economy was not ‘world class’. Indeed, the 1987/88 Annual Report of the Department of Industry, Technology and Commerce was titled ‘Towards World Class’. The supposition was clearly that we weren't there yet. The Kellys' legacies From their various positions, both of the Kellys opposed the system of ‘protection all round’. Stan joined with other members of the Commonwealth Tariff Board in opposing high tariffs. Bert became an advocate for free trade and dismantling regulation, both in and outside parliament. Father and son both opposed the high-tariff regime because it made the economy less efficient; it reduced Australians' living standards. But more than anything, they opposed the system's unfairness. Businesses and industries did well not because they produced a better product or provided the best customer service, but because they were better at persuading politicians and bureaucrats that they deserved special protections. As Gary Banks pointed out in a previous Stan Kelly Lecture, the system was designed to produce arbitrary ‘preferments’ (Banks 2013). Some firms and industries would be favoured, while others were ignored. So ‘protection all round’ was far from a progressive system. It encouraged rent-seeking. The wagesetting system didn't just support a basic ‘living wage’. For most of its existence it enforced lower pay rates on women and excluded them from many occupations. The system also limited our thinking. By protecting Australian industry from imports, it created a mindset that local firms would never be able to compete. The idea that our industries could export abroad was barely considered. Over time, the Australian economy was liberalised. This took decades. Some of the reforms, including the tariff cuts in the 1970s, might have been motivated by other concerns. But they had the same effect as if they'd been cut as a deliberate liberalisation measure: they spurred domestic firms to respond. The floating of the exchange rate in 1983 was particularly important. For a commodity-exporting country like Australia, subject to global economic fluctuations, a floating exchange rate is the best absorber of external economic shocks ever invented. And so it was that in the 1980s, the floating exchange rate absorbed the shock of our economy's increasing openness. Over the two years to January 1987, the Australian dollar depreciated by around a third on a trade-weighted basis. At the time, that depreciation was sobering. I remember our lecturers telling us economics students that it meant our living standards had declined. (It was also a response to that decline.) Some important policy responses were needed to avoid a burst of inflation; these policies also constrained real wages. But that depreciation made it easier for domestic firms to compete with imports and – perhaps surprisingly to some – become exporters. Manufactured exports roughly quadrupled their share of real GDP over the subsequent decade and a half (Graph 1). [2] And despite the boom in http://www.rba.gov.au/speeches/2017/sp-ag-2017-11-15.html 2/16 16/11/2017 Where is the Growth Going to Come From? | Speeches | RBA resource exports and the gloomy rhetoric that often surrounds Australian manufacturing, that share hasn't fallen much since then. Graph 1 Some former colleagues looked at this transition a few years after it happened and found what they called a ‘beachhead effect’. There seems to be a hurdle to becoming an exporter, but once you start, you continue (Menzies and Heenan 1993). Another way of looking at this transition is that it was the inevitable result of the shift in relative prices implied by the depreciation of the exchange rate. But a third interpretation is that it was enabled by a psychological shift. In the era of ‘protection all round’, the presumption was that Australian industry couldn't compete with overseas suppliers. That was why it ‘needed’ tariff protection. If you see yourself as inherently uncompetitive, why would you even try to export? But once Australia started opening its economy more to the rest of the world, exporting started to seem possible. And once you start believing you can compete, you have a chance of being right. Parallels with the Current Situation The Australian economy of the 21st century is structured very differently than it was during Bert's career. But there are a number of parallels and some of the challenges we face would seem familiar to him. Back then, Australia was said to ride on the sheep's back. Together, wool and wheat were close to half of Australia's goods exports in the 1960s. Agriculture accounted for more than 40 per cent of http://www.rba.gov.au/speeches/2017/sp-ag-2017-11-15.html 3/16 16/11/2017 Where is the Growth Going to Come From? | Speeches | RBA business investment. Indeed, almost all of that agricultural investment was ‘cultivated biological products’, which is mainly livestock but includes vineyards and orchards. But, even then, agricultural employment was only 11 per cent of the total. And the vast majority of Australians, then as now, lived in the biggest cities, far removed from agricultural activity. In recent years, resource exports accounted for around half of Australian exports. That figure is likely to increase a little as new liquefied natural gas (LNG) capacity comes on line. During the recent resource investment boom, mining investment exceeded non-mining investment for a period. But, even if you added in workers in sectors such as construction and professional services who were doing work on mining projects, mining-related employment is just a fraction of the workforce. That was true even at the peak of the mining investment boom. So, again, the vast majority of Australians' economic lives are relatively unconnected to the biggest exporting sector. The past decade or so also isn't the first time Australia has seen a surge and reversal in the terms of trade, either. The Korean War induced a boom–bust cycle in wool prices, a few years before Bert entered parliament. And just a few years after he left it, there was a surge in mineral commodity prices. This induced a boom in resource investment, though not as large or long-lived as the one we have just been through. Then, as recently, Australia needed to manage the consequences of that. Former treasury secretary John Stone tackled this issue when he gave this lecture in 1981 (Stone 1981). Then, as now, there were concerns that the economy would suffer from ‘Dutch Disease’, where a higher exchange rate renders the manufacturing sector uncompetitive and industrial capacity atrophies. Often it wasn't appreciated that if much of the investment equipment is imported, the exchange rate doesn't appreciate as much. Yes, other sectors, including manufacturing, will find it harder to compete with imports when the exchange rate is high. But that isn't a permanent state of affairs. In any case, the international evidence is that the Dutch disease doesn't necessarily reduce long-term growth prospects. For that to have been true, the industries that get squeezed out would need to be somehow more important for productivity growth than those that survived. That isn't what the evidence suggests (Magud and Sosa 2010). What seems more important is the quality of a nation's institutions, and their ability to ensure that the benefits of the mineral endowment are not squandered through rent-seeking (van der Ploeg 2011). Then, as now, there were concerns that our prosperity might be based on too narrow a foundation. Even around the turn of this century, I remember foreign investors telling me that Australia was an ‘old economy’. We should stop digging things out of the ground, they said, and start building microchip factories. Of course, this would have meant stopping the export of commodities in order to start the export of different commodities. And considering the relative price movements of iron ore versus microchips since then, we are better off for not having taken that path. So there are many similarities between the resources boom of the early 1980s and now. But there were also important differences. This time around, the role of foreign investment in funding that boom has been less controversial. The labour market has probably adapted to the shock more quickly, too. We see this in the interstate migration figures. Perhaps more importantly, the high wages on offer in the booming sector weren't automatically flowed through to the rest of the labour http://www.rba.gov.au/speeches/2017/sp-ag-2017-11-15.html 4/16 16/11/2017 Where is the Growth Going to Come From? | Speeches | RBA force through a centralised system. So the cost base of the economy didn't shift as much. And this time around, the Australian dollar has floated freely and done much of the work to adjust to the shock. As some of my colleagues have pointed out previously, a floating exchange rate regime has several advantages in the face of a terms of trade and investment boom. As the exchange rate appreciated, the benefits of the income shock coming from the higher terms of trade were more evenly shared. Rather than the income boost going solely to the resource industry, lower import prices raised the real incomes of all Australians. If instead we'd had a fixed exchange rate, we would have had a balance of payments surplus. That would have represented a large monetary stimulus. And we know from the wool boom during the Korean War what the result of that would have been: significant inflation, and not much to show for it afterwards. Growth in the Aftermath of the Mining Investment Boom As the mining investment boom turned down, and became a drag on growth, the question was often asked: ‘Where is the growth going to come from?’ Commentators started speaking of a growth ‘handover’: if mining investment wasn't going to provide our growth, something else needed to. And for a while, particular non-mining sectors did seem to pick up, to become in turn the new ‘engine of growth’. First to do so was residential construction. It added much less to growth than the mining investment boom did, at least directly (Graph 2). Even at its peak, it was only adding around ½ percentage point to annual GDP growth. Compare that with the mining investment boom, which added roughly 1– 2 percentage points to growth in each of 2011 and 2012, for example, even after netting out the high import content in resource investment. Residential building work remains at a high level – faster than would be needed to house our growing population – but it is no longer adding materially to growth. You could argue that there are important spillover effects from housing. People need to buy furniture and other goods to complete their new homes, after all. But it turns out not to add that much. Spending on furnishing and household equipment accounts for less than half the share of GDP that housing construction does, not all of it to furnish new homes. Housing construction contributed about 0.3 percentage points to annual GDP growth over recent years. So any spillover via furnishings must be even smaller. This sector is not where we will find an ‘engine of growth’ to pull us all along. http://www.rba.gov.au/speeches/2017/sp-ag-2017-11-15.html 5/16 16/11/2017 Where is the Growth Going to Come From? | Speeches | RBA Graph 2 The newest so-called ‘engine of growth’ is public infrastructure. Like high-density residential construction, infrastructure projects serve as a good replacement for mining investment projects in a ‘growth handover’: the human skills needed for both types of work are very similar. And spillovers to the rest of the economy are probably even stronger than for housing. It is more apparent in the large stock of announced projects than in current activity, but the program of public works in the pipeline is now much higher than usual (Graph 3). How much this will add to growth directly depends on how quickly these projects are completed. But there are also important indirect effects. Infrastructure work also supports activity in private firms, because they are doing much of the work on these projects on behalf of the public sector. And we are hearing from our contacts in industry that it is also spurring private businesses to invest in new equipment, to support that activity. Better public infrastructure is also thought to boost productivity in the economy more broadly. Transport infrastructure seems to be especially good at this. Compared with the previous upswing in infrastructure spending a decade ago, transport projects are a larger share this time around. http://www.rba.gov.au/speeches/2017/sp-ag-2017-11-15.html 6/16 16/11/2017 Where is the Growth Going to Come From? | Speeches | RBA Graph 3 I observe several things about this ‘handover’ idea. First, all of the sectors identified as new ‘engines’ of growth produce long-lived stocks of things: mines, buildings, bridges and railways. You can produce above-average amounts of these things for a while, but you can end up with an excess you don't really need if the boom continues for too long. This is the problem with any kind of construction-related boom. The stock-flow dynamics really matter. None of these sectors should be thought of as sustaining growth indefinitely. Second, in searching for a replacement for the mining investment boom, too often people forget that it gave way to a mining exports boom. That boom is now happening, and for LNG it still has a bit longer to run. We anticipate that resource exports will add about a cumulative 1.2 percentage points to GDP over the next two years. Resource exports now account for around half of Australia's export revenue, and that will remain broadly true even if commodity prices fall a bit from here. Third, it was also often forgotten that the rest of the economy had been squeezed to make way for the mining investment boom (Graph 4). Sectors such as tourism and manufacturing were affected by the exchange rate appreciation. Since the beginning of 2014, though, the Australian dollar has on average been 18 per cent below the peaks it reached in 2013, on a trade-weighted basis. The squeeze naturally reversed itself when the investment boom ended. So part of the answer to the question ‘where is the growth going to come from?’ is ‘all the industries that had been growing more slowly than usual during the boom’. http://www.rba.gov.au/speeches/2017/sp-ag-2017-11-15.html 7/16 16/11/2017 Where is the Growth Going to Come From? | Speeches | RBA Graph 4 A high exchange rate can (and did) squeeze some firms so hard that they stop exporting altogether, or even go out of business. This can have lasting effects even once the exchange rate depreciates again. Maybe the loss of export market presence or longstanding supply networks creates some path dependence. This would be the reverse of the beachhead effect identified by Menzies and Heenan (1993). It would have to be a big effect, though, to offset the increase in overall productive capacity enabled by the investment boom. There's nothing wrong with noting that some sectors pick up as others slow. But behind the idea that growth needed to ‘handover’ to something else, there also seems to be a presumption that the Australian economy needs a special something – an identifiable engine of growth – for reasonable growth to be possible at all. This view strikes me as being similar to the mindset that the Kellys opposed. The ‘protection all round’ mindset took as given that Australia had a cost base set so high that we could never compete internationally without government help. The ‘engine of growth’ mindset presumes that we need some sort of external trigger to grow, which for some reason cannot come from within. The ‘engine of growth’ mindset also seems to divide industries into the worthy and the unworthy. Only ‘good growth’, we are told, is truly sustainable. And ‘good growth’, I can't help noticing, always http://www.rba.gov.au/speeches/2017/sp-ag-2017-11-15.html 8/16 16/11/2017 Where is the Growth Going to Come From? | Speeches | RBA seems to be defined as ‘goods growth’. Services don't count. There's a hint of the eighteenth century physiocrats in this mindset, but with manufacturing and business investment taking the place of agriculture in the firmament of virtuous activities. Much of the recent growth in employment has been in household services such as health and education, which leads some to dismiss it as ‘bad growth’. Are people presuming that it's all driven by the public sector and therefore somehow artificial? Or is it that they think jobs in service industries are all low-skill, low-wage jobs and therefore bad jobs? (University academics, teachers and medical professionals would presumably disagree with that idea.) Or is it just discomfort that growth is concentrated in industries where productivity is harder to measure? Or do people genuinely think that it's not really production if you can't drop it on your foot? The literature in fact shows that growth in health and education can indeed be ‘good growth’ – sustainable growth. Both sectors contribute to stronger performance in other sectors. Better health outcomes are good for their own sake; they improve people's welfare. In addition, they improve productivity of individual workers and make it less likely that careers will be cut short (and retirement income will fall short) because of ill-health. Similarly, better education is not only good for its own sake – it builds human capital, the better skills we all need to be more productive. To support growth and living standards in parts of the economy, it is important that the increased resourcing of and employment in the health and education sectors actually translate into better outcomes. This is an ongoing conversation in public policy, one I'm not qualified to add to. I will, however, note another connection to the Kelly legacy. The Commonwealth Tariff Board, on which Stan served for many years, morphed first into the Industries Assistance Commission, then the Industry Commission, and finally, the Productivity Commission. [4] Over the past two decades of its existence in its current form, the Commission has become the key public-sector institution involved in developing policies to boost productivity. I note the Commission has recently published its fiveyear review, which contains many policy ideas for improving effectiveness and outcomes in the areas of health and education (Productivity Commission 2017). Where will the Growth Really Come From? The preceding just shows that, over time, some industries grow faster than others. For a while, the mining industry was growing faster than the rest. Other industries take the lead at other times. But it doesn't really get at the underlying drivers of growth. We need to ask: where will the growth really come from, over the longer term? In answering this question, it is hard to go past the ‘three Ps’ popularised by our colleagues at Treasury: population, participation and productivity. I'll go through each in turn. Population As the Governor noted in a speech a few years ago, Australia's population is growing faster than in almost any other OECD economy (Lowe 2014). That has remained true over the past couple of years. The rate of natural increase is higher than many other countries, but most of the difference is the large contribution from immigration. http://www.rba.gov.au/speeches/2017/sp-ag-2017-11-15.html 9/16 16/11/2017 Where is the Growth Going to Come From? | Speeches | RBA Of course, just adding more people and growing the economy to keep pace wouldn't boost our living standards. [5] But there are two reasons why we should not assume that this is all that happens. Firstly, recent migrants have a different profile to the incumbent Australian population. They are generally younger, and the youngest age group are significantly more likely to have non-school qualifications (Graph 5). This is possibly because so many recent migrants initially arrive on student visas and then stay. In line with that, service exports in the form of education have grown rapidly over the past few decades. Older migrants are on average less likely to have such a qualification than existing residents in the same age groups, but they are a small fraction of all migrants. The average education level of newly arrived Australians is actually higher than that of existing residents, precisely because they are younger. So Australia's migration program is structured in a way that, in principle at least, it can grow the economy while raising average living standards. Graph 5 Secondly, increasing economic scale is not neutral. There is more to it than just getting bigger. This is the lesson of what is sometimes called New Economic Geography: scale economies arise from product differentiation (Fujita, Krugman and Venables 1999). Bigger, denser cities are more productive. Perhaps more importantly, larger population centres allow more variety in the goods and services produced. Fujita and Thisse (2002) quote Adam Smith making the same point (Smith 1776, p 17). http://www.rba.gov.au/speeches/2017/sp-ag-2017-11-15.html 10/16 16/11/2017 ‘ Where is the Growth Going to Come From? | Speeches | RBA There are some sorts of industry, even of the lowest kinds, which can be carried on no where but in a great town. A porter, for example, can find employment and subsistence in no other place. A village is by much too narrow a sphere for him; even an ordinary market town is scarce large enough to afford him constant occupation. ’ So it is also with management consultants, medical specialists and a myriad of other occupations that can only be sustained in a large market. Participation The second of the three Ps, participation, can and has been increasing average incomes and living standards. It is usually presumed that ageing of the population will reduce participation. In Australia at least, other forces have offset that tendency in recent years. In our Statement on Monetary Policy, released last week, we noted that the participation rate has been rising recently. The increase has been concentrated amongst women and older workers. That is true of the pick-up over recent months. It is also true over a somewhat longer period, as shown in this graph (Graph 6). Older workers have increased their participation in the workforce as the trend to earlier retirement has abated. Mixed in with this is a cohort effect related to the increasing participation of women more generally. Each generation of women participates in the labour force at a greater rate than the previous generation of women did at the same age. Graph 6 http://www.rba.gov.au/speeches/2017/sp-ag-2017-11-15.html 11/16 16/11/2017 Where is the Growth Going to Come From? | Speeches | RBA There is a connection here with the increase in health and education employment I mentioned earlier. Better healthcare outcomes means that fewer people retire early because of ill-health, so participation rises. More extensive childcare options make it easier for both parents to be in paid work. Given the usual presumptions in our society about who has primary responsibility for caring for children, this shift affects participation of women more than that of men. So it's no surprise that the participation rates of women aged 35–44 have also been rising strongly. And more flexible work arrangements tend to encourage participation by both female and older workers. In the end, though, lifting participation is a once-off adjustment. Once someone enters the workforce, they can't enter it a second time without leaving first. Greater participation raises the level of living standards but it isn't an engine of ongoing growth. We must also remember that the objective is not that everyone must be in paid employment. Many people are outside the labour force for good reasons, for example because they are in full-time education, caring for children or other relatives, or doing volunteer work by choice. Productivity and Innovation That leaves us with productivity, arguably the most important of three Ps, but unfortunately also the hardest to measure. It is also an area where distributions and firm-specific decisions really matter. Some recent international evidence shows that the firms at the global productivity frontier can be several times more productive than the average firm in their industry (Andrews, Criscuolo and Gal 2015). [6] This research also finds that firms tend to adopt a new technology only after the leading firms in their own country have adopted it. That is, the national productivity frontier first has to catch up to the global frontier, by adapting the new technology to local conditions. So the average productivity of firms in an economy depends on three things. 1. How quickly the leading firms in that country adopt the technology and match the productivity levels of the globally leading firms in that industry. 2. How large the leading firms are in the national economy. 3. How quickly the laggard firms can catch up, once the national leading firms have adopted a particular technology. The findings of this research suggest that this last factor – the rate of technology adoption – has slowed down since the turn of the century. The policy implications of these findings are subtle, and depend on whether you want to affect firms near the frontier, or the firms that are lagging far behind. For example, a more flexible labour market might make it easier for the leading firms to grow faster. Average productivity would rise because those leading firms account for a greater share of output. But then you would have an economy dominated by ‘superstar firms’ (Autor et al 2017). The implications of that are not necessarily benign. For a start, inequality could be greater. Median living standards might not rise. The drivers of innovation, like the drivers of creativity more generally, are hard to pin down. But the literature does provide some pointers to them. First and perhaps most important is simply to grow: growth is more conducive to innovation than recession is. Recessions do not engender ‘creative http://www.rba.gov.au/speeches/2017/sp-ag-2017-11-15.html 12/16 16/11/2017 Where is the Growth Going to Come From? | Speeches | RBA destruction’; they produce liquidations, which are destructive destruction (Caballero and Hammour 2017). Indeed, when labour is plentiful, there is not much incentive to invest in productivity-boosting technology. And when everyone's sales are weak, there is not much incentive to invest to try to increase them. There is nothing quite like a tight labour market to make firms think about how to do things more efficiently. The pressures of strong sales or competition might spur innovation, but many other factors enable it. Infrastructure is a key enabler not only of productivity growth of existing firms, but whole new business opportunities. Often we think of communications infrastructure and the internet in this context. Transport infrastructure is at least as important, I would argue, which makes the current pipeline of public investment even more relevant to future growth outcomes. That's because online commerce still needs good physical logistics. Unless it's a purely digital product, something still needs to be delivered. Australia is a highly urbanised country, but it is also a highly suburbanised country. Improving urban transport infrastructure, as well as inter-urban transport infrastructure, could help boost productivity across a range of both traditional and new industries. Also important is the political and regulatory environment. It would not surprise Stan and Bert Kelly that much of the literature finds that product market regulation and other devices protecting laggard firms tend to retard innovation. More generally, barriers to entry make it harder for new, potentially more innovative firms to break in. It isn't all about the start-ups, though. A lot depends on the propensity of existing firms to adopt new technologies and business practices. We think that this is one of the reasons for the slow rate of growth in retail prices in Australia at present. In the face of increased competition, incumbent retailers are having to both compress margins and use technology to become more efficient. Our liaison contacts tell us that they are investing heavily in better inventory management and other costsaving measures, often by using data analysis more extensively. Adopting these innovations takes time, because firms have to become familiar with the new technologies and change their business practices to take advantage of them. It wouldn't be the first time that the computers – or perhaps this time, the machine learning algorithms – were visible everywhere except in the productivity statistics for just this reason. Adopting new technologies and business models also requires a willingness to change. Just as views to protection can change, so can society's attitudes to risk, innovation and, thus, entrepreneurship. We saw, after all, that Australia's economic culture could shift from being inward-looking to outwardlooking over the course of a couple of decades. Australia is normally seen as being a relatively fast adopter of technology. But there are some aspects where we seem to lag. One is R&D expenditure (Graph 7). While this isn't greatly below the average of industrialised countries and many similar countries get by perfectly well doing much less, it has been declining in importance lately. Some other indicators also suggest that Australian firms have in recent years been less likely to adopt innovative technologies than their peers abroad. For example, while small firms are holding their own, large firms in Australia are less likely to use cloud computing services than large firms in many other countries. [8] This wasn't always the case: a http://www.rba.gov.au/speeches/2017/sp-ag-2017-11-15.html 13/16 16/11/2017 Where is the Growth Going to Come From? | Speeches | RBA decade and a half ago, Australian firms were towards the front of the curve in adopting the ecommerce technologies that were new at the time (Macfarlane 2000). A lot depends on whether the workforce has the skills to use these new technologies, but at heart, technology adoption is a business decision. Graph 7 Parting Remarks In conclusion, I think both Kellys would be pleased to see how the Australian economy evolved. The Australia of today is less inward-looking and more flexible in the face of the considerable shocks that can occur. Removing the tariff wall and the associated regulatory restrictions has enabled higher living standards and made the economy more resilient. As a nation, we are better off for that. There are challenges for any small, open economy. Around the world, the policy conversation is turning to issues of inequality and inclusion. And rightly so: liberalisation and reform are not ends in themselves. The focus must be on the end goal, the welfare of the population. If a specific reform doesn't deliver that, it ought to be modified, whether through explicit safety nets or other means. In the end, the Kellys were right. ‘Protection all round’ hurt more than it helped. And it left a legacy of disbelief in our own competitiveness. This is, I think, part of the reason why people search for ‘engines of growth’. That older era left an ingrained doubt that Australia can become more http://www.rba.gov.au/speeches/2017/sp-ag-2017-11-15.html 14/16 16/11/2017 Where is the Growth Going to Come From? | Speeches | RBA prosperous without identifiable external triggers. I believe that it can, and that it will do so through continual innovation and productivity growth spurred by ongoing growth and competition. So next time somebody asks you ‘where’s the growth going to come from?', you can answer: ‘from all of us, trying new things, and gradually getting a bit better at what we do.’ We don't need to wait for something external to make it happen. Thank you for your time. Bibliography Andrews D, C Criscuolo and PN Gal (2015), ‘Frontier Forms, technology diffusion and public policy: Micro evidence from OECD economies’, OECD: The Future of Productivity: Main Background Papers. Autor D, D Dorn, LF Katz, C Patterson and J Van Reenan (2017), ‘The Fall of the Labor Share and the Rise of Superstar Firms’, NBER Working Paper 23396. Banks G (2013), ‘Return of the Rent-Seeking Society?’, Stan Kelly Lecture, Melbourne, 15 August. Available at <http://esavic.org.au/385/images/2013_GaryBanks.pdf>. Caballero RJ and ML Hammour (2017), ‘The Cost of Recessions Revisited: A Reverse-Liquidationist View’, , 72(1), pp 313–341. Economic Studies Review of Economics of Agglomeration, Cambridge University Press, Cambridge. Fujita M, P Krugman and AJ Venables (1999), The Spatial Economy, The MIT Press, Cambridge, MA. Hughes B (1980), Exit full employment, Angus & Robertson, London ; Sydney. Fujita M and J-F Thisse (2002), Lowe P (2014), ‘Demographics, Productivity and Innovation’, Speech to the Sydney Institute, Sydney, 12 March. Macfarlane IJ (2000), ‘Talk to World Economic Forum Asia Pacific Economic Summit’, World Economic Forum Asia Pacific Economic Summit, Melbourne, 11 September. Magud N and S Sosa (2010), ‘When and Why Worry About Real Exchange Rate Appreciation? The Missing Link between Dutch Disease and Growth’, IMF Working Paper Series WP/10/271. Menzies G and G Heenan (1993), ‘Explaining the Recent Performance of Australia's Manufactured Exports’, RBA Research Discussion Paper No 9310. Shifting the Dial: 5 Year Productivity Review, Report No. 84, Canberra. Quesnay F (1759), Tableau économique, Reprint, 3rd Edition, Macmillan, 1972, London. Smith A (1776), An Inquiry into the Nature and Causes of the Wealth of Nations, Straham and Cadell. Solow RM (1987), ‘We’d Better Watch Out', New York Book Review, p 36. Productivity Commission (2017), Stone J (1981), ‘Australia in a Competitive World: Some More Options’, Stan Kelly Lecture, Melbourne, 16 November. Available at <http://esavic.org.au/385/images/1981_JohnStone_CompetitiveAustralia.pdf>. van der Ploeg F (2011), ‘Natural Resources: Curse or Blessing?’, http://www.rba.gov.au/speeches/2017/sp-ag-2017-11-15.html Journal of Economic Literature, 49(2), pp 366–420. 15/16 16/11/2017 Where is the Growth Going to Come From? | Speeches | RBA Endnotes [*] This speech has benefited from helpful discussion with and assistance from Liz Kendall. Several other colleagues also made some useful suggestions, including Jarkko Jaaskela and Tom Rosewall. These figures are actually for the 1959/60 financial year, the first year for which Australia has quarterly national accounts comparable to current data. The share has fallen more noticeably since the peak if the calculation is expressed as of manufacturing exports as a share of GDP, but this is affected by the cycle in the terms of trade. The physiocrats believed that wealth was derived from agriculture. For example, Quesnay (1759) described how the economy functions, deriving wealth only from agriculture. See also Hughes (1980) for a discussion. The Productivity Commission also replaced the Bureau of Industry Economics and the Economic Planning Advisory Commission. Its first chair, Gary Banks, delivered the Stan Kelly Lecture in 2013 (Banks 2013). It would increase the living standards of migrants if they came from a country with lower average living standards than Australia's. Unfortunately this study does not include Australia. Apologies to Robert Solow. See Solow (1987). This information comes from the OECD database on technology access and usage by businesses, <http://oe.cd/bus>. nominal current values © Reserve Bank of Australia, 2001–2017. All rights reserved. http://www.rba.gov.au/speeches/2017/sp-ag-2017-11-15.html 16/16 | reserve bank of australia | 2,017 | 11 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Australian Business Economists Annual Dinner, Sydney, 21 November 2017. | Philip Lowe: Some evolving questions Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Australian Business Economists Annual Dinner, Sydney, 21 November 2017. * * * I would like to thank Andrea Brischetto for assistance in the preparation of this talk. It is a pleasure for me to speak at the annual dinner of the Australian Business Economists. I have spoken at this dinner three times before: in 2010, 2012 and 2014. Thank you for inviting me back. When I spoke in 2012 the title of my remarks was ‘What is Normal?’1 On that occasion, I talked about a recalibration in expectations about what was considered normal in the Australian economy. I also suggested that the normal level of interest rates might be lower than it was in the past. Five years on, we are still searching to understand what is normal. In a number of countries, low rates of unemployment are coexisting with below-average inflation. Low inflation, in turn, means low interest rates. Many investors judge that this unusual combination of low unemployment and low inflation can persist for quite some time – perhaps, that it is now normal. With inflation rates having surprised on the downside for a few years now, there is unusually low compensation for future inflation risk in many financial markets. Real income growth for many households has also been unusually slow in many countries. Not surprisingly, these households, including many here in Australia, wonder whether this slow growth in incomes is now the new normal, or whether in time it will pass. Much depends upon the answer to this, including households’ appetite and ability to spend and borrow. So we are still searching for what is normal. Tonight, I would like to use this opportunity to reflect on some of the questions we have been grappling with at the RBA over the year or so that I have had the privilege of being the Governor. A number of these questions go to what could be considered normal these days. While I am not able to give you a full suite of answers, I hope that you find the transparency around our thinking useful. There are three sets of questions that have occupied much of our time over the past year. The first is how the final stages of the transition to lower levels of mining investment would play out. The second is the degree to which an improving labour market would translate into a pick-up in wage growth and inflation. And the third is the nature of risks stemming from high and rising levels of household debt and how to deal with those risks. I will talk about each of these three issues and then conclude with how they have influenced the Reserve Bank Board’s decisions on monetary policy over the past year or so. The end of the transition For a number of years we have been describing the economy as being in transition: a transition from very high levels of mining investment to something more normal. 1 / 12 BIS central bankers' speeches It is now time, though, to move to a new narrative. The wind-down of mining investment is now all but complete, with work soon to be finished on some of the large liquefied natural gas projects. Mining investment, as a share of GDP, is now back to something more normal (Graph 1). This means that, as I talked about in a recent speech, it’s time to open a new chapter in Australia’s economic history. Over recent times, our judgement has been that this transition to lower levels of mining investment was masking an underlying improvement in the Australian economy. The decline in mining investment generated substantial negative spillovers to the rest of the economy. These spillovers were most evident in Queensland and Western Australia, where, for a while, growth in employment, investment and income were all quite weak. The good news is that these negative spillovers from lower levels of mining investment are now fading. This was first evident in Queensland, where the labour market began to improve in 2015 (Graph 2). It is now evident too in Western Australia, where conditions in the labour market have improved noticeably since late last year. Elsewhere, there has been steady growth in employment for a number of years. 2 / 12 BIS central bankers' speeches The fading of the negative spillovers is one reason why growth in the Australian economy is expected to strengthen over the period ahead. Another is the higher volume of resource exports as a result of all the mining investment. We expect GDP growth to pick up to average a bit above 3 per cent over 2018 and 2019 (Graph 3). If these forecasts are realised, it would represent a better outcome than has been achieved for some years now. This more positive outlook is being supported by an improving world economy, low interest rates, strong population growth and increased public spending on infrastructure. All these things are 3 / 12 BIS central bankers' speeches helping. Encouragingly, the outlook for business investment has brightened. For a number of years, we were repeatedly disappointed that non-mining business investment was not picking up. Part of the explanation was the negative spillover effects that I just spoke about, although, as my colleague Guy Debelle spoke about last week, there were other factors at work as well.2 Now, though, a gentle upswing in business investment does seem to be taking place and the forward indicators suggest that this will continue. It’s too early to say that animal spirits have returned with gusto. But more firms are reporting that economic conditions have improved and more are now prepared to take a risk and invest in new assets. This is good news for the economy. The improvement in the business environment is also reflected in strong employment growth. Over the past year, the number of people with jobs has increased by around 3 per cent, the fastest rate of increase for some time (Graph 4). This pick-up in jobs is evident across the country and has been strongest in the household services and construction industries. It is also leading to a pick-up in labour force participation, especially for women. Business is feeling better than it has for some time and it is lifting capital spending and creating more jobs. At the same time, though, growth in consumer spending remains fairly soft. Indeed, for a number of years consumption growth has been weaker than we had originally forecast.3 This is evident in this chart, which shows our forecasts for consumption growth at various points in time as well as the actual outcomes (black line) (Graph 5). The picture is pretty clear. For some years, consumption growth has been weaker than forecast and it has not exceeded 3 per cent for quite a few years. 4 / 12 BIS central bankers' speeches The most likely explanation for the ongoing subdued consumption outcomes is the combination of weak growth in real household income and the high level of household debt. Given the persistence of these factors, our latest forecasts have incorporated a flatter profile for consumption growth than has been the case in previous forecasts. An important issue shaping the future is how these cross-cutting themes are resolved: businesses feel better than they have for some time, but consumers feel weighed down by weak income growth and high debt levels. Our central scenario is that the increased willingness of business to invest and employ people will lead to a gradual increase in growth of consumer spending. As employment increases, so too will household income. Some increase in wage growth will also support household income. Given these factors, the central forecast is for consumption growth to pick up to around the 3 per cent mark. This would be above the average growth of consumption for the current decade, but below the average for the period prior to the financial crisis. Labour market, wages and inflation I would like to turn to the second question that has occupied us over much of the past year: the degree to which an improving labour market will translate into a pick-up in wage growth and inflation. A distinguishing feature of Australia’s recent economic performance has been the slow growth in wages. The Wage Price Index has increased by just 2 per cent over the past year. Whereas in earlier years, Australians had got used to average wage increases of around the 3½–4 per cent mark, 2–2½ per cent is now the norm (Graph 6). Growth in average hourly earnings has been weaker still: in trend terms it is running at the lowest rate since at least the 1960s. Not only are wage increases low, but some people had been moving out of high-paying jobs associated with the mining sector into lower-paying jobs. We have heard from our liaison program that there has been downward pressure on non-wage payments, including allowances, and an increase in the proportion of new employees hired on lower salaries than their predecessors. 5 / 12 BIS central bankers' speeches As I noted earlier, subdued growth in wages is also occurring in a number of other countries. Understanding this is a major priority. Low growth in wages means low inflation, which means low interest rates, which means high asset valuations. So a lot depends on understanding the reasons for slow growth in nominal and real wages. The answer is likely to be found in a combination of cyclical and structural factors. In Australia, we are still some way short of our estimates of full employment of around 5 per cent, so it is not surprising that wage growth is below average. But structural factors are likely to be at work as well. Foremost among these are perceptions of increased competition. Many workers feel there is more competition out there, sometimes from workers overseas and sometimes because of advances in technology. In the past, the pressure of competition from globalisation and from technology was felt most acutely in the manufacturing industry. Now, these same forces of competition are being felt in an increasingly wide range of service industries. This shift, together with changes in the nature of work and bargaining arrangements, mean that many workers feel like they have less bargaining power than they once did. But this is not the full story. It is likely that there is also something happening on the firms’ side as well. In other advanced economies where unemployment rates are below conventional estimates of full employment, the normal tendency for firms to pay higher wages in tight labour markets appears to be muted. Businesses are not bidding up wages in the way they might once have. This is partly because business, too, feels the pressure of increased competition. One response to this competitive pressure is to have a laser-like focus on containing costs. Over recent times there has been a mindset in many businesses, including some here in Australia, that the key to higher profits is to reduce costs. Paying higher wages can sit at odds with that mindset. Given these various effects, it is plausible that, at least for a while, the economy is less inflation 6 / 12 BIS central bankers' speeches prone than it once was. Both workers and firms feel more competition, and it is plausible that the wage- and price-setting processes are adjusting in response. This, of course, does not mean that the normal forces of supply and demand have been abandoned. Tighter labour markets should still push up wages and prices, even if it takes a little longer than we are used to. We are starting to see some hints of this in the Australian labour market. Business surveys report that firms are having more difficulty finding suitable labour than they have for some time (Graph 7). In the past, when firms found it difficult to find suitable labour, higher growth in wages resulted. Consistent with this, we are hearing reports through our liaison program that in some pockets the stronger demand for workers is starting to push wages up a bit. We expect that as employment growth continues, these reports will become more common. Another factor that has a significant bearing on the outlook for inflation is the increased competition in the retail industry. I spoke a few moments ago about how, globally, increased competition is affecting pricing dynamics. Australian retailing provides a very good example of this. Competition from new entrants is putting pressure on margins and is forcing existing retailers to find ways to lower their cost structures. Technology is helping them to do this, including by automating processes and streamlining logistics. The result is lower prices. For some years now, the rate of increase in food prices has been unusually low. A large part of the story here is increased competition. The same story is playing out in other parts of retailing. Over recent times, the prices of many consumer goods – including clothing, furniture and household appliances – have been falling (Graph 8). Increased competition and changes in technology are driving down the prices of many of the things we buy. This is making for a tough environment for many in the retail industry, but for consumers, lower prices are good news. 7 / 12 BIS central bankers' speeches A question we are grappling with here is how much further this process has to run. It is difficult to know the answer, but our sense is that the impact of greater competition on consumer prices still has some way to go as both retailers and wholesalers adjust their business models. So this is likely to be a constraining factor on inflation for a while yet. Putting all this together, we expect inflation to pick up, but to do so only gradually (Graph 9). By the end of our two-year forecast period, inflation is expected to reach about 2 per cent in underlying terms, and a little higher in headline terms because of planned increases in tobacco excise. Underpinning this expected lift in inflation is a gradual increase in wage growth in response to the tighter labour market. 8 / 12 BIS central bankers' speeches High and rising household debt The third question we have focused on over recent times is the implications of the high and rising level of household debt. The growth in household debt has been outpacing the very low growth in household incomes for a few years now. As a result, the household debt-to-income ratio has risen, although if account is taken of the increased balances held in offset accounts the rise is less pronounced (Graph 10). The low level of interest rates means that even though debt levels are higher, the share of household income devoted to paying mortgage interest is lower than it has been for some time. Perhaps reflecting this, as well as the recent decline in the unemployment rate, aggregate indicators of household financial stress remain quite low. The central issue here is how the high levels of debt affect the stability of the economy over the medium term. Our concern has not been the stability of the banking system; the banks are strong and they are well capitalised. Rather, the concern has been that as the household sector takes on ever-more debt relative to its income, the risk of medium-term problems increases. This is especially so when this debt is taken on in an unusually low-interest rate environment. 9 / 12 BIS central bankers' speeches It is difficult to be precise about exactly how much this risk has increased, but our judgement has been that, should earlier trends have continued, the risk of future problems would have continued to increase. A scenario we have focused on is the possibility of a future shock that causes households to abruptly reassess their past borrowing decisions. In this scenario, consumption might be wound back sharply to put balance sheets on a sounder footing. If this occurred, it could turn an otherwise manageable shock into something more serious. One way of guarding against this risk is for lenders to maintain strong lending standards. The various steps taken by the Australian Prudential Regulation Authority (APRA) – with the strong support of the Council of Financial Regulators – have worked in this direction. Growth in lending to investors has slowed, fewer loans are being made with very high loan-to-valuation ratios, debtservicing tests have been tightened and fewer interest-only loans are being made. The latest data suggest that the banks have more than succeeded in reducing interest-only lending to below the 30 per cent benchmark (Graph 11). These are all positive developments but it is an area we, together with the Council of Financial Regulators, continue to watch closely. 10 / 12 BIS central bankers' speeches Recently, we have also seen some cooling in the Sydney property market. This reflects a combination of factors, including increased supply of new dwellings, some tightening of credit conditions, higher interest rates on loans to investors and some reduction in offshore demand. The increasing unaffordability of prices for many people has also probably played a role. In Melbourne, where the population is growing very strongly, housing prices are still increasing faster than incomes, although the rate of increase has slowed. Elsewhere, housing prices have been little changed over recent months. Conditions are subdued in Brisbane, where the supply of apartments has increased significantly, and remain weak in Perth, owing to slowing population growth following the unwinding of the mining investment boom. It is important to be clear that the RBA does not have a target for housing prices. But a return to more sustainable growth in housing prices does reduce the medium-term risks. These risks have not gone away, but the fact that they are not building at the rate they have been is a positive development. Monetary policy I would like to conclude with what all this has meant for monetary policy over the past year or so. As you are aware, the Reserve Bank Board has kept the cash rate unchanged at 1.5 per cent since August last year. In the early part of that period, a central issue was balancing the need to support the economy in the final days of the transition to lower levels of mining investment against the risks stemming from rising household debt. Lower interest rates might have provided a bit more support, but would have done so partly by encouraging people to borrow yet more money, thus adding to the risks. The Board’s judgement was this would not have been consistent with its broad mandate for economic stability. Accordingly, with the economy expected to pick up and the unemployment 11 / 12 BIS central bankers' speeches rate to come down gradually as the mining investment transition came to an end, the Board judged it appropriate to hold the cash rate at 1.5 per cent. We were prepared to be patient in the interests of medium-term economic stability. As the year progressed, we became somewhat more confident that the expected pick-up in growth would materialise. The strengthening in the global economy has helped here. So too has the lift in employment and the better outlook for investment. This improvement meant that the case for lower interest rates weakened over the year. Also, as the year progressed, one issue the Board paid increasing attention to was the persistently weak growth in wages and household incomes and the implications for consumption. A related issue is the effect of increased competition on the wage and price dynamics in the economy. As I said earlier, we are still trying to understand this. It does, though, look increasingly likely that these factors will mean that inflation remains subdued for some time yet. We still expect headline inflation to move above 2 per cent on a sustained basis, but it is taking a bit longer to get there than we had earlier expected. So, in summary, over the past year or so there has been progress in moving the economy closer to full employment and in having inflation return to the 2 to 3 per cent range. Both of these are positive developments and suggest a more familiar normal is still in sight. Progress on these fronts has been made while also containing the build-up of risks in household balance sheets. We still, though, remain short of full employment, and inflation is expected to pick up only gradually and remain below average for some time yet. This means that a continuation of accommodative monetary policy is appropriate. If the economy continues to improve as expected, it is more likely that the next move in interest rates will be up, rather than down. But the continuing spare capacity in the economy and the subdued outlook for inflation mean that there is not a strong case for a near-term adjustment in monetary policy. We will, of course, continue to keep that judgement under review. Thank you for listening and I look forward to answering your questions. 1 Lowe P (2012), ‘What is Normal?’, Address to the Australian Business Economists Annual Dinner, Sydney, 5 December. 2 Debelle G (2017), ‘Business Investment in Australia’, Speech at UBS Australasia Conference 2017, Sydney, 13 November. 3 In contrast, the forecasts for GDP growth have been much closer to the actual outcomes and the unemployment rate has often been lower than forecast. 12 / 12 BIS central bankers' speeches | reserve bank of australia | 2,017 | 11 |
Welcome address by Mr Lindsay Boulton, Assistant Governor (Business Services) of the Reserve Bank of Australia, to High Security Printing Asia 2017 Conference, Melbourne, 5 December 2017. | Speech Security Printing: A Central Banker's Perspective – Welcome Address to High Security Printing Asia Lindsay Boulton [ * ] Assistant Governor (Business Services) HSP Asia Conference Melbourne – 5 December 2017 Introduction Good morning. Welcome to High Security Printing Asia 2017 and, for those who have travelled from overseas, welcome to Melbourne, Australia. I take this opportunity to also acknowledge the traditional custodians of the land on which we are gathered, the people of the Kulin nation, and, on behalf of everyone here, pay my respects to the Kulin elders past, present and emerging. I am honoured to be presenting the welcoming address this morning, especially as this is the first time that Australia has been the host country in the sixteen-year history of the conference. My address is also presented with considerable pride as Australia can claim a number of significant achievements in security printing. We were the first country to develop and issue polymer banknotes into general circulation, beginning with a single-denomination commemorative note in 1988. All five denominations of Australian banknotes have now been printed on polymer for over twenty years, which has kept counterfeiting of our banknotes low and production costs contained. We continued the innovation with the introduction of a world-first top-to-bottom clear window in our new banknote series, which we began releasing last year. The second note in the new series – our ten dollar – was released just over two months ago and a new $50 is scheduled for release in just under twelve months from now. Australia was also one of the first countries to embed microchips containing biometric information into its passports, which, similar to banknotes, has helped to protect Australian passports from counterfeiting. It has also helped the secure movement of travellers through our air and sea ports. I would like to open the conference with some general observations on developments in the security printing industry in recent years as well some thoughts on the industry's outlook. You won't be surprised that most of my comments will focus on the banknote segment of the industry given my central bank background. I will, of course, also focus on the Asian region, not just because this is the Asian part of the High Security Printing conference series but because this region represents approximately half of the global high security printing market and is around four times larger than the industry's next largest market region. What happens in this region is a significant representation of the industry's global performance. Let me begin with some observations on developments in the market. Current State of Play The Asian market for high security printing has experienced generally healthy growth over the past decade. Driven by good economic performance, rising incomes and infrastructure modernisation across many parts of the region, the high security printing market, as measured by the value of production, has experienced average annual growth of around 6½ per cent. [1] That said, rates of growth have been declining, albeit from a high base. From an annual increase of around 11 per cent at the turn of this decade, the market grew by an estimated 5½ per cent around the middle of the decade. Almost all segments, including payment card printing, have experienced slowing rates of growth, with the cheque printing segment reporting outright falls in the value of output. Factors specific to the different market segments have, no doubt, contributed to the slower overall growth rates. However, the factor common to most market segments is the displacement of traditional printing methods by emerging digital technologies. This is both reducing production costs for existing producers through more efficient printing methods and introducing lower cost alternatives to traditionally printed high security products. The most obvious example is the growing use of mobile payment devices and digital wallets as alternatives to using traditionally printed instruments for making consumer payments. Two segments of the market in Asia have, however, appeared to have moved against the trend of generally lower rates of growth in the value of production. One of these is ticket printing and is attributed to general upgrades in public transport infrastructure. That said, it is expected that growth in this segment will slow in the next few years as transport operators in Asia migrate from proprietary ticketing systems to more sophisticated arrangements, such as ‘open-loop systems’, in which value information for travel purposes is contained on the chips of consumers' existing payment cards, and digital tickets are available for use from consumers' mobile devices. Interestingly, the other segment is banknote production. Over the past decade, the value of banknote production in Asia has grown from around 4 per cent per year to around 5½ per cent in 2016. Although a seemingly modest increase over the period, it is significant because this segment comprises around 40 per cent of the high security printing market in Asia. It is also significant because it is occurring at the same time as the growth in production volumes of banknotes is slowing, primarily, as I mentioned, in response to the take-up of electronic and digital platforms for making payments. In the past 12 months, the volume of banknotes produced in the Asian region has risen by just 2 per cent compared with the average annual growth rate of around 5 per cent since the start of this decade. Increasing growth in the value of production at the same time that growth in production volumes is slowing means, of course, that banknote prices are rising. Put differently, central banks, as wholesalers in the banknote market, are paying proportionately higher prices for finished banknotes than they have in previous years. Furthermore, the higher price is compensating printers and other input suppliers, as producers in the market, for generally slower growth in production orders. My observation is that growth in banknote prices reflects, in part, a demand by central banks for banknotes to be printed on more durable substrates and for banknotes to have more sophisticated security features to protect against counterfeit attack. This can be seen in the increasing take-up of technologies to improve the durability of banknotes, such as polymer and polymer-composite substrates, as well as varnishes as a protective banknote overcoat. It can also be seen in the increased use of added security features such as optically variable devices – that is, foils and features that change colour and shape as the banknote is tilted. Many of these features come at premium prices compared with traditional inputs to banknote production. This is not a development unique to the Asian market but is also evident in other regions, most notably Europe and parts of North America. Two strategies underlie the demand for more expensive substrates and security features, strategies that reinforce each other. The first is that, as the growth in production volumes declines, central banks are having their banknotes printed on more durable substrates in order to extend banknote life in circulation and, thereby, reduce medium- to long-term printing costs. Industry estimates suggest that banknotes printed on polymer substrates, for example, cost twice as much to produce as paper banknotes, but last three to four times longer. This was certainly Australia's experience in the late 1990s, the first few years of printing our banknotes on polymer. Recent estimates suggest that the Australian $5 banknote – our lowest denomination banknote – has a median life of around 3½ years while our largest circulation note by volume – the $50 – has a median life of around 10 years. The second strategy is that central banks are having more sophisticated security features added to protect banknotes partly because the technology available to counterfeiters is improving and partly because the banknotes are staying in circulation for longer. In other words, banknotes are being printed with advanced security features to protect against current sophisticated counterfeiting techniques as well as as-yet unspecified and unknown techniques that may become available to counterfeiters over longer periods in which the banknotes are likely to be circulating. Future State of Play The obvious question arising from these observations is: will the current state of play continue? I would like to offer some thoughts on the future state of play, focusing, again, on the banknote segment of the market. It almost goes without saying that the outlook for banknote printing depends on the future demand for cash. There are different views on this topic, including the view that physical cash has only a finite future. I won't summarise the various views other than to say that we cannot ignore the possibility that the use of physical cash in many countries may disappear at some stage. That said, the common view seems to be that the future state – certainly in the foreseeable future – is likely in most countries to be one of relatively less cash rather than cashless. That is, cash use may decline to a level that reflects a base demand in the community for the specific characteristics that physical banknotes provide. Whatever the endpoint – less cash or cashless – the journey is likely to be a steady walk rather than a quick sprint. There are several reasons for this, but two, in particular, stand out. The demand for cash The first is that, despite its declining use in transactions, the overall demand for cash in many countries is continuing to expand. In the past few years, the median annual growth in currency in circulation across International Monetary Fund (IMF) countries was just under 9 per cent. [3] Similar annual growth was recorded for countries participating in the Pacific Rim Banknote Conference, which includes China, Korea, the Philippines, Australia and a number of other Asian countries as well as Canada and the United States. [4] In most of these countries, including Australia, the ratio of currency in circulation to measures of national production is around its highest for several decades. Underlying the expansion is a shift in overall demand towards holding cash for non-transactional reasons, such as a store of wealth and as a precautionary balance. Even so, the use of cash for transactions purposes is still growing in most countries, albeit at a slower pace. There is, in fact, only one country in the world – Sweden – where the transaction demand for cash is in retreat. This is because cash transactions, despite losing prominence to non-cash payment methods, still offer features that people find desirable – they are anonymous, exchange and settlement is instantaneous, and they are made in a liability of the central bank, which gives people confidence in the value of their exchange. Furthermore, cash transactions can be made when non-cash payments systems are unavailable, not operating, or are relatively expensive to use compared with using cash. The key point is that, whatever the underlying causes, there is a degree of resilience in the demand for cash. Arguably, the resilience is strongest in the Asian region because of the region's large population. In China, the world's most populous country, growth in currency in circulation has averaged around 5 per cent annually over the past four years even though the country has, at the same time, experienced a dramatic shift to electronic forms of payment – more dramatic, in fact, than in most other countries. Correspondingly, China's annual demand for banknote substrate is around 30,000 tonnes, some 30 per cent of annual global substrate demand. The picture is broadly the same in India and Indonesia, where strong cultural factors also underpin the demand for cash. Together, China, India and Indonesia, make up an estimated 55 per cent of global consumption of banknote substrate. By any measure, it is reasonable to assume that the momentum behind banknote demand in these countries alone will take some time to reverse direction. Investment in physical cash infrastructure The second reason to believe that the journey will take a while is that central banks are continuing to invest in banknote infrastructure. Based on my own quick survey, there are 22 central banks currently upgrading their banknotes or, at least, have done so in the past few years. A slightly larger number of central banks – 23 – are underway with or have recently completed upgrading their printing and/or banknote processing centres. China, Hong Kong, India, Malaysia, and the Philippines as well as Canada and the United States feature in the group of countries upgrading their printing and processing operations. Australia features in both groups. As I mentioned earlier, we are upgrading our banknotes with more sophisticated security features. We are also in the final stages of fitting out a recently completed storage facility with automated banknote processing equipment. The facility – which is several kilometres north of Melbourne's CBD – will more than double our existing storage capacity and increase our processing capacity by around 50 per cent. Expenditures on printing equipment, secure storage and processing are significant investments. It is difficult to get precise numbers in every case but, extrapolating on a few reported figures, the total investment in printing and processing across the 23 central banks I identified in my survey amounts to an estimated $4¼ billion (US$3½ billion). The key point is that all of these central banks could not have got the investment decision wrong. Even if the endpoint is that our communities will be using much less cash, investments in new printing and automated processing equipment will serve to keep production and processing costs down as this happens. Either way, the size of the investment decisions by central banks in banknote infrastructure are based on central banks being in a position to continue managing the use of physical cash for some time. Bringing It All Together Pulling these thoughts together, the prospect that the decline in the use of banknotes is likely to be gradual, particularly in this region of the world, is good news for the high security printing industry, of course, at least as far as printing banknotes is concerned. It suggests that the demand of central banks in recent years for banknotes to be printed on more durable substrates and with more sophisticated security features is likely to continue. This good news, however, is not without qualification. It would be unrealistic to believe that central banks will keep paying increasingly higher unit prices for banknotes. Underlying the demand for longer lasting substrates and new, automated cash processing centres is a desire to manage the costs of the banknote lifecycle more finely over the medium to long term. They will want substrates and security features at competitive prices. They may also change strategies. It is possible, as the use of physical cash declines and technology advances, that central banks will find it strategically better to shift to making small but regular changes to banknote design and functionality rather than large, decades-apart upgrades to a full banknote series. They will also want access to detailed data about the performance of various banknote features at various stages of the banknote life cycle, allowing them to finely manage their investment in banknote durability and security against the uncertainty of future banknote demand. This may mean that awarding contracts to design and print a new single-denomination banknote or a complete new series may become less common. It may, instead, become more common to award contracts to print a single new feature and incorporate it into an existing banknote design. If banknotes are staying longer in the hands of the public, it seems likely, too, that central banks will require the notes to have security features that are more overt. That is, security that can be easily seen by looking at the note or by easily scanning a banknote with a smart phone. Banknotes presently have a roughly balanced mix of overt and covert security features. So there are opportunities and challenges ahead for the high security printing industry. Both seem more acute in the Asian region because of its large population and cultural connection to using physical cash. That is why this conference is important and timely. It is an opportunity to share experiences, consider new technologies and techniques, and, with the benefit of these, discuss and plan strategy for the changes that are likely to occur over the next decade. I encourage you to make the most of this opportunity over the next few days and I look forward to talking with you and sharing ideas and thoughts. I would also encourage you to take in the Melbourne atmosphere. The city has a well-earned reputation for creativity. As always, creativity will be important in order take the opportunities ahead in the high security printing industry. Once again, welcome. Endnotes [*] I thank Malcolm McDowell and Nuwan Kalpage of Note Printing Australia and my colleagues at the Reserve Bank of Australia Kristin Langwasser and Gordon Flannigan for assistance in preparing this speech. See Smithers Pira (2015), ‘The Future of Global Security Printing Markets to 2020’, Final Report, June. Market value, production value, production cost and value of output are used interchangeably. They refer to the value of finished production, including the cost of inputs, but not necessarily the production mark-up and are compiled from a number of sources. Asia covers 28 countries. Production volume data from unpublished De La Rue Annual Banknote Survey. Asia covers 27 countries in the Asian region. Sourced from the IMF's International Financial Statistics database. Information from papers presented at the Pacific Rim Banknote Conference 2017. Sourced from Smithers Pira (2015) and papers presented at the Pacific Rim Banknote Conference 2017. © Reserve Bank of Australia, 2001–2017. All rights reserved. | reserve bank of australia | 2,017 | 12 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the 2017 Australian Payment Summit, Sydney, 13 December 2017. | Philip Lowe: An eAUD? Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the 2017 Australian Payment Summit, Sydney, 13 December 2017. * * * I would like to thank David Emery, Tony Richards and other staff in the RBA's Payments Policy Department for assistance in the preparation of these remarks. Thank you for the invitation to speak at this important summit. It is an honour for me to be able to join you. Over recent times, the payments system has evolved tremendously and AusPayNet has been at the centre of this evolution.1 In particular, it has played an important role in coordinating the industry’s response to the Strategic Review of Innovation conducted by the Payments System Board. As a result of this work, same-day settlement for direct entry transactions was introduced, the Australian Payments Council was formed and, most importantly, the New Payments Platform (NPP) was developed. I would like to thank both past and current members of the AusPayNet team for your contribution to this effort. If we look back over a slightly longer period, a clear lesson from history is that as people’s needs change and technology improves, so too does the form that money takes. Once upon a time, people used clam shells and stones as money. And for a while, right here in the colony of New South Wales, rum was notoriously used. For many hundreds of years, though, metal coins were the main form of money. Then, as printing technology developed, paper banknotes became the norm. The next advance in technology – developed right here in Australia – was the printing of banknotes on polymer. No doubt, this evolution will continue. Though predicting its exact nature is difficult. But as Australia’s central bank, the RBA has been giving considerable thought as to what the future might look like. We are the issuer of Australia’s banknotes, the provider of exchange settlement accounts for the financial sector, and we have a broad responsibility for the efficiency of the payments system, so this is an important issue for us. Today I want to share with you some of our thinking about this future and to address a question that I am being asked increasingly frequently: does the RBA intend to issue a digital form of the Australian dollar? Let’s call it an eAUD. The short answer to this question is that we have no immediate plans to issue an electronic form of Australian dollar banknotes, but we are continuing to look at the pros and cons. At the same time, we are also looking at how settlement arrangements with central bank money might evolve as new technologies emerge. As we have worked through the issues, we have developed a series of working hypotheses. I would like to use this opportunity to outline these hypotheses and then discuss each of them briefly. As you will see, we have more confidence in some of these than others. There will be a further significant shift to electronic payments, but there will still be a place for banknotes, although they will be used less frequently. It is likely that this shift to electronic payments will occur largely through products offered by the banking system. This is not a given, though. It will require financial institutions to offer customers low-cost solutions that meet their needs. An electronic form of banknotes could coexist with the electronic payment systems operated by the banks, although the case for this new form of money is not yet established. If an electronic form of Australian dollar banknotes was to become a commonly used payment method, it would probably best be issued by the RBA and distributed by financial institutions, 1 / 11 BIS central bankers' speeches just as physical banknotes are today. Another possibility that is sometimes suggested for encouraging the shift to electronic payments would be for the RBA to offer every Australian an exchange settlement account with easy, low-cost payments functionality. To be clear, we see no case for doing this. It is possible that the RBA might, in time, issue a new form of digital money – a variation on exchange settlement accounts – perhaps using distributed ledger technology. This money could then be used in specific settlement systems. The case for doing this has not yet been established, but we are open to the idea. So these are our five working hypotheses. I would now like to expand on each of these. 1. The shift to electronic payments An appropriate starting point is to recognise that most money is already digital or electronic. Only 3½ per cent of what is known as ‘broad money’ in Australia is in the form of physical currency. The rest is in the form of deposits, which, most of the time, can be accessed electronically. So the vast majority of what we know today as money is a liability of the private sector, and not the central bank, and is already electronic. With most money available electronically, there has been a substantial shift to electronic forms of payments as well. There are various ways of tracking this shift. One is the survey of consumers that the RBA conducts every three years. When we first conducted this survey in 2007, we estimated that cash accounted for around 70 per cent of transactions made by households. In the most recent survey, which was conducted last year, this share had fallen to 37 per cent (Graph 1). 2 / 11 BIS central bankers' speeches A second way of tracking the change is the decline in cash withdrawals from ATMs. The number of withdrawals peaked in 2008 and since then has fallen by around 25 per cent (Graph 2). This trend is likely to continue. 3 / 11 BIS central bankers' speeches The third area where we can see this shift is the rapid growth in the number of debit and credit card transactions and in transactions using the direct entry system. Since 2005, the number of transactions using these systems has grown at an average annual rate of 10 per cent (Graph 3). This stands in contrast to the decline in the use of cash and cheques. 4 / 11 BIS central bankers' speeches The overall picture is pretty clear. There has been a significant shift away from people using banknotes to making payments electronically. Most recently, Australia’s enthusiastic adoption of ‘tap-and-go’ payments has added impetus to this shift. In many ways, Australians are ahead of others in the use of electronic payments, although we are not quite in the vanguard. It is also worth pointing out, though, that despite this shift to electronic payments, the value of banknotes on issue is at a 50-year high as a share of GDP (Graph 4). Australians are clearly holding banknotes for purposes other than for making day-to-day payments. 5 / 11 BIS central bankers' speeches This shift towards electronic payments, and away from the use of banknotes for payments, will surely continue. This will be driven partly by the increased use of mobile payment apps and other innovations. At the same time, though, it is likely that banknotes will continue to play an important role in the Australian payments landscape for many years to come. For many people, and for some types of transactions, banknotes are likely to remain the payment instrument of choice.2 2. Banks are likely to remain at the centre of the shift to electronic payments In Australia, the banking system has provided the infrastructure that has made the shift to electronic payments possible. In some other countries, the banking system has not done this. For example, in China and Kenya non-bank entities have been at the forefront of recent strong growth in electronic payments. A lesson here is that if financial institutions do not respond to customers’ needs, others will. At this stage, it seems likely that the banking system will continue to provide the infrastructure that Australians use to make electronic payments. This is particularly so given the substantial investment made by Australia’s financial institutions in the NPP. The new system was turned on for ‘live proving’ in late November and the public launch is scheduled for February. It will allow Australians to make payments easily on a 24/7 basis, with recipients having immediate access to their money. The RBA has built a critical part of this infrastructure to ensure interbank settlement occurs in real time. Payments will be able to be made by just knowing somebody’s email address or mobile phone number and plenty of information will be able to be sent with the payment. This system has the potential to be transformational and will allow many transactions that today are conducted with banknotes to be conducted electronically. Importantly, the new system offers instant settlement and funds availability. It provides this, while 6 / 11 BIS central bankers' speeches at the same time allowing funds to be held in deposit accounts at financial institutions subject to strong prudential regulation and that pay interest. This combination of attributes is not easy to replicate, including by closed-loop systems outside the banking system. However, the further shift to electronic payments through the banking system is not a given. It requires that the cost to consumers and businesses of using the NPP is low and that the functionality expands over time. If this does not happen, then the experience of other countries suggests that alternative systems or technologies might emerge. One class of technology that has emerged that can be used for payments is the so-called cryptocurrencies, the most prominent of which is Bitcoin. But in reality these currencies are not being commonly used for everyday payments and, as things currently stand, it is hard to see that changing. The value of Bitcoin is very volatile, the number of payments that can currently be handled is very low, there are governance problems, the transaction cost involved in making a payment with Bitcoin is very high and the estimates of the electricity used in the process of mining the coins are staggering. When thought of purely as a payment instrument, it seems more likely to be attractive to those who want to make transactions in the black or illegal economy, rather than everyday transactions. So the current fascination with these currencies feels more like a speculative mania than it has to do with their use as an efficient and convenient form of electronic payment.3 This is not to say that other efficient and low-cost electronic payments methods will not emerge. But there is a certain attraction of being able to make payments from funds held in prudentially regulated accounts that can earn interest. 3. Electronic banknotes could coexist with the electronic payment system operated by the banks In principle, a new form of electronic payment method that could emerge would be some form of electronic banknotes, or electronic cash. The easiest case to think about is a form of electronic Australian dollar banknotes. Such banknotes could coexist with the electronic account-toaccount-based payments system operated by the banks, just as polymer banknotes coexist with the electronic systems today.4 The technologies for doing this on an economy-wide scale are still developing. It is possible that it could be achieved through a distributed ledger, although there are other possibilities as well. The issuing authority could issue electronic currency in the form of files or ‘tokens’. These tokens could be stored in digital wallets, provided by financial institutions and others. These tokens could then be used for payments in a similar way that physical banknotes are used today. In thinking about this possibility there are a couple of important questions that I would like to highlight. The first is that if such a system were to be technologically feasible, who would issue the tokens: the RBA or somebody else? The second is whether the RBA developing such a system would pass the public interest test. In terms of the issuing authority, our working hypothesis is that this would best be done by the central bank. In principle, there is nothing preventing tokenised eAUDs being issued by the private sector. It is conceivable, for example, that eAUD tokens could be issued by banks or even by large nonbanks, although it is hard to see them being issued as cryptocurrency tokens under a bitcoinstyle protocol, with no central entity standing behind the liability. So, while a privately issued eAUD is conceivable, experience cautions that there are significant difficulties and dangers 7 / 11 BIS central bankers' speeches associated with privately issued fiat money. The history of private issuance is one of periodic panic and instability. In times of uncertainty and stress, people don’t want to hold privately issued fiat money. This is one reason why today physical banknotes are backed by central banks. It is possible that ways might be found to deal with this financial stability issue – including full collateralisation – but these tend to be expensive. This suggests that if there were to be an electronic form of banknotes that was widely used by the community, it is probably better and more likely for it to be issued by the central bank. If we were to head in this direction, there would be significant design issues to work through. The tokens could be issued in a way that transactions could be made with complete anonymity, just as is the case with physical banknotes. Alternatively, they might be issued in a way in which transactions were auditable and traceable by relevant authorities. We would also need to deal with the issue of possible counterfeiting. Depending upon the design of any system, we might be very reliant on cryptography and would need to be confident in the ability to resist malicious attacks. This brings me to the second issue here: is there a public policy case for moving in this direction? Such a case would need to be built on electronic banknotes offering something that account-toaccount transfers through the banking system do not. We would also need to be confident that there were not material downsides from moving in this direction. Our current working hypothesis is that with the NPP there is likely to be little additional benefit from electronic banknotes. This, of course, presupposes that the NPP provides low-cost efficient payments. One possible benefit of electronic banknotes for some people might be that they could have less of an ‘electronic fingerprint’ than account-to-account transfers, although this would depend upon how the system was designed. But having less of an electronic fingerprint hardly seems the basis for building a public policy case to issue an electronic form of the currency. So there would need to be more than this. Among the potential downsides, the main one lies in the area of financial stability. If we were to issue electronic banknotes, it is possible that in times of banking system stress, people might seek to exchange their deposits in commercial banks for these banknotes, which are a claim on the central bank. It is likely that the process of switching from commercial bank deposits to digital banknotes would be easier than switching to physical banknotes. In other words, it might be easier to run on the banking system. This could have adverse implications for financial stability. Given these various considerations, we do not currently see a public policy case for moving in this direction. We will, however, keep that judgement under review. 4. Exchange settlement accounts for all Australians? Another possible change that some have suggested would encourage the shift to electronic payments would be for the central bank to issue every person a bank account – for each Australian to have their own exchange settlement account with the RBA. In addition to serving as deposit accounts, these accounts could be used for low-cost electronic payments, in a similar way that third-party payment providers currently use accounts at the RBA to make payments between themselves. Some advocates of this model also suggest that the central bank could pay interest on these accounts or even charge interest if the policy rate was negative.5 On this issue, we have reached a conclusion, rather than just develop a hypothesis. The conclusion is that we do not see it as in the public interest to go down this route. 8 / 11 BIS central bankers' speeches If we did go down this route, the RBA would find itself in direct competition with the private banking sector, both in terms of deposits and payment services. In doing so, the nature of commercial banking as we know it today would be reshaped. The RBA could find itself not just as the nation’s central bank, but as a type of large commercial bank as well. This is not a direction in which we want to head. A related consideration is the same financial stability issue that I just spoke about in terms of electronic banknotes. In times of stress, it is highly likely that people might want to run from what funds they still hold in commercial bank accounts to their account at the RBA. This would make the remaining private banking system prone to runs. The point here is that exchange settlement accounts are for settlement of interbank obligations between institutions that operate third-party payment businesses to address systemic risk – something that is central to our mandate. A decision to offer exchange settlement accounts for day-to-day use would be a step into a completely different policy area. 5. New settlement systems based on distributed ledger technology and central bank money? One final possibility is for the RBA to issue Australian dollars in the form of electronic files or tokens that could be used within specialised payment and settlement systems. The tokens could be exchanged among members of a private, permissioned distributed ledger, separate from the RBA’s Real-time Gross Settlement (RTGS) system, but with mechanisms for the tokens to be exchanged for central bank deposits when required. Such a system might allow the payment and settlement process to become highly integrated with other business processes, generating efficiencies and risk reductions for private business. As part of this, the tokens might also be able to be programmed and sit alongside smart contracts, enabling multi-stage transactions with potentially complex dependencies to take place securely and automatically. This seems to be the general model that some people have in mind when they talk about ‘putting AUD on the blockchain’, although other technologies might be able to achieve similar outcomes. Whether a strong case for the development of these types of systems emerges remains an open question. We need to better understand the potential efficiencies for private business and why it would be preferable for such a settlement system to be provided by the central bank, rather than the private sector; why privately issued tokens or files could not do the job. We would also need to understand why any efficiency improvement could not be obtained by using the existing Exchange Settlement Accounts and the NPP. We would also need to understand whether and how risk in the financial system would change as a result of such a system. It remains unclear which way this could go. On the one hand, these types of processes could use a very different technology from the current system, which is based on account-to-account transfers, so they could add to the resilience of the overall payments system. But there would be a whole host of new technology issues to manage as well. To help understand these various issues, Reserve Bank staff have been liaising closely with fintechs and financial institutions. We also regularly talk with other central banks that have tested distributed ledger technologies in some related contexts. We are also currently working with some external entities to observe or participate in proof-of-concepts similar to those of other central banks. So this area remains a work in progress for us. Conclusion This brings me to the end of the elaboration of my set of five working hypotheses. I would like to conclude by summarising. There is a lot going on in the world of payments. Much of this is being driven by advances in 9 / 11 BIS central bankers' speeches technology. These advances are opening up possibilities that were difficult even to dream about a little while ago. These changes are leading to much greater use of electronic means of payment and the development of new electronic payment methods. This process has much further to run, although physical banknotes are likely to remain an important part of the payments landscape for many years to come. This shift to electronic payments is most likely to occur through products offered by the banking system. The NPP is a very big step here. If it had not been developed it is likely that non-bank solutions would have gained wide acceptance. This may still happen. But it seems plausible that Australian households and businesses will continue to hold the bulk of their money in the form of commercial bank deposits, which come with flexible, low-cost electronic payment options, earn interest and are prudentially regulated. But this will require the banks to offer the services that customers want at a reasonable price. The case for adding an electronic form of Australian banknotes to the payments mix has not been established, even if it were technologically feasible. My working hypothesis here is that the NPP will serve this purpose. The RBA is in close contact with our peers in other countries on this issue and few see electronic banknotes on the horizon. We do not see a case for the RBA offering every Australian a bank account for the purposes of making payments. Doing so would fundamentally change our banking system in a way that would not promote the public interest. A convincing case for issuing Australian dollars on the blockchain for use with limited private systems has not yet been made. It is certainly possible that this type of system could lead to more efficient, lower-cost business processes and payments. My working hypothesis here is that such a case could develop, although we need to work through a range of complex operational and policy questions. As we work though these various issues, we look forward to an ongoing dialogue with the payments industry and other interested parties. Finally, before I finish I would like to briefly highlight three other issues that I know are of current interest to the payments industry as well as the Payments System Board.6 These are: the importance of allowing merchants to route debit card transactions through the least-cost network the need to address rising rates of fraud in card-not-present transactions the need to develop a strong system of digital identity that can be used in the financial sector, and perhaps elsewhere. In the Payments System Board’s view, it is in the public interest that timely progress be made in all three areas. The Board’s preference is that this progress be made by industry participants, without the need for regulation. In the event that this did not occur, the Board would need to consider what steps it might take to promote the public interest. Thank you for listening and I am happy to answer questions. 1 AusPayNet stands for Australian Payments Network. Prior to mid 2017 it was the Australian Payments Clearing Association (APCA). 2 In our most recent consumer payments survey, around 12 per cent of respondents used cash for all of their in- person transactions during the survey week, and cash was used more intensively by older Australians and those in rural and regional areas. See Doyle M-A, C Fisher, E Tellez and A Yadav (2017), ‘How Australians Pay: 10 / 11 BIS central bankers' speeches Evidence from the 2016 Consumer Payments Survey’, RBA Research Discussion Paper No 2017–04. 3 So-called Initial Coin Offerings – crowdfunding-type ventures, typically blockchain-enabled, that allow participants to contribute digital currencies or other funds in return for digital tokens that may provide certain future rights or benefits – appear to be contributing to some of this speculative mania. 4 The concept of electronic cash is actually not new. Areport from the Bank for International Settlements from over 20 years ago noted that e-money innovations ‘have the potential to challenge the predominant role of cash for making small-value payments and could make retail transactions easier and cheaper for consumers and merchants’ (Bank for International Settlements (1996), ‘Implications for Central Banks of the Development of Electronic Money’, October). A tokenised eAUD could also be seen as an updated version of the 1990s technologies that yielded prototypes such as Digicash and Mondex. These were ultimately not commercially successful, but they demonstrated that versions of electronic cash were feasible. 5 Of course, it might also be possible to pay/charge interest on electronic banknotes as well. This would raise some of the same issues discussed here. 6 These were noted in the Bank’s Payments System Board updates following the August 2017 and November 2017 meetings. 11 / 11 BIS central bankers' speeches | reserve bank of australia | 2,018 | 1 |
Speech by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the 30th Australasian Finance and Banking Conference, University of New South Wales, 13 December 2017. | Christopher Kent: The availability of business finance Speech by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the 30th Australasian Finance and Banking Conference, University of New South Wales, 13 December 2017. * * * I thank Ellis Connolly and Ben Jackman for invaluable assistance in preparing these remarks, which also draw upon an article they have authored: Connolly E and Jackman B (2017), ‘The Availability of Business Finance ’, RBA Bulletin, December, pp 55–66. It is a pleasure to be here to discuss the availability of business finance in Australia. Businesses need funding for their day-to-day operations and to undertake investment. These funds can be generated internally, from profits, or they can come from various external sources. The availability of funding has an important bearing on current and future economic activity. My remarks today are structured around three key issues. First, I’ll talk about the internal and external sources of funds and the way in which businesses use those funds. External finance has become available on increasingly favourable terms for large borrowers over recent years, including because of increased competitive pressures in this market. However, for the business sector as a whole, internal funds are the key source of funding for investment. Growth in external funding has only a weak relationship to investment. Debt funding appears to be linked to mergers and acquisitions activity, which has remained relatively modest compared with levels prior to the financial crisis. The second issue I want to discuss is the experience of entrepreneurs seeking to start or expand a small business. They are typically more reliant on external finance, which remains difficult for them to obtain. Access to finance for such small businesses is important though, since they generate significant employment growth, drive innovation and boost competition in markets. The third issue I’ll cover is the potential to improve access to finance for entrepreneurs. Much of what I have to say today draws on the information from a Small Business Finance Advisory Panel that the Reserve Bank has convened each year for the past 25 years.1 We’ve gained a variety of perspectives by talking to entrepreneurs from a range of industries and locations across Australia. It’s been an invaluable way to better understand the challenges faced by innovative small businesses. Business funding and investment But first, I’ll start with some observations about the business sector overall. Data from the Australian Bureau of Statistics on the balance sheet of the Australian business sector shows that businesses are financed by around 60 per cent equity and 40 per cent debt (Graph 1).2 Business debt is dominated by loans from financial institutions, with debt securities playing a relatively minor role. This capital structure is similar to most other comparable advanced economies. The United States, to which we are often compared, is actually an outlier. Bank loans are a much smaller share of business funding in the US. 1 / 17 BIS central bankers' speeches The primary source of new finance for Australian businesses is internal funding (Graph 2). That is supplemented by funds raised externally. The primary use of funds is for productive investment, such as commercial buildings, machinery, software and other forms of intellectual property. A non-trivial share, though, is used to pay dividends and to purchase financial assets, or for mergers and acquisitions.3 2 / 17 BIS central bankers' speeches It is well established in the literature that businesses prefer to finance investment using internal funds. Raising funds externally is more costly and can involve restrictions being imposed on the managers. Internal funding is closely related to business investment. They are similar in size. This is evident in Graph 3, in which the dots comparing the level of internal funding (in a given year) with the level of business investment (the following year) are clustered around the 45 degree line. Also, there is a clear positive relationship between internal funding and investment.4 3 / 17 BIS central bankers' speeches In contrast, the relationship between external financing and investment is less clear in the aggregate data. External financing is generally much smaller than investment – that is, the external funding dots in Graph 3 tend to be well to the left of the 45 degree line. Moreover, there is only a weak positive relationship between businesses’ external funding and investment.5 Debt funding has moved more closely with mergers and acquisitions activity (Graph 4).6 For instance, in the period leading up to the global financial crisis, debt finance was used by a small number of highly leveraged firms to fund several mergers and acquisitions. 4 / 17 BIS central bankers' speeches Like the growth of external debt, listed equity raisings have been relatively modest over the past 10 years, with relatively little capital raised through initial public offerings (IPOs) (Graph 5). This followed a period of significant equity raisings during the 2000s, partly driven by a number of privatisations through public floats. 5 / 17 BIS central bankers' speeches Overall, external finance has become more readily available over recent years. Monetary policy, both here and abroad, is very accommodative, and interest rates on business loans and corporate bonds are near historic lows. Accordingly, the interest being paid by businesses is around its lowest level since the early 1960s (relative to operating profits; Graph 6).7 Also, equity raising is relatively attractive at current valuations. 6 / 17 BIS central bankers' speeches A consistent message from business surveys and the RBA’s liaison program has been that funding conditions have generally improved over the past five years. Despite this, the demand for borrowing by businesses has been relatively moderate. Following the crisis, there was significant deleveraging across the corporate sector (Graph 7). Subsequently, gearing ratios outside the resources sector have remained relatively low. Over recent years, non-mining business investment has been growing and the outlook for investment has improved. However, as I’ve already noted, firms have been able to finance investment from internal sources. Even in the resources sector, while gearing rose after the global financial crisis, it did not reach the levels that prevailed immediately before the crisis. It has declined in the past couple of years, as resource companies have been using the boost to their cash flows from higher commodity prices and rising output to pay down debt. 7 / 17 BIS central bankers' speeches Some parts of the business sector haven’t seen the supply of external funding improve over recent years. The domestic banks have sought to constrain their exposures to the resources sector and commercial property, partly in response to prudential supervision from the Australian Prudential Regulation Authority. 8 Also, small businesses continue to find it challenging to obtain external finance. Indeed, this could be one factor that helps to explain why investment by small businesses has been unusually weak over recent years (Graph 8).9 8 / 17 BIS central bankers' speeches Finance for small businesses The challenge of obtaining finance has been a consistent theme of the Small Business Finance Advisory Panel. In this context, it is important to distinguish between two types of small businesses. First, there are the many established small businesses that are not expanding. Their needs for external finance are typically modest. Second, there are small businesses that are in the start-up or expansion phase. They are not generating much in the way of internal funding. Accordingly, those businesses have a strong demand for external finance. I’ll focus my comments on the issues relevant to this second group of small businesses. I should emphasise again that access to finance for small businesses is important because they generate employment, drive innovation and boost competition in markets. Indeed, small businesses in Australia employ almost 5 million people, which is nearly half of employment in the (non-financial) business sector. They also account for about one-third of the output of the business sector.10 Compared with larger, more established firms, smaller, newer businesses find it difficult to obtain external finance since they are riskier on average and there is less information available to lenders and investors about their prospects. Lenders typically manage these risks by charging higher interest rates than for large business loans, by rejecting a greater proportion of small business credit applications or by providing credit on a relatively restricted basis. The reduction in the risk appetite of lenders following the global financial crisis appears to have had a more significant and persistent effect on the cost of finance for small business than large business. After the crisis, the average spread of business lending rates to the cash rate widened dramatically. The increase was much larger and more persistent, though, for small business loans (Graph 9). In part, this increase owed to the larger increase in non-performing loans for 9 / 17 BIS central bankers' speeches small businesses than for large business lending portfolios (Graph 10). It’s not clear, however, whether the increase in interest rates being charged on small business loans relative to those charged on large business loans (over the past decade or so) reflects changes in the relative riskiness of the two types of loans.11 10 / 17 BIS central bankers' speeches Over recent years, there has been strong competition for large business lending, which has resulted in a decline in the interest rate spread on large business loans. Part of the competition from banks for large business loans has been driven by an expansion in activity by foreign banks. Large businesses also have access to a wider array of funding sources than small businesses, including corporate bond markets and syndicated lending. In contrast, competition has been less vigorous for small business lending. Indeed, some providers of small business finance were acquired by other banks or exited the market following the onset of the crisis.12 Also, the interest rates on small business loans have remained relatively high. This difference in competitive pressures is evident in the share of lending provided to small business by the major banks, which is relatively high at over 80 per cent. This compares with a share of around two-thirds in the case of large businesses. Small businesses continue to use loans from banks for most of their debt funding because it is often difficult and costly for them to raise funds directly from capital markets. The RBA’s liaison has highlighted that if small business borrowers are able to provide housing as collateral, it significantly reduces the cost and increases the availability of debt finance. Lenders have indicated that at least three-quarters of their small business lending is collateralised and they only have a limited appetite for unsecured lending. However, there are a number of reasons why entrepreneurs find it difficult to provide sufficient collateral for business borrowing via home equity: they may actually not own a home, or have much equity in their home if they are relatively young; similarly, they may not have sufficient spare home equity if they’ve already borrowed against 11 / 17 BIS central bankers' speeches their home to establish a business and now want to expand their business; and even if they have plenty of spare home equity, using their homes as collateral concentrates the risk they face in the event of the failure of the business. Many entrepreneurs have limited options for providing alternative collateral, since banks are far more likely to accept physical assets (such as buildings or equipment), rather than ‘soft’ assets, such as software and intellectual property. Given the higher risk associated with small businesses, particularly start-ups, equity financing would appear to be a viable alternative to traditional bank finance. However, small businesses often find it difficult to access equity financing beyond what is issued to the business by the founders. Small businesses have little access to listed equity markets, and while private equity financing is sometimes available, its supply to small businesses is limited in Australia, particularly when compared with the experience of other countries (Graph 11). Small businesses also report that the cost of equity financing is high, and they are often reluctant to sell equity to professional investors, since this usually involves relinquishing significant control over their business. Innovations improving access to business finance There are several innovations that could help to improve access to finance by: providing lenders with more information about the capacity of borrowers to service their debts, and connecting riskseeking investors with start-up businesses that could offer high returns. 12 / 17 BIS central bankers' speeches Comprehensive credit reporting Comprehensive credit reporting will provide more information to lenders about the credit history of potential borrowers. The current standard only makes negative credit information publicly available. When information about credit that has been repaid without problems also becomes available publicly, the cost of assessing credit risks will be reduced and lenders will be able to price risk more accurately; this may enhance competition as the current lender to any particular business will no longer have an informational advantage over other lenders. It may also reduce the need for lenders to seek additional collateral and personal guarantees for small business lending, particularly for established businesses. Indeed, the use of personal guarantees is more widespread in Australia than in countries that have well-established comprehensive credit reporting regimes, such as the United Kingdom and the United States. For several years, the finance industry has attempted to establish a voluntary comprehensive credit reporting regime in Australia. Participation has so far been limited. 13 However, several of the major banks have committed to contribute their credit data in coming months. The Australian Government has announced that it will legislate for a mandatory regime to come into effect mid next year. Open banking The introduction of an open banking regime should make it easier for entrepreneurs to share their banking data (including on transactions accounts) securely with third-party service providers, such as potential lenders. When assessing credit risks, lenders place considerable weight on evidence of the capacity of small business borrowers to service their debts based on their cash flows. For this reason, making this data available via open banking would reduce the cost of assessing credit risk. A review is currently being conducted with a view to introducing legislation to support an open banking regime. Large technology companies Technology firms can use the transactional data from their platforms to identify creditworthy borrowers, and provide loans and trade credit to these businesses from their own balance sheets. This could supply small innovative businesses that are active on these online platforms with a new source of finance. Amazon and Paypal are providing finance to some businesses that use their platforms. For example, Amazon identifies businesses with good sales histories and offers them finance on an invitation-only basis. Loans are reported to range from US$1 000 to US$750 000 for terms of up to a year at interest rates between 6 and 14 per cent. Repayments are automatically deducted from the proceeds of the borrower’s sales. Alternative finance platforms Alternative finance platforms, including marketplace lending and crowdfunding platforms, use new technologies to connect fundraisers directly with funding sources. The aim is to avoid the costs and delays involved in traditional intermediated finance. While alternative financing platforms are growing rapidly, they are still a very minor source of funding for businesses, including in Australia. The largest alternative finance markets are in China, followed by the United States and the United Kingdom. But even these markets remain small relative to the size of their economies (Graph 12). 13 / 17 BIS central bankers' speeches Marketplace lending platforms provide debt funding by matching individuals or groups of lenders with borrowers. These platforms typically target personal and small business borrowers with low credit risk by attempting to offer lower cost lending products and more flexible lending conditions than traditional lenders. Data collected by the Australian Securities and Investments Commission indicate that most marketplace lending in Australia is for relatively small loans to consumers at interest rates comparable to personal loans offered by banks (Graph 13). 14 / 17 BIS central bankers' speeches It is unclear whether marketplace lending platforms are significantly reducing financial constraints for small businesses. Unlike innovations such as comprehensive credit reporting, which have the potential to improve the credit risk assessment process, marketplace lenders do not have an information advantage over traditional lenders. As a result, they need to manage risks with prices and terms in line with traditional lenders.14 Nevertheless, these platforms could provide some competition to traditional lenders, particularly as a source of unsecured short-term finance, since they process applications quickly and offer rates below those on credit cards. Crowdfunding platforms have the potential to make financing more accessible for start-up businesses, although their use has been limited to date. Crowdsourced equity funding platforms typically involve a large number of investors taking a small equity stake in a business. As a result, entrepreneurs can receive finance without having to give up as much control as expected by venture capitalists.15 Several legislative changes have been made to facilitate growth in these markets, including by allowing small unlisted public companies to raise crowdsourced equity. Conclusion The provision of external finance to Australian businesses is dominated by the banks. Funding from that source has generally become available on increasingly favourable terms for large borrowers over recent years. Even so, much of business investment is financed from internally generated funds, while growth in business debt is more closely related to mergers and acquisitions activity, which has remained relatively modest compared with levels seen before the global financial crisis. Entrepreneurs starting or expanding a small business are typically more reliant on external finance, which remains difficult to obtain. Lending to small businesses is dominated by the major banks and, there is less competition in this market. Interest rates paid by small businesses are also much higher than those paid by large businesses; it’s not clear the extent to which this 15 / 17 BIS central bankers' speeches difference reflects the greater risk involved in extending loans to small businesses. Entrepreneurs starting businesses often resort to personal credit cards for day-to-day funding, while those seeking to expand their businesses are concerned by the collateral required to obtain funding at lower interest rates. There are several innovations that have the potential to improve access to finance, although their use has been limited to date. The most promising development in the near term is mandatory comprehensive credit reporting, which has the potential to lower the cost of credit risk assessment for all lende 1 The Panel’s discussion are a useful input into Bank work, for example Reserve Bank of Australia (2012), ‘Small Business Finance Roundtable: Summary of Discussion’, RBA Bulletin, June, pp 91–94. Information about the panel can also be found on the RBA website: www.rba.gov.au/about-rba/panels/small-business-financeadvisory-panel.html. 2 The finances of the business sector are challenging to measure, since the boundary between businesses, households and the government is not clearly defined and evolves over time. Unincorporated businesses tend to be closely intertwined with the households that own them and, as a result, it is virtually impossible to separately identify their balance sheets. In addition, the privatisation of many public corporations over recent decades has shifted the responsibility for financing these businesses from the public sector to the private sector. To deal with these challenges, the business sector is defined here to include all private and public corporations. 3 Mergers and acquisitions within the Australian business sector are not captured in the data shown in Graph 2, which is based on net transactions by the Australian business sector with other sectors, including foreigners. 4 A similar positive relationship is observed between internal funding and investment in the same year. However, the correlation is larger between internal funding this year and investment next year, which is consistent with businesses being secure about their finances ahead of committing to sizeable investment outlays. External funding is somewhat positively correlated with investment in the same year and that correlation is a bit stronger than between external funding this year and investment next year. This result makes sense as it would be costly for a business to obtain external funding and then not put that funding to use as quickly as possible. 5 Similarly, relatively timely indicators such as business loan approvals and credit have not been found to be useful for forecasting investment. Previous RBA research has found a significant relationship between investment and variables such as the user cost of capital, cash flow, sales, business confidence and the terms of trade: La Cava G (2005), ‘Financial Constraints, the User Cost of Capital and Corporate Investment in Australia’, RBA Research Discussion Paper No 2005–12 and Cockerell L and S Pennings (2007), ‘Private Business Investment in Australia’, RBA Research Discussion Paper No 2007–09. 6 The ABS data on business debt funding, which is a broad measure of loans and debt securities, have been weaker over the past year than RBA business credit, which measures lending by ADIs to businesses. The weaker growth of total debt is likely to reflect companies repurchasing debt securities and reducing offshore borrowing, particularly in the resources sector. The repayment of government loans following the privatisation of some public corporations has also played a role. 7 The decline in interest paid since the late 1980s has been driven entirely by lower interest rates, as the ratio of debt relative to operating profits has increased a little over this period. 8 See Byres W (2017), ‘Prudential Perspectives on the Property Market’, Remarks at CEDA’s 2017 NSW Property Market Outlook Sydney, 28 April. Available at: . 9 See Debelle G (2017), ‘Business Investment in Australia’, Remarks at UBS Australasia Conference 2017, Sydney, 13 November. The estimates for Graph 8 are sourced from the ABS’ BLADE (Business Longitudinal Analytical Data Environment) database. The results of these studies are based, in part, on ABR data supplied by the Registrar to the ABS under ANew Tax System (Australian Business Number) Act 1999 and tax data supplied by the ATO to the ABS under the Taxation Administration Act 1953. These require that such data are only used for the purpose of carrying out functions of the ABS. No individual information collected under the Census and Statistics Act 1905 is provided back to the Registrar or ATO for administrative or regulatory purposes. Any discussion of data limitations or weaknesses is in the context of using the data for statistical purposes, and is not related to the ability of the data to support the ABR or ATO’s core operational requirements. Legislative 16 / 17 BIS central bankers' speeches requirements to ensure privacy and secrecy of this data have been followed. Only people authorised under the Australian Bureau of Statistics Act 1975 have been allowed to view data about any particular firm in conducting these analyses. In accordance with the Census and Statistics Act 1905, results have been confidentialised to ensure that they are not likely to enable identification of a particular person or organisation. 10 These shares have been relatively stable over the past decade. These data refer to businesses that employ fewer than 20 people and are sourced from Australian Industry, 2015–16, ABS Cat no. 8155. 11 Note that Graph 10 is based on default probabilities, not expected or actual losses, which will also depend on losses given default. Those, in turn, will depend (among other things) on collateral held against the loans, which in the case of many small business loans is housing. 12 These included, for example, Bankwest, St. George Bank and GE Capital. 13 Productivity Commission (2017), ‘Data Availability and Use: Overview & Recommendations’, Productivity Commission Inquiry Report No 82, Canberra. 14 A survey by the Federal Reserve Bank of New York found that small businesses were noticeably less satisfied with online lenders than with traditional lenders, with more complaints about the interest rates charged and the repayment terms imposed by online lenders. Federal Reserve (2016), ‘Small Business Credit Survey’, Report on Employer Firms’, April, available at . 15 Some crowdfunding platforms also allow businesses to raise funds through presales of a new product. These platforms offer some advantages to small business, since they receive direct funding from customers, require no collateral, and can provide a gauge of market interest. However, success on these markets is unpredictable, and the sites are geared towards consumer-oriented products. 17 / 17 BIS central bankers' speeches | reserve bank of australia | 2,018 | 1 |
Dinner remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the A50 Australian Economic Forum, Sydney, 8 February 2018. | Philip Lowe: Dinner remarks to A50 Australian Economic Forum Dinner remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the A50 Australian Economic Forum, Sydney, 8 February 2018. * * * I would like to thank Michael Plumb for assistance in the preparation of these remarks. Thank you for the invitation to speak at the A50 Dinner. I would like to offer a particularly warm welcome to those of you who are visiting Australia. The A50 Forum provides a unique opportunity to hear directly from leaders in the worlds of business, politics and Australia’s policy institutions. You will find us open and transparent, not only in our assessments of the opportunities that Australia faces, but also the challenges confronting us. One of the facts that visitors to Australia most frequently remark upon is that Australia has experienced 26 years of economic growth. Over those 26 years we have certainly experienced some slowdowns and periods of rising unemployment, but this long record of economic expansion and stability is not matched elsewhere among the advanced economies. Importantly, it has been accompanied by a long period of stability in our financial system. These are significant achievements. This is especially so in light of the very large structural changes that have occurred in the global economy since the early 1990s, and the instability we have witnessed elsewhere. A country doesn’t experience these types of outcomes without some good fortune and, importantly, without sensible policy and strong institutions. In Australia, we have had all three. Partly through sensible and pragmatic policy, the Australian economy has developed the flexibility to adjust to a changing world. An important element of this flexibility is our floating exchange rate. Another is our labour market, which has developed the flexibility to adjust to changes in the economic landscape. A third element is the fact that both monetary and fiscal policy have maintained their ability to adapt to changing circumstances. All these things have helped us adjust to some very large shifts in the economy. Australia has also benefited from our openness to the world. We are an outward-looking country. Over many decades, our prosperity has been built on our ability to trade in open and competitive markets, to attract investment and ideas from abroad, and to attract talented people to Australia. We have benefited tremendously from an open, inclusive and rules-based international system. We have as much at stake as any other country in the continuation of this system. Our location on the globe and our mineral and energy resources have both given us a deal of good fortune. In earlier generations, our location was seen as a liability – we were simply too far from the major engines of global growth. Today, though, our location is seen as an asset. We live in the most dynamic region of the global economy and we have capitalised on this with strong trade and personal links with Asia. Over recent times, we have benefited significantly from these links. The most obvious example is the very strong growth in exports of our resources. But increasingly, it is also being seen in the growth of exports of high-quality services, food and manufactured goods to Asia. Naturally enough, after 26 years of economic expansion people wonder what the future holds. This is an issue that often comes up in discussions with overseas investors. So I would like to use the opportunity of this dinner to address three related questions that we are frequently asked. These questions are: 1/5 BIS central bankers' speeches What are the next few years likely to hold for the Australian economy? What are the challenges facing the Australian economy? As other central banks reduce monetary accommodation won’t the RBA have to, too? The next few years For a while now we have been expecting the Australian economy to grow more strongly in 2018 and 2019 than it did, on average, over recent years. There are a number of reasons for this. We are all but through the decline in mining investment to more normal levels, there is a large pipeline of urban infrastructure work to be done, the global economy is experiencing a solid upswing, commodity prices are up and financial conditions remain accommodative. All this is helping. The RBA will be releasing our latest economic forecasts tomorrow in the Statement on Monetary Policy. These forecasts will be largely unchanged from the previous set of forecasts. The RBA’s central scenario remains for the Australian economy to grow at an average rate of a bit above 3 per cent over the next couple of years. This outlook has not been affected by the volatility in the stock market over recent days. Indeed, it is worth keeping in mind that the catalyst for this volatility was a reassessment in financial markets of the implications of strong growth for inflation in the United States. For some time, many investors had been working under the assumptions that unusually low inflation and unusually low volatility in asset prices would persist, even with above-trend growth at a time of low unemployment. A reassessment of these assumptions now appears to be taking place against the backdrop of strong economic conditions globally. Looking beyond these financial events, the data we have received on the real economy over the summer have been consistent with our assessment that GDP growth will pick up over 2018. Taken together, the recent domestic and global data on the real economy suggest that 2018 has started on a more positive note than did recent years. Particularly noteworthy has been the labour market, with employment increasing by 3¼ per cent over the past year. This strong performance has been accompanied by a large number of people joining the workforce, so that the participation rate has returned to around the level reached at the peak of the mining investment boom. There have been noticeable increases in the participation rates of both women and older Australians. At the same time, the unemployment rate has declined to around 5½ per cent and a further gradual decline is expected over the next couple of years. Business conditions are around their highest level since before the global financial crisis and there has also been an improvement in business confidence. Non-mining business investment has been stronger than we had expected a year ago and the investment outlook has brightened. One ongoing area of uncertainty, though, is consumer spending. Household incomes are growing slowly and debt levels are high. I will return to these issues in a moment. On the prices front, we continue to experience subdued outcomes, although inflation is higher than it was a year ago. Over 2017, inflation was a bit under 2 per cent, in both headline and underlying terms. Last week’s data provided further confirmation of trends we have been witnessing for some time. Increased competition in retailing is contributing to price declines for many consumer durables. And subdued wage increases are contributing to low rates of inflation for a range of market services. The rate of rent inflation also remains low. The immediate outlook is for a continuation of these broad trends, but for inflation to pick up gradually as the economy and labour market strengthen. We are expecting CPI inflation to be in the 2 to 2½ per cent range over the next couple of years. Underlying inflation, which is less affected by the scheduled increases in tobacco excise, is expected to be a bit lower than CPI inflation. 2/5 BIS central bankers' speeches I would now like to touch on a couple of issues that we are paying close attention to and that could have a significant bearing on the outlook for growth and inflation over the next couple of years. The first of these is wage growth. Not only are most workers experiencing low wage increases, but following the resources boom some people have moved out of highly paid jobs. The result is that after many years of Australians experiencing strong growth in real incomes, growth in average nominal and real incomes has been much slower over recent times. The effects of low real wage growth on the economy work in different directions. On the one hand, the restrained growth in labour costs is one of the factors that has boosted employment. But, on the other hand, the slow growth in incomes has weighed on spending, including by making it harder for some households to pay down their debts. On balance, though, in the current environment, some pick-up in wage growth would be a welcome development. Ideally, this would be on the back of stronger productivity growth. But even if productivity growth were to be around the average of recent years, a faster rate of wage increase should be possible. Indeed, a lift in wage growth is likely to be necessary for inflation to average around the midpoint of the 2–3 per cent medium-term inflation target. Stronger growth in real wages would also boost household incomes and create a stronger sense of shared prosperity. Our central scenario is for this pick-up in wage growth to occur as the economy strengthens, but to do so only gradually. Through our liaison with business we hear some reports of wage pressures emerging in pockets where labour markets are tight. We expect that over time we will hear more such reports. After all, the laws of supply and demand still work. I have spoken previously about the factors affecting wages, and they have a global dimension. Globalisation and advances in technology have increased competition, and greater competition means less pricing power. Given the strength and pervasiveness of these forces, it is unlikely that they are going to disappear quickly, so the pick-up in wage growth is likely to be fairly gradual. A second factor shaping the outlook is the level of household debt. Indeed, the high level of household debt in Australia is remarked upon by international investors almost as often as the fact of 26 years of growth. A while back we had become quite concerned about some of the trends in household borrowing, including very fast growth in lending to investors and the high share of loans being made that did not require regular repayment of principal. Our concern was not that developments in household balance sheets posed a risk to the stability of the banking system. Rather, it was more that they posed a broader macro stability risk – that is, the day might come, when faced with bad economic news, households feel they have borrowed too much and respond by cutting their spending sharply, damaging the overall economy. We have worked closely with APRA, including through the Council of Financial Regulators, to address these issues. This work, together with other steps taken by APRA, has helped improve the quality of lending in Australia. In the housing market, there has also been a change. National measures of housing prices are up by only around 3 per cent over the past year, a marked change from the situation a couple of years ago. This change is most pronounced in Sydney, where prices are no longer rising and conditions have also cooled in Melbourne. These changes in the housing market have reduced the incentive to borrow at low interest rates to invest in an asset whose price is increasing quickly. 3/5 BIS central bankers' speeches On balance then, from a macro stability perspective, the situation looks less risky than it was a while ago. We do, however, continue to watch household balance sheets carefully as there are still risks here. Challenges I would now like to move to the second question that I get asked frequently. Beyond the short term, what are the challenges facing the Australian economy? When I spoke at this forum last year I talked about four challenges: the need to reinvigorate productivity growth finding ways of capitalising on the opportunities in Asia providing the infrastructure needed for a growing population and to support productivity making sure that our public finances were on the right track and that our tax system was internationally competitive. This is by no means a complete list; at a minimum, you could add some of the issues I have just spoken about. But it remains a reasonable list and I thought it useful to offer an update. Improving our productivity remains the key to further improvement in our living standards. Average growth in labour productivity has been a bit higher since the peak in the mining boom than it was in the preceding five years, although capital deepening has been an important part of the story here. Late last year the Productivity Commission provided some guidance about how we might lift our performance with the release of the first of its five-yearly reports – the Shifting the Dial report. This is another example of Australian policy institutions tackling important issues through serious and systematic reviews. A central theme of the report is the importance of services and cities. Most Australians now work in the service sector and live in cities, so how we deliver services and how our cities function have a major influence on our future living standards. This is yet another area where we will benefit from a strong innovation mindset. On building our links with Asia, we continue to see progress. New trade agreements are opening up new opportunities for Australian business in the region and the share of Australia’s exports going to Asia continues to rise. Last year, the value of Australia’s merchandise exports increased by more than 15 per cent to each of China, Japan, Korea, Taiwan, Indonesia and the Philippines. Exports of resources have been an important part of the story, but it is broader than that, with strong growth in exports of services too. Person to person links also continue to deepen, with half of all international visitors to Australia last year coming from Asia. On infrastructure, the story is also a positive one. Increased public investment in infrastructure in our largest states is currently providing a boost to the economy and it is also building productive capacity for the future. With our population continuing to grow at a relatively fast rate for an advanced economy – around 1½ per cent a year – this is an area for us to continue to focus on. As we do this, we need to pay close attention to the governance of decisions around project selection, the control of construction costs, usage pricing and the allocation of risk between the public and private sectors. Good governance is important in these areas to support sound decision-making and to retain public trust and confidence in governments’ spending plans. Finally, on the fiscal side, the latest estimates are that things are on track to meet the Australian Government’s projection of returning the budget to balance by 2020/21. Australia’s record of careful management of public finances meant that when the financial crisis hit a decade ago, fiscal policy was able to play a role stabilising the economy. Ensuring that our public finances are on a sustainable footing is important to ensuring that we have similar flexibility in the future. The issue of how the tax system affects the competitiveness of Australia as a destination for investment is one of ongoing political debate. There have been some cuts in company tax and 4/5 BIS central bankers' speeches parliament is considering further changes. Reduction of monetary stimulus globally I would now like to turn to the final question that I often get asked: as other central banks raise interest rates, won’t the RBA have to, too? It is understandable that this question is asked. Over time, there is a common element to movements in interest rates around the world. The level of interest rates in all countries is influenced by movements in the neutral global real interest rate. During the financial crisis, the neutral global rate fell and this has had an important influence on the setting of interest rates in all countries, including here in Australia. If we had not lowered our interest rates as global rates fell, the Australian economy would have grown by less and inflation would have been even lower than it turned out to be. The fact that there is a common element in interest rates, however, does not mean that interest rates need to move in lock-step with one another. Countries with a floating exchange rate, like Australia, still retain considerable flexibility to set interest rates based on their domestic considerations. We did not lower our interest rates to the extraordinarily low levels seen elsewhere after the financial crisis. Our circumstances were different: we didn’t have a meltdown in the financial system and we experienced a very large cycle in commodity prices and mining investment. Just as we did not move in lock-step on the way down, we don’t need to do so in the other direction. It’s understandable that some other central banks are raising rates. They lowered their rates by more than us and, in a number of countries, the unemployment rate is now below conventional estimates of full employment at a time when above-trend growth is expected. Our circumstances are a little different. We are still some way from what could be considered full employment and our central scenario for inflation is for it to remain below the midpoint of the medium-term target range for the next couple of years. We expect, though, to make further progress in reducing unemployment and having inflation return to the midpoint of the target range. If we do make that progress, at some point it will be appropriate for interest rates in Australia to also start moving up. So, given recent developments in Australia and overseas, it is likely that the next move in interest rates in Australia will be up, not down. If this is how things play out, the likely timing will depend upon the extent and pace of the progress that we make. As I have discussed, while we do expect steady progress, that progress is likely to be only gradual. Given this, the Reserve Bank Board does not see a strong case for a near-term adjustment in monetary policy. It will of course keep that judgement under review at future meetings. I hope that these remarks this evening have helped you understand the Australian economy, our opportunities and some of the challenges we face. I look forward to answering your questions. 5/5 BIS central bankers' speeches | reserve bank of australia | 2,018 | 2 |
Address by Ms Michele Bullock, Assistant Governor (Financial System) of the Reserve Bank of Australia, to the Responsible Lending and Borrowing Summit, Sydney, 20 February 2018. | 21/02/2018 Household Indebtedness and Mortgage Stress | Speeches | RBA Speech Household Indebtedness and Mortgage Stress Michele Bullock [ * ] Assistant Governor (Financial System) Address to the Responsible Lending and Borrowing Summit Sydney – 20 February 2018 Thank you for the opportunity to be here today. The title of the summit, ‘Responsible Lending and Borrowing – Risk, Responsibility and Reputation’, really struck a chord with me because there has been much discussion over the past few years about housing prices and the increasing debt being taken on by the household sector. The Reserve Bank's interest in this area springs from both its responsibility for monetary policy and its mandate for financial stability. From the perspective of monetary policy, high debt levels will influence the calibration of interest rate changes. The more debt households have, the more sensitive their cash flow, and hence consumption, is likely to be to a rise in interest rates. Households with higher debt levels may also sharply curtail their consumption in response to an adverse shock such as rising unemployment or large falls in house prices, amplifying any economic downturn. My focus today, however, is on the potential risks to financial stability from this build up in debt. One of the key issues we have been focusing on is the extent to which rising household debt might presage stress in household budgets, with flow on effects to financial stability and ultimately to the economy. There has been a lot said and written about this issue in recent times, using a multitude of data sources and anecdotes. What I hope to do today is to put this information into some context to provide a balanced view on the current and prospective levels of household financial stress, and hence the implications for financial stability. I want to make a couple of points at the outset. The first is that there are clearly households in Australia at the moment that are experiencing financial stress. By focusing on whether financial stress has implications for financial stability, I am not in any way playing down the difficulties some households are experiencing. There is a very real human cost of financial stress. Second, some of the most financially stressed households are those with lower incomes which typically rent rather than borrow to buy a home. Access to suitable affordable housing for this group is clearly an important social issue. But given the topic of this summit and the potential link to http://www.rba.gov.au/speeches/2018/sp-ag-2018-02-20.html 1/14 21/02/2018 Household Indebtedness and Mortgage Stress | Speeches | RBA financial stability, I am going to focus in this talk on household mortgage debt and the potential for financial stress resulting from this. What is Financial Stress? Definitions of financial stress are many and varied. One definition could be where a household fails to pay its bills or scheduled debt repayments on time because of a shortage of money. This is quite narrow – it captures only those households for which stress has already manifested in missed payments. A much broader definition of financial stress might be a situation where financial pressures are causing an individual to worry about their finances, or where an individual cannot afford ‘necessities’. These definitions might be good leading indicators of failures to meet debt repayments or defaults. So there is a role for a variety of indicators of stress. One way of thinking about financial stress is in terms of a spectrum or a pyramid, running from mild stress to severe stress (Graph 1). At the mild end, the base of the pyramid, people may perceive that they are financially stressed when they have to cut back on some discretionary expenditure, such as a holiday or a regular meal out. Slightly further up the pyramid, they may not be able to pay bills on time, or might have to seek emergency funding from family. At the top of the pyramid – severe financial stress – a household might be unable to meet mortgage repayments or ultimately be facing foreclosure or bankruptcy. Graph 1 http://www.rba.gov.au/speeches/2018/sp-ag-2018-02-20.html 2/14 21/02/2018 Household Indebtedness and Mortgage Stress | Speeches | RBA The pyramid is wider at the bottom than the top reflecting the fact that there will always be more households in milder stress than in severe stress. For some households experiencing milder stress their circumstances might deteriorate and they will move to a more severe form of financial stress. But some others might continue to restrain spending on discretionary items so as to meet essential payments. Others might experience a change in circumstances that improves their financial position. Triggers and Protections from Financial Stress Most people don't consciously set out to put themselves in a position of financial stress. Sometimes people might choose to stretch themselves initially in taking out a loan, perhaps even putting themselves into mild, temporary financial stress. But they would typically be doing so on the expectation that it will become more manageable over time as their income rises. More serious financial stress often only comes about by a combination of what turns out to be excessive debt and changed circumstances. A level of mortgage debt that looked manageable when it was taken out might become unmanageable if, for example, the primary income earner of a household becomes unemployed. Or if life circumstances change, such as through ill health, the birth of a child or breakdown of a relationship. So what do conditions in the housing sector over the past few years suggest about the potential for financial stress? You are all familiar with the broad story. House prices have been rising rapidly, particularly in Sydney and Melbourne. At the same time, household mortgage debt has been rising while incomes have been growing relatively slowly. As a result, the average household mortgage debt-to-income ratio has risen from around 120 per cent in 2012 to around 140 per cent at the end of 2017 (Graph 2, left panel). Furthermore, the increasing popularity of interest-only loans over recent years meant that by early 2017, 40 per cent of the debt did not require principal repayments (Graph 3). A particularly large share of property investors has chosen interest-only loans because of the tax incentives, although some owner-occupiers have also not been paying down principal. This presents a potential source of financial stress if a household's circumstances were to take a negative turn. http://www.rba.gov.au/speeches/2018/sp-ag-2018-02-20.html 3/14 21/02/2018 Household Indebtedness and Mortgage Stress | Speeches | RBA Graph 2 http://www.rba.gov.au/speeches/2018/sp-ag-2018-02-20.html 4/14 21/02/2018 Household Indebtedness and Mortgage Stress | Speeches | RBA Graph 3 This is where lending standards come in. There is always a balance to be struck with lending standards. If they are too tight, access to credit will be unreasonably constrained, potentially impacting economic activity and restricting some households from making large purchases that they can afford. If they are too loose, however, borrowers and lenders could find risks building on their balance sheets which, if large enough, might have implications for financial stability. Over the past few years in Australia, regulators have been concerned that lending standards have erred on the more relaxed side. An exuberant housing market in some parts of the country and strong competition among lenders raised the question of whether financial institutions had been appropriately prudent in assessing a household's ability to meet repayments. In response, a number of measures were implemented by APRA and ASIC to strengthen mortgage lending standards. These measures have helped improve the quality of lending over the past couple of years. But there is still a large stock of housing debt out there, some of which probably would not meet the more conservative lending standards currently being imposed. How large a risk does this pose to financial stability? It depends on a number of things, including how lax the previous lending standards were, how much of the stock was lent under less prudent standards and the repayment patterns of borrowers. One way of assessing the risk though is to look at the level and trajectory of mortgage stress. http://www.rba.gov.au/speeches/2018/sp-ag-2018-02-20.html 5/14 21/02/2018 Household Indebtedness and Mortgage Stress | Speeches | RBA Measures of Financial Stress There is no single measure that captures the level of financial stress. There are comprehensive surveys, such as the survey of Household, Income and Labour Dynamics in Australia (HILDA) and the Survey of Income and Housing (SIH), that are methodologically robust, but are only available with a lag. A number of private sector surveys are more timely but it can be harder to assess whether their methodologies are well focused on financial stress. There is also information on nonperforming loans, insolvencies and property repossessions that is fairly timely and reliable, but is only an indicator of pretty severe stress. I am going to talk through a few measures and see what they imply about the current level of mortgage stress among Australian households. Let's start with some high-level data on debt and debt servicing. As I noted above, the average household mortgage debt-to-income ratio has been rising over recent years. In a sense, this is not really surprising. With historically low interest rates, households have been able to service higher levels of debt. Indeed, the debt-servicing ratio (defined as the scheduled principal and interest mortgage repayments to income ratio) has remained fairly steady at around 10 per cent despite the rise in debt (Graph 2, right panel). But these are averages. It is important to look at the distribution of this debt – are the people holding it likely to be able to service it? Graph 4 The HILDA survey provides information on the distribution of household indebtedness and debt servicing as a share of disposable income. Looking only at owner-occupier households that have mortgage debt, the survey suggests that the median housing debt-to-income ratio has risen steadily http://www.rba.gov.au/speeches/2018/sp-ag-2018-02-20.html 6/14 21/02/2018 Household Indebtedness and Mortgage Stress | Speeches | RBA over the past decade to around 250 per cent in 2016 (Graph 4, left panel). [1] However, the median ratio of mortgage servicing payments to income has been fairly stable through time, remaining around 20 per cent in 2016 (Graph 4, right panel). In fact 75 per cent of households with owneroccupier debt had mortgage payments of 30 per cent or less of income, which is often used as a rough indicator of the limit for a sustainable level of mortgage repayments. [2] This suggests that, as recently as 2016, mortgage repayments were not at levels that would indicate an unusual or high level of financial stress for most owner-occupiers. But there is a significant minority for whom mortgage stress might be an issue. Other data sources suggest that the number of households experiencing mortgage stress has fallen over the past decade. The Census data show that the share of indebted owner-occupier households for which actual mortgage payments (that is, required and voluntary payments) were at or above 30 per cent of their gross income declined from 28 per cent in 2011 to around 20 per cent in 2016. And the 2015/16 Household Expenditure Survey indicates that the number of households experiencing financial stress has steadily fallen since the mid 2000s. Furthermore, a large proportion of indebted owner-occupier households are ahead on their mortgage repayments. We have highlighted this point in recent Financial Stability Reviews. Total household mortgage buffers – including balances in offset accounts and redraw facilities – have been rising over the past few years as households have taken advantage of falling interest rates to pay down debt faster than required. In 2017, total owner-occupier buffers were around 19 per cent of outstanding loan balances or around 2 ½ years of scheduled repayments at current interest rates (Graph 5, left panel)). There is some variation in buffers. While one-third of outstanding owner-occupier mortgages had at least two years' buffer, around one-quarter had less than one month (Graph 5, right panel). Not all of these loans, however, are necessarily vulnerable to financial stress. If households are building up other assets instead of building up mortgage buffers, they may still be well positioned to weather any change in circumstances. http://www.rba.gov.au/speeches/2018/sp-ag-2018-02-20.html 7/14 21/02/2018 Household Indebtedness and Mortgage Stress | Speeches | RBA Graph 5 All of this suggests that a large proportion of households have some protection against financial stress. There are, however, some households that are more vulnerable, probably those with lower income who cannot afford prepayments or those with relatively new mortgages who have yet to make many inroads. Another way of measuring financial stress is by asking survey respondents to self-assess. For example, a survey might ask about the respondent's ability to meet payments, the type of financial stress they have experienced, or whether they have had difficulty raising money in an emergency. The HILDA survey also provides some information on this. In general, measures such as these indicate that financial stress for owner-occupiers with mortgage debt has not changed much over the past decade, and is actually lower than in the early 2000s. Around 12 per cent of such households indicated that they would expect difficulty raising funds in an emergency in 2016 (Graph 6). The survey also asks people what sort of financial difficulties they had experienced over the past twelve months. For example, did they have difficulty paying a mortgage or bills on time? Were they unable to heat their home or did they have to go without meals? Did they have to ask for financial assistance from family or a welfare agency? A bit less than 20 percent of owner-occupier households said they had experienced at least one difficulty in the past 12 months, but only 5 per cent reported experiencing three or more of these difficulties. Most of these indicators also suggest that, in line http://www.rba.gov.au/speeches/2018/sp-ag-2018-02-20.html 8/14 21/02/2018 Household Indebtedness and Mortgage Stress | Speeches | RBA with some of the earlier data I noted, stress has declined since 2011, which probably largely reflects the fall in interest rates since that time. Graph 6 Unfortunately, while the HILDA and SIH data are rich in terms of the information provided, they are not very timely. We have, for example, only just received the 2016 data. So much of the discussion on household stress relies on more timely private surveys. These surveys measure stress in different ways. Some focus specifically on mortgage stress. Others look at housing affordability, including for renters. And still others attempt to measure financial ‘comfort’ more broadly than just housing. Many of these suggest that housing stress has been increasing over the past year or so. Looking at the history for which we have data for both the private and comprehensive surveys, it is a little difficult to reconcile their findings. But there do seem to be some methodological differences that mean some surveys might overstate financial stress somewhat. For example, in some of these surveys, self-assessed living expenses are used. If households include discretionary expenditure that could be cut back in an emergency, the amount of income available to meet scheduled repayments might be understated. Furthermore, if actual mortgage repayments are used, those households that are routinely ahead of their payments schedule might be assessed as having little spare income for emergencies when in reality they have been building up buffers and have surplus cash flow. Most of the measures I have discussed so far are more in the nature of potential financial stress. For some households this will likely turn out to be temporary until their circumstances change. But others http://www.rba.gov.au/speeches/2018/sp-ag-2018-02-20.html 9/14 21/02/2018 Household Indebtedness and Mortgage Stress | Speeches | RBA may find themselves in a prolonged period of belt tightening or, in the extreme, having to sell their property or default on their payments. In this latter case, financial stress will show up in nonperforming loans on banks' balance sheets and perhaps even in property repossessions or bankruptcies. What do these data tell us? Banks' non-performing housing loans have been trending upwards over the past few years, although they remain very low in absolute terms at around 0.8 per cent of banks' domestic housing loan books (Graph 7). Much of this rise is attributable to a rise in non-performing loans in the mining-exposed states of Western Australia and Queensland – not unexpected given the large falls in employment and housing prices in some of these regions. Graph 7 Personal insolvencies as a share of the population have remained fairly stable over the past few years. Applications for property possession as a share of the total dwelling stock have generally declined since 2010, with the exception being Western Australia (Graph 8). This indicates that financial stress has a high cyclical component, and there are likely to be some regions of the country that are in more difficult times than others. But the focus for financial stability considerations is largely a national rather than a regional perspective. http://www.rba.gov.au/speeches/2018/sp-ag-2018-02-20.html 10/14 21/02/2018 Household Indebtedness and Mortgage Stress | Speeches | RBA Graph 8 So my overall interpretation of these myriad pieces of information is that, while debt levels are relatively high, and there are owner-occupier households that are experiencing some financial stress, this group is not currently growing rapidly. This suggests that the risks to financial institutions and financial stability more broadly from household mortgage stress are not particularly acute at the moment. Housing Investors Most of my focus so far has been on owner-occupiers who account for around two-thirds of housing debt outstanding. But investment in housing has been growing strongly in recent years. So it is worth briefly considering the risk of financial stress emanating from this group of borrowers. The risks to financial stability associated with investor mortgage debt are probably a bit different from those associated with owner-occupier debt. Investors tend to have larger deposits, and hence lower starting loan-to-valuation-ratios (LVRs) (Graph 9). They often have other assets, such as an owner-occupied home, and also earn rental income. Higher-income taxpayers are more likely to own investment properties than those on lower incomes, so may be better able to absorb income or interest rate shocks. http://www.rba.gov.au/speeches/2018/sp-ag-2018-02-20.html 11/14 21/02/2018 Household Indebtedness and Mortgage Stress | Speeches | RBA Graph 9 But investors have less incentive than owner-occupiers to pay down their debt. As noted above, many take out interest-only loans so that their debt does not decline over time. If housing prices were to fall substantially, therefore, such borrowers might find themselves in a position of negative equity more quickly than borrowers with an equivalent starting LVR that had paid down some principal. Indeed, the macro-financial risks are potentially heightened with investor lending. For example, since it is not their home, investors might be more inclined to sell investment properties in an environment of falling house prices in order to minimise capital losses. This might exacerbate the fall in prices, impacting the housing wealth of all home owners. As investors purchase more new dwellings than owner-occupiers, they might also exacerbate the housing construction cycle, making it prone to periods of oversupply and having a knock on effect to developers. Data from the Australian Taxation Office (ATO) provide some information on housing investors. While not particularly timely, these data show that the share of taxpayers who are property investors has increased steadily over the past few years. In 2014/15, around 11 per cent of the adult population, or just over 2 million people, had at least one investment property and around 80 per cent of those were geared (Graph 10). Most of those investors own just one investment property but an increasing number own multiple properties. There has also been a marked increase in the share of geared housing investors who are over 60. These factors do not necessarily increase the risk of financial stress but they bear watching. http://www.rba.gov.au/speeches/2018/sp-ag-2018-02-20.html 12/14 21/02/2018 Household Indebtedness and Mortgage Stress | Speeches | RBA Graph 10 The recent increases in interest rates on investor loans, in response to APRA's measures to reduce the growth in investor lending, has probably affected the cash flows of investors. Interest rates on outstanding variable-rate interest-only loans to investors have increased by 60 basis points since late 2016. However, over the past few years, lenders have been assessing borrowers' ability to service the loan at a minimum interest rate of at least 7 per cent. So while interest rates and required repayments have likely risen, many borrowers should be relatively resilient to the recent changes. Furthermore, a large proportion of interest-only loans are due to expire between 2018 and 2022. Some borrowers in this situation will simply move to principal and interest repayments as originally contracted. Others may choose to extend the interest-free period, provided that they meet the current lending standards. There may, however, be some borrowers that do not meet current lending standards for extending their interest-only repayments but would find the step-up to principal and interest repayments difficult to manage. This third group might find themselves in some financial stress. While we think this is a relatively small proportion of borrowers, it will be an area to watch. Conclusion The historically high levels of mortgage debt in Australia raises questions about the resilience of household balance sheets to a change in circumstances and the ability of the financial system to absorb a widespread increase in household financial stress. The information we have suggests that, while there are some pockets of financial stress, the overall level of stress among mortgaged http://www.rba.gov.au/speeches/2018/sp-ag-2018-02-20.html 13/14 21/02/2018 Household Indebtedness and Mortgage Stress | Speeches | RBA households remains relatively low. Furthermore, the banking system is strong and well capitalised, and is supported by prudent lending standards. The risks to financial stability from this source therefore remain low although we will need to keep an eye on developments. Appropriately prudent lending standards will continue to play an important role in ensuring that the financial system remains stable and households borrow responsibly. Endnotes [*] I am grateful to Bernadette Donovan, Jonathan Kearns, David Orsmond, Grace Taylor and Michelle Wright for assistance. These ratios differ to those shown on the earlier graph, Household Mortgage Debt Indicators, because of different coverage. The Household Mortgage Debt Indicators graph shows aggregate mortgage debt over aggregate household income (all households, including those without debt). The numbers in the text only cover households with owner-occupier mortgage debt and compares this debt to their income. There are shortcomings with using this indicator because it assumes living expenses are identical across households and are a constant proportion of income. However, living expenses typically rise as income rises. But high income households can often devote a larger share of their income to meeting debt repayments while meeting living expenses. This speech uses unit record data from the Household, Income and Labour Dynamics in Australia (HILDA) Survey. For more information, see HILDA Survey Disclaimer Notice. © Reserve Bank of Australia, 2001–2018. All rights reserved. http://www.rba.gov.au/speeches/2018/sp-ag-2018-02-20.html 14/14 | reserve bank of australia | 2,018 | 2 |
Speech by Ms Luci Ellis, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Australian Business Economists (ABE) Conference, Sydney, 13 February 2018. | Speech Three Questions About the Outlook Luci Ellis Assistant Governor (Economic) Address to the ABE Conference Sydney – 13 February 2018 I'd like to thank the Australian Business Economists for once again giving me the opportunity to speak to you this morning. Last Friday we released our regular . There is a lot in there, not all of which I can cover today. Instead I'd like to take the opportunity to talk a bit more about some selected themes in that document. In particular, I'd like to talk about some of the questions we grapple with as we consider the outlook for the domestic economy. Statement on Monetary Policy Before I do, let me briefly summarise our current thinking on the global and domestic economies. The global economy has been picking up since mid 2016, and seems to have improved further over the course of 2017. As we came into the new year, we and other forecasters continued to upgrade our views of the outlook for the global economy. In Australia, our forecasts for growth are essentially unchanged from the ones we published in November. We still expect growth to pick up to around 3¼ per cent over 2018 and 2019. While our forecasts for wage growth and inflation are also unchanged, there are some positive signs that make us a bit more confident that the expected pick-up in wage growth and inflation will eventuate. Business conditions are looking more positive, employment growth has been rapid, and short-term indicators of future hiring have picked up further. We are still a bit further behind some other advanced economies in working down the spare capacity in the economy, so it might take a bit longer for the turnaround in inflation to happen here than elsewhere. But there has been progress on this front, and we expect more progress will be made over the next few years. The current expansionary stance of monetary policy has been helpful in that regard. This progress is, however, expected to be quite gradual. In considering this more positive outlook, forecasters nonetheless must grapple with a range of uncertainties. We talk about these in the , as part of the Outlook chapter. I'd like to focus on three of these uncertainties today, which we can frame as three questions. Statement How much spare capacity is there? How much (and how quickly) will wage growth and inflation pick up as spare capacity declines? How resilient will consumption growth be if income growth stays weak? How Much Spare Capacity Is There? As I already noted, global economic conditions strengthened further over the course of 2017. The three major advanced economies are all growing above the rate of growth of productive capacity, also known as the potential growth rate. This is clear from the large and ongoing declines in the unemployment rate. The question is how much spare capacity remains in these economies. So far, inflation hasn't picked up much, and neither has wage growth. This might normally suggest that there is still some spare capacity. As this graph shows, estimates of the ‘full employment’ rate of unemployment – the rate of unemployment below which wage growth starts to pick up – in fact suggest that the United States and Japan are already at that point, if not below it. So are some of the individual countries within the euro area (Graph 1). This full employment rate of unemployment, or non-accelerating-inflation rate of unemployment (NAIRU), is inherently unobservable, so it has to be estimated. It can be estimated a number of ways, and there is a deal of uncertainty around those estimates. Often, they come from statistical models which treat every undershoot in the inflation (or wage growth) outcome as a sign that the NAIRU is actually lower than you previously thought. Graph 1 It's therefore useful to think about the economics, and the behaviour, underlying the existence of a NAIRU. It implies that there will still be some people unemployed at the point that firms have to start bidding up wage offers in order to find suitable staff. This is not so surprising when you consider that the labour market isn't homogeneous. There are so many different occupations and types of firms, and these aren't evenly distributed across the economy. So we shouldn't expect labour shortages to appear everywhere at the same time. What happens instead is that they turn up in a few pockets of the labour market, then a few more, and gradually become more widespread as conditions tighten. How quickly this happens depends partly on where the strong demand for labour is concentrated, and how much of the labour force has the applicable skills to perform those roles. So you'd expect wage growth to pick up more – and the NAIRU to seem higher – if the labour market is highly segmented and workers can't easily shift to the areas of strong demand. More flexible labour markets will, all else being equal, have lower NAIRUs. Some of the unemployment underlying the NAIRU simply reflects people who are between jobs, but will find one soon. (This is sometimes called ‘frictional’ unemployment.) How quickly people find a job in a tight labour market is partly a technological question. They need to find what vacancies are out there, work out if the job (and the firm) is a good match for their skills and interests, and then go through a selection process. How long these activities take will help determine how many people are between jobs even in a tight market. The overall rate of job turnover will also matter, because that helps determine the flow of people into job search. All of those things can change, for example because technological change makes job search or selection processes more efficient, or because transaction costs make it more expensive to move for a job. So we shouldn't expect the NAIRU to stay at the same level forever. Rather it can shift gradually in response to structural changes in the labour market and the hiring process, among other things. But because it can't be directly observed, we can only know this from the actual behaviour of wages. Another aspect of spare capacity that isn't always fully appreciated is the scope for extra workers to come directly from outside the labour force, or from incumbent workers working more hours, rather than from the ranks of the currently unemployed. The more that extra labour demand is met from new entrants or longer hours, the slower the unemployment rate declines. So we can think of broader notions of spare capacity than the NAIRU. These would explain why the economy might grow at seemingly above-potential rates for longer without hitting capacity constraints. This has been a factor here in Australia, where labour force participation has increased sharply over the past year, especially for women (Graph 2). It is now very close to the historical peak it reached in 2010, during the mining investment boom. Meanwhile the unemployment rate has drifted down, but not as quickly as in some other countries. The increase in participation has been especially marked in Australia but has not been unique to us. In a number of other industrialised economies, ageing of the population might have been expected to lead to the participation rate trending down. But instead it has been flat in the euro area and is trending up in Japan, where female participation rates are also increasing noticeably. It has also stabilised recently in the US, after declining a little faster than what would have been suggested by ageing alone. Graph 2 There also seems to be a cyclical phenomenon that can change the point where economies hit capacity constraints. As we saw in that earlier graph, as economies approach the NAIRU, especially if they do so gradually, the estimate of it often seems to decline. This happens on the upside as well – a prolonged period of high unemployment seems to raise estimates of the NAIRU. Some of you will know this path-dependence phenomenon by the unlovely name of ‘hysteresis’. At the current point in the global economic cycle, there is at least some chance that hysteresis will allow some of the economies with tight labour markets to grow a bit faster for a bit longer than might have previously been expected. But eventually, the point where wage growth starts to pick up is reached, and from there, inflation also increases. In Australia, we estimate that there is still some spare capacity in the labour market. Last year we published a central estimate of the NAIRU of around 5 per cent (Cusbert 2017). Since then we have not seen a reason to change that broad assessment. But we are mindful that, as we approach that figure, there's a risk we find there is more room to come down before wage growth picks up in earnest. How Much (and How Quickly) Will Wage Growth and Inflation Pick Up? Whatever judgement one might make about the extent of spare capacity, it is clear that both here and overseas, it is being absorbed. As it reaches the point of being fully absorbed, wage growth and inflation should increase. The question is, how much and how quickly will they pick up? For the technically minded, this is a question about the slope of the Phillips Curve. Here in Australia, wage growth has been quite weak even allowing for (what we estimate to be) the extent of spare capacity. Our forecasts are for wage growth to pick up from here, but not immediately and then only gradually. We are seeing some signs of labour market tightening in the business surveys, which are telling us that suitable labour is becoming increasingly difficult to find. So far, though, the response to that difficulty has not been to pay people more to ensure they stay, or poach them from elsewhere. Instead, we hear that firms are increasingly using other creative ways to attract and keep staff without paying across-the-board wage rises. These include everything from hiring bonuses, to offering extra hours, to increasing perks and workplace conditions. Their reasons for doing so stem from the competitive landscape, or at least how it is perceived. Even when facing strong demand and rising cost pressures, firms seem reluctant to raise their prices. This is a theme from our liaison with the business community. They appear to believe that competition is so intense that they would lose too much business if they did so. So they are especially reluctant to grant wage rises, because this would increase one of their most important costs. We are seeing this particularly in new enterprise agreements, which lately have tended to involve smaller wage increases than the ones they replaced. These agreements usually last for a couple of years, so this will weigh on overall wage outcomes for a while. If wage growth is to pick up, wage increases for other workers – including in future enterprise agreements or in other wage-setting streams – will need to pick up. Because of these factors, there will probably be some lag between the reports of labour shortages and a generalised pick-up in wage growth. We expect, though, that paying more will eventually become part of firms' response. Wage growth, when it comes, will tend to boost labour costs per unit of output. Despite firms' reluctance to raise prices, margins cannot be squeezed forever. Higher costs will therefore boost price inflation over time. A number of important parts of the CPI basket, including many services, have a large labour component to their input costs. These are the areas where wage pressures can be expected to show up most clearly as higher inflation. Working against this effect, though, will be the ongoing effects of heightened competition in retail. Australia has seen a marked increase in the number of major retail players. Foreign retailers have entered the local market in recent years and continue to do so. This has also induced the existing players to reduce their costs to stay competitive, for example by improving inventory management. This has probably been a bit easier for larger or less-diversified retailers than for smaller firms. Perhaps this is one of the reasons why growth in retail sales has been much weaker for smaller firms than larger firms. Whether through lower costs, narrower margins or a combination of both, this competitive dynamic has weighed on prices for consumer durables (Graph 3, top panel). And for staples such as food, competition and related changes in pricing strategy (such as Everyday Low Price strategies) have contributed to keeping prices barely changed in net terms for at least seven years. [2] This is clear from the bottom panel of the graph. Graph 3 Technological change is also often thought to be holding down both wage and price inflation here and overseas. The idea that robots can take your jobs – or overseas websites take your customers – will naturally dampen anyone's enthusiasm for raising their asking prices. But an important step in the march of the robots is often forgotten: technological progress requires business investment. First, as with every wave of technology, someone has to design and make the robots. Next, businesses must invest to implement those new technologies and processes. Jobs will still get created in both stages, but they are different jobs to the ones replaced. The issue is therefore one of distribution: whether particular countries have the skills needed to become part of that next wave of jobs, and how the income from the ensuing increase in labour productivity is shared between labour and the owners of capital. These are important questions for society, but they don't repeal the laws of supply and demand. How Resilient Will Consumption Growth Be If Income Growth Stays Weak? The previous two uncertainties were general to both the global economy, especially the major advanced economies, as well as Australia. We are in a different place in terms of the amount of spare capacity that remains, but the overall drivers and questions might not be that different. One aspect of recent developments where Australia's experience differs, though, relates to household income and consumption. As we discussed in the Statement, consumption growth in the major advanced economies has been quite robust, supported by strong growth in employment. In Australia, we've also had especially strong employment growth over the past year – more than double the rate of growth in the working-age population. But that hasn't translated into strong consumption growth. Household income growth has been weak for a number of years, and that has weighed on consumption growth (Graph 4). Consumption growth hasn't slowed as much as income growth. This is what you'd expect, given that households generally try to smooth their consumption through episodes of income volatility. But there's a real question of how long that could continue if income growth stays weak. This clearly has implications for how we think about the risks to our consumption forecasts. Graph 4 The weakness in incomes goes beyond the downward pressure on wage growth that I've already spoken about. Yes, growth in the wage price index (WPI) has stepped down. But the WPI captures a fixed pool of jobs. It abstracts from compositional change. Average earnings as measured in the national accounts have been even weaker than the WPI (Graph 5). This has not occurred because workers shifted between industries; it is also seen within industries. It might be partly driven by the end of the mining investment boom, as workers moved out of mining-related work, including in the construction and business services industries. But it seems to have been broader than that. Our central forecast is that this weakness will end as the drag from the end of the boom dissipates and spare capacity is absorbed, such that average earnings growth recovers. There is no guarantee of this, though, and therein lies the risk. Graph 5 The living cost pressures that many households feel have therefore been an income story, not a price inflation story. Although utilities prices did increase significantly in some states in recent quarters, much of households' regular spending has seen relatively little in the way of price increases for a number of years. Weak income growth can run below consumption growth for a time, but not forever. If households start to see this weakness in income growth as permanent, they are likely to change their spending patterns in response. We might be seeing this in the details of the consumption figures: growth in spending on discretionary items, like travel and eating out, has slowed while growth in spending on essentials has held up (Graph 6). Graph 6 Continued weak income growth presents a particular risk to the consumption outlook in the context of high household indebtedness. Households do not just wake up one day and collectively decide to pay down their debt. But if incomes turn out weaker than they expect, or some other adverse news should arise, the households carrying the most debt might feel they have to rein in their spending quite a bit. Concluding Remarks The past and present are never completely clear; the future is even less so. The three questions I discussed today are not the only ones relevant to the current outlook. They are central, though, and in many ways they are connected. After a long period of spare capacity and low inflation, the global economy is now in an upswing phase. How that upswing plays out, both here and overseas, is a focus of our work. And as we do that work, we are mindful of the structural and other factors that can make a difference to economic behaviour. Thank you for your time. Bibliography Cusbert T (2017), ‘Estimating the NAIRU and the Unemployment Gap’, RBA Bulletin, June, pp 13–22. Endnotes All else is not equal, of course. Japan is estimated to have a low NAIRU of about 3½ per cent, even though the labour market is quite segregated between full-time, permanent jobs and more casual or part-time jobs. Excluding restaurant meals and take-away food. © Reserve Bank of Australia, 2001–2018. All rights reserved. | reserve bank of australia | 2,018 | 2 |
Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 16 February 2018. | Philip Lowe: Opening statement to the House of Representatives Standing Committee on Economics Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 16 February 2018. * * * Chair Members of the Committee My colleagues and I welcome these opportunities to explain our thinking on the Australian economy and to answer your questions. We view it as an important part of the accountability process for the Reserve Bank. Since we last met in August, the improvement in the global economy has continued and forecasts for world growth have been revised up. Rather than just one or two economies doing better, the improvement has been broadly based, with a synchronised upswing taking place. Partly as a result, both international trade and commodity prices have picked up and this is helping the Australian economy. The stronger economic growth has resulted in unemployment rates falling further. In a number of countries, the unemployment rate is now below conventional estimates of full employment. Inflation has remained low, partly reflecting the fact that wage growth has been quite subdued despite the low unemployment rates. Low inflation has meant low interest rates. And for much of past year, volatility in asset prices was also unusually low. Over recent times, many investors have been proceeding on the basis that this combination of strong growth, low unemployment, low inflation and low interest rates would persist. Many also expected the low volatility in asset prices to continue. A couple of weeks ago we saw a reevaluation of some of these assumptions by some investors, with the catalyst being a pick-up in wage growth in the United States. The result has been an increase in bond yields, a decline in equity prices and increased market volatility. While the exact timing of changes in investors’ assumptions is difficult to predict, the fact that some reassessment took place, at some point, is not that surprising. Above-trend growth at a time of low unemployment should be expected to see inflation lift, even if that lift is gradual because of factors that are affecting wage and price pressures globally. To add to the mix, fiscal policy in some countries, most noticeably the United States, is becoming more expansionary. So I expect rising inflation pressures will figure more prominently in discussions of the global economy than they have for some time. Another important international influence on our economy is what happens in China. Like other economies, China is benefiting from the global upswing. At the same time, there are ongoing efforts to increase the sustainability of China’s economic growth, both in terms of its financing and the environment. These efforts are affecting both the structure of finance in the Chinese economy and commodity markets. The Chinese authorities face the difficult challenge of getting the balance right between containing medium-term risks and supporting near-term growth, and we continue to watch developments there closely. I would now like to turn to the Australian economy. On balance, the news over the summer has generally had a more positive tone than it has had for a while. For some time we had been expecting GDP growth to be a bit stronger in 2018 and 2019 than in the recent past. The recent data have been consistent with this. Over this year and next we expect GDP growth to be a bit above 3 per cent, which is faster than our current estimate of trend growth for the Australian 1/4 BIS central bankers' speeches economy. This outlook has not been affected by the recent volatility in the equity market. The Australian labour market has been noticeably stronger than we were expecting, which is good news. Over the past year, the number of people with a job increased by 400 000, and there has been a marked increase in the participation rate for women. We don’t expect a repeat of these very strong outcomes in 2018, but we do expect employment growth to be fast enough to see a further gradual reduction in the unemployment rate. The unemployment rate, though, is likely to remain above conventional estimates of full employment in Australia for some time. A range of business indicators have also improved since we last met. Business conditions have lifted and so too has the outlook for capital expenditure. It would be an exaggeration to say that animal spirits have fully returned, but the mood has certainly brightened in much of the business community. There are a number of reasons for this, but in parts of the country the lift in mood is being helped by the large infrastructure projects underway. Not only are these projects creating jobs today, but they are building much needed productive capacity for the future. Against this general backdrop of improving conditions, one uncertainty remains the strength of consumer spending. In the September quarter, spending growth was quite weak, especially for discretionary items. More recently, the retail trade figures have been better and suggest a stronger outcome for the December quarter. Most households are experiencing only slow growth in their incomes and many expect that this will continue for some time yet. This lowering of expectations about income growth is likely to be affecting spending, especially in an environment of high levels of household debt. A pick-up in income growth, by way of ongoing increases in jobs and stronger wage growth should help here. We continue to look carefully at household balance sheets. On balance, our assessment is that there has been some containment of the build-up of risk in this area. This is a positive development. Lending standards are stricter than they were previously and there has been a welcome decline in the share of interest-only loans, following measures taken by APRA. Housing credit growth has also slowed a bit, especially to investors. In the property market, prices are no longer rising in Sydney, and have fallen for higher-priced houses. The Melbourne market has also cooled somewhat. Increased supply of housing, changes in the nature and availability of financing, and some reduction in foreign demand have all played a role. While the Reserve Bank does not target housing prices or household debt, it would be a good outcome if we now experienced a run of years in which the rate of growth of housing costs and debt did not outstrip growth in our incomes in the way that they did over the past five years. In terms of CPI inflation, the picture is pretty much the same as it was when we met six months ago. Inflation, in headline and underlying terms, is still running at a little under 2 per cent. This is higher than the inflation rate a year ago, but inflation does remain low. The most recent data confirmed themes that we have been seeing for some time. Strong competition from new entrants and changes in retailers’ business models are putting downward pressure on the prices of consumer durables and groceries. The prices of many of these goods are lower than they were a few years ago. This is good news for consumers, although not for some retailers. We do expect to see some lessening of this downward pressure on prices at some point, although not for a while yet. The second ongoing theme is higher prices for utilities and tobacco. Both of these have added materially to the CPI over the past year, and further increases are expected. The third theme is the subdued increase in wages feeding through into subdued price increases, particularly for a range of market services. This, too, is likely to continue for a while yet. We have discussed on previous occasions the reasons for the subdued wage increases. These 2/4 BIS central bankers' speeches include the continuing spare capacity in the economy after the unwinding of the mining investment boom; the heightened sense of competition due to globalisation and technological change; and changes in bargaining arrangements. These factors are still at work, although through our liaison program we hear reports of pockets where the labour market is tight and firms are finding it hard to find workers with the right skills. In some of these areas wages are now rising more quickly than previously, but many firms remain wary of adding to their cost base in the current environment. Over time, we expect wage growth to pick up as the labour market strengthens further. The pickup, though, is likely to be gradual. This increase in wage growth and the more general reduction in spare capacity in the economy are expected to contribute to inflation picking up as well. But to continue the theme, this pick-up, too, is expected to be only gradual. This year and next, we expect CPI inflation to be between 2 and 2½ per cent. As you would be aware, the Reserve Bank Board has held the cash rate at 1½ per cent since August 2016. This represents an accommodative setting of monetary policy, aimed at supporting the economy and employment, and returning inflation towards the mid-point of the medium-term target range. As we have discussed with this Committee on previous occasions, the Board has sought to strike a balance between these benefits of monetary stimulus and the medium-term risks associated with the increase in the already high level of household debt. We have sought to steer a middle course, promoting sustainable growth in the economy. Over the past year the economy has been moving in the right direction. Progress has been made in reducing unemployment and having inflation return to around the mid-point of the target range. And on the financial side, the build-up of risks in household balance sheets has been contained, although risks there remain. Over the coming year we expect to make further progress. Our central scenario for the Australian economy is for a further reduction in the unemployment rate and an increase in inflation towards the mid-point of the target range. Of course, this is just the central scenario, and there are other scenarios as well. But if this is how things play out, at some point it will be appropriate to have less monetary stimulus and for interest rates in Australia to move up, as is already happening in some other countries. In other words, it is more likely that the next move in interest rates will be up, rather than down. The timing of any future move will depend upon the extent and pace of progress that we make in reducing the unemployment rate and having inflation return to target. As things currently stand, we expect that progress to be steady, but to be only gradual. Given this assessment, the Reserve Bank Board does not see a strong case for a near-term adjustment of monetary policy. We will, of course, keep that judgement under review at future meetings. Before finishing, I would like to mention a couple of developments on the payments side of the Bank’s responsibilities. The first is the launch this week of the New Payments Platform. This is a major piece of national infrastructure, which will benefit households and businesses. Its development is the result of a very complex collaborative industry effort over many years. This new payment system will allow Australians to make faster, simpler and smarter payments on a 24/7 basis. One element of this is the use of PayIDs instead of having to know BSBs and account numbers for many transactions. A major focus of the development effort has been security and to protect people from fraud. The process for initially registering PayIDs, which is now underway, requires users to verify their identity. The new platform also requires users to confirm the recipient before a payment is completed. We would be happy to discuss further details of the new arrangements during the course of this hearing. 3/4 BIS central bankers' speeches The second development on the payments side is the release yesterday of the design of the new $50 banknote. This new banknote will be issued into circulation from October this year. There are more $50 banknotes in circulation than any other note, so it is a big task. All up, there are 700 million $50s on issue – they are used heavily in transactions as well as being the main ATM banknote. The new $50 banknote will feature the same world-leading security features as the $5 and $10 banknotes, including the clear top-to-bottom window. It will also have four bumps to help people with impaired vision recognise the note. As with the current $50 banknote, the new one honours two very significant Australians: David Unaipon and Edith Cowan. While these two Australians came from very different backgrounds, they were both significant pioneers. David Unaipon was Australia’s first published Aboriginal author, writing about, in his owns words, Aboriginal ‘customs, beliefs and imaginings’. The micro-text on the banknote is an extract from his book, the Legendary Tales of the Australian Aborigines . Edith Cowan was the first female member of an Australian parliament, being elected to the Western Australian Parliament in 1921. I am pleased to be able to say that the new banknote contains text from her first speech to that parliament. We are proud to have these two distinguished Australians on our most widely used banknote. Thank you. My colleagues and I look forward to answering your questions. 4/4 BIS central bankers' speeches | reserve bank of australia | 2,018 | 2 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Australian Financial Review Business Summit, Sydney, 7 March 2018. | Speech The Changing Nature of Investment Philip Lowe [ * ] Governor Address to the Australian Financial Review Business Summit Sydney – 7 March 2018 Thank you for the invitation to speak at this year's AFR Business Summit. It is very good to be here. The underlying question being asked at this summit is: how does Australian business prosper in today's changing world? This is an important question to be asking. A strong and prosperous business sector is central to Australia's economic success. It is businesses – both small and large – that employ the bulk of Australians. It is businesses that have to compete globally and find new markets around the world for the goods and services that we produce here in Australia. And it is businesses that are responsible for most of the investment spending in the country. So it is in our collective interest to have a prosperous business sector. This morning I would like to talk about the importance of investment in helping deliver that prosperity. It is through investment that firms develop new products, find better ways of doing things and expand their productive capacity. This means that the investment climate and the level and nature of investment have an important bearing on our future prosperity. My remarks will be in three parts. First, I will focus on recent cyclical developments in non-mining investment, including the recent lift in investment. Second, I will discuss some structural changes in the nature of investment in the Australian economy, including the increasing importance of investment in technology and knowledge-based capital. I will finish with some remarks about the investment climate and the role the RBA can play. Recent Trends Over the past decade or so, the resources sector has been the dominant investment story in Australia. This investment has greatly expanded productive capacity in the resources sector, and this is flowing into increased exports. This story is well known so I will not go over it again today. Instead my focus is on non-mining investment. During the mining investment boom it was understandable that investment in the rest of the economy was subdued. But as the boom unwound, the pick-up in non-mining business investment was slow to come. For a few years, a common theme in commentary from the RBA was that nonmining investment was weaker than we had been expecting. Indeed, for six or seven years the level of non-mining investment did not change very much (Graph 1). During this period, the RBA highlighted high hurdle rates of return and a lack of animal spirits. And the businesses we spoke with cited numerous uncertainties: uncertainty about the global economy, technology, politics and the level of household debt, among other things. For many firms, these uncertainties were a reason to delay investment spending; to wait for more clarity before proceeding. Graph 1 Over the past year the picture has begun to change. While we don't get the final investment figures for 2017 until later this morning, we estimate that over the past year, non-mining business investment increased by around 9 per cent. This is stronger than we were expecting a year ago and would be the largest increase since the onset of the global financial crisis. We expect to see further growth over this year. While businesses still face some significant uncertainties, including the future strength of consumer spending in a world of low real income growth and high household debt, the picture is a better one than it has been for some time. The pick-up in investment reflects a combination of factors. One is the stronger global economy, which has boosted demand and reduced some of the uncertainties that businesses face. Another is the continuation of accommodative monetary policy in Australia; borrowing costs here remain low and finance is available. The ongoing growth in Australia's population has also played some role. Since 2008, Australia's population has increased by 3½ million people, or 16 per cent. This growth, combined with low levels of investment, has started to put pressure on capacity utilisation (Graph 2). It is also relevant that businesses are reporting stronger business conditions than at any time since before the financial crisis. Graph 2 Another important part of the investment story recently is strong growth in investment in public infrastructure (Graph 3). The pick-up has been particularly noticeable in spending on transport infrastructure in the eastern states and the pipeline of work to be completed is large. The extra investment is directly creating demand in the economy today and adding to tomorrow's productive capacity. The Bank's analysis is that there are positive spillovers to the rest of the economy from the spending on public infrastructure, especially given that we still have some spare capacity. [1] In our business liaison, a number of firms report that they are investing more to meet the extra demand from infrastructure projects. So it is a positive story. Graph 3 Changing Nature of Investment I would now like to take a more structural perspective and highlight two changes in the structure and nature of investment. The first is the increasingly important role played by investment in information technology. And the second is a change in the industries in which investment is occurring. Over recent times, one of the central themes in the RBA's discussions with businesses has been the much greater use of information technology to increase productivity. Among other things, we hear about the possibilities and the challenges of data analytics, machine learning, artificial intelligence, the better use of sensors to control production and the automation of processes and production methods. A similar picture emerges from a survey undertaken by Ai Group last year, where CEOs were asked about their main investment priority for the year ahead. At the top of the list were investment in technology and the staff training that is needed to support that investment (Graph 4). Next on the list was investment in research and development (R&D). Further down the list was investment in physical assets. If we look back at previous surveys, it's clear that this focus on investing in technology has increased over time. Graph 4 This is not to underplay the importance of investment in physical assets. This remains critical. We need places to work, live, shop and play, and investment in buildings & structures and machinery & equipment remains central to this. But increasingly, investment decisions in these areas are also often just as much about technology as they are about other things. In every industry – in manufacturing, mining, agriculture, the health sector and business services – businesses are having to make investments in information technology to remain competitive. This is changing the way we think about investment. Tracking this shift in investment for the economy as a whole is complicated by some limitations in the available data. The ABS does, however, publish separate figures for investment in buildings & structures, machinery & equipment and intellectual property (Graph 5). Graph 5 These data show that over the past couple of decades, investment in intellectual property has grown noticeably faster and more consistently than investment in buildings & structures and machinery & equipment. This is particularly so since 2009/10. Over this period, the weakness in overall nonmining investment is explained by there being almost no growth in investment in tangible assets. In contrast, investment in intellectual property has grown at an average rate of 5 per cent. Following this sustained period of strong growth in investment in intellectual property, this component now accounts for around 20 per cent of total non-mining investment, in nominal terms. By way of comparison, this share was just 3 per cent in the early 1980s (Graph 6). Conversely, the share of investment spending on machinery & equipment has declined over time. This is partly, but not wholly, explained by the steady decline in the relative price of machinery & equipment. Graph 6 These shifts are significant and are consistent with the rising importance of investment in information technology. Within the broad heading of intellectual property, we can further disaggregate the data into investment in computer software, R&D and artistic originals (Graph 7). Over recent times, the strongest growth has been in investment in software, with investment in this area doubling over the past seven years. The picture for R&D is a little different; investment in R&D has not grown for a few years now, but this follows earlier strong growth. Graph 7 The impact of the increased investment in technology is also evident in the figures for output growth by industry. In particular, since the early 1990s, the fastest growing industries in the Australian economy have been information, media & telecommunications and professional, scientific & technical services. Both have grown faster than the mining industry, recording compounded average growth of around 5 per cent per year. The effects are also evident in the labour market, with strong demand for various types of workers in information technology. Indeed, some of the pockets of the Australian labour market in which wage growth has picked up over recent times are in professional, scientific & technical roles. The second structural change that I want to highlight is a shift in the industries in which investment is taking place. This shift can be seen in this next graph, which shows the share of non-mining investment accounted for by various industries (Graph 8). In the 1980s, the manufacturing industry accounted for around one quarter of non-mining investment in Australia. At that time, manufacturing required high levels of investment in machinery & equipment, not only to expand capacity, but to offset fairly high rates of depreciation. So investment in the manufacturing industry accounted for a large share of total investment. But since the mid 1990s, manufacturing has accounted for a steadily declining share of non-mining investment. Today, that share stands at just 11 per cent. In contrast, the shares of investment accounted for by information, media & telecommunications and professional, scientific & technical services have increased significantly. Combined, these two industries now account for about 16 per cent of non-mining investment, up from around 8 per cent in the early 1990s. Investment in health, education and transport has also increased as a share of total investment. Graph 8 Given these structural changes, one question that sometimes gets asked is: do we need less investment than we used to? This question has also been raised in the context of the subdued levels of non-mining investment over recent years: perhaps we simply don't need to devote the same share of output to investment as we once did? There isn't a straightforward answer to this question, but our analysis points to a couple of conclusions. The first is that the increased emphasis on technology and the shift to an increasingly serviceoriented economy explains some – but only some – of the subdued levels of investment spending over recent years. Rather, the bulk of the explanation for low levels of investment lies in what has been going on within individual industries, not shifts across industries. In most industries, the ratio of investment spending to output has been relatively low over recent years (Graph 9). Graph 9 The second conclusion is that, from a longer-term perspective, it is plausible that non-mining investment will account for a lower share of GDP than used to be the case. This largely reflects the decline in manufacturing as a share of the economy and the fact that the ratio of investment to output in the manufacturing industry is higher than in most other industries. While putting precise numbers on the size of any change is difficult, we estimate that this shift away from manufacturing could reduce the steady-state ratio of non-mining business investment to GDP by 1 to 2 percentage points. It is important, though, to point out that this does not mean the ratio of total investment to GDP will necessarily decline by this amount. This is because of what has happened in the resources sector, where there has been a very large increase in the capital stock. This higher capital stock means more depreciation, and more depreciation requires more investment to maintain the higher capital stock. So it is likely that the amount of investment in the resources sector, as a share of GDP, will be higher than it was before the mining investment boom. We are already seeing some evidence of this, with increased spending on ‘sustaining’ the capital stock being one of the factors behind the recent improvement in the Western Australian economy. The main point of all these facts and figures is that the nature of investment in the Australian economy is changing. There is a much greater focus on information technology and a shift to investment in the service industries. This has implications for how we think about investment and the measures necessary to create an environment that supports investment in our modern economy. The Investment Climate This brings me to the third issue I raised at the outset: that is the importance of a positive investment climate. No matter what type of investment a firm is considering, the environment in which the decision is being made has a major bearing on the decision to invest or not. Australia's long record of economic and financial stability is a positive from this perspective. So, too, are our strong legal system and our well-established institutions. To this list I could add the opportunities offered by our links to the fastest-growing part of the global economy and our skilled, diverse and flexible workforce. All these things make Australia an attractive place to invest. But we can't rest on these advantages. It is a competitive world out there and the nature of comparative advantage is changing. Once upon a time, comparative advantage came largely from a country's endowments or resources. Indeed, in our own case, the big waves of investment in Australia have been to capitalise on our natural endowments. These resources have made us wealthy and they are central to our continued prosperity. But in today's world, comparative advantage is just as likely to be built, as it is to come from endowments. It is likely to be built through innovation, creativity and ingenuity. And it is likely to be built through investing in information technology and the skills of our labour force. Creating a positive environment that encourages this investment is a joint responsibility of government and private business. The government certainly has an important role to play, but so does business. A business culture that highly values innovation and competition and that is not afraid of taking risk will surely help in creating this positive environment. There are no simple answers here. But a recent report by Innovation and Science Australia provides some guideposts. The report's subtitle is ‘A plan for Australia to thrive in the global innovation race’. It is worth a read. The report rightly focuses on the importance of education and the accumulation of human capital. Our ability to innovate rests on the skills of our workforce, so investing in these skills is central to building a positive investment climate. The report also discusses the way we go about research and development and how we can support innovative firms. It also discusses the importance of culture and ambition. Over recent times there has also been quite a lot of discussion about the effect of tax on the investment climate and international competitiveness. This is an important discussion to have as Australia does need to remain an attractive place for global capital to invest. As we have this discussion, it is also important that we keep focused on the other issues I just touched on, as these areas play an important role in building durable comparative advantage and prosperity. I would like to finish with a few words about the role of the RBA in contributing to a positive investment climate. We obviously have no role in influencing the structural considerations that I just spoke about. We do, though, have an influence on the overall environment within which business investment decisions are made. At the highest level we seek to be a source of stability and confidence. Having strong credible institutions in the country helps provide the community with a degree of confidence. We seek to build and maintain this credibility through developing a reputation for being a central bank that is transparent, independent, pragmatic and analytical. Beyond this contribution, the investment climate is obviously better if we are able to deliver on our core goals of monetary and financial stability. Investors should have confidence that, over time, CPI inflation in Australia will average between 2 and 3 per cent. They can expect some variation from year to year, but over the medium term the average inflation rate will be 2 point something. As I have spoken about on previous occasions, we pursue that objective in a way that promotes sustainable growth in the economy and pays close attention to financial stability risks. You may have noticed that at yesterday's meeting, the Reserve Bank Board left the cash rate unchanged at 1½ per cent, where it has been since August 2016. Our assessment is that the economy is moving in the right direction. We expect stronger growth in 2018 than in 2017 and a further reduction in the unemployment rate. We also expect inflation to increase a little from its current low rate. These developments should help support the climate for business investment. With the economy moving in the right direction, and interest rates still quite low, it is likely that the next move in interest rates in Australia will be up, not down. Having said that, the expected progress in reducing unemployment and having inflation return to target is likely to be only gradual. With only gradual progress expected, the Board does not see a strong case for a near-term adjustment of monetary policy. We will, of course, keep that judgement under review at future meetings. Thank you for listening. I am happy to answer questions. Endnotes [*] I would like to thank Andrea Brischetto, Mark Chambers and Michelle van der Merwe for assistance in the preparation of this talk. See Reserve Bank of Australia 2018. Data on investment in cultivated biological resources – that is farmed livestock, orchards and the like – are also published. These are excluded from the figures reported in this section. Investment in cultivated biological resources has declined from over 40 per cent to just below 4 per cent as a share of overall non-mining investment over the past six decades as livestock farming has become a smaller part of the economy. Statement on Monetary Policy ‘Box C: Spillovers from Public Investment’, February © Reserve Bank of Australia, 2001–2018. All rights reserved. | reserve bank of australia | 2,018 | 3 |
Address by Ms Michele Bullock, Assistant Governor (Financial System) of the Reserve Bank of Australia, to Seamless Payments 2018, Sydney, 13 March 2018. | Michele Bullock: Fast payments in Australia Address by Ms Michele Bullock, Assistant Governor (Financial System) of the Reserve Bank of Australia, to Seamless Payments 2018, Sydney, 13 March 2018. * * * Thank you to the organisers for the opportunity to speak at this session of Seamless Payments. There is a lot going on in the payments space at the moment, driven by the burgeoning use of technology to make consumer and merchant experiences with payments more convenient and dare I say ‘seamless’. Today I am going to talk about a significant piece of national infrastructure that will be really important in this context – the New Payments Platform, or NPP as it is known. But before I talk specifically about the NPP and the future, I want to do a little retrospective – where have we come from? Developments in the payments system Over the past 20 years, the way we pay in Australia has changed dramatically. In particular, the use of cash and cheques, which were the most common method of payment in the mid 1990s, has declined and the use of electronic payment instruments has risen very sharply. While we don’t have data on cash transactions in the mid 1990s, we are confident that cash use was at least as high, if not higher than the 70 per cent of day-to-day transactions that cash accounted for in the Reserve Bank’s first survey of consumer payments in 2007. Our most recent survey in 2016 suggests this share has fallen to around 35 per cent. We have better information on noncash transactions. In the mid 1990s, there were around 110 non-cash transactions per capita per year. The most used non-cash payment instrument was the cheque. There were around 45 cheque transactions per person per year, accounting for a little more than one-third of all noncash transactions. At that time, the now ubiquitous payment cards accounted for a further third of non-cash payments – around 40 per person per year, split fairly evenly between debit and credit cards. 1/6 BIS central bankers' speeches Now the landscape looks completely different. There are now around 500 non-cash payments per person per year. The number of cheques written is now equivalent to around 4 per person per year and continuing to fall sharply. Cards, on the other hand, now account for around twothirds of all non-cash payments and the use of debit cards, in particular, has grown very strongly. But direct debits and credits, which go through the direct entry (DE) system, have also grown steadily over the past two decades. While the growth in direct credits was initially mainly driven by bulk payments such as payrolls and welfare, more recently they have been increasingly used to make person-to-person payments directly between bank accounts and to pay invoices. But while tried and tested, and cheap, the DE system had a number of issues that became increasingly constraining as our e-society grew. First, while DE payment files are exchanged multiple times during a business day, there is usually a considerable delay – often some hours – between when a payment is initiated and the time the funds are available in the beneficiary customer’s account. Payments initiated on weekends and public holidays had to wait even longer until sometime on the next business day. Second, there were only 18 characters of free text to indicate what the payment was for. This can be a significant limitation, particularly for one-off payments where the beneficiary requires a material amount of information to ensure the payment is dealt with appropriately. And finally, payers had to know (and payees had to divulge) the BankState-Branch (BSB) number and the account number and name to make the payment. These issues, among other concerns about barriers to innovation in the payments system, ultimately led to the Reserve Bank’s Strategic Review of Innovation in the Payments System, the conclusions of which were published in 2012. The strategic objectives set out in that review included a number of requirements of the payments system of the future: the ability to make real-time retail payments the ability to make and receive low-value payments outside normal banking hours 2/6 BIS central bankers' speeches the ability to send more complete remittance information with payments the ability to address payments in a relatively simple way. Sound familiar? These are indeed all the things that the NPP will deliver. So where are we? The NPP – Australia’s fast payments system As you know, the NPP launched to the public in mid February. It is the culmination of more than 5 years’ work from inception to launch. It involved unprecedented cooperation between financial institutions to build the capability to send and receive individual payment messages between themselves in real time, with settlement also occurring transaction-by-transaction through the Reserve Bank’s Fast Settlement Service. But it also required banks to upgrade their internal systems to allow posting to customer accounts within a few seconds. The resources involved in delivering the system as a whole were substantial. Australia is obviously not the first country to build a fast payments system. FIS in its 2017 report on fast retail payment systems noted that there were some retail payment systems with realtime features as early as the 1970s and 1980s.1The report listed 25 countries with live real-time systems in 2017. It listed a further 10 systems under development, at that time including Australia. FIS also provided a useful taxonomy to compare and contrast the various systems – its Faster Payment Innovation Index (FPII). The index rates faster payment systems on the basis of the features they provide. At a basic level, in order to be classified as a fast payment service the system must provide interbank, account-to-account payments in less than one minute endto-end and be irrevocable. But, the more value-added services and openness to innovation, the higher the rating. The Australian NPP was not rated in this report since it was not live at the time. But it certainly will offer many of the features that rate highly in the FPII. For example, the taxonomy lists ISO standard and 24/7 availability as being highly desirable features enhancing customer value – the NPP offers both these. It lists fast settlement, the ability to include remittance information with payment and the ability to assign an alias to a bank account as being some of the optional features that maximise customer value. The NPP also delivers these features. There are other capabilities that the NPP does not currently provide – like ‘pull payment’ capability – but the infrastructure will allow other services to be offered in the future. One of the things that is unique about our NPP is the architecture. There are three facets to this. The first is that the infrastructure for exchanging messages is based on a distributed architecture rather than a centralised hub. Participating institutions implement payment gateways that exchange messages with other payment gateways. There is no centralised infrastructure that processes and switches messages. One key advantage of this architecture is that there is no central point of failure. It also means that many of the functions that might typically be performed in a hub, such as fraud monitoring and exceptions processing, are done by the individual participants. This might be desirable for institutions that want to maintain control over these processes. The second facet of the architecture that is quite innovative is the separation of the clearing and settlement infrastructure from commercial overlays. The infrastructure has been set up as a utility, and pricing will be on a cost recovery basis. This infrastructure can then be utilised by any number of commercial ‘overlays’ to deliver services that use the NPP’s real-time clearing and settlement capabilities. The first of these is Osko – initially offering person-to-person payments but within a year or so offering payment with document and request to pay. It is also expected that other innovative services will look to leverage the real-time payment capability of the NPP. The third relatively unusual facet is the real-time transaction-by-transaction settlement of retail payments 24 hours a day, 7 days a week. Australia has had a real-time gross settlement system 3/6 BIS central bankers' speeches for high-value payments for weekday settlements for the past 20 years. And this is indeed best practice around the world for high-value payments. But not many countries currently provide realtime settlement of retail payments, and even fewer offer it 24/7. Many fast retail payments services, for example, settle payments in batches through the day or only during business hours. The advantage of utilising real-time settlement in our fast payment service is that it extinguishes settlement risk and removes the need for other controls over settlement risk, such as caps on exposures. The fact that these controls are not required removes some limitations that might otherwise need to be considered by overlay service providers as they design their products. So now we have this world-class infrastructure, what for the future? The first point to note is that it is still early days. Given the complexity of the build and the longterm nature of this important piece of infrastructure, the launch was never intended to be a ‘big bang’. While there had been extensive testing ahead of launch, including an extended period of live proving, moving into production always uncovers some issues. A cautious approach to ramping up volumes was therefore an appropriate way to manage the operational risks. Second, the experience of fast payment systems around the world suggests that volumes will increase quite slowly at first. It took the UK Fast Payment Service around 3½ years to get to 10 transactions per person per annum and Swish, the Swedish system, just under 3 years to get to this level. There are probably a couple of reasons for the initially relatively slow growth in volumes. It will take some time for people to become familiar with the new system – people are typically quite set in their payment habits. Furthermore, like all networks, there are positive externalities the more participants there are. That is, as more financial institutions offer fast payments and the reach of the system grows, it provides greater value to both individuals and businesses. If none of my family and friends can receive payments through the NPP I am less likely to sign up for an alias and use it. But the more people I can pay using the system (and the more people I can receive money from) the higher value I get from the system. 4/6 BIS central bankers' speeches Third, as noted earlier, the system has been set up to encourage the development of commercial ‘overlays’ using the real-time payment capability to deliver value-added services to consumers and businesses. Aside from the additional Osko services in prospect, possible overlays might include services for superannuation, e-invoicing and motor vehicle sales. I am sure there are many innovative minds turning to the possibilities. This brings me to an issue that has caused some concern among potential new players in this space – access to the NPP. They observe that the system has been built by the financial institutions and is governed by a board made up of those institutions, including the four major banks. They worry that these institutions will either make participation very difficult or costly or, alternatively, will have the inside running on developing and launching commercial overlay services. I think there are a few reasons to be optimistic that access will not be an issue. To begin with, as I noted earlier, the NPP is a utility. It is aiming to cover costs, not make a profit. Further, given that many of its costs are fixed, it is in the interests of NPP Australia (NPPA) to get as many payments through the system as possible to lower the per-transaction cost. The structure of the board and the constitution also provide some protection. The board is comprised of eight participant financial institutions (the four major banks plus four elected representatives of smaller institutions), two independent non-executive directors (of which one is chair) plus a director representing the Reserve Bank. Each director has one vote and the constitution notes that an objective of NPPA is to promote the public interest, including through fair access. But it is also worth noting that the NPP at its core is an infrastructure that facilitates clearing of payment messages between financial institutions and settlement of those obligations across accounts at the Reserve Bank. In this sense, it is similar to other clearing and settlement systems – cheques, direct entry or payment cards, for example. It is not necessary, or even necessarily efficient, for all financial institutions to participate directly in clearing and settlement. In the NPP, for example, there are three aggregators that provide indirect access to institutions that do not want to incur the cost of participating directly. Indeed, there are already around 50 smaller banks, credit unions and building societies that are able to offer fast payments to their customers using the aggregators. Similarly, it is not necessary for non-financial institutions that want to use the real-time capability of the NPP to participate directly in clearing and settlement. Just as they use the rails of other payment systems through a financial institution to offer their services to customers, they will be able to use the NPP. NPPA is already engaging with start-ups on how they might utilise the infrastructure. More generally, if a business doesn’t like the price for fast payments it is getting from its bank, there are many other institutions that can offer an alternative. In the end, though, if it looks as though lack of access is stifling competition, the Reserve Bank has the power to designate and set an access regime. As I said, I am fairly optimistic that we will not have to. But it is always an option. Security and real-time payments Finally, let me say a few words about fraud. It has been noted that in a world of real-time payments, fraud can also be done in real time. Unlike the current system, where there is at least a few hours to review and halt a fraudulent payment, in a fast payment system the money can be expected to be gone. The risk isn’t new – it just happens faster. This was an issue that was thoroughly considered in the development of the NPP, drawing on experience from overseas systems, particularly the United Kingdom. There are a few ways in which the NPP and participants are attempting to address fraud risks. 5/6 BIS central bankers' speeches Banks have their own fraud detection systems and controls associated with interbank transfers. These include such things as transaction limits, two-factor authentication and algorithms designed to identify suspicious transactions. These will continue to be in place with the NPP. But in addition, when making an NPP payment to a PayID, the sender will be shown the name of the account to which they are paying and have an opportunity to confirm that they wish to make the payment. This is an extra step that will assist payers to make sure they are paying who they think they are. There are also verification processes in place for registering PayIDs (the system that allows customers to assign an alias to their bank account) to ensure people are who they say they are. Indeed PayID registration can only take place from within a customer’s internet banking portal or app. The NPP also has a fraud liability framework in place that is consistent with existing consumer protection frameworks, and allocates liability where fraud is the result of inadequate verification practices. But like all payment systems, customers need to be alert to the potential for fraudsters to trick them out of details that would allow a fraud to occur – like their passwords.2 Educating consumers on these risks remains an imperative for the regulators and for the financial institutions. Conclusion The NPP is an important piece of payments system infrastructure that will pave the way for further innovation in the payments system. It has taken many years of hard work from the industry, undertaken in a great spirit of cooperation. But we now have a world-class fast payments system that I encourage the industry to embrace and create valuable services for their customers. 1 FIS (2017), ‘Flavours of Fast’, Final Report, June. 2 I am using the term ‘fraud’ broadly here, to include not only situations where there is a theft or misuse of account information, or the compromise or hacking of customer authentication details, but also to cover ‘scams’, where the victim is tricked or persuaded into making a transfer to the fraudster’s account. These might occur via forged invoices, from bogus emails from foreign jurisdictions offering a share of a large sum of money, various social media scams. The ACCC’s Scamwatch’, available at <www.scamwatch.gov.au/>, website provides a range of information and warnings for consumers. 6/6 BIS central bankers' speeches | reserve bank of australia | 2,018 | 3 |
Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Debt Capital Markets Summit, Sydney, 14 March 2018. | Christopher Kent: Australian fixed income securities in a low rate world Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Debt Capital Markets Summit, Sydney, 14 March 2018. * * * I would like to thank Leon Berkelmans for help in preparing this material. This is my first time at the Debt Capital Markets Summit. I appreciate the opportunity to speak at such an important event in the Australian fixed income calendar. Over the course of recent months, interest rates on a range of fixed income securities across the globe have risen. Nevertheless, they remain at historically low levels. At the same time, spreads between non-government and government debt have remained low. Indeed, over the past year or so they have declined to be around their lowest levels since the global financial crisis. Accommodative monetary policies and generally low levels of inflation are contributing to easy financial conditions for issuers. In my presentation today, I’ll lay out some of the factors contributing to these financial conditions and then discuss how Australian issuers have responded. In brief, more has been issued, by a more diverse set of issuers at longer average tenors. I’ll finish by looking forward to the year ahead. The global story To tell the story on pricing, for the most part I’m going to focus my attention on spreads between yields on non-government debt and those on government debt. That’s a familiar way of thinking about a key part of cost of those funds. At the same time it provides a sense of the market’s view of the risks involved.1 Globally, spreads on non-government debt are low and they have tightened further over the past year. Indeed, spreads in many markets are as low as they have been since the financial crisis. For corporate bonds that’s true of both investment grade and non-investment grade debt (Graph 1). In short, demand for fixed income securities is strong. 1 / 15 BIS central bankers' speeches Why might that be? One contributing factor has been the improvement in global economic conditions. This is supporting business profits, which helps to reduce actual and prospective defaults. In turn, this underpins a narrowing of credit premia. We see evidence of this, for example, in the decline in default rates on high-yield US bonds over the past few years, although some of the decline since last year may also reflect the improvement in conditions affecting US oil producers. Another part of the story may be that uncertainty has declined. This has been most evident in the low levels of financial market volatility observed last year and early this year. That suggests that market participants are more confident about their forecasts of the future. A sense of greater certainty is consistent with the reduction in the variability of many key macroeconomic indicators, which has been accompanied by a decline in revisions to analysts’ forecasts of these variables.2 Yet another possible reason for the low spreads is that financial market participants appear to be willing to take on risks at lower levels of compensation. In other words, the price of risk may have declined. This could be as a consequence of a few developments. Importantly, accommodative monetary policies have provided investors with an incentive to take more risk so as to achieve a reasonable rate of return. As investors take on more risk, they will tend to bid down its price – as captured by spreads, for example. This is the search for yield that we hear about a lot. Why does this matter for Australia? So what is the relevance of the decline in spreads on offshore fixed income assets for Australian markets? First, it matters because many of our corporations issue overseas. This offshore issuance facilitates capital inflows, which are the financial counterpart to Australia’s current account deficit.3 2 / 15 BIS central bankers' speeches Most bonds issued by Australian companies are issued offshore, whether they are financial or non-financial companies (Graph 2). For non-financial companies, the influence of mining firms in this market had been significant over recent years. Overseas issuance is quite natural for miners operating in Australia because their revenue streams are often denominated in foreign currencies. Second, the decline in spreads offshore also matters because they are highly correlated with spreads in the domestic market (Graph 3). For example, spreads on bonds issued by Australian banks in the Australian market have a strong relationship with the spreads faced by US corporations. The same is true for spreads on bonds issued by non-residents in the Australian market (so called ‘Kangaroo bonds’). This should not be that surprising because the market for capital is a global one. If the price of risk in Australia were to deviate too far from the global price – beyond that suggested by any differences in fundamental credit quality – there would be opportunities for profitable arbitrage. One way or another, the process of arbitrage would lead to a degree of convergence between spreads. 3 / 15 BIS central bankers' speeches The response So spreads have declined in Australia, much like the rest of the world. Is that the end of the story? Far from it. Non-government issuers have responded to these developments in a number of ways. Low spreads have made it more attractive for companies to issue fixed income securities. Issuance is up across a range of markets. But quantities are not the only part of the story. Good demand conditions have also made it easier for a more diverse range of companies to issue. Moreover, tenor has increased, notably in the domestic market. Quantities Let me start with quantities. Issuance in many markets is up.4 Gross issuance of bank bonds in 2017 was the second highest since the global financial crisis (Graph 4). In 2016, banks acted ahead of time in preparation for the implementation of the Net Stable Funding Ratio (NSFR) requirement. So, having issued a bit more paper in 2016 than had been the case for some time, it seemed reasonable to have expected that 2017 was going to be a somewhat subdued year for bank bond issuance. As it happened, though, banks took advantage of favourable funding conditions over the past year or so to tap the bond market more actively than might otherwise have been the case. 4 / 15 BIS central bankers' speeches Corporate bond and Kangaroo issuance rebounded from their 2016 levels in 2017, although there have been recent years where issuance was higher. Issuance of residential mortgage-backed securities (RMBS) was particularly strong in 2017. Indeed, it was the strongest since the global financial crisis. Part of that is likely to have owed to extra issuance by non-banks (i.e. financial institutions that are not authorised deposit taking institutions, or non-ADIs). Their housing lending picked up strongly at the same time as the growth of lending by the major banks was easing. (That in turn reflected the decline in the growth of the major banks’ investor and interest-only loans as the banks responded to the Australian Prudential Regulation Authority (APRA) and Australian Securities and Investments Commission’s (ASIC) actions to tighten lending standards.) Despite these supply-side motivations, it still appears that demand-side factors were the dominant influence. If the only influence on RMBS spreads had been via increased supply of paper from non-banks to fund their lending, then spreads would have increased. However, spreads have tightened, consistent with a rise in the demand for RMBS. Diversity The RMBS market is an important source of funds for mortgages issued by smaller competitors to the major banks. So, it’s reasonable to expect that low spreads should encourage some more of those competitors to come to the market. Indeed, that’s what we have seen (Graph 5). As a whole, non-major banks (labelled as ‘other ADI’ in the graph) issued $16 billion of securities last year, the highest since 2007. Perhaps more remarkable was the number of ‘other’ (non-major) banks that issued RMBS – by our count it was 17, the highest ever. 5 / 15 BIS central bankers' speeches Interestingly, major banks have been relatively inactive in this market. Only 13 per cent of the total volume of issuance in 2017 was accounted for by the majors, the lowest since 2010. One reason the majors have not been more active is that, even with the decline in RMBS spreads, pricing is not particularly attractive for them. Rather, alternative sources of funds – such as unsecured wholesale markets – remain more attractive because spreads in those markets have also narrowed. It’s worth noting that many of the other banks, and non-bank securitisers, have rather limited access to long-term wholesale funding, particularly in offshore markets. So they cannot avail themselves of the favourable terms currently on offer there. An alternative way of showing the increase in diversity is through a Herfindfahl-Hirschman index, which is a standard way of measuring concentration. The lower the index, the lower the level of concentration.5 There was a sizeable fall in that index in 2017 for RMBS issuers (Graph 6). By this metric, concentration has been falling since 2014, when non-banks issued less than half what they did in 2017 and major banks were far more active in the market. 6 / 15 BIS central bankers' speeches The diversity of issuers has increased in other markets as well. I have made the point in a previous speech that the mining industry is an important part of the Australian corporate debt market.6 For a number of years following the financial crisis, those companies issued debt to help fund the mining investment boom, although most finance was raised internally. 7 Over the past couple of years, however, resource-related companies have been relatively inactive; some have even bought back bonds as they have sought to reduce their gearing (thereby contributing to the decline in offshore bonds on issuance for non-financial corporations shown in Graph 2). Meanwhile, other companies have stepped up their issuance (Graph 7). In 2017, we saw particularly strong issuance from utility companies. Indeed, combined issuance across nonresource-related sectors was at a record high in 2017. I should note that we would expect issuance to grow in nominal terms as the economy expands. Regardless, it is worth noting that the market is not dominated by resource companies in the way it has been in the past. 7 / 15 BIS central bankers' speeches We also have seen a more diverse type of issuer in the Kangaroo market. Again, this is not a story of the past year alone (Graph 8). If we look back 10 years, the Kangaroo market had previously been reliant on financial corporations and European based supranational, sovereign or quasi-sovereign agency entities, known collectively as SSA’s. However, as time has passed, we have seen more non-European SSA’s enter the market. Also, over the past three years or so, non-financial corporations have begun to issue in the Kangaroo market, such as companies from the United States. 8 / 15 BIS central bankers' speeches This increase in the variety of the types of issuers in the Kangaroo and non-financial bond markets can also be summarised by Herfindahl indicies (Graph 9). These show a clear decrease in concentration over the past few years, with the indices reaching their lowest levels for some time. 9 / 15 BIS central bankers' speeches Tenor Finally, another development worth highlighting is the lengthening in the tenor of issuance in some parts of the market in 2017 (Graph 10). In the case of domestic issuance for non-financial corporations, this increase is part of a longer-running trend, which has been a positive development for domestic markets. Recent increases in average tenor more generally may also be related to the low levels of spreads. In the case of overseas issuance by Australian banks, 2017 saw some notable deals with quite long tenors. We understand that this lengthening of tenor by the banks has been influenced by market conditions. In particular, banks are taking advantage of the lack of any term premium for longer-term funding. The regulatory environment, particularly the NSFR requirement, may also be contributing to a desire to issue at longer tenors. You may have noticed that offshore issuance tends to be at longer average tenors than domestic deals. It seems that it is easier, or at least has been in the past, to borrow at term overseas than in the Australian market. By all accounts, Asian investors have helped support longer-term Australian dollar issuance of late.8 It does not yet seem to be the case that resident investors are able to provide the demand needed for a large volume of longer-term issuance, although that could evolve over time. 10 / 15 BIS central bankers' speeches Where to now? These developments I’ve summarised have generally been positive. To recap, accommodative monetary policies and greater confidence in the outlook for global growth have contributed to low spreads on a range of non-government debt. Australian issuers have benefited, with greater issuance, across a more diverse range of issuers and at longer average tenors. But the outlook is not without risks. Indeed, accommodative monetary policies have encouraged greater risk-taking by both lenders and borrowers. This is one of the important ways in which the monetary transmission mechanism works. It has supported the decline in spreads and other positive developments I’ve just discussed. At the same time, however, the combination of low interest rates and low volatility in financial markets is of concern to the extent that it can lead to excessive risk-taking via a search for yield. This is something that the Reserve Bank has been noting for a time.9 Is there evidence of excessive risk-taking in fixed income markets? It’s hard to say. Spreads have been bid down across a range of Australian markets to levels that are close to those that prevailed ahead of the global financial crisis (Graph 11). However, spreads for RMBS are not quite so low relative to that history (Graph 12).10 First and foremost, this reflects the reassessment at the time of the crisis by investors globally of the risk of this type of asset. That assessment has persisted. Also, it may be that the spread is somewhat higher in Australia than it was a few years ago in response to the build-up of risks in housing markets and household balance sheets – on the back of high and rising household indebtedness. We have talked about that at length for a time now.11 11 / 15 BIS central bankers' speeches 12 / 15 BIS central bankers' speeches It’s not clear that the relatively low level of spreads in fixed income markets represents irrational mispricing of risk or is, by itself, a cause of concern. Issuance has picked up, but it is not especially high. Moreover, measures of corporate indebtedness are generally not elevated (Graph 13). This has been helped by some deleveraging among resource companies, which have been able to reduce the extent of their debt.12 13 / 15 BIS central bankers' speeches Still, it is possible that we could see a noticeable pick-up in financial market volatility, a sharp repricing of assets and, as a result, a tightening in financial conditions, including higher spreads for corporate issuers. The recent experience in US equity markets has been a stark reminder of that possibility. While US equity markets reacted sharply, and other equity markets around the world responded (though generally to a somewhat lesser extent), the knock-on effect to other markets was modest. In particular, spreads on corporate debt were little changed. My sense is that this limited response of spreads reflected at least two features of the bout of equity market volatility. First, the sharp response of the US equity market was driven, at least in part, by some sizeable positions that had been taken on the back of an expectation that volatility in that market would remain low. Second, the equity market turbulence was triggered by a reassessment of the outlook for US inflation and monetary policy. In particular, there was evidence of stronger wages growth and a prospect of rising inflation. It would be appropriate and welcome in that case to see a tightening in financial conditions. If that were to be sustained, it would naturally be accompanied by a reduction in the search for yield and some increase in spreads, which would tend to weigh on issuance. While there’s nothing that guarantees that the path of adjustment will be smooth and pain free, the forces that might push the US economy in that direction are not unwelcome in of themselves. And while other advanced economies are further from that point, including in Australia, the expectation is that these same forces will come into play as spare capacity is gradually eaten into and inflation rises. Thank you for your attention. I look forward to answering questions you might have. 14 / 15 BIS central bankers' speeches 1 An important aspect of that is default risk, which I suspect is the thing many people have in mind when I mention risk. However, these spreads will also incorporate liquidity premia – government bonds tend to be quite liquid, and that will also affect their pricing vis-à-vis private sector debt. 2 For further discussion of this point, see RBA (2018), ‘Box A: The Period of Low Volatility in Financial Markets’, Statement on Monetary Policy, February, pp 25–26. 3 Debelle G (2017), ‘Recent Trends in Australian Capital Flows’, Address to the Australian Financial ReviewBanking and Wealth Summit, Sydney, 6 April. 4 The data in Graph 2 show that the outstanding stock has fallen in overseas markets recently. These data include the effect of issuance and maturities of bonds, as well as exchange rate movements and bond buybacks. 5 If the market is accounted for by only one player, this index is 1. If, on the other hand, n participants each have an equal share of the market, the index is 1/n. 6 Kent C (2017), ‘Fixed Income Markets and the Economy’, Address to Bloomberg, Sydney, 9 August. 7 Arsov I, B Shanahan and T Williams (2013), ‘Funding the Australian Resources Investment Boom’, RBA Bulletin, March, pp 51–61. 8 For example, see Davidson L (2018), ‘Taking Stock’, KangaNews, Dec 17/Jan 18, pp 12–13. Available at <http: //www.kanganews.com/document/magazines/2017/2017-dec-jan/141-kndecjan17column>. 9 See, for example, RBA (2017), Financial Stability Review, October. 10 The RMBS spreads are shown relative to BBSW, which is not a risk-free benchmark. Calculating spreads to Australian Government Securities is difficult given the pre-payment uncertainty of RMBS, nonetheless, when we attempt to do so, we get a similar picture as emerges in Graph 12. 11 Lowe P (2017), ‘Household Debt, Housing Prices and Resilience’, Address to Economic Society of Australia (QLD) Business Lunch, Brisbane, 4 May. 12 Kent C (2017), ‘Fixed Income Markets and the Economy’, Address to Bloomberg, Sydney, 9 August. 15 / 15 BIS central bankers' speeches | reserve bank of australia | 2,018 | 3 |
Address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the Financial Risk Day 2018, Sydney, 16 March 2018. | Guy Debelle: Risk and return in a low rate environment Address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the Financial Risk Day 2018, Sydney, 16 March 2018. * * * Thanks to Christian Vallence for his input and to Tomas Cokis, David Halperin and Paul Hutchinson for the volatility analysis. Today I am going to talk about some issues around risk and return in a low rate environment, in line with the theme of the conference. I am going to highlight questions that strike me as worth asking about the way return and risk are reflected in the current configuration of asset prices. I will suggest some considerations worth thinking about in trying to answer those questions from the investor side. I will also describe how issuers have adjusted their strategies to avail themselves of the low rate environment. One of the main points I would like to make is that the low interest rate structure underpins many asset prices. That is, asset prices which might look expensive are more reasonably priced given that the rate structure currently is at historically low levels. So in my view, a fundamental question that you need to think about as an investor is: will the current rate structure remain at these levels, or will it return to the higher levels we have seen in the past? If the rate structure remains near historic lows, then valuations can persist. But if it rises, then asset valuations need to be reassessed. The second and related question is: what is the risk that such a shift in the rate structure occurs and am I being adequately compensated for that risk? Low interest rates I am going to use the rate structure in the US, and particularly the yield on a US 10-year Treasury bond to illustrate the shift in the rate structure (Graph 1). 1 / 14 BIS central bankers' speeches As you are all aware, in the wake of the financial crisis and the sharp decline in global growth and inflation, monetary policy rates round the world were reduced to historically low levels. In a number of countries (Australia being one notable exception), the policy rate was lowered to its effective lower bound, which in some cases was even in negative territory. In part reflecting the low level of policy rates and the slow nominal growth post crisis, long-term bond yields also declined to historically low levels. 10-year government bond yields in some countries, including Germany, Japan and Switzerland have been negative at various times in recent years. In 2015, over US$14 trillion of sovereign paper had negative yields. For the past decade, the yield structure in the US has been lower than at any time previously. Let me put in context the current excitement about the 10-year yield in the US reaching 3 per cent. In the three decades prior to 2007, the low point for the yield was 3.11 per cent. All this goes to say that we have been living in a period of unusually low nominal bond yields. How long will this period last? One way to think about this question is to ask whether what we are seeing is the realisation of a tail event in the historical distribution of interest rates.1 While this tail event has now lasted quite a long time, if you thought it was a tail event, then you would expect yields to revert back to their historical mean at some point. You also wouldn’t change your assessment of the distribution of future realisation of interest rates. On the other hand, it might be the case that the yield structure has shifted to a permanently lower level because of (say) secular stagnation resulting in structurally lower growth rates for the major economies for the foreseeable future. If this were the case, you would change your assessment of future interest rate outcomes. I don’t know the answer to this question, but it has material implications for asset pricing. 2 / 14 BIS central bankers' speeches As I said earlier, the prices of many assets could be broadly validated if you believe the low rate structure is here to stay. 2 This is because the lower rate structure means that the rate with which you discount expected future returns on your asset is lower and hence the asset price is higher for any given flow of future earnings. The current constellation of asset prices seems to be based on the view that the global economy can grow strongly, with associated earnings growth, but that strong growth will not lead to any material increase in inflationary pressure.3 You might want to question how long such a benign conjuncture could last. Current asset pricing suggests that the (average) expectation of market participants is that it will last for quite a while yet. It is also worth pointing out that it is possible that a move higher in interest rates occurs alongside higher expected (nominal) dividends because of even higher real growth. If this were to occur it would not necessarily imply that asset prices have to adjust. It would depend upon the relative movements in earnings expectations and interest rates; that is, the numerator and denominator in the asset price calculation.4 How might we know whether the distribution of interest rates has shifted? One can think of the interest rate distribution as being anchored by the neutral rate of interest. I talked about this in the Australian context last year. 5 As I said then, empirically the neutral rate of interest is difficult to estimate. It is even harder to forecast. The factors which affect it are often slow moving. But sometimes they aren’t, most notably around the time of the onset of the financial crisis in 2007– 08, when estimates of the neutral rate declined rapidly and significantly. Currently, there is a debate in the US as to whether the neutral rate of interest has bottomed and is shifting up. This raises the question as to the degree and speed with which such a movement in the neutral rate in the US might translate globally. All of these questions highlight to me the inherent uncertainty about the future evolution of interest rates. One might decide that interest rates are going to continue to remain lower for longer, but I struggle to see how one can hold that view with any great certainty. Yet there appears to me to be very little, if any, compensation for this uncertainty in fixed income markets. Most estimates of the term premium in the 10-year US Treasuries are around zero, or are even negative (Graph 2). Investors are not receiving any additional compensation for holding an asset with duration. 3 / 14 BIS central bankers' speeches That is, one can have different views about the longevity of the current rate structure.6 But, in part reflecting these different views about longevity as well as the unusual nature of the current environment, there is a significant degree of uncertainty about the future. Yet many financial prices do not obviously offer any compensation for that uncertainty. Low volatility It’s not only in the term structure of interest rates where compensation for uncertainty is low. Measures of implied volatility indicate that compensation for uncertainty about the path of many other financial prices is also low, and has been low for some time. This has been true across short and long time horizons, across countries, including Australia, across asset classes, and across individual sectors within markets (Graph 3 and 4). I will discuss some of the possible explanations for this, drawing on material published in the RBA’s February Statement on Monetary Policy, and also discuss the recent short-lived spike in volatility in equity markets. 4 / 14 BIS central bankers' speeches 5 / 14 BIS central bankers' speeches Implied volatility is derived from prices of financial options. Just as the term premium measures compensation for uncertainty about the future path of interest rates, implied volatility reflects uncertainty about the future price of the asset(s) underlying a financial option. The more certain an investor is of the future value of the underlying asset, or the higher their risk tolerance, the lower the volatility implicit in the option’s price will be. Thus, one interpretation of the recent low level of volatility is that market participants have been more confident in their estimates of future outcomes. This is consistent with the observed reduction in the variability of many macroeconomic indicators, such as GDP and inflation, and a decline in the frequency and magnitude of the revisions that analysts have made to their forecasts of such variables (Graph 5). Given the importance of these variables as inputs into the pricing of financial assets, it’s no surprise that greater investor certainty about their future values has in turn given investors more certainty about the future value of asset prices. 6 / 14 BIS central bankers' speeches As you can see from all three graphs, a similar degree of certainty about the future was present in the mid 2000s, when there was a high degree of confidence that the ‘Great Moderation’ was going to deliver robust growth and low inflation for a number of years to come. Monetary policy is also an important input into the pricing of financial assets, so a reduction in the perceived uncertainty around central bank policy settings may also have contributed to low financial market volatility. Monetary policy settings have been relatively stable in recent years, and where central banks have adjusted interest rates or their purchases of assets, these changes have tended to be gradual and clearly signalled in advance. Central banks have also made greater use of forward guidance as a policy tool to attempt to provide more certainty about the path of monetary policy. But while central banks might act gradually and provide this guidance, the market doesn’t have to believe the guidance will come to pass. There are any number of instances in the past where central bank forward guidance didn’t come to pass. In my view, it is more important for the market to have a clear understanding about the central bank’s reaction function. That is, how the central bank is likely to adjust the stance of policy as the macroeconomic conjuncture evolves. If that is sufficiently clear, then forward guidance does not obviously have any large additional benefit, and runs the risk of just adding noise or sowing confusion. Hence an explanation for the low volatility could be the assumption of a stable macro environment together with an understanding of central bank reaction function, rather than the 7 / 14 BIS central bankers' speeches effect of forward guidance per se. The low level of implied volatility could also reflect greater investor willingness to take on financial market risk. This is consistent with measures that suggest demand for derivatives which protect against uncertainty has declined. It is also consistent with other indicators of increased investor appetite for financial risks, such as the narrowing of credit spreads. This increased risk appetite may in part reflect the low yield environment of recent years; protection against uncertainty is not costless, and so detracts from already low returns. There has also been an increased interest in the selling of volatility-linked derivatives by investors to generate additional returns in the low yield environment in recent years. Effectively, some market participants were selling insurance against volatility. They earned the premium income from those buying the insurance whilever volatility remains lower than expected, but they have to pay out when volatility rises. In recent years, there was a steady stream of premium income to be had. (This is even more so if I were a risk neutral seller of insurance to a risk-averse buyer, in which case, the expected value of the insurance should be positive.) But the payout, when it came, was large. I will come back to this shortly in discussing recent developments. This reduced demand for volatility insurance combined with increased supply saw the price fall. Such an extended period of low volatility is not unprecedented, although the recent episode was among the longest in several decades (Graph 6). Prolonged periods of low volatility have sometimes been followed by sudden increases in volatility – although generally not to especially high levels – and a repricing of financial assets. A rise in volatility could be associated with a reassessment of economic conditions and expected policy settings, in which case, one might not expect the rise to last that long. In contrast, a structural shift higher in volatility requires an 8 / 14 BIS central bankers' speeches increase in uncertainty about future outcomes, rather than simply a reassessment of them. But just as I find it puzzling that term premia in fixed income markets have been so low for so long, I similarly find it puzzling that measures of volatility do not seem to embody much uncertainty either. The recent spike in volatility in early February is interesting in terms of the market dynamics, coming as it did after a prolonged period of low volatility.7 From around September 2017, there had been a rise in bond yields, most notably in the US, as confidence about the outlook for the US and global economy continued to improve. This rise in yields accelerated in January 2018, again most notably in the US, in large part in response to the passage of the fiscal stimulus there. As Graph 7 shows, the rise in Treasury yields in the first part of this year reflected both a rise in real yields and compensation for inflation. This reassessment of the macroeconomic outlook was also reflected in a reassessment (albeit relatively small) of the future path of monetary policy in the US. It is also worth noting that the real yield can incorporate any risk premium on the underlying asset. So the recent rise may also be a result of a change in the assessment of investors about the riskiness of US Treasuries. In light of the reassessment of the macro environment it was somewhat surprising that through the month of January, equity prices in the US rose as strongly as they did. As I discussed at the outset of this speech, I would expect that a shift upwards in the structure of interest rates would result in a repricing of asset prices more generally. In late January, this indeed is what happened: equity prices declined, again most sharply in the US. There was a sharp rise in volatility. The initial rise in volatility was exacerbated by the unwinding of a number of products that allowed retail investors (and others) to sell volatility insurance, and the hedging by the institutions that had offered those products to their retail customers. Indeed, unwinding is a euphemism as, in some cases, the retail investor lost all of their capital investment. Having seen the legendary Ed 9 / 14 BIS central bankers' speeches Kuepper and the Aints again last Friday, it’s worth remembering to “Know Your Product”, otherwise it will be “No, Your Product”. What is particularly noteworthy about this episode is how much the rise in volatility, and the large movements in prices, was confined to equity markets. While volatility rose in other asset classes, it did not increase to particularly noteworthy levels. For example, there was relatively little spillover to emerging markets. This is in stark contrast to similar episodes in the past. The fact that these products were particularly associated with volatility in US equity prices appears to have contributed to the limited contagion. Also noteworthy is how short-lived the rise in volatility has been (to date). In discussions with market participants, one possible cause of this is that the unwinding of volatility positions has been largely confined to the retail market, which was relatively small in size. There does not seem to have been much adjustment in the volatility exposures of large institutional market participants to date. That said, it is conceivable that this episode gives a foretaste of the sort of market dynamics that might occur if there were to be a further rise in yields as the market reassesses the outlook for output and, particularly, inflation. Demand and supply dynamics Another consideration in thinking about future developments in the yield structure is the balance of demand and supply in the sovereign debt market. It is often difficult to assess the degree of influence that demand and supply dynamics have on the market. But there are some noteworthy developments occurring at the moment that are worth highlighting. Graph 8 shows the net new debt issuance by the governments of the US, the euro area and Japan, and the net purchases of sovereign debt by their respective central banks. It shows that the peak net purchases by the official sector occurred in 2016. This happens to coincide with the low point in sovereign bond yields, but I would not attribute full causation to that. The central bank purchases are a reaction to the macroeconomic conjuncture at the time which itself has a direct influence on the yield structure. That said, one of the main aims of the central bank asset purchases was to reduce the term premium. 10 / 14 BIS central bankers' speeches But in 2018, there is going to be a net supply of sovereign debt to the market from the G3 economies for the first time since 2014. This reflects a few different developments. The Federal Reserve started the process of reducing the size of its balance sheet last year by not fully replacing maturing securities with new purchases. While this is a very gradual process, it is a different dynamic from the previous eight years. At the same time, the US Treasury will issue considerably more debt than in recent years to finance the US budget deficit, which has grown from 2 per cent of GDP in 2015 to over 5 per cent in 2019 as the Trump administration implements its sizeable fiscal stimulus. In Europe, the fiscal position is gradually improving, but the ECB has started the process of scaling back its purchases of sovereign debt, with some expectation these might cease entirely at the end of the year. In Japan, the Bank of Japan is still undertaking very large purchases of Japanese Government debt, which are larger even than the sizeable net issuance to fund Japan’s fiscal deficit. Meanwhile, there is no expectation of significant reserve accumulation by central banks or sovereign asset managers, which can often take the form of sovereign debt purchases. And financial institutions, which have been significant accumulators of sovereign bonds in recent years as they sought to build their liquidity buffers, are not expected to accrue liquid assets to the same extent again in the foreseeable future. So the net of all of this is that some of the demand/supply dynamics in sovereign bond markets 11 / 14 BIS central bankers' speeches will be different this year from previous years. For a number of years, central banks purchased duration from the market, but that is in the process of reversing. In that regard, an issue worth thinking about is that the central banks don’t manage their duration risk in their bond holdings at all. Nor do they rebalance their portfolios in response to price changes, unlike most other investors whose actions to rebalance their portfolios back to their benchmarks act as a stabilising influence. An additional issue worth thinking about is that, through its purchases of mortgage-backed securities, the US Federal Reserve removed much of the uncertainty associated with the early prepayment of mortgages by homeowners by absorbing the impact of prepayments on the maturity profile of its bond portfolio. Private investors typically hedge this risk, and their hedging activity contributes to volatility in interest rates. As the Fed winds down its balance sheet, it is putting this negative convexity risk back in the hands of private investors, and the associated interest rate volatility will return to the market. Issuance in a low rate environment To date I have been discussing developments in the rate structure from the perspective of the investor. But it is also interesting to examine how issuers have responded to the historically low rate structure. Graph 9 shows that many issuers have responded to the low rate structure, and particularly the absence of any material term premium, by lengthening the maturity of their debt, aka “terming out”. Moreover, lower interest rates on their new issuance have resulted in the average duration of their debt rising by even more. The first two panels show that is true of most sovereigns. The Australian governments, Commonwealth and State, have proceeded along this path. The Australian Office of Financial Management (AOFM) has significantly extended the curve in Australia, by issuing out to a 30-year 12 / 14 BIS central bankers' speeches bond. A number of bonds have been issued well beyond the 10-year maturity, which was the standard end of the yield curve for a number of years. This has also helped state governments to increase the maturity of their issuance. One interesting exception to the general tendency to term out their debt is the US Treasury, which is undertaking a sizeable amount of issuance at the short end of the curve. Corporates have also termed out their debt. Some corporates have issued debt with maturities as long as 50 years, which is interesting for at least two reasons. Firstly, a 50-year bond starts to take on more equity-like features. Secondly, many corporates don’t even last 50 years. The Australian banks have also availed themselves of the opportunity to term out their funding for relatively little cost. The recently implemented Net Stable Funding Ratio (NSFR) further incentivises them to do this. As my colleague Christopher Kent noted a couple of days ago, the average maturity of new issuance of the Australian banks has increased from five years in 2013 to six years currently (Graph 10).8 As with other issuers, this materially reduces rollover risk. The banks have been able to issue in size at tenors such as seven or ten years that they historically often thought to be unattainable at any reasonable price. While the low rate structure has often been perceived to be a challenge from the investor point of view, it has been an opportunity for issuers to reduce their rollover risk by extending debt maturities. Conclusion The structure of interest rates globally has been at an historically low level for a number of years. This has reflected the aftermath of the financial crisis and the associated monetary policy response. If the global recovery continues to play out as currently anticipated, one would expect that the monetary stimulus will unwind, which would see at least the short-end of yield curves rise. 13 / 14 BIS central bankers' speeches At the same time, there have been factors behind the low structure of interest rates which are difficult to understand completely and raise questions about its durability. I have discussed some of them here today. In particular, I find it puzzling that there is little compensation for duration in the rate structure. While there are explanations for why interest rates may remain low for a considerable period of time, there is minimal compensation for the uncertainty as to whether or not this will actually occur. At the same time, equity prices embody a view of the future that robust growth can continue without generating a material increase in inflation. Again, there is little priced in for the risk that this may not turn out to be true. The ongoing improvement in the global economy, together with the fiscal stimulus in the US has caused some investors to question these views. If interest rates continue to rise without a similar rise in expectations about future earnings growth, one would expect to see a repricing of other assets, particularly equity markets. Such a repricing does not necessarily mean a major derailing of the global recovery, indeed it is a consequence of the recovery, but it may have a dampening effect. At the same time, we need to be alert for the effect the rise in the interest rate structure has on financial market functioning. The recent spike in volatility is one example of this. In my view, that was a small example of what could happen following a larger and more sustained shift upwards in the rate structure. The recent episode was primarily confined to the retail market. The large institutional positions that are predicated on a continuation of the low volatility regime remain in place. That said, I have expected that volatility would move higher structurally in the past and this has turned out to be wrong. But I think there is a higher probability of being proven correct this time. 1 See Kozlowski J, L Veldkamp, V Venkateswaran (2018), ‘The Tail that Keeps the Riskless Rate Low’, available at , NBER Working Paper No. 24362. 2 One may also want to think about the relatively low level of spreads in a number of fixed income markets, as my colleague Christopher Kent talked about earlier this week. In some markets (but not all), these spreads are close to pre-financial crisis levels. See Kent C (2018), ‘Australian Fixed Income Securities in a Low Rate World’, Address to the Debt Capital Markets Summit, Sydney, 14 March. 3 Note this scenario is at odds with a secular stagnation view of the world where future earnings growth would not be strong. 4 Blanchard OJ (1981), ‘Output, the Stock Market and Interest Rates’, American Economic Review, Vol 71, Issue 1, pp 132–143. 5 Debelle G (2017), ‘Global Influences on Domestic Monetary Policy’, Committee for Economic Development of Australia (CEDA) Mid-Year Economic Update, Adelaide, 21 July. 6 To be clear, by the current rate structure, I don’t mean that the yield curve remains literally unchanged but rather that short-term rates will evolve in line with the forward rates embedded in the current yield curve. 7 For a discussion of some of the market structure issues, see various posts over recent months under the title of ‘People are Worried that People aren’t Worried Enough’ in his Money Stuff blog’, available at , by Matt Levine, as well as “VIX VapoRubOut’, available at ,”, blog post by Craig Pirrong aka the Streetwise Professor. 8 Kent C (2018), ‘Australian Fixed Income Securities in a Low Rate World’, Address to the Debt Capital Markets Summit, Sydney, 14 March. 14 / 14 BIS central bankers' speeches | reserve bank of australia | 2,018 | 3 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Australia-Israel Chamber of Commerce (WA), Perth, 11 April 2018. | Philip Lowe: Regional variation in a national economy Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Australia-Israel Chamber of Commerce (WA), Perth, 11 April 2018. * * * I would like to thank James Bishop and Andrea Brischetto for assistance in the preparation of this talk. I would like to thank the Australia-Israel Chamber of Commerce for the invitation to speak at this lunch today. It is great to be back in Perth again. I look forward to learning more about how the Western Australian economy is going. Later this year, the full Reserve Bank Board will be here for our monetary policy meeting on the first Tuesday in September. When I was in Perth six months ago I gave a speech titled ‘The Next Chapter’. In that speech I explored some of the likely plot lines in the next chapter of Australia’s economic history. I would like to continue that broad theme today. For most of the past decade, a common shorthand description of the Australian economy was that it was a ‘two-speed’ economy. For some time, Western Australia and Queensland were growing very quickly on the back of investment in the resources sector, but growth in the other states was subdued. And then things turned around: growth was weak in Western Australia and Queensland, and stronger elsewhere. So it’s understandable that people have talked about a ‘two-speed’ economy. In a country as large and diverse as Australia, it is not surprising that we experience differences like this from time to time. It is important that the Reserve Bank understands these differences and, indeed, we devote considerable resources to doing this. But today, rather than focus only on the differences across regions, I also want to focus on the similarities. I would like to do this from two perspectives. The first is from a cyclical perspective and the second is from a structural perspective. From the cyclical perspective, the good news is that conditions have improved across most of Australia over the past year. And from a structural perspective, over time the differences in the structure of output and employment across regions are tending to become smaller, rather than larger. So I would like to talk about this. There are, of course, still important differences across the country and I will discuss some of these as well. Finally, I will finish with some comments about the recent monetary policy decisions of the Reserve Bank Board. The cyclical perspective Over the past year, when discussing the national economy, the Reserve Bank has focused on a number of themes. I would like to highlight four of these again today (Graph 1). 1 / 16 BIS central bankers' speeches The first is the strong growth in employment. Over the past year, the number of Australians with jobs has increased by 3½ per cent, which is a very positive outcome. Labour force participation has also increased, especially by women. The unemployment rate has also fallen over the past year, although it has been steady at around 5½ per cent over the past six months. The second theme is a pick-up in non-mining business investment. We had been waiting a long time for this to occur, but in 2017 the long-forecast lift in investment finally took place. Over the year, non-mining business investment increased by 12½ per cent, the largest rise in a decade, and a further increase is expected. The third theme is an improvement in business conditions, as reported in surveys. These surveys are currently more positive than they have been at any time since the financial crisis. They also suggest that capacity utilisation has been increasing. The fourth theme has been slow growth in wages. Wage increases around 2 per cent have become the norm in many parts of the country. This is in contrast to the 3 to 4 per cent increases that were the norm for most of the past two decades. This change is having a sobering effect on the finances of many households. It is also contributing to inflation being low. The latest data suggest that the rate of wages growth has now troughed, with a pick-up evident in the most recent quarter. A further lift is expected, but it is likely to be only gradual. So the overall picture for the national economy is one of gradual improvement: businesses are feeling better than they have for some time and they have increased their investment and hiring. It is therefore reasonable to expect that economic growth in 2018 will be stronger than the 2.4 per cent outcome we saw last year. This improvement in the economic climate has occurred across the country, not just in one or two areas. There are, of course, regional differences, but these four themes are evident across the country, although to varying degrees. 2 / 16 BIS central bankers' speeches Over the past year, employment has risen in all states (Graph 2). This is a different picture than we’ve seen for some time. Here in Western Australia, there was virtually no employment growth for more than four years after the peak in mining investment. Over this period, Western Australia went from having an unemployment rate of two point something to six point something. Recently, though, the labour market here has begun to improve, with employment increasing by 2½ per cent over the past year and the unemployment rate having come off its peak. There has been strong growth in jobs in education and health, as there has been around the country. Turning to non-mining investment, the state-level data are less timely. We do know, however, that in most states total business investment picked up through 2017, with particularly strong growth in non-residential construction (Graph 3). Here in Western Australia, the picture is a little different, given the ongoing unwinding of the mining investment boom. Over the past year, total business investment in Western Australia has been broadly steady, after earlier sharp declines. There has, however, been a pick-up in non-residential building approvals, which suggests that a turning point in non-mining business investment has now been reached. One area, though, that does remain weak is investment in dwellings, with the level of activity here in the west standing in contrast to the high level of dwelling investment in the eastern states. 3 / 16 BIS central bankers' speeches The third theme – the pick-up in survey-based measures of business conditions – is also evident across the country. For sake of simplicity, this next graph shows business conditions for Western Australia only and the rest of Australia (Graph 4). The direction of change is the same, even if conditions here are not as bright as elsewhere. In all states, including in Western Australia, reported business conditions are now currently above their long-term averages. 4 / 16 BIS central bankers' speeches The final of the four themes is weak wages growth. This, too, is a national story. Over the past year, the wage price index increased by around 2 per cent or less in all states (Graph 5). For a number of years, growth in wages in Western Australia was running considerably above that in the rest of the country, with the result that the average level of wages here rose noticeably above that in other states. In the past couple of years, this differential has narrowed, with growth in wages here below the national average. It is also worth pointing out that the most recent data show slightly stronger growth in wages in all states. This is a positive development. 5 / 16 BIS central bankers' speeches So the cyclical themes that we are seeing at the national level are playing out right across the country, although to differing degrees. We are now all moving in the same direction. The structural perspective I would now like to turn to the structural perspective. The main point is that, abstracting from the cyclical dynamics, there is a longer-run trend towards more similarity, rather than more divergence, in the underlying economic structure across the country. An important area where this can be seen is the labour market. Over time, there has been a marked reduction in the dispersion of unemployment rates across the country (Graph 6). In particular, the standard deviation of the unemployment rate across the 87 individual regions for which the Australian Bureau of Statistics (ABS) publishes data is markedly lower than it was at the turn of the century. 6 / 16 BIS central bankers' speeches It is also worth noting that the average unemployment rate outside the capital cities is lower than the average unemployment rate in the capital cities for the first time in a long while (Graph 7). The gap between the participation rates for prime-aged workers in the capital cities and outside the capitals has also narrowed. So there has been a convergence of sorts. 7 / 16 BIS central bankers' speeches There are a number of possible explanations for this. One is that the labour market has become more flexible, including through the movement of people. Another is that the economic shocks experienced have become less region specific. It is hard to be definitive, but both explanations are likely to have played some role.1 The improved flexibility of the Australian labour market is no doubt part of the story, and the willingness of people to move for jobs is part of this. However, the propensity of people to move interstate, or within their state, has declined over the period that the dispersion in unemployment rates has declined (Graph 8). For the two decades to the mid 2000s, around 2 per cent of us moved states each year. Over recent times that share has fallen to 1½ per cent. 8 / 16 BIS central bankers' speeches Another important part of the story is overseas migration. This is evident in this next graph, which shows the contribution to employment growth from interstate migration, overseas migration and people already living within the state (Graph 9).2 The role that overseas migration played in the adjustment process here in Western Australia is clear. When the boom was in full swing the workforce in Western Australia was boosted significantly by workers from overseas. And then after the boom, the flow of immigrants slowed considerably. It is also clear that, over recent years, more people have been moving from Western Australia to other states than vice versa. This is in stark contrast to the boom years. The overall conclusion here is that the movement of people has helped even things out across the economy. 9 / 16 BIS central bankers' speeches The other possible explanation for the reduced dispersion in unemployment rates is that many of the economic shocks we experience nowadays are less regionally concentrated – with the mining investment boom being an obvious exception! – perhaps because of less variation in the structure of regional economies. It is difficult to test this idea rigorously, especially the nature of the shocks. But we can look at the variation across the country in the industries in which people work and the type of jobs they have. My colleagues at the RBA have done this using Census data for the more than 300 separate geographical areas in Australia. 3 Using these data, they have constructed indices of how different the various regions are in terms of the industries that people work in and the occupations that they have. I will spare you the technical details of these calculations.4 My colleagues have also calculated how these indices have moved through time and they have conducted the exercise both including and excluding the regions with a heavy concentration in mining. The results are shown in this next graph (Graph 10). 10 / 16 BIS central bankers' speeches The main conclusion from this work is that, on average, regions are becoming more similar. Over time, the industries we are working in, and our occupations, are becoming more alike across Australia, not more different. There are, of course, still large differences across regions, but they are smaller than they once were. One important reason for this is the increasing relative importance of service industries, and the decline in the relative importance of manufacturing. Both of these are national phenomena. Using the data from the 300-plus individual regions, it is clear that the variation across the country in the share of the workforce employed in the manufacturing industry has declined since the early 2000s (Graph 11). In 2016, the distribution is more tightly clustered around a lower average than it was in 2001. It is also clear from the Census data that those regions that had a relatively high share of workers employed in manufacturing in 2001 have tended to have faster growth in services employment than have other regions. So we are becoming more alike. 11 / 16 BIS central bankers' speeches None of this is to say that there are not big differences across our country. There clearly are, and I will come to some of these in a moment. But, on average, the growth of the services industries has meant that the differences in industrial structures across regions have narrowed over time. I would expect that this would continue. As I have spoken about on previous occasions, the growth of services and increasing investment in technology mean that investment in human capital is critically important to the country’s future success. This needs to be a national focus. We are making progress, but there is more to be done, with investment in human capital central to building comparative advantage. This next graph shows the distribution across regions in the share of the population with an advanced qualification, defined here as a Certificate III or higher (Graph 12). There has been a marked shift to the right in the distribution. By 2016, there were only a few regions in which less than half of all 25–44 year olds held an advanced qualification. This is a noticeable change from the early 2000s and suggests the lift in qualifications is broadly based across regions. If anything, the dispersion across regions has also lessened over time. 12 / 16 BIS central bankers' speeches So far I have spoken about the commonalities in the cyclical and structural stories. It is important, though, to recognise that there are significant differences across regions. One illustration of this is the different average level of wage income across the country, which we can calculate from individual tax returns (Graph 13). There is considerable variation across the country, with some regions having average wage income more than 50 per cent above the national average. Wage income also tends to be higher in the capital cities than elsewhere. In part, this is explained by the types of jobs available in larger cities. For example, the capital cities are home to over 80 per cent of all IT, business, HR and marketing professionals, while only around 65 per cent of people live in these cities. On average, these business-service roles attract higher wages than many other occupations. 13 / 16 BIS central bankers' speeches Another notable difference across regions is the level of housing prices. This reflects not just differences in average incomes, but the underlying demand and supply dynamics. This next graph shows the standard deviation in housing prices across the country, using data for around 330 separate regions (Graph 14). The picture is pretty clear: the dispersion in housing prices is currently larger than it has been in a very long time. This mostly reflects the big run-up in housing prices in Sydney and Melbourne at a time when price growth in the rest of the country has been subdued. 14 / 16 BIS central bankers' speeches It’s clear from this graph that, in the past, this measure of variation has had a cyclical element: it increases for a while and then declines. It is understandable why this happens. When prices increase a lot in one area, relative to another, some people relocate to where prices are lower, especially if jobs are available. This certainly happened in the late 1990s/early 2000s, when there was a marked pick-up in people moving from New South Wales to Queensland following the big increase in housing prices in Sydney. It’s too early to tell whether the same type of adjustment will happen this time, but the number of people moving from New South Wales, where housing prices are highest, to Queensland (and, to a lesser extent, Victoria) has begun to pick up. Monetary policy I would now like to turn to monetary policy. The Reserve Bank’s responsibility is to set monetary policy for Australia as a whole. We seek to do that in a way that keeps the national economy on an even keel, and inflation low and stable. No matter where one lives in Australia, we all benefit from this stability and from being part of a national economy. This is so, even if, at times, in some areas, people might wish for a different level of interest rates from that appropriate for the national economy. In setting that national rate, I can assure you we pay close attention to what is happening right across the country. As you are aware, the Reserve Bank Board has held the cash rate steady at 1½ per cent since August 2016. This has helped support the underlying improvement in the economy that I spoke about earlier. In thinking about the future, there are four broad points that I would like to make. The first is that we expect a further pick-up in the Australian economy. Increased investment and hiring, as well as a lift in exports, should see stronger GDP growth this year and next. The better labour market should lead to a pick-up in wages growth. Inflation is also expected to gradually 15 / 16 BIS central bankers' speeches pick up. So, we are making progress. There are, though, some uncertainties around this outlook, with the main ones lying in the international arena. A serious escalation of trade tensions would put the health of the global economy at risk and damage the Australian economy. We also have a lot riding on the Chinese authorities successfully managing the build-up of risk in their financial system. Domestically, the high level of household debt remains a source of vulnerability, although the risks in this area are no longer building, following the strengthening of lending standards. The second point is that it is more likely that the next move in the cash rate will be up, not down, reflecting the improvement in the economy. The last increase in the cash rate was more than seven years ago, so an increase will come as a shock to some people. But it is worth remembering that the most likely scenario in which interest rates are increasing is one in which the economy is strengthening and income growth is also picking up. The third point is that the further progress in lowering unemployment and having inflation return to the midpoint of the target zone is expected to be only gradual. It is still some time before we are likely to be at conventional estimates of full employment. And, given the structural forces also at work, we expect the pick-up in wages growth and inflation to be only gradual. The fourth and final point is that, because the progress is expected to be only gradual, the Reserve Bank Board does not see a strong case for a near-term adjustment in monetary policy. While some other central banks are raising their policy rates, we need to keep in mind that their economic circumstances are different and that they have had lower policy rates than us over the past decade, in some cases at zero or even below. A continuation of the current stance of monetary policy in Australia will help our economy adjust and should see further progress in reducing unemployment and having inflation return to target. Thank you very much for listening. I look forward to your questions. 1 For discussion of other explanations of the convergence in unemployment rates over time, see Gruen D, B Li and T Wong (2012), ‘Unemployment disparity across regions’, Economic Roundup, Issue 2, pp 63–78. 2 Within-state factors that contribute to employment growth include changes in unemployment and participation rates and natural increase in the population. 3 This work has been conducted by James Bishop and Mary-Alice Doyle. They have also conducted this exercise for the more than 2 100 smaller geographical areas for which data are available, with similar results to those discussed here. 4 In broad terms, the Theil information-theory index of segregation measures the extent to which industries and occupations are geographically segregated across regions (Theil and Finizza, 1971). It compares the distribution of occupations or industries in each location to the national distribution. The index ranges from 0 to 1, with a higher value indicating more segregation and a lower value indicating more similarity. These estimates are constructed using single-digit industries and occupations. For more details, see Kaplan G and S Schulhofer-Wohl (2017), ‘Understanding the long-run decline in interstate migration’, International Economic Review, Volume 58, Issue 1, pp 57–94. 16 / 16 BIS central bankers' speeches | reserve bank of australia | 2,018 | 4 |
Address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the RBA Conference 2018, Sydney, 12 April 2018. | Guy Debelle: Twenty-five years of inflation targeting in Australia Address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the RBA Conference 2018, Sydney, 12 April 2018. * * * This draws on a number of pieces I have written on inflation targeting over the past two decades, both at the RBA and the IMF. Thanks to Claudia Seibold for her assistance with the data. Introduction It has been 25 years since Australia adopted an inflation-targeting regime as the framework for monetary policy. At the time of adoption, inflation targeting was in its infancy. New Zealand had announced its inflation target in 1989, followed by Canada and Sweden. The inflation-targeting framework was untested and there was little in the way of academic analysis to provide guidance about the general design and operational principles. Practice was very much ahead of theory. Now 25 years later, inflation targeting is widely used as the framework for monetary policy. While there are differences in some of the features across countries, the similarities are more pervasive than the differences. And generally, the features of inflation-targeting frameworks have tended to converge over time. It is interesting to firstly examine how the inflation-targeting framework in Australia has evolved over the 25 years. Secondly, it is also timely to reassess the appropriateness of the regime. The first is the main task of my paper, the second is the task of the conference collectively. In terms of the first, the main point I will make is that the Australian framework has not changed much over the past 25 years. The flexible nature of the framework, which was there at its inception, has proven to be resilient to the quite substantial changes in the macroeconomic environment that have taken place since. This is in contrast to some other countries that have moved from an initially rigid definition (which may well have been appropriate at their inception) toward something more flexible. The framework in Australia was adaptable from the start, which caused some issues in convincing some people of the seriousness with which the Reserve Bank was adopting an appropriate monetary framework. While the specification of the regime has not materially changed, one thing that has changed is the degree of confidence that the regime might actually work. Australia, like other countries, came to inflation targeting after trying a number of alternative approaches to monetary policy. These approaches had not delivered either the desired price stability nor acceptable macroeconomic outcomes. Inflation targeting was the next attempt to try and better achieve these outcomes. There was no guarantee of success. Now, after 25 years, there is considerably greater confidence that the regime can contribute to sound macroeconomic outcomes in terms of both inflation and growth. The proof of the pudding has been in the eating. There is greater confidence and understanding about the framework from the public, from the political process, from financial markets and from the policymakers themselves. There is also now a large academic literature supporting inflation targeting and examining and advising on various questions about the appropriate design and operation of the framework. That has validated many of the decisions taken by policymakers in setting up their inflation-targeting frameworks, but has also questioned some features of the framework. One noteworthy change in the inflation-targeting framework in Australia (and elsewhere) is communication. The content and scope of the communication has increased considerably over 25 years. I will spend some time outlining these changes and the motivation for them. 1 / 14 BIS central bankers' speeches As I said, the second question about the appropriateness of the regime is very much the theme of this conference. What, if any, changes to the framework might be worth considering? In the final section I will raise some questions that will be considered by later speakers at the conference and provide some brief observations on them. When Glenn Stevens and I wrote in 1995 about the motivations for the (then) new inflationtargeting framework in Australia, we said: ‘if, some years hence, we can look back and observe that the average rate of inflation has a “2” in front of the decimal place, that will be regarded as a success’.1 We are now quite some years hence and we can look back and observe that the average rate of inflation has a “2” in front of the decimal place. How did the regime come about? Unlike a number of inflation-targeting countries, the adoption of an inflation-targeting framework in Australia was evolutionary rather than revolutionary. 2 It was not accompanied by a change to the central bank’s legislation as was the case in New Zealand. Nor did it result from a rapid departure from an exchange rate regime as in the UK and Sweden. But, like those other cases, it reflected the recognition that previous monetary frameworks had not been successful in delivering either price stability in the form of low inflation, nor desirable macroeconomic outcomes in terms of sustainable full employment. The inflation target in Australia was outlined in a number of speeches by the then Reserve Bank Governor Bernie Fraser in 1993 and 1994.3 It was a low-key launch, in part reflecting the political climate of the time. As Steve Grenville and Ian Macfarlane noted, it was in the context of locking in the low inflation that had occurred in the aftermath of the early 1990s recession. The target was the operational interpretation of the goals of monetary policy set out in the Reserve Bank of Australia’s founding legislation in 1959, namely: 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. The stability of the currency goal reflects the fact the legislation was written when fixed exchange rates were the norm. It has been interpreted as preserving the purchasing power of the currency and hence is consistent with the maintenance of low and stable inflation. As noted, the inflation target was first adopted by the Reserve Bank in 1993. It was verbally endorsed by the government of the day. But it was not formally endorsed by the government until 1996, when the first Statement on the Conduct of Monetary Policy was signed jointly by the incoming government and the new Reserve Bank Governor, Ian Macfarlane. The political support for the inflation target has been bi-partisan. The Statement has been renewed at the start of the term of each of the subsequent two Governors. It has also been endorsed with each change of government. The Reserve Bank Act 1959 states that monetary policy has both nominal and real objectives. Consistent with that, the Statement on the Conduct of Monetary Policy makes it clear that the inflation-targeting framework recognises both nominal and real objectives. The flexibility of the target in terms of specifying that the inflation goal will be achieved over the cycle (subsequently adjusted to be ‘in the medium term’) is the feature that recognises the dual mandate. To maintain full employment requires that the economy be on a sustainable path. Thus the trajectory of economic growth matters, as does the presence of low inflation and financial stability. In the case of demand shocks, there is not a material conflict between the real and nominal 2 / 14 BIS central bankers' speeches objectives, as the monetary response is effectively the same. That said, the flexibility of the target potentially allows for greater inflation variability to achieve lower variability in the real economy. However, the experience of other inflation-targeting central banks suggests that this difference is not substantial in practice. In the case of supply shocks, where the monetary response to achieve the real and nominal objectives is likely to be in conflict in the short term, the medium-term horizon of the inflation target in Australia allows for a greater weight to be placed on output stabilisation and a more gradual return of the inflation rate to target, than with a strict inflation target. Again, the practice of most central banks over the past two decades has tended to evolve towards the sort of flexibility explicitly recognised in the Australian target, notwithstanding the lexicographic ranking of inflation and output objectives in the specification of some other inflation targets.4 The Statement has not undergone much change since 1996. The current formulation is: ‘the appropriate target for monetary policy in Australia is to achieve an inflation rate of 2–3 per cent, on average, over time.’ Beyond some drafting changes that simply reflect the passage of time, the most substantive change has been the articulation of the financial stability objective of the Reserve Bank, which I will return to later. In terms of the description of the inflation target itself, the only change has been the objective from keeping ‘underlying inflation between 2 and 3 per cent, on average, over the cycle’ to keeping ‘consumer price inflation between 2 and 3 per cent, on average, over time’. I regard this as purely a presentational change without any operational consequences.5 As I noted in a speech at the Bank of England6 last year, inflation targeting and central bank independence are sometimes conflated given their similar birth dates in a number of countries. In large part, this is because both were a response to the inflation experience of the 1970s and 1980s. In Australia, just as the inflation target was evolutionary rather than revolutionary, so too, greater central bank independence also evolved through time rather than there being a distinct break from past practice. As Ian Macfarlane stated: ‘the Reserve Bank, by virtue of its Act in 1959, was always given a high degree of general independence as an institution. The fact that it had been unable to exercise this independence in monetary policy for much of the post-war period was due to a practical impediment – it did not possess the instruments of monetary policy.’ As these impediments were removed, the Reserve Bank was able to become more independent in its setting of monetary policy. Thus while the formal recognition of this independence was not completely visible until the first Statement on Monetary Policy in 1996, the practical independence had been there some time before that. The inflation target in practice How has the inflation target in Australia actually delivered in practice? 3 / 14 BIS central bankers' speeches The inflation target can be thought of as a ‘thick point’.7 This doesn’t mean that inflation with a 2 in front of it implies a zone of policy inaction. It simply acknowledges that inflation will obviously 4 / 14 BIS central bankers' speeches vary through time and that there is probably not much to be gained from being too precise about the appropriate inflation rate, whilst also recognising that the specification of the inflation target plays an important role in anchoring inflation expectations. It would appear that the latter goal has been achieved because the inflation expectations of the public have generally been consistent with the target.Graph 1 shows the outcomes for inflation and unemployment (as well as the cash rate, the instrument of monetary policy) and Table 1 summarises the macroeconomic outcomes since the early 1970s. It updates a similar table in Stevens (2016). The table shows that the average inflation rate over the inflation-targeting period has been 2.5 per cent. So the inflation target has been achieved over its period of operation. At times, the inflation rate has been above the band, at times it has been below the band (though none of these deviations have been that persistent). This also illustrates the flexibility of the framework, which I will discuss in more detail in the next section. Of note, as is apparent in the graph, the inflation outcomes in the past decade have been at the lower end of the distribution of outcomes over the period. That is, as in other countries, inflation in Australia has been lower in the post-crisis period than in the decade preceding it. I will return to this point later in discussing some of the current challenges. While the average inflation rate has been consistent with the target, the real economic outcomes have also been good. The average unemployment rate in the most recent decade is lower than the one in the decade preceding it, which in turn was lower than the one prior to that. Clearly, these outcomes are also a function of the macroeconomic environment, and cannot be solely attributable to the inflation target. Part of the first period of inflation targeting was the NICE8 decade and macroeconomic outcomes in the late 1990s and early 2000s were better in many countries, regardless of whether they had a (formal) inflation target or not. That said, many of the early adopters of inflation targets had continued to experience sub-par economic outcomes in the 1980s, particularly in terms of high inflation, when other countries had been able to achieve successful disinflations. But it is important to note that the period for which the inflation-targeting framework has been in place has not been that benign. Most obviously, it has included the Asian crisis and the global financial crisis, as well as one of the largest rises (and falls) in the terms of trade in Australia’s economic history – an event that has been the undoing of the Australian economy a number of times in its history. Moreover, to paraphrase some words from Glenn Stevens in his final speech as Governor: ‘had anyone [in 1993] accurately forecast all the international events and simultaneously predicted that things would turn out in Australia as they have, they would not have been believed. But here we are.’9 The variability in global output has been higher in recent years, but by contrast in Australia it has been lower. At the same time, the table shows variability of inflation has been lower in the inflation-targeting period than in the period prior to that. When inflation targeting was in its infancy, there was a lot of research in central banks examining the trade-off between output and inflation variability and assessing the ability of different policy rules to achieve different points on that trade-off.10 This work followed on from that of John Taylor, along with Dale Henderson and Warwick McKibbin. The inflation target has been associated with the inflation/output variability curve in Australia shifting in, notwithstanding the volatility of the world more generally. As Glenn noted, one significant contributor to the lower output volatility in Australia has been the avoidance of a large downturn. But the avoidance of a large downturn is in part a function of the avoidance of an inflation breakout, which in turn, I would argue can be attributed, to a reasonable extent, to the operation of monetary policy under the inflation target. Hence, when we look back over the past 25 years: the inflation target has been achieved; real 5 / 14 BIS central bankers' speeches growth has been robust; average unemployment has declined through time; and nominal and real variability has been lower. So, I think it is reasonable to argue that the inflation-targeting framework in Australia does seem to have played some part in contributing to the improved outcomes. Flexibility in practice I will use four episodes over the past 25 years to illustrate some different features of the operation of the inflation target in Australia, in particular illustrating the flexibility of the target in practice, as well as its forward-looking nature.11 The first episode is the first tightening cycle with the inflation-targeting framework in 1994/95; the second, the response to the Asian crisis a few years later. The third episode is the introduction of the Goods and Services Tax (GST) in 2000 where the price level was boosted by 3 per cent overnight. The fourth episode is the period around the onset of the global financial crisis in 2007–08. 1994/95 By the middle of 1994, inflation pressures were building as economic growth was accelerating. The unemployment rate had declined by 3 percentage points in two years and wage pressures were evident. There were doubts about whether the Australian inflation-targeting regime was sufficiently serious enough to be able to curtail these burgeoning inflation pressures. Indeed there were doubts about whether we even really had an inflation-targeting framework. One manifestation of this was that the Bank of England was organising a conference on the nascent area of inflation targeting and wasn’t sure whether Australia should be invited or not. Graciously they did end up including us and invited Glenn Stevens and me to talk about the Australian model alongside the stricter frameworks of New Zealand and Canada.12 The flexible specification of the inflation target in Australia was seen as a vulnerability. It didn’t have the electric fence of the more hard-edged inflation targets in some other countries. The ‘over the cycle’ language was too ‘fuzzy’. Reflecting such concerns, bond yields had risen quite significantly in 1994 in anticipation of a material increase in inflation. But inflation was still at its post-recession lows of 2 per cent when the Bank increased the cash rate by 275 basis points in three moves over the second half of 1994. This pre-emptive tightening was assessed to be necessary to curtail the Bank’s forecast that inflation would rise. It is noteworthy that the tightening occurred with inflation still only 2 per cent. Financial markets had anticipated that significantly more tightening would be required, reflecting their lack of faith in the new framework. Subsequently, inflation did actually rise to slightly above 3 per cent. The flexibility of the target allowed the avoidance of an unnecessary cost to the real economy of trying to cap the rise in inflation to below 3 per cent, consistent with the dual mandate. In 1996, as demand pressures were easing, the Bank’s forecast was for inflation to decline. The stance of policy was eased, even though inflation was still above 3 per cent. The flexibility of the target, and its forward-looking focus, allowed the assessment of whether the inflation target was at risk in the medium term sense to determine the appropriate policy response. That episode went a long way to enhancing the credibility of the framework with wage and price setters as well as with financial markets. It also increased the confidence within the Bank that the inflation-targeting framework would be successful in achieving the Bank’s legislated goals. The Asian crisis and exchange rate shocks At the onset of the Asian crisis, the Australian economy was growing at around trend rates, with domestic demand beginning to accelerate, and underlying inflation at 1.6 per cent. Monetary 6 / 14 BIS central bankers' speeches policy had been eased over the prior year or so in anticipation of the decline in inflation that subsequently occurred. Thus the Asian crisis hit the Australian economy at a time when it was in reasonable shape with the stance of monetary policy already relatively expansionary. Exports to east Asia accounted for around one-third of Australia’s exports at the time. In the year following the onset of the crisis, Australia’s exports to the region declined by nearly 20 per cent, directly subtracting around 1 percentage point from aggregate growth. Thus the decline in output in the east Asian region represented a significant negative demand shock to the Australian economy. Australia’s terms of trade also fell sharply as commodity prices declined, further exacerbating the decline in export demand. In the event, inflation in Australia rose by less than was forecast, in part because of the decline in the pass-through of the exchange rate depreciation, as well as a greater-than-expected disinflationary impulse from the Asian region that put downward pressure on import prices. If policy had been set to ensure that inflation did not rise above 3 per cent, the necessary rise in interest rates would have exacerbated the contractionary shock to foreign demand. With the benefit of hindsight, given the lower-than-expected inflation outcomes, this would have resulted in a significant undershooting of the inflation target. The flexible inflation target served as a useful framework to think about the Asian crisis. Strong consideration was given to the goal of output stabilisation because the inflation target in the medium term was not felt to be in jeopardy. In addition, the policy credibility that had built up since the adoption of the inflation-targeting regime also allowed the Reserve Bank greater flexibility in its policy response. Gst 2000 On 1 July 2000, a 10 per cent goods and services tax was introduced. As a result, the price level as measured by the CPI increased by 3 per cent overnight. Hence inflation as measured by the CPI was boosted, in a year-ended sense, by 3 percentage points for the next 12 months. The increase in the price level was fully anticipated by the public and financial markets. 7 / 14 BIS central bankers' speeches The Bank did not seek to offset the effect of the GST on the price level. Its assumption was that the boost to the price level would be once-off, and that the (by now well-enhanced) credibility of the inflation target would ensure that medium-term inflation expectations would remain well anchored. The Bank communicated that this was its assessment well in advance of the introduction of the GST to help condition expectations. Again, the specification of the regime allowed the Bank the flexibility to look through the increase in the price level. It is worth noting that such flexibility would be more problematic under a price level targeting regime, or even a nominal income target. With a strict price level target, the effect of the GST in boosting the price level would have to be unwound over some period of time, notwithstanding that households were compensated for the change by income tax cuts. In the event, the credibility of the target and the Bank’s strategy was demonstrated. Inflation expectations remained anchored. Nearly all of the public discussion at the time focused on the inflation rate net of the GST effect. While policy was tightened around that time, it reflected standard sources of price pressure such as strong growth, a rise in oil prices and a depreciating exchange rate, not the effect of the price level shock. While the mid 1990s episode went a long way to building the credibility of the framework, the GST episode confirmed that the framework was well entrenched in wage and price-setting behaviour in the Australian economy. 2007/08 From around 2006, it became clear that inflation pressures were again growing in the Australian economy. The Bank’s forecasts for inflation were revised upwards in late 2007 and into 2008. Monetary policy was tightened to contain the rise in inflation as the Australian economy was 8 / 14 BIS central bankers' speeches overheating. Inflation reached as high as 5 per cent. But as the events in the global economy turned south sharply, the Bank was able to change the settings of monetary policy quickly and rapidly, even with inflation still high. As the facts changed and the outlook changed, in this case quite dramatically, the Bank changed its assessment about the appropriate setting of policy. The fact that inflation was still high as these events unfolded did not constrain the decision to reduce the cash rate. Again, the flexibility and forward-looking nature of the framework together with its recognition of both the real, as well as the nominal goals, of monetary policy provided the necessary scope for action.13 So throughout its 25 years, the specification of the framework has allowed the Bank to focus on the medium-term outlook for inflation and not be unnecessarily constrained by any current level of the inflation rate. That seems obviously appropriate behaviour now, and reflects the decisionmaking process in all inflation-targeting frameworks today. But it was not obvious that this was the appropriate approach to monetary policy back at the inception of inflation targeting. While the confidence in being able to use the flexibility in the framework has undoubtedly increased, the willingness to use it has always been there. You will note that I have not included the current cycle of monetary policy in this assessment. That is still to play out and I will leave it to a later iteration of this conference to conduct a post-mortem. Communication While the flexible operational approach to inflation targeting has been present throughout, the communication by the Bank has changed quite substantially. Prior to the introduction of the inflation target, the principal vehicle for the Bank’s economic commentary was the Annual Report and the RBA Bulletin. This commentary often ran to no more than a few pages. There were speeches on macroeconomic issues by the Governor and Deputy Governor. Changes in the stance of monetary policy had been announced since 1990 (which was quite innovative at the time), but were generally a one line statement announcing the decision to change the cash rate. That was the extent of the public communication. There was not much information to understand the central bank’s general approach to monetary policy or the central bank’s reaction function. Financial markets had to employ large teams of analysts to divine the central bank’s intentions. The advent of the inflation-targeting framework saw communication increase, though it should be noted that this was a worldwide phenomenon and not confined to inflation-targeting central banks. Why was there such an increase in communication? One reason that I have stated before is that the inflation-targeting central banks did not have a good track record of monetary policymaking. So there was a need to build that track record. A track record requires a track and inflation targeting provided that track. But then you also need to make it clear to people how you are progressing along that track and that is where the communication is important. Given the relatively poor starting point, a high level of communication and transparency was necessary to build credibility as quickly as possible, to enhance the effectiveness of monetary policy and to help anchor inflation expectations. Mervyn King described this as ‘trust building by talk’.14 That was very much the goal of communication when inflation targeting was in its infancy. Similarly, communication was a mechanism to deliver accountability. As I noted earlier, inflation targeting often went hand in hand with greater central bank independence. The quid pro quo for greater independence was greater accountability. In Australia’s case, the need for accountability, and communication as one mechanism to deliver that accountability, was reflected in the first Statement on the Conduct of Monetary Policy, which stated that ‘it is important the Bank report on how it sees developments in the economy, currently and in prospect, affecting expected inflation outcomes’. It noted that this would include the Statements on Monetary Policy, public 9 / 14 BIS central bankers' speeches addresses and required semiannual appearances of the Governor before the parliament. Today, the extent and nature of communication have increased still further. The Statement on Monetary Policy is a comprehensive document detailing the assessment of the current conjuncture, the Bank’s outlook for the economy, the risks and uncertainties around that outlook, and an explanation of the Board’s assessment of the monetary policy settings. The scope and content of these documents have grown materially over the past 25 years. All monetary policy decisions are accompanied by a statement explaining the basis of the decision (whether the stance is change or not). Minutes of the Board’s decision-making meeting are published two weeks later. 15 The number and frequency of speeches by the Governor and Deputy Governor, as well as other senior Bank staff, have increased. The Financial Stability Review is published twice each year providing the Bank’s assessment of those issues. There is a website which makes this material, as well as other material describing the monetary policy framework, readily available to the public. There is an extensive business liaison program and recently an increase in focus on public education about the Bank’s role. So the volume of communication and overall transparency have increased materially. In considering the changed nature of the communication, it is important to ask two questions: what is the objective of the communication, and to whom are we communicating? One of the critical roles of communication is a vehicle for accountability. That communication is directed to the parliament and the public, to whom the Bank is accountable. It is also important that the public and parliament have a good understanding of the inflation-targeting framework to enhance understanding as to why policy decisions are being taken. They may not always agree with them, but it is important that they can understand the rationale behind them. Communication can help anchor inflation expectations, which in turn helps enhance the effectiveness of the regime. There is strong evidence that anchoring of inflation expectations has been enhanced over the past 25 years.16 It is also important the central bank’s reaction function is understood. That is helpful for the effective and timely transmission of monetary policy. It helps ensure that inadvertent monetary policy surprises don’t occur, which serves to enhance the overall credibility of the regime. This communication is important for businesses and households in their decision-making. On the basis of their outlook for the economy, they can have confidence in how the central bank is likely to react and what that would imply for their borrowing costs. An understanding of the reaction function is also important for financial markets participants in setting financial market prices that form an important part of the transmission mechanism of monetary policy actions. The effectiveness of communication or transparency is sometimes measured by interest rate surprises. While this might be appropriate in some cases, sometimes the surprise happens through a previous signal by the central bank. In my view, the surprise should be primarily confined to data or event surprises. That is, with a well-understood reaction function, the vast bulk of surprises should come from unexpected developments, not unexpected actions by the central bank. The amount and content of communication has been one of the most substantive changes over the past 25 years. That has, in my opinion, been clearly beneficial for the accountability of the Reserve Bank, as well as the effective functioning of the inflation-targeting framework. That said, it is always worth checking that the increased communication is delivering signal rather than noise. That is, the quality of the message is more important than the quantity. 10 / 14 BIS central bankers' speeches Open issues I have argued that the inflation target has delivered macroeconomic outcomes that have been beneficial for the Australian economy. I think a strong case can be made that it has contributed materially to better economic outcomes than the monetary frameworks that preceded it. I have also noted that the framework in Australia has not changed much over the 25 years of its operation, with the notable exception of communication. So does that mean that the current configuration of the inflation target is the most appropriate or that even that is the most appropriate framework for monetary policy? What changes could be contemplated? Those questions are going to be addressed in other papers at this conference. But let me raise some here and discuss issues worth considering around each of them. The first is the role of financial stability in an inflation-targeting framework. The Reserve Bank research conference last year considered this issue at some length.17 As I said earlier, financial stability is now articulated in the Statement on the Conduct of Monetary Policy. I talked about this issue at the Bank of England18 last year and Ben Broadbent is addressing it at this conference. One question that arises is how the financial stability goal interacts with the inflation target. Is it a separate goal that sets up potential trade-offs or is it aligned with the inflation-targeting goal? In the latter case, a potential reconciliation is the time horizon. When it materialises, financial instability is likely to be detrimental to inflation and unemployment/output: the global recession of 2008 and the subsequent slow recovery in a number of economies bears testament to the potential costs of financial instability (although here in Australia we didn’t experience this to as great an extent). So over some time horizon, potentially quite long, the inflation target and financial stability are aligned. But translating this into monetary policy implications over a shorter time horizon is a large challenge, which still seems to me to be far from resolved. What about alternative regimes? Price level targeting is one that has been considered in some countries, including Canada, and has been proposed in the academic literature.19 One argument for a price level target is that it delivers predictability of the price level over a long horizon. It is not clear to me that this is something that is much valued by society. By revealed preference, the absence of long-term indexed contracts suggests that the benefits are not perceived to be high. I struggle to think of what contracts require such a degree of certainty. To me the benefits mostly derive from having inflation at a sufficiently low level that it doesn’t affect decisions. That supports an inflation target rather than a price level target. One important difference is that an inflation target allows bygones to be bygones, whereas a price level target does not. In a world where there are costs to disinflation (and particularly deflation), the likely small gains from the full predictability of the price level that comes with a price level target are not likely to offset the costs of occasional disinflations following positive price level shocks. Another challenge is how fast the price level should be returned to its target level. This presents both a communication and operational challenge as the speed is likely to vary with the size of the deviation. While the argument at the moment is that a price level target allows the central bank to let the economy grow more strongly after a period of unexpectedly low inflation, again I do not think that practically this will deliver better outcomes than a flexible inflation target. That is an empirical question in the end which is worth testing. The appropriate level of the inflation target is currently being debated in some parts of the world, including the US. The argument for a higher target rate of inflation is that it might reduce the risk of hitting the zero lower bound because a higher inflation rate would result in a higher nominal interest rate structure. In thinking about this, we should ask the question as to whether what we have seen is the realisation of a tail event in the historical distribution of interest rates (for a given level of the real interest rate).? While this event has now lasted quite a long time, if you thought it was a tail event, then you would expect the nominal rate structure to revert back to its historical mean at some point. If it is a tail event, and the world has just been unlucky enough to have 11 / 14 BIS central bankers' speeches experienced a realisation of that tail event, then there would not obviously be a need to raise the inflation target. We also need to question whether the real interest rate structure has shifted lower permanently, because of permanently lower trend growth say, which would also shift down the nominal rate structure and increase the likelihood of hitting the zero lower bound. Also, as with price level targeting, in thinking about this question, it needs to be taken into account that it is highly beneficial to have the inflation target at a level where it doesn’t materially enter into economic decision-making. Two to three per cent seems to achieve that. We know that some number higher than a 2–3 per cent rate of inflation will materially enter decision-making, because we have had plenty of experience of higher rates of inflation that demonstrates that. How much higher though, we don’t really exactly know. Another consideration in answering the question of whether the inflation target is at the right level is the range of policy instruments in the tool kit. Over the past decade, this tool kit has expanded in a number of central banks. For example, we now know that the zero lower bound is not at zero. Asset purchases have been utilised and these have included sovereign paper but also assets issued by the private sector. An assessment of the effectiveness of these instruments is still a work in progress. We also need to think about whether they are part of the standard monetary policy tool kit or whether they should only be broken out in case of emergency. Nominal income targeting is another alternative regime to inflation targeting. I am not convinced that flexible inflation targeting of the sort practiced in Australia is significantly different from nominal income targeting in most states of the world. I also think that there are some quite significant communication challenges with nominal income targeting. Firstly, nominal income is probably more difficult to explain to people than inflation. Secondly, as a very practical matter, nominal income is subject to quite substantial revisions, which poses difficulties both operationally and again in communicating with the public. Finally, one criticism of inflation targeting more generally is that central banks are fighting the last war. The fact that for a number of years now, inflation globally has been stubbornly low is not obviously the signal to declare victory over inflation and move on. Indeed, the declaration of victory may well be the signal that hostilities are about to resume and that inflation will shift up again. Moreover, even if victory can be declared that doesn’t mean you should go off to fight another war in another place without securing the peace. Inflation targeting can help secure the peace. Conclusion Today, inflation targeting is now the default framework for monetary policy. This is stark contrast to the situation 25 years ago, when inflation targeting was greeted with a large degree of scepticism. At its heart, inflation targeting is a simply expressed acknowledgement of what monetary policy can achieve and what it can’t. The flexible version of inflation targeting that has been present in Australia since its inception was regarded as an outlier but now we have seen most other regimes evolve in that direction, either through explicit changes to the regime or in practice. The dual mandate of the Reserve Bank of Australia is embodied in the flexible expression of the target. Over the past 25 years, there have not really been material changes in the specification of the inflation target in Australia. The extent and content of the communication has increased, in line with the general trend across all central banks. This has helped to enhance the understanding of the public of what the Reserve Bank is aiming to achieve and thereby helped the effectiveness of monetary policy. The inflation target has made a material contribution to the very satisfactory macroeconomic outcomes that the Australian economy has enjoyed over the past 25 years. Inflation has been consistent with target. The unemployment rate on average has been lower and less variable than 12 / 14 BIS central bankers' speeches in earlier periods. This has gone a long way to fulfilling the mandate of the Reserve Bank of contributing to the welfare and prosperity of the Australian people. But it is important to continue to question whether the framework remains the right framework going forward and whether there are enhancements that could be made to it. There is now a much greater community to draw on to help answer those questions, both from central banks and from academia, in contrast to the situation 25 years ago when inflation targeting was a new frontier. 1 Stevens G and G Debelle (1995), ‘Monetary Policy Goals for Inflation in Australia’, in A Haldane (ed), Targeting Inflation: a conference of central banks on the use of inflation targets organised by the Bank of England, Proceedings of a Conference, Bank of England, London, pp 81–100. 2 For detailed accounts of the conception of inflation targeting in Australia, those present at its birth are the best source: Grenville S (1997), ‘The Evolution of Monetary Policy: From Money Targets to Inflation Targets’, in P Lowe (ed), Monetary Policy and Inflation Targeting, Proceedings of a Conference, Reserve Bank of Australia, Sydney, pp 125–158; Macfarlane I (1998), ‘Australian Monetary Policy in the Last Quarter of the Twentieth Century’, Shann Memorial Lecture, University of Western Australia, Perth, 15 September; Stevens G (2003), ‘Inflation Targeting: A Decade of Australian Experience ’, Address to South Australian Centre for Economic Studies April 2003 Economic Briefing, Adelaide, 10 April. 3 Fraser B (1993), ‘Some Aspects of Monetary Policy’, RBA Bulletin, April, pp 1–7. Fraser B (1994), ‘ Managing the Recovery’, RBA Bulletin, April, pp 20–28. 4 For example, the Bank of England Act 1998 states that the objectives of the Bank of England shall be (a) to maintain price stability, and (b) subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment. See Kuttner K (2004), ‘A Snapshot of Inflation Targeting in its Adolescence’, in C Kent and S Guttman (eds), The Future of Inflation Targeting, Proceedings of a Conference, Reserve Bank of Australia, Sydney, pp 6–42. 5 The change from underlying inflation in large part reflected the change in the measurement of the CPI to exclude mortgage interest rates. 6 Debelle G (2017), ‘Central Bank Independence in Retrospect’, Address at Bank of England Independence: 20 Years On Conference, London, 28 September. 7 Stevens and Debelle (1995) op cit. 8 Non-Inflationary Continuous Expansion. 9 Stevens G (2016), ‘An Accounting’, Address to the Anika Foundation Luncheon, Sydney, 10 August. 10 Stevens G and G Debelle (1995), op cit, is an example of this. See also De Brouwer G and J O’Regan (1997), ‘Evaluating Simple Monetary-policy Rules for Australia’, in P Lowe (ed), Monetary Policy and Inflation Targeting, Proceedings of a Conference, Reserve Bank of Australia, Sydney, pp 244–276. 11 Debelle G (2009), ‘The Australian Experience with Inflation Targeting ’, Speech at Banco Central do Brasil XI Annual Seminar on Inflation Targeting, Rio de Janeiro, 15 May. 12 Haldane A (ed) (1995), Targeting Inflation: a conference of central banks on the use of inflation targets organised by the Bank of England, Proceedings of a Conference, Bank of England, London. 13 In this instance, most central banks responded in a similarly flexible way. In large part, I would argue this reflects the convergence to more flexible frameworks by this time. 14 King M (1997), ‘Changes in UK Monetary Policy: Rules and Discretion in Practice’, Journal of Monetary Economics, 39(1), pp 81–97. 15 The RBA’s accountability is collective rather than individual so the minutes represent the collective view of the Board rather than conveying any individual’s views. The Board as a whole is accountable, in large part reflecting its composition where the majority of members are business people rather than practising economists. Individual accountability in the RBA’s case may compromise the ability of the business members of the Board to 13 / 14 BIS central bankers' speeches take decisions in the national interest rather than their sectoral interest (Stevens G (2007), ‘Central Bank Communication’, Address to the Sydney Institute, 11 December). 16 This is very evident in consensus forecasts and surveys of union inflation expectations, inter alia. 17 Hambur J and J Simon (eds) (2017), Monetary Policy and Financial Stability in a World of Low Interest Rates, Proceedings of a Conference, Reserve Bank of Australia, Sydney. 18 Debelle (2017), op cit. 19 Ball L, N Gregory Mankiw and R Ricardo (2005), ‘Monetary Policy for Inattentive Economies’, Journal of Monetary Economics, Elsevier, 52(4), pp 703–725, May. 14 / 14 BIS central bankers' speeches | reserve bank of australia | 2,018 | 4 |
Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Housing Industry Association Breakfast, Sydney, 24 April 2018. | Christopher Kent: The limits of interest-only lending Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Housing Industry Association Breakfast, Sydney, 24 April 2018. * * * I would like to thank Michael Tran and Ben Jackman for help in preparing this material, and my colleagues Bernadette Donovan and Ben Shanahan from the Financial Stability Department for their helpful comments and suggestions. Introduction I’d like to thank the Housing Industry Association for the opportunity to speak to you about the role of interest-only loans. Mortgages on interest-only terms have become an increasingly prominent part of Australian housing finance over the past decade. At their recent peak, they accounted for almost 40 per cent of all mortgages. While interest-only loans have a role to play in Australian mortgage finance, their value has limits. Other things equal, interest-only loans can carry greater risks compared with principal-andinterest (P&I) loans. Because there’s no need to pay down principal initially, the required payments are lower during the interest-only period. But when that ends, there is a significant step-up in required payments (unless the interest-only loans are rolled over). This owes to the need to repay the principal over a shorter period; that is, over the remaining term of the loan. Also, because the debt level is higher over the term of the loan, the interest costs are also larger. For housing investors, the key motivation for using an interest-only loan is clear. By enabling borrowers to sustain debt at a higher level over the term of the loan, interest-only loans maximise interest expenses, which are tax deductible for investors. They also free up funds for other investments. For those purchasing a home to live in, there are other motivations for an interest-only loan. They provide a degree of flexibility when it comes to repayment. They can assist households to manage a temporary period of reduced income or heightened expenditure. That might occur, for example, when a household wants to work less in order to raise children, cover the cost of significant renovations or obtain bridging finance to buy and sell properties. They can also appeal to households without a steady flow of regular income, such as the self-employed. So there are understandable reasons why borrowers have taken out interest-only loans. During interest-only periods, disciplined borrowers will be able to provision for future repayment of principal. They can accumulate funds in an offset or redraw account, or build up other assets. With sufficient saving over the interest-only period, the health of their balance sheet need be no different than it would have been with a P&I loan.1 If, however, a borrower spends the extra cash flow available to them during the interest-only period (compared with the alternative of a P&I loan), they will need to make sizeable adjustments when that ends. They will have to either secure additional income by that time or reduce their consumption (or some combination of both). That will be more difficult and possibly come as a shock to the borrower if they haven’t planned for it in advance. If the borrower has made no provisions and is unable to make the necessary adjustment, they may need to sell the property to repay the loan. Therein lies an additional risk inherent in interestonly lending. Moreover, the borrower’s ability to service the loan is not fully tested until the end of the interest-only period. If the borrower defaults, the potential loss for the lender will be larger than 1 / 13 BIS central bankers' speeches in the case of a P&I loan given that interest-only loans by design allow borrowers to maintain the debt at a higher level over the term of the loan. That’s why, when providing interest-only loans, prudent lenders will carefully assess the borrower’s ability to make both interest and principal payments. Among other things, banks have to make their loan ‘serviceability assessments’ based on the status of the borrower’s income and expenditure at the time of origination.2 To help manage risks, lenders also typically limit the maximum interest-only period to five years.3 The role of interest-only lending and its potential implications for financial stability have been of interest to the Reserve Bank for some time. The possible effects of the transition at the end of interest-only periods were discussed in the recent Financial Stability Review.4 I will come to that issue shortly, but first I want to review the regulatory responses to the strong growth of interestonly lending in recent years. Tightening of lending standards Interest-only loans had grown very strongly for a number of years in an environment of low mortgage rates and heightened competitive pressures among lenders. The share of housing credit on interest-only terms had increased steadily to almost 40 per cent by 2015 (Graph 1). The share of credit on interest-only terms has always been much higher for investors than owneroccupiers (consistent with the associated tax benefits for investors). But interest-only loans for owner-occupiers had also grown strongly. In 2014, the Australian Prudential Regulation Authority (APRA) acted to tighten standards for 2 / 13 BIS central bankers' speeches interest-only loans, and mortgages more generally. APRA required serviceability assessments for new loans to be more conservative by basing them on the required principal and interest payments over the term of the loan remaining after the interest-only period. (Previously, some banks were assuming that the principal was being repaid over the entire life of the loan, which was clearly a lower bar for the borrower to meet.) At about the same time, APRA acted to ensure that the interest rate ‘buffer’ used in the serviceability assessments for all loans was at least 2 percentage points above the relevant benchmark rate (with an interest rate floor of at least 7 per cent). Also, that test was required to include other, existing debt (which is often substantial for investors). The application of such a buffer in serviceability assessments implies that borrowers should be able to accommodate a notable rise in required repayments. When APRA tightened loan serviceability requirements, it also limited the growth of investor lending (to 10 per cent annually).5 The share of interest-only loans in total housing credit then stabilised for a time at around 40 per cent, having increased steadily up to that point. In early 2017, in recognition that continued strong growth of interest-only loans was contributing to rising risks, APRA further tightened standards on interest-only lending. Among other things, banks were required to limit new interest-only lending to be no more than 30 per cent of new mortgage lending.6 Banks were also required to tightly manage new interest-only loans extended at high loan-to valuation ratios (LVRs). The past year or so In response to those recent regulatory measures, the banks raised interest rates on investor and interest-only loans. From around the middle of 2017, the average interest rates on the stock of outstanding variable interest-only loans increased to be about 40 basis points above interest rates on equivalent P&I loans (Graph 2). Prior to that, there was little difference in interest rates on these loans.7 3 / 13 BIS central bankers' speeches The higher interest rates contributed to a reduction in the demand for new interest-only loans. In addition, because banks had raised interest rates on all of their (variable rate) interest-only loans, existing customers had an incentive to switch their loans from interest-only to P&I terms before their scheduled interest-only periods ended. Many took up that option.8 The combination of higher interest rates and tighter lending standards contributed to the share of new loans that are interest-only falling comfortably below the 30 per cent limit. The stock of interest-only loans in total housing credit has also declined noticeably, from close to 40 per cent to almost 30 per cent. This reduction in the stock of interest-only loans over the past year was substantial. It represented about $75 billion of loans (out of a total stock of interest-only loans of almost $600 billion in late 2016). While many of the customers switching chose to do so in response to the higher rates on interest-only loans, there are likely to have been some borrowers who had less choice in the matter. Some borrowers may have preferred to extend their interest-only periods but may not have qualified in light of the tighter lending standards. We don’t have a good sense of the split between those borrowers that switched voluntarily and those that switched reluctantly. However, our liaison with the banks suggests that most borrowers have managed the transition reasonably well. Also, the share of non-performing housing loans over the past year remains little changed at relatively low levels. Moreover, the growth of household consumption has been sustained; indeed it picked up a touch in year ended-terms over 2017. Given the large number of borrowers switching to P&I loans, it’s not surprising that scheduled housing loan repayments have increased over the past year (Graph 3). Meanwhile, unscheduled payments have declined. With total payments little changed, the rise in scheduled payments has had no obvious implications for household consumption. 4 / 13 BIS central bankers' speeches The next few years So, many interest-only borrowers appear to have responded voluntarily to the pricing incentives and switched to P&I loans. This means that it is possible that the current pool of interest-only borrowers is a little more likely than usual to want to continue with their interest-only loans. For some of these borrowers, the decision not to switch to a lower interest rate P&I loan may reflect the higher required payments for such a loan. Some commentators have gone so far as to suggest that when scheduled interest-only periods end, many borrowers will be forced onto P&I loans and will find it challenging to make the higher required payments.9 Commentators go on to suggest that such borrowers will either have to sell their property or reduce other expenditure significantly in order to service their loans. In what follows, I’ll explore these concerns by providing some estimates of the effect of borrowers switching to P&I loans in the years ahead. I’ll focus my attention on the potential size of the change in households’ cash flows as well as the effect on the household sector’s consumption. Around two-thirds of interest-only loans in the Reserve Bank’s Securitisation Dataset are due to have their interest-only periods expire by 2020 (Graph 4).10 That is consistent with interest-only periods typically being around five years. Only a small share of loans have interest-only periods of 10 years (or longer), with very few loans on these terms having been written (and securitised) since 2015. This is in line with the earlier measures to tighten lending standards. 5 / 13 BIS central bankers' speeches Applying this profile of expiries to the total value of all interest-only loans suggests that about $120 billion of interest-only loans is scheduled to roll over to P&I loans each year over the next three years (Graph 5). This annual figure is equivalent to around 7 per cent of the stock of housing credit outstanding. While the value of loans scheduled to reach the end of the interest-only periods appears large, it is worth emphasising that expirations of this size are not unprecedented. At the end of 2016, a similar value of loans was due to have their interest-only periods expire in 2017. What is different now, however, is that many households have already switched willingly in 2017 in response to pricing differentials, and lending standards were tightened further in recent years. This could affect the ability of some borrowers to extend their interest-only periods or to refinance to a P&I loan with a longer amortising period so as to reduce required payments on the loan. 6 / 13 BIS central bankers' speeches To estimate the effect of the expiry of interest-only periods, I’ll consider the case where all of the interest-only periods expire as scheduled. While extreme, this provides a useful upper-bound estimate of the effect of the transition ahead. Consider a ‘representative’ interest-only borrower with a $400,000 30-year mortgage with a 5year interest-only period.11 The left-hand side bar in Graph 6 shows the approximate interest payments (of 5 per cent) that such a borrower makes during the interest-only period. At the expiry of the interest-only period, required payments will increase by around 30–40 per cent (with an example shown in the bar on the right). (As shown in the graph, the interest rate applied to the loan is expected to be lower when it switches to P&I (by around 40 basis points) but this effect is more than offset by the principal repayments.) 7 / 13 BIS central bankers' speeches The rise in scheduled payments amounts to about $7,000 per year for the representative interest-only borrower. This is a non-trivial sum for the household concerned. But how big is this cash flow effect when summed up across all households currently holding interest-only loans? Again, I adopt the extreme assumption that all interest-only periods expire as scheduled over the coming few years. As a share of total household sector disposable income, the cash flow effect in this scenario is estimated be less than 0.2 per cent on average per annum over each of the next three years (Graph 7). For the household sector as a whole, this upper-bound estimate of the effect is relatively modest. Even so, there are a number of reasons why the actual cash flow effect is likely to be even less than this. More importantly, the actual effect on household consumption is likely to be lower still. So let me step through the various reasons. 8 / 13 BIS central bankers' speeches Savings Many borrowers make provisions ahead of time for the rise in required repayments. It is common for borrowers to build up savings in the form of offset accounts, redraw balances or other assets. They can draw upon these to cover the increase in scheduled payments or reduce their debt. Others may not even need to draw down on existing savings. Instead, they can simply redirect their current flow of savings to cover the additional payments. In either case, such households are well placed to accommodate the extra required payments without needing to adjust their consumption very much, if at all. As shown in the chart above, about half of owner-occupier loans have prepayment balances of more than 6 months of scheduled payments. While that leaves half with only modest balances, some of those borrowers have relatively new loans. They wouldn’t have had time to accumulate large prepayment balances nor are they likely to be close to the scheduled end of their interestonly period. There are borrowers who have had an interest-only loan for some time but haven’t accumulated offset or redraw balances of substance.12 Offset and redraw balances are typically lower for investor loans compared with owner-occupier loans. That is consistent with investors’ incentives to maximise tax deductible interest. However, in comparison to households that only hold owneroccupier debt, there is evidence that investors tend to accumulate higher savings in the form of other assets (such as paying ahead of schedule on a loan for their own home, as well as accumulating equities, bank accounts and other financial instruments).13 Refinancing Another option for borrowers is to negotiate an extension to their interest-only period with their 9 / 13 BIS central bankers' speeches current lender or refinance their interest-only loan with a different lender. Similarly, they may be able to refinance into a new P&I loan with a longer loan term, thereby reducing required payments. Based on loans in the Securitisation Dataset, a large majority of borrowers would be eligible to alter their loans in at least one of these ways.14 Any such refinancing will reduce the demands on a borrower’s cash flows for a time. However, it is worth noting that by further delaying regular principal repayments, eventually those repayments will be larger than otherwise. Extra income or lower expenditures What about borrowers who have not built up savings ahead of time or are unable to refinance their loans? The Securitisation Dataset suggests that such borrowers are in the minority. More importantly, most of them appear to be in a position to service the additional required payments. Indeed, the tightening of loan serviceability standards a few years ago was no doubt helpful in that regard. Some fraction of interest-only borrowers may have used the reduced demands on their cash flows during the interest-only period to spend more than otherwise. However, the available data, and our liaison with the banks, suggest that there are only a small minority of borrowers who will need to reduce their expenditure to service their loans when their interest-only periods expire.15 Sale of the property Finally, some interest-only borrowers may have to consider selling their properties to repay their loans. Difficult as that may be – most notably for owner-occupiers – doing so could free up cash flow for other purposes. It would also allow them to extract any equity they have in the property. The extent of that can be gauged by estimating LVRs from the Securitisation Dataset. 16 The LVRs of almost all of those interest-only loans (both owner-occupier and investor) are below 80 per cent (based on current valuations and including offset balances) (Graph 8). This reflects the combined effects of loan serviceability tests and the increase in housing prices over recent years. 10 / 13 BIS central bankers' speeches Some risks remain While the various estimates I’ve provided suggest that the aggregate effect of the transition ahead on household cash flows and consumption is likely to be small, some borrowers may experience genuine difficulties when their interest-only periods expire. The most vulnerable are likely to be owner-occupiers, with high LVRs, who might find it more difficult to refinance or resolve their situation by selling the property. Currently, it appears that the share of borrowers who cannot afford the step-up in scheduled payments and are not eligible to alleviate their situation by refinancing is small. Our liaison with the banks suggests that there are a few borrowers needing assistance to manage the transition. Over the past year, some banks have reported that there has been a small deterioration in asset quality. For some borrowers this has tended to be only temporary as they take time to adjust their financial affairs to cope with the rise in scheduled payments.17 For a small share of borrowers, though, it reflects difficulty making these higher payments. That share could increase in the event that an adverse shock led to a deterioration in overall economic conditions. Conclusion Today, I have discussed some of the risks associated with interest-only loans, which imply that their value as a form of mortgage finance has limits. I have also presented rough estimates of the likely effect of the upcoming expiry of interest-only loan periods. The step-up in required payments at that time for some individual borrowers is non-trivial. For the household sector as a whole, however, the cash flow effect of the transition is likely to be moderate. The effect on household consumption is likely to be even less. This is because some interest-only borrowers 11 / 13 BIS central bankers' speeches will be willing and able to refinance their loans. Also, many others have built up a sufficient pool of savings, or will be able to redirect their current flow of savings to meet the payments, or have planned for, and will manage, this change in other ways. Indeed, the substantial transition away from interest-only loans over the past year has been relatively smooth overall, and is likely to remain so. Nevertheless, it is something that we will continue to monitor closely. Finally, the observation that the transition is proceeding smoothly is not an argument that the tightening in lending standards on interest-only loans was unwarranted; far from it. The tightening in standards starting in 2014 has helped to ensure that borrowers are generally well placed to service their loans. And the limit on new interest-only lending more recently has prompted a reduction in the use of those loans during a time of relatively robust growth of employment and still very low interest rates. In this way, it has helped to lessen the risk of a larger adjustment later on in what could be less favourable circumstances. 1 This can be true even for investors today since (over a relatively long horizon) the benefit of the tax deduction can offset the cost of paying the higher interest rate on interest-only loans that now apply. Also, if the investor has attractive alternative investments, they may be willing to pay more for an interest-only loan. 2 The term ‘bank’ here refers to all authorised deposit-taking institutions, namely banks, building societies and credit unions, which are regulated by APRA. 3 Investors are sometimes given a clear option to extend into a second interest-only period, but that would normally proceed only after ascertaining that the borrower’s financial position remains sound. 4 For more discussion of the risks associated with interest-only loans, see RBA (Reserve Bank of Australia) (2017), Financial Stability Review, April. 5 Strictly speaking, APRA imposed a 10 per cent benchmark on investor lending growth. If a lender breached that growth it would face higher capital charges and more scrutiny from APRA. 6 For details, see APRA (2017), ‘APRA Announces Further Measures to Reinforce Sound Residential Mortgage Lending Practices’, Media Release No 17.11, 31 March. 7 The gap between actual rates paid on interest-only loans and on P&I loans prior to 2016 largely disappears when we control for the differences between loan characteristics (such as loan size or LVR). For more details, see Kent C (2017), ‘Some Innovative Mortgage Data’, Address to Moody’s Analytics Australia Conference 2017, Sydney, 14 August. 8 Indeed, lenders actively encouraged their existing interest-only borrowers to switch and allowed them to do so without penalty. Banks had an incentive to do so as their existing interest-only customers may otherwise have chosen to switch to a (lower rate) P&I loan with another lender. 9 For example, Shapiro J and Greber J (2017), The Australian Financial Review, ‘Interest-only loans could be ‘Australia’s sub-prime’, available at , 21 May; Hughes D (2018), The Australian Financial Review, ‘Interest-only borrowers brace for mortgage crunch’, available at , 17 January; and Kirby J (2018), The Australian, ‘Interest-only crisis time bomb ticking as repayments rise’, available at , 3 March. 10 The Reserve Bank collects detailed information on asset-backed securities it accepts as collateral in its domestic market operations. Most of the asset-backed securities in the dataset are underpinned by residential mortgages, covering around $400 billion of mortgages or about one-quarter of the total value of housing loans in Australia. Although the dataset is not representative of the entire mortgage market across all its dimensions, the aggregate share of interest-only loans in the Securitisation Dataset is similar to other measures that cover the broader housing market. For more details, Kohler M (2017), ‘Mortgage Insights From Securitisation Data’, Address to Australian Securitisation Forum, Sydney, 20 November. 11 This is based on the median loan size of interest-only loans from the Securitisation Dataset originated since 2013. 12 Fixed-rate loans do not allow substantial prepayments. Nevertheless, even those borrowers could be 12 / 13 BIS central bankers' speeches accumulating savings in other assets. 13 This is based on internal analysis using data from the survey of Household, Income and Labour Dynamics in Australia (HILDA). 14 To obtain these estimates, each borrower’s maximum borrowing capacity is estimated using a measure aligned with APRA’s prudential standards and conservative assumptions where possible (such as around minimum expenses). Also, borrowers who took out interest-only loans prior to 2015 are likely to have accumulated positive equity because of substantial price growth in recent years. This would help them to qualify for refinancing into a longer P&I term if they desired it. 15 The Australian Securities and Investment Commission has required eight lenders to provide remediation to borrowers that face financial stress as a direct result of poor lending practices related to interest-only lending. As yet, however, only a small number of borrowers have been identified as being eligible for such remediation action. 16 This is done by indexing property valuations (typically provided at the time a loan is originated) by a measure of housing prices and accounting for offset balances. 17 Banks can assist their borrowers experiencing temporary difficulties under their ‘hardship programs’, including by extending the interest-only period for brief period, for example. 13 / 13 BIS central bankers' speeches | reserve bank of australia | 2,018 | 4 |
Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Reserve Bank Board Dinner, Adelaide, 1 May 2018. | Philip Lowe: Remarks at Reserve Bank Board Dinner Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Reserve Bank Board Dinner, Adelaide, 1 May 2018. * * * Good evening. It is great to be back in Adelaide today. On behalf of the Reserve Bank Board, I want to warmly thank you all for joining us at this community dinner. These dinners provide an opportunity for you to hear directly from the members of the Reserve Bank Board and for us to hear from you about how things are here in South Australia. So, welcome. I would like to begin by paying tribute to Kathryn Fagg. Kathryn’s five-year term on the Board comes to an end next week and so today was her final meeting. Over those five years, Kathryn has made an outstanding contribution to the Board’s deliberations, drawing on her extensive experience in many different industries. Kathryn has also served as chair of the Board’s Audit Committee and has been the Board’s representative on the board of Note Printing Australia Limited. She has carried out these roles, not only to the highest professional standards, but also with the greatest humanity. Kathryn, you are going to be missed by your many friends and admirers at the Reserve Bank. As you are aware, at our meeting today, the Board kept the cash rate unchanged at 1½ per cent. It has been at this level since August 2016 – that is for 21 months – which is the longest period without a change. I sometimes read that the Board’s job has become very easy: we just meet and do nothing. No doubt, the Board members here tonight will tell you a different story. They will assure you that each month when we meet, we diligently assess the pulse of the Australian economy. We also deliberate carefully over what setting of monetary policy will best deliver low and stable inflation in Australia. As we conduct those deliberations, we are conscious that our ultimate objective is enhancing the economic prosperity and welfare of the Australian people. This objective has been part of the Reserve Bank Act since it was written in 1959. Such a broad objective became unfashionable in most central banking circles around the world over recent decades. But in my view, it is an important part of the Australian policy framework and it has more than stood the test of time. At today’s meeting, when we measured the pulse of the Australian economy, we assessed it to be stronger than a year ago. Business conditions are around their highest level for many years and the long-awaited pick-up in non-mining business investment is taking place. There has been a large pick-up in infrastructure spending in some states. The number of Australians with jobs has also grown strongly over the past year. The unemployment rate is lower than it was a year ago, although there has been little change for the past six months. Growth in consumer spending has been solid, although it is lower than it was before the financial crisis. Here in South Australia, we heard how the pulse has also quickened over the past year. This follows a number of years of difficult structural adjustment after the closure of the car industry. But over the past year, domestic final demand in South Australia increased by 5 per cent, which is a very positive outcome. As we have seen nationally, there has been a pick-up in business conditions and investment in South Australia. There are positive signs in a number of areas, including tourism, high-value food and beverage production and some parts of advanced engineering and manufacturing. Helping the economy here in South Australia and elsewhere in Australia are the positive outcomes at the international level. Investment has picked up around the world and international 1/4 BIS central bankers' speeches trade is stronger than it has been for some time. As a group, the advanced economies are growing faster than trend and unemployment rates are low. And the Chinese economy is still growing strongly, although at a lower rate than in the past. So, at the moment, the international backdrop is pretty positive. At our meeting today, we also discussed the latest inflation data, which showed that both CPI and underlying inflation were running marginally below 2 per cent. This was in line with our expectations and provides further confirmation that inflation has troughed, although it remains low. Strong competition in retailing is holding down the prices of many goods: for example, over the past year, the price of food increased by just ½ per cent, the price of clothing and footwear fell 3½ per cent and the price of household appliances fell 2½ per cent. Importantly, these outcomes are helping to offset some of the cost of living pressures arising from higher electricity prices, which nationally are up 12 per cent over the past year. Another factor influencing recent inflation outcomes is the subdued growth in wages. Increases in wages of around 2 per cent have become the norm in Australia, rather than the 3–4 per cent mark that was the norm a while back. This is an issue we have been discussing around our board table for some time. While low growth in wages has helped boost employment, it has also put the finances of some households under strain, especially those who borrowed on the basis that their incomes would grow at the old rate. And in terms of the inflation target, it is difficult to see how a continuation of 2 per cent growth in wages is compatible with us achieving the midpoint of the inflation target – 2½ per cent – on a sustained basis. So from that perspective alone, a pick-up in wages growth over time would be welcome. Perhaps more importantly, sustained low wages growth diminishes the sense of shared prosperity that we have in Australia. In our liaison with businesses, including here in Adelaide, many tell us about the very competitive environment in which they are operating. They tell us about how this competitive environment means that they have limited ability to pay bigger wage increases. At the same time, though, we are hearing a few more reports of larger increases in those areas where there is a shortage of workers with the necessary skills. After all, the laws of supply and demand still work. We also see evidence in the aggregate data that wages growth has troughed and we expect to see a further pick-up. This is likely to be a gradual process, though. At today’s meeting, the Board also reviewed the staff’s latest forecasts for the economy. These will be published on Friday in our quarterly Statement on Monetary Policy. Those of you who are close readers of this document will notice some changes in this issue, as we seek to make the report more thematic. The latest forecasts should not contain any surprises, with only small changes from the previous set of forecasts, issued three months ago. This year and next, our central scenario remains for the Australian economy to grow a bit faster than 3 per cent. This would be a better outcome than the average of recent years. If we are able to achieve this, we will make inroads into the remaining spare capacity in the economy and see a further modest decline in the unemployment rate. Inflation is expected to remain low, at around its current level for a while yet, before gradually increasing over the next couple of years, towards 2½ per cent. A key element here is the pick-up in wages growth that I just mentioned. So, in summary, there has been progress in lowering unemployment and having inflation return to around the middle of the target range, and we expect further progress in these two areas over the next couple of years. The other key point is that the progress we are making is only gradual: our central scenario is for a gradual pick-up in wages growth, a gradual lift in inflation, and a gradual reduction in the unemployment rate. While we might like faster progress, it is encouraging that things are moving in the right direction and are likely to continue to do so. 2/4 BIS central bankers' speeches If this is how things turn out, it is reasonable to expect that the next move in interest rates will be up. This would reflect conditions in the economy returning to normal. In our discussions today, though, the Board again agreed that there was not a strong case for a near-term adjustment in the cash rate. This reflects our view that the progress in moving towards full employment and having inflation return to the middle of the target range is likely to be only gradual. The Board’s view is that while this progress is occurring, the best contribution we can make to the welfare of the Australian people is to hold the cash rate steady and for the Reserve Bank to be a source of stability and confidence. So that is where we are at the moment. At our meeting we also discussed some of the risks around this general outlook. These lie largely in the international arena. One of the prominent ones is a possible escalation of protectionist measures in the United States and elsewhere. The very clear lesson from history is that this would be bad for growth. As a country that has prospered through openness, Australia has a lot resting on this not happening. We also have a lot resting on the Chinese authorities successfully managing the very significant build-up of debt in their economy. Over recent times, they have paid increasing attention to this issue, which is a positive sign. Given the importance of this issue, it was the subject of an extensive discussion at our Board meeting today. Domestically, for some time, we have seen the main risk to be related to household balance sheets. For a while, trends in household credit were quite concerning. On this front, things now look less worrying than they were a while back, although the level of household debt remains very high, which carries certain risks. In terms of financing, we also discussed the potential for some tightening in financial conditions in Australia. In the United States, the cost of US dollar funding has increased for reasons not directly related to monetary policy and this increase is flowing through into higher money market rates in Australia. We expect some of this to be reversed in time, although it is difficult to tell by how much and when. It is also possible that lending standards in Australia will be tightened further in the context of the current high level of public scrutiny. We will continue to watch these issues carefully. So these are the issues we worked through today. I hope that they give you the sense that, even if we have not changed interest rates for a long time, we have a lot on our plate. Before I finish, I’d like to say a few words about some of the Reserve Bank’s other activities. You would be aware that the Bank issues Australia’s banknotes. We are currently undertaking a major exercise to issue a new high-tech series to make sure that we stay a few steps ahead of counterfeiters. We have already issued new $5 and $10 banknotes and the new $50 note will be issued later this year. This is a very big logistical exercise. All up, there are more than 700 million individual $50 notes on issue – that averages out to around 30 for every person in Australia. Not all of these, of course, are in active circulation. Many are located in ATMs and some are used as a store of wealth, perhaps stored under mattresses. The $50 note is of special significance for South Australia. I say this because on one side it has the portrait of David Unaipon, a great Australian. David Unaipon was a Ngarrindjeri man born at Point McLeay in the Lower Murray Lakes and Coorong region and lived most of his life in South Australia. He was a great pioneer in many areas, pushing back against the injustice experienced by the Aboriginal people. David Unaipon was also Australia’s first published Aboriginal author writing about, in his owns words, Aboriginal ‘customs, beliefs and imaginings’. He was a tireless advocate for Aboriginal people, and wrote and spoke eloquently about how to make things better. And in what spare time he had he worked on various inventions – right up until his 90s – so much so that he earned a reputation as ‘Australia’s Leonardo Da Vinci'. So we are very proud to have David Unaipon on our $50 note. And we are equally proud to have Edith Cowan on the other side of the note, who was the first female member of an Australian parliament. 3/4 BIS central bankers' speeches The first $50 note was introduced into circulation 45 years ago, in 1973. In today’s money, it was worth almost $500 at the time, 10 times today’s value! Reading back through our archives, the main argument for introducing such a high-value banknote was that it would help people conveniently pay for large household purchases, like cars, whitegoods, etc. It is yet another sign of just how much the world has changed. Today, most of us don’t need banknotes to make these types of payments. Many of us make the bulk of our small and large payments electronically. This is one reason why today’s highest value banknote – the $100 note – is worth only a fifth of what the $50 note was worth when it was introduced. This shift to electronic payments is being helped by another project the Reserve Bank has been involved in – that is the New Payments Platform. The Bank played an important policy role in getting this new system off the ground and has built a core piece of the supporting infrastructure. This new payments system allows near-instantaneous payments between bank accounts. Ultimately, it will provide the rails for innovative new payment services using its fast payments functionality. But its first service allows people to make payments to one another that will be received within seconds simply knowing somebody’s mobile phone number or email. I hope that many of you have registered your PayID, which makes it easy to use this system. So far, almost 1.4 million Australians have done exactly this and they are now able to make efficient low-cost payments 24/7. If you have not already done so, I encourage you to look into it and register your PayID as soon as your bank offers you the service. That is as close as I am allowed to get to giving you financial advice, so I think it is time to have dinner. Again, thank you very much for joining us tonight. 4/4 BIS central bankers' speeches | reserve bank of australia | 2,018 | 5 |
Opening keynote speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the CFO Forum, Sydney, 15 May 2018. | Guy Debelle: The outlook for the Australian economy Opening keynote speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the CFO Forum, Sydney, 15 May 2018. * * * Thanks to Lynne Cockerell for her help in preparing this speech. Today I would like to talk about the Bank’s outlook for the economy. We published this in the Statement on Monetary Policy (SMP) earlier this month.1 This set of forecasts was little changed from the previous set of forecasts we released three months earlier. This is because the economy, both domestically and globally, has been evolving generally in line with our expectations. When reading through the Bank’s forecasts, I think it is useful to avoid false precision. An important question to ask is: are these revisions to the Bank’s outlook consequential for the monetary policy decision? Similarly you can ask, do I think these changes affect my own decisions about my household or my business? A tenth or two of a percentage point here or there on the outlook for GDP or inflation is unlikely to matter that much for any of those decisions. Often, these revisions reflect the new information that has come to hand over the previous quarter. This leads us to reassess the starting point for our forecasts of where the economy is then likely to go. In making this assessment, we ask whether the incoming data have been viewchanging or view-validating. Over the previous three months (and, indeed, the three months before that too), the data have generally been view-validating. The forecasts that are published can best be characterised as the modal forecast for the economy. That is, they are the path for the economy which we think is most likely to occur. But there are a number of risks to that outlook. The SMP talks about some of those uncertainties too. Today I will also spend some time drawing out some of the issues around those uncertainties.2 The central forecast As I just said, the forecasts we have just published are little changed from those we published in February. Table 1 shows the Bank’s outlook for GDP growth, the unemployment rate and inflation until June 2020. This is generally the time horizon that is relevant for the Board’s deliberations on monetary policy. The forecasts embody a number of technical assumptions. These include that the cash rate 1 / 13 BIS central bankers' speeches evolves broadly in line with the market expectations. Currently the market assumes that the cash rate is likely to remain unchanged for at least the next 12 months, and then rise only very slowly beyond that. The forecasts also assume that the exchange rate and oil prices remain at their current levels. Historically, we have found that assuming those variables remain constant is at least as good as any other forecast, while recognising that they are highly likely to change. In saying that, it is worth noting that the exchange rate has moved within a fairly narrow range over the past two years. These small variations have probably not been a major factor in your decision-making as CFOs. In contrast, I would expect that the 20 per cent depreciation of the Australian dollar in 2014–2015 did have a material impact on decision-making at any business with an export or import-competing focus. Other developments in financial conditions can affect the forecasts too. One example is developments in money market rates. In the SMP, we document the recent rise in money market interest rates in the US, particularly LIBOR (Graph 1). There are a number of explanations for the rise, including a large increase in bill issuance by the US Treasury and the effect of various tax changes on investment decisions by CFOs at some US companies with large cash pools.3 This rise in LIBOR in the US has been reflected in rises in money market rates in a number of other countries, including here in Australia. This is because the Australian banks raise some of their short-term funding in the US market to fund their $A lending, so the rise in price there has led to a similar rise in the cost of short-term funding for the banks here; that is, a rise in BBSW. 4 This increases the wholesale funding costs for the Australian banks, as well as increasing the costs for borrowers whose lending rates are priced off BBSW, which includes many corporates. However, the effect to date has not been that large in terms of the overall impact on bank funding costs. Thus far, it has not been a consequential development from a forecasting point of view. It is not clear how much of the rise in LIBOR (and hence BBSW) is due to structural changes in money markets and how much is temporary. In the last couple of weeks, these money market rates have declined noticeably from their peaks. We will continue to monitor how this unfolds in the period ahead. The outlook for the economy in 2018 and 2019 is expected to be a little stronger than occurred in 2 / 13 BIS central bankers' speeches 2017. GDP growth is expected to pick up from around 2½ per cent currently to be around 3¼ over the next couple of years. What is driving that pick-up in growth? One part of the answer is that the global conjuncture is constructive. We have been witnessing the most synchronised pick-up in the global economy for quite some time. The US economy is doing well. Europe is doing better than it has been for the past decade. The Japanese economy has recorded its longest period of quarterly growth in almost three decades. The global conjuncture has been reflected in a pick-up in global industrial production and trade that is particularly beneficial to the east Asian region, which is leveraged to the global cycle. China stands a little in contrast to these developments, though. Growth in China has moderated somewhat, in part because the authorities are pursuing other policy objectives to address pollution and financial stability risks. But the easing in growth has been small. It remains to be seen just how much tolerance the Chinese authorities would have to any significant slowing in growth. One interesting point about the global conjuncture is that while the recovery is synchronised, to date we haven’t seen it accelerate in any meaningful way. Historically, synchronised growth cycles have tended to be self-reinforcing, leading to a continuing pick-up in growth. Today, growth in most economies is good, often a little above trend. But no economy is growing that much above trend. Forecasts for global growth in 2018 and 2019 are below the outcome for 2017, notwithstanding some upward revisions to those forecasts (Graph 2). Why aren’t we seeing a further pick-up in global growth? I think part of the explanation is that the global financial crisis has left long-lasting scars. For a number of years, risks to the outlook have generally been characterised as being on the downside by both policy-makers and business 3 / 13 BIS central bankers' speeches people. In contrast, in previous synchronised global upswings, the risks have generally had an optimistic slant to them. Even though we have seen a pick-up in business sentiment right around the world, a sizeable degree of caution and scepticism has accompanied that improvement in sentiment. We may be close to a tipping point where we see that tendency for pessimism swing to optimism. That pessimism filter has been reflected in the focus on restraint in investment decisions in the decade after the financial crisis. It is also evident in the focus on cost-cutting and contributes to the subdued outcomes for wages and prices we have seen in many countries. The current, more positive, pace of global growth is predicated on the stimulatory settings of monetary policy in place in most countries. That is, these policy settings have been necessary to deliver these growth outcomes. They have countered the headwinds that have been present in the global economy over the past decade. The headwinds have abated but it is not clear they have yet switched to be tailwinds. One potential exception to this is the US. The fiscal stimulus that is in train this year and next is being delivered in an economy with limited spare capacity. Historically, such as in the late 1960s/early 1970s, such episodes have generally led to stronger growth but also higher inflation. I will come back to that in my discussions of some of the uncertainties around the outlook in a few minutes. This constructive global outlook provides a solid backdrop for domestic developments. It is underpinning growth in our exports. Exports have also been bolstered by the additional capacity coming on stream in LNG. We expect that the additions to capacity in our main resource exports – iron ore, LNG and coal – will be largely complete by the end of the year. That also means that we are close to the end of the decline in mining investment. That has been a major drag on economic growth over the past several years (Graph 3). The absence of that negative is a positive, particularly when one factors in the associated export growth that has resulted from the investment. 4 / 13 BIS central bankers' speeches The decline in mining investment also has had negative spillovers to the non-mining sector, particularly in the resource-intensive states.5 That now is largely past. Moreover, the increase in public infrastructure spending is creating positive spillovers.6 And importantly, the rise in business sentiment globally is also evident in Australia. All of these factors are reflected in the pick-up in investment in the non-mining sector we have seen over the past four years. Turning to consumption, we have had more validation of our outlook with recent data revisions. We had been concerned that our forecast may have been a little optimistic, but are now more confident in it. In statistical terms, the weight on the modal forecast has risen. But uncertainties remain around the outlook for consumption, which I will discuss shortly. It is worth noting that domestic demand growth has outstripped growth in GDP, running at around 3¼ per cent. This gives us confidence in our forecast of GDP growth a little above trend over the next couple of years. That is, that GDP growth is likely to have a 3 in front of it. The surveys of business conditions very much support that assessment with conditions in many parts of the economy assessed to be well above average (Graph 4). 5 / 13 BIS central bankers' speeches That pace of growth, should it transpire, will eat gradually into the spare capacity in the economy. Hence we expect the unemployment rate to gradually decline from here. The unemployment rate declined by a ¼ percentage point over the past year; we are expecting something similar over the year ahead. The reduction in the unemployment rate has stalled for some months. I find the unemployment rate is the most useful single statistic to assess the state of the labour market. The unemployment rate has remained steady in an environment where employment growth has been measured to be particularly strong. Labour supply has risen strongly alongside it. Part of the explanation for this is an increase in female participation and older workers remaining in employment longer than previously. 7 The strong employment growth has reduced unused capacity, which is a positive development, but not in a way that has lowered the unemployment rate. Forward indicators in terms of vacancies and hiring intentions remain positive. GDP growth is expected to pick up. This gives me reasonable confidence that the unemployment rate will resume its gradual downward trend (Graph 5). 6 / 13 BIS central bankers' speeches The gradual decline in spare capacity is expected to lead to a gradual pick-up in wages growth. A critical question is: when will wages start to rise in a meaningful way? Recent data on wages provides some assurance that wages growth has troughed. The majority of firms surveyed in the Bank’s liaison program expect wages growth to remain broadly stable over the period ahead. Over the past year, there has been a pick-up in firms expecting higher wage growth outcomes. Some part of that is the effect of the Fair Work Commission’s decision to raise award and minimum wages by 3.3 per cent. Talking to businesses, such as yourselves, suggests that there are pockets where wage pressures are more acute. But, while those pockets are increasing gradually, they remain fairly contained at this point (Graph 6). 7 / 13 BIS central bankers' speeches The most recent inflation data were also consistent with our forecasts. The data show that inflation remains low but stable. Domestic price pressures remain subdued. Inflation is very close to 2 per cent: 1.9 per cent on a CPI basis, marginally below the bottom of our inflation target. We expect upward pressure on prices over the next couple of years, but again this is expected to be quite a gradual process (Graph 7). 8 / 13 BIS central bankers' speeches As you might have gathered by now, the key word in this discussion of the outlook is gradual. Further progress on both inflation and unemployment is expected over the period ahead, but it is expected to be only gradual. For some time the Reserve Bank Board’s view has been that holding the cash rate steady at 1½ per cent would assist that progress, with steady monetary policy promoting stability and confidence. If the economy continues to evolve as expected, higher interest rates are likely to be appropriate at some point. Notwithstanding this, the Board does not currently see a strong case for a near-term adjustment in the cash rate. Having talked about the central forecast, I will now talk about some of the uncertainties around this central forecast. Uncertainties One uncertainty relates to the global inflation outlook. We have experienced low inflation globally for a long period of time. There are signs of inflation starting to pick up. The global economy is close to full capacity, particularly in the advanced economies. The US fiscal stimulus is still to have its full effect in an economy that, as I said earlier, is very close to full capacity. This is a similar situation to that in the late 1960s and could lead to more inflation in the US than currently anticipated. In turn, that could lead to more tightening in monetary policy than currently expected. While markets expect some tightening, they don’t expect too much more at this point. Moreover, in such circumstances, you might also expect the neutral policy rate to rise, albeit gradually. Such a rise in growth and inflation offshore could lead to a depreciation of the Australian dollar, given that the Australian economy appears currently to have more spare capacity than some other advanced economies. If this were to occur, we would expect it to boost domestic output and lead to a faster rise in inflation than currently assumed, but somewhat later than in other economies. There is also a significant risk to the global economy from the current tensions around trade policy. While the effect of the measures announced thus far has been modest, there is clearly 9 / 13 BIS central bankers' speeches the potential for this to escalate. Australia has benefited from an open, inclusive and rules-based international system. We have as much at stake as any other country in the continuation of this system. The SMP has for some time highlighted the uncertainties around the outlook for China. I won’t discuss them today, as the Governor will talk about them in depth in a speech next week. Turning to uncertainties around the domestic outlook, one important uncertainty relates to household balance sheets. Australian households have a relatively large amount of mortgage debt. This means that they are more likely to be sensitive to changes in income and interest rates. This poses risks to the outlook for the largest component of spending, household consumption. One reason why I think debt remains high relative to income has been because income growth has been unexpectedly low. In past decades, one of the easiest ways to pay down your mortgage was through inflation. Higher inflation was accompanied by higher wages growth. Because the mortgage is fixed in nominal terms, the debt level declined quite rapidly relative to a household’s income when incomes were growing quickly. Household income growth has been subdued for a number of years, which means that a number of households may be carrying a larger mortgage for longer than they expected when they took out the loan. While they can service the mortgage, it has consumed a larger share of their income for longer than they might have intended. Over recent years, a number of steps have been taken by regulators that have helped to strengthen resilience in household balance sheets. It is worth remembering that lending standards have been tightened for a number of years now. From 2014, APRA and ASIC have strengthened their focus on lending practices. This has included ensuring that lenders’ serviceability tests for new borrowers must use an interest rate of at least 7 per cent. That is, households should be able to afford a mortgage rate well more than 2 per cent higher than it is currently (and remember, many households took out their loans when rates were higher than today). More recently, APRA has also been focused on ensuring that lenders assess borrowers’ income appropriately. While the Royal Commission has highlighted a number of cases where this has not been the case, an important consideration from a macroeconomic perspective is how widespread this has been, and whether it is consequential for the ability of most households to afford to service their loans. I take some comfort from the fact that arrears rates on mortgages remain low. Even in Western Australia, where there has been a marked rise in unemployment and where house prices have fallen by around 10 per cent, arrears rates have risen to around 1½ per cent, which is not all that high compared with what we have seen in other countries in similar circumstances and earlier episodes in Australia’s history. We have provided some information in the latest SMP on interest rate resets on interest-only loans. These can see the required mortgage payments rise by nearly 30–40 per cent for some borrowers. There are a number of these loans whose interest-only periods expire this year. It is worth noting that there were about the same number of loans resetting last year too. Our assessment is that there are quite a few mitigants which will allow these borrowers to cope with this increase in required payments, including the prevalence of offset accounts and the ability to refinance to a principal and interest loan with a lower interest rate. While some borrowers will clearly struggle with this, our expectation is that most will be able to handle the adjustment so that the overall effect on the economy should be small.8 This switch away from interest-only loans should see a shift towards a higher share of scheduled principal repayments relative to unscheduled repayments for a time. We are seeing that in the data (Graph 8). It also implies faster debt amortisation, which may have implications for credit growth. 10 / 13 BIS central bankers' speeches There is a risk of a further tightening in lending standards in the period ahead. This may have its largest effect on the amount of funds an individual household can borrow, more than the effect on the number of households that are eligible for a loan. This, in turn, means that credit growth may be slower than otherwise for a time. To me, that has more of an implication for house prices, than it does for the outlook for consumption. Finally, in thinking about the resiliency of household balance sheets to higher interest rates, it is important to think about the environment in which interest rates would be rising. That environment is highly likely to be one where wages and household incomes are also growing faster than currently, improving the ability of households to afford higher mortgage repayments. One final risk that I would like to touch on is the related risk stemming from low wages growth. How much longer is wages growth going to remain at its current low rates? The experience of other countries with labour markets closer to full capacity than Australia’s is that wages growth may remain lower than historical experience would suggest. In Australia, 2 per cent seems to have become the focal point for wage outcomes, compared with 3–4 per cent in the past.9 Work done at the Bank shows the shift of the distribution of wages growth to the left and a bunching of wage outcomes around 2 per cent over the past five years or so (Graph 9). As I said earlier, while there are signs of wage pressure emerging, they remain localised for now. There is a risk that it may take a lower unemployment rate than we currently expect to generate a sustained move higher than the 2 per cent focal point evident in many wage outcomes today. 11 / 13 BIS central bankers' speeches These are some of the uncertainties that the Board discusses in its monetary policy deliberations. They are not the central case, but they are some of the risks around it. Should these risks come to pass, then they are likely to have a material effect on the Bank’s outlook for the economy. In turn, it is quite possible that such revisions would be consequential for the Board’s assessment of the appropriate stance of monetary policy. But it is important to remember to think about the context in which these risks materialise. As is often the case, they may not materialise in isolation. Some of them may materialise at the same time or the actual manifestation of them may be different from the form I have discussed here. Conclusion Monetary policymaking, just like the business decisions that you make as CFOs, is about decision-making under uncertainty. I have highlighted some of these uncertainties around the Bank’s central forecast for the economy. That central forecast is for the economy to grow a little faster in 2018 and 2019 than in 2017. That should see the unemployment rate resume its gradual decline. It should also see wages growth and inflation gradually pick up. In time, should that central forecast come to pass, higher interest rates are likely to be appropriate. But the Board does not see a strong case for a nearterm adjustment in the cash rate and holds the view that by holding the cash rate steady, it can best assist the achievement of the desired economic outcomes. 1 RBA (Reserve Bank of Australia) (2018), Statement on Monetary Policy, May. 2 I spoke about uncertainties in forecasting at the 7th Warren Hogan Memorial Lecture last year. See Debelle G (2017), ‘Uncertainty’, 7th Warren Hogan Memorial Lecture, Sydney, 26 October. 3 Note that the rise is not attributable to increased concerns about the global banking system as was the case in 2008 and 2009. 4 The rise in LIBOR has also resulted in higher money market rates in Hong Kong, New Zealand and the UK. But 12 / 13 BIS central bankers' speeches there has been less of an effect on European or Japanese rates. This is because while European and Japanese banks also raise funds in the US money markets, they do so to fund $US assets, rather than assets in their own currencies. 5 Debelle G (2017), ‘Business Investment in Australia’, Speech at UBS Australasia Conference, Sydney, 13 November. 6 See RBA (2018), ‘Box C: Spillovers from Public Investment’, Statement on Monetary Policy, February, pp 40–42. 7 See RBA (2018), ‘Box B: The Recent Increase in Labour Force Participation’, Statement on Monetary Policy, May, pp 33–34. 8 See RBA (2018), ‘Box C: The Expiry of Interest-only Loan Terms’, Statement on Monetary Policy, May, pp 45– 48. Also Kent C (2018), ‘The Limits of Interest-only Lending’, Address to the Housing Industry Association Breakfast, Sydney, 24 April. 9 Bishop J and N Cassidy (2017), ‘Insights into Low Wage Growth in Australia’, RBA Bulletin, March, pp 13–20. 13 / 13 BIS central bankers' speeches | reserve bank of australia | 2,018 | 5 |
Keynote speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the ISDA (International Swaps and Derivatives Association) Forum (appearance via video link), Hong Kong, 15 May 2018. | Guy Debelle: Interest rate benchmark reform Keynote speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the ISDA (International Swaps and Derivatives Association) Forum (appearance via video link), Hong Kong, 15 May 2018. * * * Good morning and thanks to ISDA for the opportunity to speak here today. Reform of interest rate benchmarks has been a key focus of central banks and financial regulators over recent years.1 These benchmarks are referenced in a wide range of financial contracts, including derivatives, loans and securities. In light of the issues around LIBOR (the London Inter-Bank Offered Rate) and other benchmarks that have arisen over the past decade, substantial effort has gone in to reforming these benchmarks to support the smooth functioning of the financial system. Today I will provide an update on the work underway to strengthen interest rate benchmarks. I'll focus on the developments since last year's announcement by the UK Financial Conduct Authority (FCA) on the future of LIBOR. In particular, I will highlight the important role for ‘risk-free’ interest rates as an alternative to credit-based benchmarks such as LIBOR. I will then summarise the work underway to ensure that the major interest rate benchmark for the Australian dollar, the bank bill swap rate (BBSW), remains robust for the long term. I will also discuss how some credit-based benchmarks, such as BBSW, can coexist with risk-free rates in a post-LIBOR world. Global benchmark reform and the future of LIBOR Central banks and financial regulators have been working with the industry to address the shortcomings in the major interest rate benchmarks, the ‘interbank offered rates’ (IBORs). For several years, the Financial Stability Board's (FSB's) Official Sector Steering Group (OSSG) has been monitoring progress on three work streams: 1. to strengthen the IBORs by anchoring them to a greater number of transactions, and improve benchmark governance 2. to identify robust alternative risk-free rates and encourage derivatives to be referenced to them instead of the IBORs 3. to ensure that contracts referencing IBORs include robust fall-back provisions to reduce the risk of financial instability if an IBOR were to be discontinued. LIBOR is the key interest rate benchmark for several major currencies, including the US dollar and British pound. In July last year, Andrew Bailey, who heads the FCA, raised some serious questions about the sustainability of LIBOR. The key problem he identified is that there are not enough transactions in the short-term interbank funding market to reliably calculate the benchmark. The banks that make the submissions used to calculate LIBOR are uncomfortable about continuing to do this, as they have to rely mainly on their ‘expert judgment’ in determining where LIBOR should be rather than on actual transactions. To prevent LIBOR from abruptly ceasing to exist, the FCA has received assurances from the current banks on the LIBOR panel that they will continue to submit their estimates to sustain LIBOR until the end of 2021. But beyond that point, there is no guarantee that LIBOR will continue to exist. The FCA will not compel banks to provide submissions and the panel banks may not voluntarily continue to do so. Let me be clear, LIBOR is not under threat because of the regulators. Rather it has been kept going to date because of the actions of regulators, but that is not going to occur beyond 2021. Then it comes down to whether the submitting banks are willing to maintain LIBOR in its current 1/5 BIS central bankers' speeches form, and there is no guarantee at all that will be the case. Andrew Bailey has made this announcement to give market participants enough time to transition away from LIBOR. The process is not straightforward. LIBOR is referenced in around US$350 trillion worth of contracts globally. A large share of these contracts have short durations, often three months or less, so these will roll off well ahead of 2021, but they should not continue to be replaced with another short-dated contract referencing LIBOR. A very sizeable number of current contracts would extend beyond 2021, with some lasting as long as 100 years. Market participants that use LIBOR need to work on transitioning their contracts to alternative reference rates. The transition will involve a substantial amount of work for users of LIBOR, both to amend contracts and update systems. Given how hard it has been to sustain LIBOR, regulators around the world have been working closely with the industry to identify alternative risk-free rates that can be used instead of LIBOR. These alternative rates are based on overnight funding markets since there are plenty of transactions in these markets to calculate robust benchmarks. Last month, the Federal Reserve Bank of New York began publishing the Secured Overnight Financing Rate (SOFR) as the recommended alternative to US dollar LIBOR. For the British pound, SONIA has been identified as the alternative risk-free rate, and the Bank of England has recently put in place reforms to ensure that it remains a robust benchmark. One issue is that the chosen risk-free rates are overnight rates, while the LIBOR benchmarks are term rates. Some market participants would prefer for the LIBOR replacements to also be term rates. While the development of term risk-free rates is on the long-term agenda for some currencies, they are unlikely to be available anytime soon. This reflects that there are currently not enough transactions in markets for term risk-free rates – such as overnight indexed swaps (OIS) – to support robust benchmarks. Given this reality, it is very important that users of LIBOR are planning their transition to the overnight risk-free benchmarks that are available, such as SOFR for the US dollar and SONIA for the British pound. For the risk-free rates to provide an alternative to LIBOR, the next challenge is to generate sufficient liquidity in derivative products that reference the risk-free rates. This will take some time, particularly for the US dollar, where SOFR only recently started being published. Nevertheless, progress is being made, with the first futures contracts referencing SOFR recently being launched. Market participants also need to be prepared for a scenario where the LIBOR benchmarks abruptly cease to be published. In such an event, users would have to rely on the fall-back provisions in their contracts. However, for many products the existing fall-back provisions would be cumbersome to apply and could generate significant market disruption. For instance, some existing fall-backs involve calling reference banks and asking them to quote a rate. To address this risk, the FSB has encouraged ISDA to work with market participants to develop a more suitable fall-back methodology, using the risk-free rates that have been identified. But LIBOR is very different from an overnight risk-free rate as it includes bank credit risk and is a term rate. So the key challenge is to agree on a standard methodology for calculating credit and term spreads that can be added to the risk-free rate to construct a fall-back for LIBOR. This needs to be resolved as soon as possible, and we encourage users of LIBOR to engage with ISDA on this important work. Interest rate benchmarks for the Australian dollar The key IBOR benchmark for the Australian dollar is BBSW. The RBA and the Australian Securities and Investments Commission (ASIC) have been working closely with industry to ensure that it remains robust. The critical difference between BBSW and LIBOR is that there are enough transactions in the 2/5 BIS central bankers' speeches local bank bill market each day to calculate a robust benchmark.2 Australia has an active bank bill market, where the major banks issue bills as a regular source of funding, and a wide range of wholesale investors purchase bills as a liquid cash management product. For several years, BBSW has been calculated from the best executable bids and offers for the bills issued by the major banks. This method is referred to as National Best Bid and Offer (NBBO). Until recently, a significant concern had been the low trading volumes in the interbank market at the time of day that BBSW was being measured (around 10.00 am). While there are enough transactions over the course of the day, there were nowhere near enough occurring in the (small) rate set window. We consulted with market participants on why there was a lack of trading during the rate set, and they gave us a couple of reasons: 1. They faced a potential conflict of interest when they participated in the market underpinning the benchmark and the derivatives market that references it. They stated that they were uncertain about how regulators expected them to manage these conflicts. 2. Managers of investment funds were reluctant to trade at outright yields. They preferred to transact at the yet-to-be-determined BBSW since this minimised tracking error against their performance benchmarks. To address these challenges, two key steps are being taken to support BBSW. First, the BBSW methodology is being strengthened to enable the benchmark to be calculated directly from the wider set of market transactions that occur each day. Second, a new regulatory framework for financial benchmarks is being introduced. The work on implementing the new BBSW methodology is progressing well. The new methodology will involve calculating BBSW as the volume-weighted average price (VWAP) of bank bill transactions. The new methodology has broadened the BBSW rate set to include transactions outside the interbank market during a longer trading window. This reflects that bank holdings of bills have declined over recent years to around a tenth of total issuance. Holdings by investment funds have increased to over half of total issuance. Previously, these investors had purchased bills outside the rate set, agreeing to the transaction at the yet-to-be-determined BBSW rate. Since late last year, banks and investors have been expected to trade bills at outright yields during the rate set window. This change in market practice has been successfully implemented, enabling these transactions to be used to calculate BBSW. The new arrangements are also improving the infrastructure in the bank bill market, encouraging more electronic trading and straight-through processing of transactions. The Australian Securities Exchange (ASX) (the administrator of BBSW) has been conducting a parallel run of the new VWAP methodology over recent weeks and the results are promising. On average, there are around $1.5 billion in transactions during the rate set each day, with a wide range of institutions participating. On most days, it has been possible to calculate the key 3month and 6-month rates using the VWAP method. In addition, the difference between the rate calculated using VWAP and the existing NBBO method is very close to zero. Given these results, there should be a seamless transition to the new BBSW methodology, which is due to go live shortly. The VWAP parallel run has confirmed that the most robust tenors are 3- and 6-month BBSW, which are the tenors most frequently referenced in derivatives. Despite this, there are still many contracts that reference 1-month BBSW. The liquidity of 1-month BBSW is lower than it once was, mainly in response to the introduction of liquidity standards that have reduced the incentive for banks to issue very short-term paper. Given this, users of products referencing 1-month BBSW should consider referencing 3- or 6-month BBSW going forward. 3/5 BIS central bankers' speeches The VWAP method will be at the top of a robust calculation waterfall for BBSW, so the benchmark can continue to be published as conditions change in the bank bill market. If there are not enough transactions on a day, BBSW will instead be calculated using NBBO (which is the current method), and if quotes are unavailable, there are algorithms that can be used to calculate the benchmark for a time. To rebuild confidence in trading during the rate set window, the ASX worked closely with market participants to develop a new set of trading guidelines for BBSW. These guidelines are an important part of the new BBSW methodology, as they provide guidance on the trading of bank bills during the rate set window. ASIC and the RBA have made it clear that they expect all bank bill market participants – including the banks that issue the bank bills, as well as the participants that buy them – to adhere to the guidelines and support the new BBSW methodology. This has helped to address the concerns that some market participants had about trading during the rate set. Turning to the second key step to help ensure that BBSW remains a robust benchmark, the Australian Government has recently introduced a new regulatory framework for financial benchmarks.3 The legislation empowers ASIC to set the rules for and license administrators of significant benchmarks such as BBSW. ASIC will also have the power to compel submissions to a significant benchmark in the rare circumstances where the benchmark would otherwise cease to be published. Finally, the legislation makes it an offence to manipulate financial benchmarks. This new regulatory framework has helped to address the uncertainty that institutions were facing when participating in the BBSW rate setting process. It should also support the continued use of BBSW in the European Union (EU), where new regulations require benchmarks used in the EU to be subject to a robust regulatory framework. Finding the balance between credit-based and risk-free benchmarks While we expect that BBSW will remain a robust benchmark, it is important for market participants to ask whether BBSW is the most appropriate benchmark for their financial contracts. This is particularly worth considering in the light of the transition that is taking place away from LIBOR towards risk-free rates. For some financial products, it can make sense to reference a risk-free rate instead of a creditbased benchmark. For instance, floating rate notes (FRNs) issued by governments, non-financial corporations and securitisation trusts, which are currently priced at a spread to BBSW, could instead tie their coupon payments to the cash rate. As the RBA's operational target for monetary policy and the reference rate for OIS and other financial contracts, the cash rate is the risk-free interest rate benchmark for the Australian dollar. The RBA measures the cash rate directly from transactions in the interbank overnight cash market, and we have ensured that our methodology is in line with the IOSCO benchmark principles.4 However, consistent with the challenges faced by users of LIBOR looking to transition to alternative risk-free rates, the cash rate is not a perfect substitute for BBSW, as it is an overnight rate rather than a term rate, and doesn't incorporate a significant bank credit risk premium. We think that BBSW can continue to exist even if credit-based benchmarks, such as LIBOR, are discontinued in other jurisdictions. For many financial products, it will still make sense to reference a credit-based benchmark that measures banks' short-term wholesale funding costs. This is particularly the case for products issued by banks, such as FRNs and corporate loans. The counterparties to these products would still need derivatives that reference BBSW so that they can hedge their interest rate exposures. In the event that LIBOR was to be discontinued, with contracts transitioning to risk-free rates, there may be some corresponding migration away from BBSW towards the cash rate. This will depend on how international markets for products 4/5 BIS central bankers' speeches such as derivatives and syndicated loans end up adapting in a post-LIBOR world. The infrastructure is already in place for BBSW and the cash rate to coexist as the key interest rate benchmarks for the Australian dollar. The OIS market is linked to the cash rate and has been operating for almost 20 years. It already has good liquidity at the short end, and the infrastructure is there for longer term OIS. A functioning derivatives market for trading the basis between the benchmarks is important for BBSW and the cash rate to smoothly coexist. Such a basis swap market is also in place, allowing market participants to exchange the cash flows under these benchmarks. Conclusion There are three main points I would like to leave you with concerning interest rate benchmarks. First, the longevity of LIBOR cannot be assumed. You should be considering today what that might mean for any contracts you have that reference LIBOR. Please do not hope that if you wait long enough, all the problems will go away. Users of LIBOR should pay close attention to the work being undertaken by ISDA to establish more robust fall-back provisions on contracts. Second, in Australia, in contrast to other markets, the changes to enhance the longevity of BBSW are well advanced, and it has been possible to anchor the benchmark to a greater number of transactions. Third, users should consider whether risk-free benchmarks are more appropriate for financial contracts than credit-based benchmarks. There is still a place for robust credit-based benchmarks in the financial infrastructure, and we expect that BBSW and the cash rate will be able to coexist as the key benchmarks for the Australian dollar. 1 I have talked about this issue previously: Debelle G (2017). ‘Interest Rate Benchmarks’, Speech at FINSIA Signature Event: The Regulators, Sydney, 8 September; Debelle G (2016), ‘Interest Rate Benchmarks’, Speech at KangaNews Debt Capital Markets Summit 2016, Sydney 22 February; Debelle G (2015). ‘Benchmarks’, Speech at Bloomberg Summit, Sydney, 18 November. 2 The instruments traded in the bank bill market are typically negotiable certificates of deposit (NCDs). 3 See <www.aph.gov.au/Parliamentary_Business/Bills_Legislation/Bills_Search_Results/Result?bId=r5962>. 4 For more details about the methodology for the cash rate, see <www.rba.gov.au/mktoperations/resources/cash-rate-methodology/>. The RBA has also conducted a self-assessment against the IOSCO benchmark principles: <www.rba.gov.au/mkt-operations/resources/cash-ratemethodology/compliance.html>. 5/5 BIS central bankers' speeches | reserve bank of australia | 2,018 | 5 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Australia-China Relations Institute, Sydney, 23 May 2018. | 5/25/2018 Australia's Deepening Economic Relationship with China: Opportunities and Risks | Speeches | RBA Speech Australia's Deepening Economic Relationship with China: Opportunities and Risks Philip Lowe [ * ] Governor Address to the Australia-China Relations Institute Sydney – 23 May 2018 Thank you very much for the invitation to address the Australia-China Relations Institute. It is an honour for me to be here with so many China experts. What happens in China is important to Australia, and to the broader global community. This is as true in the world of economics as it is in other areas. So we all have a strong interest in understanding China. For some years now, China has been Australia's largest export destination. This is likely to remain so for the foreseeable future. China's share of global GDP is also likely to continue to rise as average living standards in China improve further. Given that China's population is roughly four times that of the United States, the Chinese economy will be roughly twice the size of the US economy when average per capita incomes in China reach just half those in the United States – something which should be achievable. It will take some time to get to this point, but it is clear that what happens in China matters to us all, and increasingly so. Given this, the Reserve Bank of Australia has devoted considerable resources to understanding China and its economy. We have three staff in Beijing and they work closely with the team here in Sydney, including in our Asian Economies Research Unit. We have more staff looking at China than any other single overseas economy. This reflects not just the importance of the Chinese economy to us, but also the fact that Australia and China have different political systems, different governance arrangements and different financial systems. Understanding these various differences is important to understanding the Chinese economy, and we are devoting considerable resources to doing this. In this evening's talk I would like to elaborate on two issues. http://www.rba.gov.au/speeches/2018/sp-gov-2018-05-23.html 1/20 5/25/2018 Australia's Deepening Economic Relationship with China: Opportunities and Risks | Speeches | RBA The first is the depth of Australia's economic relationship with China. Too often this relationship has been viewed largely through the prism of resource exports. These exports are certainly important, but this perspective is too narrow. Over time, we are seeing a broadening and deepening of our economic relationship with China and I would like to talk about this. The second issue is the Chinese financial system. Among the largest economic risks that Australia faces is something going wrong in China. And perhaps the single biggest risk to the Chinese economy at the moment lies in the financial sector and the big run-up in debt there over the past decade. Given the significance of this risk and the RBA's natural interest in finance, we study this area very closely. Indeed, at the most recent Reserve Bank Board meeting we had a deep dive into the Chinese financial system. I would like to share some of this analysis with you this evening. A Deepening Economic and Financial Relationship The facts about Australia's trade links with China are well known. Our trade with China has expanded very rapidly over the past decade, to the point where China is now Australia's largest trading partner. China accounts for nearly one-third of our exports and around one-fifth of our imports (Graph 1). Graph 1 http://www.rba.gov.au/speeches/2018/sp-gov-2018-05-23.html 2/20 5/25/2018 Australia's Deepening Economic Relationship with China: Opportunities and Risks | Speeches | RBA Our trade relationship with China is sometimes summarised as: we export resources to China and we import manufactured goods. It's understandable that people have used this shorthand: after all, exports of resources account for around two-thirds of our exports to China, with iron ore and coal alone accounting for 57 per cent. But it would be a mistake to view the trade relationship solely in these terms. Our exports to China are much more diverse than this. In many individual categories, we now export more to China than any single other destination. So what happens in China is now directly relevant to a broad spectrum of Australian industries. One area where this is obvious is in the export of services (Graph 2). Over the past decade, Australia's service exports to China have grown at an average annual rate of 15 per cent. As a result, our service exports to China are now greater than those to the United States and the United Kingdom combined. Graph 2 The growth has been particularly strong in the areas of tourism and education (Graph 3). There has also been strong growth in exports of business services. http://www.rba.gov.au/speeches/2018/sp-gov-2018-05-23.html 3/20 5/25/2018 Australia's Deepening Economic Relationship with China: Opportunities and Risks | Speeches | RBA Graph 3 Last year there were 1.4 million visitors from China to Australia, up from around 400,000 a decade ago. In 2009, just four passenger airlines flew between China and Australia. Today, there are 15 airlines and last year there were more than 15,000 direct flights between our two countries. On average, Chinese visitors tend to stay longer in Australia and spend more money than other visitors. As a result, they now account for around 25 per cent of total visitor expenditure in Australia, a considerably larger share than any other country (Graph 4). This shift is having a significant effect on the tourism industry. http://www.rba.gov.au/speeches/2018/sp-gov-2018-05-23.html 4/20 5/25/2018 Australia's Deepening Economic Relationship with China: Opportunities and Risks | Speeches | RBA Graph 4 On the education front, there are currently around 200,000 Chinese students studying in Australia (Graph 5). Education exports to China now account for around one-third of Australia's total education exports, up from around one-fifth in 2009. Most of the students are studying at the tertiary level, but there has also been an increase in enrolments in Australian schools and vocational education programs. Even so, more than half of all Chinese tertiary enrolments in Australia are in the broad fields of management and commerce. For many educational institutions, foreign students, including those from China, have become an important source of fee revenue, with foreign students paying higher fees than domestic students. http://www.rba.gov.au/speeches/2018/sp-gov-2018-05-23.html 5/20 5/25/2018 Australia's Deepening Economic Relationship with China: Opportunities and Risks | Speeches | RBA Graph 5 Moving beyond services, China has become the largest single export market for a range of Australia's manufactured food items (Graph 6). Exports of dairy products and alcoholic beverages have grown especially strongly, as have a range of other food and health-related products (of which vitamin sales are often remarked to be growing strongly). And more broadly, there has also been strong growth in exports to China of scientific instruments, pharmaceuticals and some telecommunication products. http://www.rba.gov.au/speeches/2018/sp-gov-2018-05-23.html 6/20 5/25/2018 Australia's Deepening Economic Relationship with China: Opportunities and Risks | Speeches | RBA Graph 6 On the financial side, there has also been a broadening and deepening of the relationship, although it is not as developed as the trade side. Currently, Chinese investment accounts for only a small share of the total stock of outstanding foreign investment in Australia – just 3 per cent. In contrast, the United States accounts for the largest share, at around 30 per cent. Over time, though, there has been an increase in the amount of Chinese investment in Australia. There was a large wave of investment in the resources sector during the mining investment boom (Graph 7). Since this tailed off, there has been significant investment in other areas, including transport infrastructure and commercial property, although investment in commercial property has slowed recently, partly due to tighter Chinese restrictions in this area. The large Chinese banks now operating in Australia have helped facilitate this investment, and they are also providing banking services to a wide range of businesses in Australia. http://www.rba.gov.au/speeches/2018/sp-gov-2018-05-23.html 7/20 5/25/2018 Australia's Deepening Economic Relationship with China: Opportunities and Risks | Speeches | RBA Graph 7 The RBA sees first-hand the stronger financial relationship between our two countries. Since 2012, the RBA has had a currency swap agreement with the People's Bank of China, with the goal of giving market participants in Australia confidence that renminbi (RMB) will be available for trade settlement and other payment obligations. The RBA also now holds 5 per cent of our foreign currency reserves in RMB. Furthermore, in 2014, the Bank of China was designated the official RMB clearing bank in Australia so as to better facilitate cross-border transactions in RMB. So there has been a lot happening on the financial side too. One other dimension of the deepening relationship that I would like to draw your attention to relates to people. Over the past decade, the Chinese-born resident population in Australia has grown at an average rate of around 8 per cent per year (Graph 8). This builds on the long history of Chinese migration to Australia, which has contributed to the rich multicultural society we are today. According to the latest Census, people born in mainland China account for 2 per cent of Australia's population (around 510,000 people), and there are more than one million people who identify themselves as having some Chinese ancestry. It is not surprising, then, that Mandarin is now the second most commonly spoken language in Australian homes and Cantonese the fourth most common. http://www.rba.gov.au/speeches/2018/sp-gov-2018-05-23.html 8/20 5/25/2018 Australia's Deepening Economic Relationship with China: Opportunities and Risks | Speeches | RBA Graph 8 The overall picture, then, is one of a broader and deeper economic relationship with China. Of course, the same could be said for many other countries in our region. This means that China is important to us not just because of our substantial direct links, but also because of the indirect links through our other regional trading partners. The deepening of our economic relationship with China has greatly benefited Australia. It has created new opportunities for us and significantly boosted our national income. It was also one of the factors that helped our economy through the global financial crisis. The deepening relationship has also benefited China in many ways. This means that both countries have a strong interest in managing this important relationship well. It is in our mutual interests to do this. Together, we can also be a strong voice for the importance of an open international trading system and for effective regional cooperation. We will, of course, have differences from time to time, but we will surely be better placed to deal with these if we understand one another well. Building strong connections across business, finance, politics, academia and the community more generally is important to deepening this understanding. The Chinese Financial System I would now like to turn to an issue that the RBA has focused on over recent times: that is the Chinese financial system. Understanding what is going on here is important. If a major economic shock were to originate from China over the coming years, its origin is most likely to be in the http://www.rba.gov.au/speeches/2018/sp-gov-2018-05-23.html 9/20 5/25/2018 Australia's Deepening Economic Relationship with China: Opportunities and Risks | Speeches | RBA Chinese financial system. Not surprisingly, addressing this risk has become a priority of the Chinese authorities. We all have a strong interest in their efforts being successful. I would first like to provide some background by briefly reviewing the development of the Chinese financial system. I will then discuss the risks, including those that have built up in the shadow banking sector. And then finally, I will turn to the recent measures taken by the Chinese authorities to address these risks. Some Background If we go back to just 1978 – which is not that long ago – China's financial system was very undeveloped; there were no equity, bond or funding markets, and most of the country's limited banking services were provided by just one bank – the People's Bank of China. It is fair to say that the financial system played only a rudimentary role in the Chinese economy. Since then things have changed a lot. In the initial reform years, post 1978, some of the functions of the People's Bank of China were carved out into state-owned commercial banks and later into specialised policy banks. It was during these years that the Chinese financial system developed some particular characteristics. Two are worth highlighting. The first is that the system was very government centric. It was configured with the objective of channelling China's very high household savings into state-owned enterprises (SOEs) through government-owned banks. And it did this on very favourable terms to the SOEs. This was part of the strategy of fast-tracking industrial development and urbanisation. The second characteristic was that there was very heavy financial repression – extensive capital controls, low deposit rates for savers, extensive restrictions on what banks could and could not do, a lack of alternative investment opportunities for savers, and limited access to finance for the fledgling private sector. There was, of course, some progressive liberalisation and financial market innovation over time, but up until fairly recently the evolution was relatively modest. Things, though, began to change more noticeably around the time of the global financial crisis, and the result has been an extraordinarily large increase in debt since then. This change was part of the effort by the Chinese authorities to boost internal demand, when exports fell during the financial crisis. As part of this effort, there was a very large lift in spending on infrastructure and construction. In other countries this might have been financed on the government's balance sheet, but in China it was financed mainly through the financial system. Achieving this required some lessening of the long-standing constraints on the supply of credit. The end result was a big increase in debt, with the ratio of debt to GDP rising significantly to its current level of around 260 per cent (Graph 9). http://www.rba.gov.au/speeches/2018/sp-gov-2018-05-23.html 10/20 5/25/2018 Australia's Deepening Economic Relationship with China: Opportunities and Risks | Speeches | RBA Graph 9 This increase in the debt ratio over the past decade has been larger than in any other major economy. This can be seen in this next chart, which shows the increase in this ratio since 2009 for a range of countries and the current level of that ratio (Graph 10). China clearly stands out. The stock of credit outstanding in China, relative to the size of the economy, is now unusually high by emerging market standards. And this ratio is already higher than in many advanced economies. So what has happened in China is quite different to the normal pattern. http://www.rba.gov.au/speeches/2018/sp-gov-2018-05-23.html 11/20 5/25/2018 Australia's Deepening Economic Relationship with China: Opportunities and Risks | Speeches | RBA Graph 10 Over the period of rapid credit expansion, there was a series of reforms to modernise the Chinese financial system. Interest rate controls have been relaxed, although there is still ‘guidance’. A deposit insurance system has been introduced and the regulatory system has been strengthened. The capital markets are playing a more prominent role in the financial system. The large state-owned banks are now listed on stock exchanges in China and Hong Kong. It is also now somewhat easier for private firms to obtain equity finance. Controls on capital flows have also been relaxed somewhat over the last decade. It is worth recognising that, taken together, these are significant changes. A decade ago, many outside observers were sceptical that the Chinese authorities would undertake reforms across many of these fronts. Yet they have made significant progress. Despite this progress, there is still much to be done before the Chinese financial systems looks like financial systems we see in the advanced economies. One area where the Chinese financial system is moving towards a more modern form is in households' access to mortgage finance. Prior to the late 1990s, mortgages were essentially nonexistent. But in recent years, households have progressively enjoyed increased access to finance, which has helped lift the share of consumption in national income. At the same time, as property prices have risen households have taken on larger mortgages. As a result, there has been a doubling of the ratio of household debt to GDP (Graph 11). Relative to other emerging market economies, household debt is no longer low in China, although it is much lower than in the advanced economies. http://www.rba.gov.au/speeches/2018/sp-gov-2018-05-23.html 12/20 5/25/2018 Australia's Deepening Economic Relationship with China: Opportunities and Risks | Speeches | RBA Graph 11 Putting all this together, the Chinese financial landscape and Chinese balance sheets look very different from a decade ago. At the same time, though, the financial system retains elements of its distinguishing characteristics: a heavy focus on state-owned banks providing credit to SOEs and relatively limited banking services for small to medium private businesses. The Build-up of Risk I would now like to turn to the risks that have built up in this system. The historical cross-country experience is reasonably clear. The experience is that the build-up of financial risks like those seen in China is almost always followed by a marked slowdown in GDP growth or a financial crisis. It is important to point out that these outcomes are not inevitable and that China is able to learn from the experience of other countries, including Australia. Even so, it is understandable that concerns have been raised. One of these concerns is that during the big run-up in debt, a lot of bad loans were made. Assessing the extent of this issue is made more complicated by the particular nature of the Chinese financial system. On the one hand, the influence of the state and the incentives within financial institutions have almost surely distorted credit allocation and led to some poor lending decisions. For example, rapid credit expansion supported excess capacity developing in some heavy industries, with large lossmaking enterprises kept afloat with additional borrowing. Provincial authorities also borrowed heavily http://www.rba.gov.au/speeches/2018/sp-gov-2018-05-23.html 13/20 5/25/2018 Australia's Deepening Economic Relationship with China: Opportunities and Risks | Speeches | RBA through opaque off-balance sheet structures, so as to meet their growth targets. It is not unreasonable to suggest that many of these loans would have failed to meet credit standards in other banking systems. So these are reasons to be concerned about future problem loans. On the other hand, though, the involvement of the state can make it easier to work through problems when they arise, and we have seen past examples of this in China. The state has the capacity, and the demonstrated willingness, to address financial problems when they occur. However, this has also tended to add to the moral hazard in the system. Whether this willingness to extend assistance to troubled borrowers and lenders will extend into the future is therefore difficult to tell. So it is complicated. Another concern is the growth of the so-called ‘shadow banking’ system – that is, credit extended outside the formal banking system. The growth in non-bank financing is evident in this next graph, which again shows the ratio of debt to GDP, but broken down into the type of entities that are providing the credit (Graph 12). The picture is pretty clear. Most of the growth in debt has occurred outside the formal banking sector; non-bank financing now accounts for 45 per cent of total debt, up from 25 per cent a decade ago. Graph 12 This growth of shadow banking reflects a few factors. Many entities in China, including private businesses and provincial governments, have had restricted access to credit through the large stateowned banks. As a result, they have sought finance outside the formal sector and they have been http://www.rba.gov.au/speeches/2018/sp-gov-2018-05-23.html 14/20 5/25/2018 Australia's Deepening Economic Relationship with China: Opportunities and Risks | Speeches | RBA prepared to pay higher rates. On the other side of the equation, many investors have sought higher returns on their savings than those available through holding conventional deposits in the formal banking sector. Over time, thousands of smaller banks and other financial institutions emerged to connect those seeking to borrow outside the formal sector with those seeking higher returns. Many of these connections were very innovative and were often made through opaque structures, sometimes in off-balance sheet vehicles. Hence, the term, shadow financing. It is useful to provide a couple of examples. One is so-called ‘entrusted loans’ (Graph 13). These loans effectively involve one entity (say, a business) lending directly to another entity (say, another business), rather than the loan being intermediated through a bank balance sheet. Notwithstanding this, a bank would normally act as a trustee to the transaction and there can be a perceived promise by the bank to absorb any credit losses. So in some respects it is like a bank loan, but structured in a way that sidesteps some of the restrictions on lending and on interest rates paid to depositors. The popularity of these ‘entrusted’ loans increased greatly over the past decade. Graph 13 Another example of shadow financing is wealth management products. These products were sold in bank branches, again often with an implicit guarantee from the bank. They are effectively an investment vehicle, offering investors a fixed rate of return in excess of bank deposits, and investing in a range of assets such as loans and securities. Much of this financing operated in a very similar way to bank loans, but just in another legal form and packaged differently. The products again http://www.rba.gov.au/speeches/2018/sp-gov-2018-05-23.html 15/20 5/25/2018 Australia's Deepening Economic Relationship with China: Opportunities and Risks | Speeches | RBA offered a way of sidestepping some of the regulations and helped underpin the rapid growth of debt. They offered banks an important new source of income to partly offset the decline in net interest margins that followed deposit and lending rate liberalisation. The smaller banks have played an important role in the growth of shadow financing. This is evident in the rapid growth of their claims on non-bank financial institutions (Graph 14). There are now over 3,500 smaller institutions, with many of them channelling money to the shadow banking activities, including through trust companies in exchange for ‘participation’ or ‘beneficiary’ rights. They have been more active participants in the shadow banking industry because their thinner deposit base did not allow for a big increase in traditional loans. Graph 14 So it is a complex web of interconnections that has been built. New institutions have also emerged and a lot of this has been in the shadows, outside of the regulatory net. It's worth recalling that we saw a similar process here in Australia in the 1970s. As some of the regulations were eased here and more things became permissible, we too saw new institutions emerge – just has been the case in China – to sidestep the regulations that remained. In our case, this did not end well! This helps explain why we are watching things in China so carefully. The complex web that has developed in China is characterised by opaque risk transfers, implicit guarantees and complex connections. To the extent that experience elsewhere in the world is any guide, it is difficult to escape the conclusion that this complex web in a highly indebted economy is a risky situation. http://www.rba.gov.au/speeches/2018/sp-gov-2018-05-23.html 16/20 5/25/2018 Australia's Deepening Economic Relationship with China: Opportunities and Risks | Speeches | RBA The Policy Response Dealing with this risk has become a key priority for the Chinese authorities. Reflecting this, at a recent policy meeting convened by President Xi Jinping, the leadership called for a gradual reduction in the debt-to-GDP ratio. This marked a significant change from earlier statements from officials suggesting the target was only to slow the growth in leverage. The authorities are clearly taking the issue seriously and they are making progress. The policy response, to date, has had a number of related elements. One is to subject shadow banking, including asset management activities, to more stringent oversight. The new rules include stricter leverage caps for investment products and restrictions on investment in certain types of non-standard credit assets. Another element of the response has been stronger guidance to banks regarding their exposures to non-bank financial institutions. As part of this, the People's Bank of China recently widened the scope of its quarterly Macro-Prudential Assessment (MPA) of banks to better assess and address shadow banking risks. The MPA now includes consideration of the risks to banks from exposures through offbalance sheet vehicles, including wealth management products. There have also been efforts to address the significant risks in local government financing, including by increasing transparency. As part of this effort, local governments have been participating in a ‘debt swap’ program, where off-balance sheet debt is swapped for local government bonds. The Ministry of Finance has also tightened off-balance sheet financing channels for local governments and their related entities. And at the National Financial Work Conference last year, it was suggested that officials would have ‘lifelong accountability’ for debt balances. This was designed to reduce incentives to pursue higher growth by increasing debt. Finally, the regulatory structure has been strengthened. In particular, a Financial Stability and Development Committee was established in June last year, with strong political backing. The committee is responsible for coordinating regulatory reforms and considering financial stability risks. The banking and insurance regulators have also been merged, partly to address the concerns about regulatory arbitrage. These various measures provide a strong signal that the Chinese authorities are serious about addressing the vulnerabilities. Consistent with this, the lower economic growth target for 2018 of 6.5 per cent suggests some tolerance for a gradual slowing in growth. This is a positive development, given that over recent years there was a concern that the authorities would fail to address the financial risks for fear of damaging the economy in the short term. While it is still early days, the evidence to date is that the various measures are having an effect (Graph 15). Growth in credit outstanding has slowed to be around the same pace as that in nominal GDP. This is the first time that this has been the case for some years. There has also been a sharp slowing in growth in shadow financing, as reflected in banks' claims on non-bank financial institutions. http://www.rba.gov.au/speeches/2018/sp-gov-2018-05-23.html 17/20 5/25/2018 Australia's Deepening Economic Relationship with China: Opportunities and Risks | Speeches | RBA Graph 15 This tightening on the financial side, together with measures to reduce pollution, has led to some slowing in economic growth in China, although growth remains solid (Graph 16). The slowing is evident in fixed asset investment, although overall activity continues to be supported by strong conditions in the property sector and rapid growth in infrastructure investment. In addition, a number of structural developments are providing some offset to the tightening in credit conditions. In recent years, the services sector has become the strongest contributor to growth, and consumption has been resilient. The government is also promoting industrial upgrading, including through its ‘Made in China 2025’ policy to make China a global leader in numerous high-tech sectors. So there are a lot of moving parts at the moment. http://www.rba.gov.au/speeches/2018/sp-gov-2018-05-23.html 18/20 5/25/2018 Australia's Deepening Economic Relationship with China: Opportunities and Risks | Speeches | RBA Graph 16 It is too early to tell whether the authorities will be successful in managing the transition from a growth model heavily dependent upon the accumulation of debt to one where credit is less central. It is a very significant task. The experience of other countries suggests caution and, elsewhere, there have been serious accidents along the way. The Chinese authorities can learn from this experience and are now moving in the right direction. China's challenge is made more complicated by the dual nature of the task to bring down debt levels while also reconfiguring the financial system so as to better meet the needs of the people. There are pressing needs to make financing more widely available to small and medium enterprises, to strengthen the pension system to bolster retirement incomes, to increase transparency and reduce implicit guarantees associated with local government and SOE borrowing. So there is still a lot to be done. At the RBA we are watching this process carefully. We know from our own experience here in Australia that the journey of financial reform can be a bumpy one. We also know that this journey is well worth undertaking, and leaves the financial system stronger, more efficient and better able to serve the needs of the real economy. I look forward to the day when China will be able to reach the same conclusion about its journey. Finally, it is worth repeating that Australia has a strong interest in this being the case. A stable and robust financial system in China is clearly in Australia's interest. So too is a prosperous China as part of a rules-based international system. As the economic relationship between our two countries broadens and deepens, developments in China are having a material impact on more and more Australian industries: it is more than just about resources. It is therefore important that we have a http://www.rba.gov.au/speeches/2018/sp-gov-2018-05-23.html 19/20 5/25/2018 Australia's Deepening Economic Relationship with China: Opportunities and Risks | Speeches | RBA thorough understanding of one another. We all have a role to play in helping build that understanding. Thank you and I would be happy to answer your questions. Endnote [*] I would like to thank Adam Cagliarini, Brad Jones, Kate McLoughlin, Ivan Roberts and Miles Waring for assistance in the preparation of this talk. © Reserve Bank of Australia, 2001–2018. All rights reserved. http://www.rba.gov.au/speeches/2018/sp-gov-2018-05-23.html 20/20 | reserve bank of australia | 2,018 | 5 |
Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Australian Government Fixed Income Forum 2018, Tokyo, 6 June 2018. | 6/7/2018 Some Features of the Australian Fixed Income Market | Speeches | RBA Speech Some Features of the Australian Fixed Income Market Christopher Kent [ * ] Assistant Governor (Financial Markets) Australian Government Fixed Income Forum 2018 Tokyo – 6 June 2018 I'd like to thank the Australian Office of Financial Management for the opportunity to address the forum here in Tokyo. Today I'll discuss some of the interesting features of the Australian fixed income market and how that market has evolved over the years. The Australian financial market is very much part of the global capital market. Indeed, the extent of that integration has increased progressively over time. Over the past decade, foreign capital coming into Australia from the major advanced economies has increased by more than those economies have grown (Graph 1). For example, as a share of Japan's GDP, Japanese investment in Australia is now around three times the size it was 10 years ago. http://www.rba.gov.au/speeches/2018/sp-ag-2018-06-06.html 1/19 6/7/2018 Some Features of the Australian Fixed Income Market | Speeches | RBA Graph 1 This means that developments in the major financial markets around the world, including in key financial centres such as Tokyo, have an influence on Australian financial conditions. Australia has an extensive history of making productive use of foreign capital. It has long been recognised that there are reliable opportunities for overseas investors to profit from investment in Australian assets, whether they be physical or financial assets. This has enabled Australia to have sustained sizeable current account deficits over the course of the past 150 years or more (Graph 2). http://www.rba.gov.au/speeches/2018/sp-ag-2018-06-06.html 2/19 6/7/2018 Some Features of the Australian Fixed Income Market | Speeches | RBA Graph 2 After Australia opened up its capital account in the early 1980s, the current account deficit became a bit larger on average than it had been for some time. That led to a steady build-up in the ratio of net foreign liabilities to GDP (Graph 3). Over the past decade, net liabilities have continued to increase, but by no more than the rise in nominal GDP, so that ratio has been little changed at around 55 per cent. Underneath that overall stability, there have been important changes in the make-up of the different types of liabilities, and the different types of institutions drawing upon foreign funding. The share of longer-term debt has increased noticeably, while the share of short-term debt has declined. Also, the net equity position has changed from a notable deficit to one that is roughly in balance. http://www.rba.gov.au/speeches/2018/sp-ag-2018-06-06.html 3/19 6/7/2018 Some Features of the Australian Fixed Income Market | Speeches | RBA Graph 3 There is a common perception that Australia's foreign borrowings have been largely intermediated by the banks. While the banks do raise a portion of their debt offshore in order to fund their lending to Australian businesses and households, the extent of this is much less than in the past (Graph 4). By contrast, non-financial corporations have been willing and able to access offshore funding more so than in prior decades so that they now account for a larger share of foreign borrowing than banks. Also, federal government borrowing from offshore increased as a share of GDP following the global financial crisis. I'll return to this last point in a few minutes, but for now, I'll note that the government debt is issued to overseas investors in Australian dollars, in contrast to offshore issuance by the private sector in foreign currency terms. http://www.rba.gov.au/speeches/2018/sp-ag-2018-06-06.html 4/19 6/7/2018 Some Features of the Australian Fixed Income Market | Speeches | RBA Graph 4 The reduced use of offshore funding by the banks has been offset by much greater use of domestic deposits (Graph 5). The big shift away from short-term debt towards deposits started around the time of the global financial crisis. These changes were in response to the demands of the market and those of regulators for banks to make greater use of more stable sources of funding. http://www.rba.gov.au/speeches/2018/sp-ag-2018-06-06.html 5/19 6/7/2018 Some Features of the Australian Fixed Income Market | Speeches | RBA Graph 5 While the use of short-term debt (i.e. less than one year) is less than it was, it still accounts for around 20 per cent of banks' funding. And about 60 per cent of that debt (on a residual maturity basis) is raised offshore (Graph 6). [1] Global money markets, in the United States and elsewhere, provide the Australian banks with a much deeper market with a wider investor base than the relatively small domestic market. This short-term debt is issued in foreign currency terms, but the banks fully hedge their exchange rate (and interest rate) exposures at relatively low cost. http://www.rba.gov.au/speeches/2018/sp-ag-2018-06-06.html 6/19 6/7/2018 Some Features of the Australian Fixed Income Market | Speeches | RBA Graph 6 Because Australian banks raise a portion of their funding in US money markets to finance their domestic assets, they responded to higher US rates earlier this year by marginally shifting towards domestic markets to meet their needs. Hence, the rise in the US 3-month LIBOR rate (relative to the Overnight Index Swap (OIS) rate) was closely matched by a rise in the equivalent 3-month bank bill swap rate (BBSW) spread to OIS in Australia (Graph 7); similarly, the two spreads have declined of late by similar orders of magnitude (relative to their respective OIS rates). Equivalent spreads in some other money markets around the world also moved higher, though to a lesser extent than spreads in Australia. In contrast, rates in the euro area and Japan were not affected by the tightness in the US markets. That difference appears to reflect the fact that although European and Japanese banks tap into US money markets, they do so largely to fund US dollar assets. http://www.rba.gov.au/speeches/2018/sp-ag-2018-06-06.html 7/19 6/7/2018 Some Features of the Australian Fixed Income Market | Speeches | RBA Graph 7 Changes in BBSW rates in Australia feed through to banks' funding costs in a number of ways. First, they flow through to rates that banks pay on their short- and long-term floating rate wholesale debt. Second, BBSW rates affect the costs associated with hedging the risks on banks' fixed-rate debt, with the banks typically paying BBSW rates on their hedged liabilities. [2] Third, interest rates on wholesale deposits tend to be closely linked to BBSW rates. In short, the costs of a range of different types of funding have risen a bit for Australian banks in the past few months. But they remain relatively low and pressures in short-term money markets have eased, with BBSW about 10 basis points lower than its recent peak (relative to OIS). While some business lending rates are closely linked to BBSW rates – and so have increased a little – there have been few signs to date of changes to rates on loans for housing or small businesses. While developments in global financial markets such as I've just described influence Australian financial conditions, the link is far from one-to-one. This is not surprising given that the Reserve Bank sets monetary policy according to the outlook for Australian economic activity and inflation, and within a freely floating exchange rate regime. So even though the yield on 10-year government bonds in Australia moves quite closely with the equivalent US yield from day to day, over time these yields follow their own paths. Indeed, this year the difference between yields on 10-year Australian government bonds and equivalent US Treasury securities has become negative for the first time in quite a while (Graph 8). Also, the federal funds rate has now risen from close to zero a few years ago to be at the same level as the Australian cash http://www.rba.gov.au/speeches/2018/sp-ag-2018-06-06.html 8/19 6/7/2018 Some Features of the Australian Fixed Income Market | Speeches | RBA rate. These changes reflect a few important differences across the two economies. In the United States, the economy has moved beyond what most consider to be full employment, inflation is close to the Fed's target and expectations are that the Federal Open Market Committee will continue to raise its policy rate; moreover, the United States is embarking on a significant fiscal expansion. By contrast, there remains spare capacity in the Australian labour market – notwithstanding strong employment growth over the past year – inflation is expected to rise gradually towards the Reserve Bank's target, and market pricing implies no expectation of a rise in the cash rate until around mid next year at the earliest. Fiscal policy in Australia is also on a different course to the United States, but there are other speakers here today addressing that topic. Graph 8 So yields have risen in Australia a bit, but by less than in the United States and they remain low. Spreads have also increased of late, but they too remain at low levels across a number of Australian markets (Graph 9). Over the past year or more, spreads declined in response to a number of factors. Accommodative monetary policy and the low rate of inflation have contributed to easy financial conditions for issuers. Also, there has been a noticeable improvement in measures of business conditions to well above average levels (Graph 10). The resulting improvement in, and outlook for, business profits has helped reduce actual and prospective defaults. In turn, this has underpinned a narrowing of credit premia. http://www.rba.gov.au/speeches/2018/sp-ag-2018-06-06.html 9/19 6/7/2018 Some Features of the Australian Fixed Income Market | Speeches | RBA Graph 9 http://www.rba.gov.au/speeches/2018/sp-ag-2018-06-06.html 10/19 6/7/2018 Some Features of the Australian Fixed Income Market | Speeches | RBA Graph 10 These low spreads are mirroring developments overseas (Graph 11). Again, this is consistent with Australia's open capital markets. Spreads reflect an assessment of risk, and if the price of risk in Australia were to deviate too far from the global price – beyond that suggested by any differences in fundamental credit quality – there would be opportunities for profitable arbitrage. One way or another, the process of arbitrage would lead to a degree of convergence between spreads. http://www.rba.gov.au/speeches/2018/sp-ag-2018-06-06.html 11/19 6/7/2018 Some Features of the Australian Fixed Income Market | Speeches | RBA Graph 11 Australian issuers have responded to the low yields and low spreads over the past couple of years. Issuance in many markets is up. Banks have taken advantage of favourable funding conditions to tap the bond market. In 2017, their gross issuance of bonds was the second highest since the global financial crisis (Graph 12). And net issuance this year is currently running well ahead of issuance at the equivalent time last year. http://www.rba.gov.au/speeches/2018/sp-ag-2018-06-06.html 12/19 6/7/2018 Some Features of the Australian Fixed Income Market | Speeches | RBA Graph 12 Corporate bond and Kangaroo issuance rebounded from their 2016 levels in 2017, although there have been recent years where issuance was higher. In early 2018, spreads in the Kangaroo market narrowed to levels seen prior to the global financial crisis (Graph 9). The Kangaroo market, where non-resident issuers tap the Australian market, is familiar to Japanese investors; Japanese pension funds and life insurance companies are active investors here. Activity in this market is important because foreigner issuers typically hedge the exchange rate risk arising from their Australian dollar liabilities. This source of demand helps to keep down the costs of hedging exchange rate risk for Australian entities issuing liabilities in US dollars (and other foreign currencies). Another place where we understand Japanese investors play an important role is in the residential mortgage-backed securities (RMBS) market. Issuance in the RMBS market in 2017 was the strongest it has been since the global financial crisis. Part of that owed to extra issuance by non-banks. Their housing lending picked up strongly at the same time as the growth of lending by the major banks eased, which was driven, in part, by regulatory actions to tighten lending standards. Despite these supply-side motivations, spreads remain relatively tight, consistent with a rise in the demand for RMBS over the past couple of years (Graph 13). http://www.rba.gov.au/speeches/2018/sp-ag-2018-06-06.html 13/19 6/7/2018 Some Features of the Australian Fixed Income Market | Speeches | RBA Graph 13 Across the three markets I've just mentioned there has been an increase in the diversity of issuers over the past few years. In the RMBS market, low spreads have encouraged more issuance by smaller competitors to the major banks; last year these numbered 17, which was the highest ever. Also, resource-related companies have been much less active now that the mining investment boom has come to an end, while companies outside of the resource sector stepped up their issuance to high levels last year (Graph 14). http://www.rba.gov.au/speeches/2018/sp-ag-2018-06-06.html 14/19 6/7/2018 Some Features of the Australian Fixed Income Market | Speeches | RBA Graph 14 We have also seen more diversity in the types of issuer in the Kangaroo market (Graph 15). http://www.rba.gov.au/speeches/2018/sp-ag-2018-06-06.html 15/19 6/7/2018 Some Features of the Australian Fixed Income Market | Speeches | RBA Graph 15 Another development worth highlighting is the lengthening in the tenor of bond issuance in some parts of the market (Graph 16). In the case of domestic issuance for non-financial corporations, this increase is part of a longer-running trend, which has been a positive development for domestic markets. In the case of overseas issuance by Australian banks, there have been some notable deals of late with quite long tenors. This lengthening of tenor reflects banks taking advantage of the low term premium for longer-term funding. http://www.rba.gov.au/speeches/2018/sp-ag-2018-06-06.html 16/19 6/7/2018 Some Features of the Australian Fixed Income Market | Speeches | RBA Graph 16 While foreign investment in Australia has grown significantly over many years, the share of government debt held by foreigners has declined since earlier in this decade (Graph 17). [5] Even so, it remains at a relatively high level in the case of Australian Government debt. The share of Australian corporate debt held by foreigners has been high and stable, even drifting up in the case of non-financial corporations. The recent pick-up in foreign ownership of asset-backed securities is interesting. It suggests that non-residents have entered the secondary market to purchase assetbacked securities, thereby adding some liquidity to a market that is normally not particularly liquid. http://www.rba.gov.au/speeches/2018/sp-ag-2018-06-06.html 17/19 6/7/2018 Some Features of the Australian Fixed Income Market | Speeches | RBA Graph 17 In conclusion, Australian fixed income markets are increasingly integrated with global capital markets. Not surprisingly, developments in major advanced economies have some influence on domestic financial conditions; the episode of recent tightness in US money markets is one such example. However, Australian financial conditions do not move in lock-step with those offshore, with domestic developments also having a major influence. While Australian banks still play a role in tapping into funding offshore, that role is less important than it used to be. Indeed, over recent years a broader range of issuers have been obtaining funding, in both onshore and offshore markets, and this has occurred at somewhat longer tenors than in the past. Endnotes [*] I would like to thank Leon Berkelmans for his help in preparing this material. About two-thirds of long-term debt is issued offshore. Even though banks issue mostly fixed-rate bonds, and mostly offshore, they swap much of the related exposures into floating rate Australian dollar exposures. This aligns the nature of the rates for their funding with those of their assets (which are largely variable interest rate loans). http://www.rba.gov.au/speeches/2018/sp-ag-2018-06-06.html 18/19 6/7/2018 Some Features of the Australian Fixed Income Market | Speeches | RBA Wholesale deposits include deposits from large corporations, pension funds and the government, and account for around 30 per cent of banks' debt funding. A decade ago, the Kangaroo market had been reliant on financial corporations and European-based supranational, sovereign or quasi-sovereign agencies, known collectively as SSAs. However, as time has passed, we have seen a more diverse range of issuers enter the market, including non-European SSAs and more recently non-financial corporations, such as companies from the United States. Foreign holdings in absolute terms have increased over this period but they haven't kept pace with the growth in the stock of government debt. © Reserve Bank of Australia, 2001–2018. All rights reserved. http://www.rba.gov.au/speeches/2018/sp-ag-2018-06-06.html 19/19 | reserve bank of australia | 2,018 | 6 |
Keynote speech by Ms Michele Bullock, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the 5th Bund Summit on Fintech, Shanghai, 8 July 2018. | Michele Bullock: Financial technology and payments regulation Keynote speech by Ms Michele Bullock, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the 5th Bund Summit on Fintech, Shanghai, 8 July 2018. * * * My thanks to Chay Fisher, Jiamin Lim, Sean Langcake and Stephanie Bolt who carried out the work on which this speech is based. Thank you to the Shanghai Finance Institute for the invitation to speak at this summit. The theme of the summit – New Finance, New Technology, New Trends – really captures the excitement of the payments industry at the moment. But it is also a challenging time for regulators who want to encourage innovation but at the same time ensure that payment systems remain safe for users and that there is a level regulatory playing field. Today I am going to talk about some of those challenges and how we are thinking about them at the Reserve Bank of Australia. I will start by briefly setting out the Australian regulatory framework for payments before talking about the key forces shaping payments. I will then talk about some of the potential implications for retail payments and for regulators. Payments Regulation in Australia Like in China, the primary regulator of the payments system in Australia is the central bank – the Reserve Bank of Australia. The Reserve Bank’s payments system policy is determined by the Payments System Board (PSB), which is chaired by the Governor of the Reserve Bank and includes a number of external members. The key duties of the PSB with respect to the payments system are to ensure that the powers of the Bank are exercised in a way that best contribute to controlling risk in the financial system, promoting efficiency of the payments system and promoting competition in the market for payment services consistent with overall stability of the financial system. The Reserve Bank has strong powers to regulate payments systems and in some cases it does. For example, certain competition and efficiency issues associated with credit card systems could not be addressed by participants so the Bank introduced regulation that required changes to certain practices in these schemes. But the Bank’s preferred approach is to identify areas where competition, efficiency or safety could be enhanced and then encourage industry to address those issues. A good example of this was the development of the New Payments Platform (NPP). The NPP is an open access infrastructure for fast payments in Australia. It went live earlier this year and is gradually ramping up. It allows users of the payments system to send real-time payments with simple addressing 24/7. It also allows more complete information to be sent with payments. But this wasn’t a spontaneous creation of the industry. It was developed in response to a number of strategic objectives for the Australian payments system set by the Reserve Bank. While the industry determined how it would achieve the objectives, the Reserve Bank played a significant role in encouraging and facilitating the cooperation required to develop and build the system. The Forces Shaping Retail Payments There are three key forces that are introducing innovation and competition to retail payment systems around the world: new payment channels, new technologies and new participants. Increasingly, consumers are reducing their use of cash and using electronic payment methods. But they are also making electronic payments through new channels. One example is payment 1/5 BIS central bankers' speeches using mobile devices. These devices have become ubiquitous and are now being used for payment at the point of sale, online payments and ‘in-app’ payments. Wearables and the ‘internet of things’ more broadly are also expanding the devices through which payments can be made. In Australia, most of these new payment channels use the existing payment rails – in particular those of the card schemes. New technologies are also shaping retail payments. Distributed ledger technology has been receiving a lot of attention lately, with suggestions that new payment mechanisms using this technology might be more efficient (e.g. cross-border payments) and even result in a reduced role for traditional financial institutions. But other technologies that are likely to facilitate innovation in the payments system include cloud computing, artificial intelligence and cryptography. These technologies have the potential to improve payment experiences for customers as well as support new payment instruments. They are also potentially allowing non-traditional players without a large physical footprint to compete with the established financial institutions. Which brings me to the third force shaping the retail payments system – new participants. There are broadly three types of potential competitors. Most similar to the incumbents are digital banks, sometimes called neobanks. These banks offer banking services typically by mobile app. They are unencumbered by legacy systems and physical branch networks and can use newer technologies, potentially making them more flexible and responsive to consumer needs. Then there are fintech firms, many of which are using technology to address particular frictions and gaps in the payments market. Online payments, point-of-sale technology and cross-border payments are all areas in which fintechs are innovating. And, finally, there are the large global technology companies that can leverage their already extensive networks to offer proprietary closed loop payment services. In China there are two at the forefront of this – AliPay and WeChat Pay. But Google, Apple, Facebook and Amazon all have some payment functionalities within their networks that they could potentially expand. Moves to require banks to share the data of their customers with other participants (open banking) have the potential to further promote competition and innovation. In Australia, we are in the process of implementing an open banking regime that will put consumers in control of their banking data. It is expected that consumers will be able to use these data to access better products and services. For example, consumers could ask their bank to share their credit card transaction history, interest rate, fees and other relevant data with a product comparison website. Using this information, the website could provide a tailored assessment of the best possible credit card for that particular individual, including an accurate estimate of potential savings compared with their current card. While there are a number of challenges in implementing this ambitious reform, such as ensuring data security and customer privacy, these can be addressed. The Reserve Bank is confident about the potential of open banking to deliver benefits for consumers. Implications for the Retail Payments System With all this innovation and competition in the financial system, and the payments system in particular, a logical question is: what are the implications for policy and regulation? I will address four here: Challenges in balancing innovation and regulation Implications for efficiency of the payments system Security Resilience Financial regulation 2/5 BIS central bankers' speeches An important challenge for regulators is how to limit barriers to innovation while maintaining safe and efficient payments systems. This requires regulators to be alert to any detrimental impact that regulations might have on innovative new technologies and participants. But new entrants might also find that it is difficult to get access to the underlying payments infrastructure. And some innovations might require participants that are otherwise competitors to cooperate, making it difficult to get an innovative product or system off the ground. The Reserve Bank therefore sees a need to play a proactive role in facilitating cooperative projects and monitoring potential access issues. Most regulators around the world seem to be encouraging innovation while taking a proportionate approach to regulation. This often involves a graduated approach to regulation, depending on the activities of the new participants. For example, many jurisdictions have some type of regulatory ‘sandbox’ in which new participants can develop their services without the full weight of regulation. Some jurisdictions authorise payment service providers under less onerous conditions than apply to full financial institutions. In Australia, the Australian Prudential Regulation Authority (APRA) and the Australian Securities and Investments Commission (ASIC) are also taking a graduated approach to new entrants. ASIC has a regulatory sandbox framework that is specifically designed to provide eligible fintech businesses the flexibility to test new products and services without the need for a licence. Similarly APRA has established a framework for licencing ‘Restricted ADIs’, which allows potential entrants to the banking sector to conduct limited banking business for a period of time under a simpler prudential framework while they develop their capabilities and resources. Importantly though, under both these frameworks, new entrants are expected to eventually meet the same requirements as other financial service providers, ensuring a level playing field. There are two issues in the Australian payments system that are potentially going to be of interest to financial regulators. The first is access. New payment service providers will need access to the underlying payments infrastructure to compete with the incumbent financial institutions. Non-bank providers of payment services already have access to accounts at the Reserve Bank for the purposes of settlement. But they will also need access, either direct or indirect, to payment clearing systems. While they might be able to commercially negotiate an agency arrangement, this could add to their costs and they might therefore prefer direct access. If incumbent financial institutions control access, they might seek to put up unreasonable barriers to entry. Regulators will need to be alert to potential anti-competitive conduct. The second area is stored value products. Traditionally, payment services have been provided by regulated financial institutions through transaction accounts. These institutions are prudentially supervised to ensure that the public can have confidence that they will be able to meet their financial commitments under all reasonable circumstances. In addition, in most countries, including Australia, retail deposits would be protected if a bank were to fail. But some of the new entrants are holding client funds on their books as ‘stored value’. This raises a number of policy questions. Should the funds being held be treated like deposits? If not, do the firms holding the funds need to be regulated in some other way to protect consumers? If the new entrants are very large, like the big technology companies, they could potentially hold substantial amounts of value in their closed systems. What are the implications for systemic risk of such a market structure? Regulators are still working through these questions. Efficiency The potential for new products to improve payment services will depend on the extent to which there are gaps or frictions in the payment process. Three areas that are often identified are micropayments, ‘programmable money’ and cross border payments. The concept of micropayments – of, say, one-hundredth of a Yuan or an Australian dollar – is not new (indeed, the concept has been around for decades). In recent years, demand for a 3/5 BIS central bankers' speeches micropayment service has typically been from internet content providers looking for alternatives to the advertising or monthly subscription-fee business models. But, looking ahead, the development of an ‘internet of things’ potentially greatly broadens the demand for the ability to make and receive very small payments at low cost. A challenge in addressing this gap has been how to recover costs – or even be profitable – when the value of each transaction is so small. ‘Programmable money’, that is, payments that occur automatically if certain terms or conditions are met, could improve efficiency by minimising the need for human intervention. For example, online payments for goods could be held as a deposit with an independent third party and automatically released once goods are confirmed as delivered. Other possible applications include payments that occur within business supply chains. Cross-border payments are widely regarded as an area in which significant potential efficiency gains exist. Current processes are slow and costly, involving significant compliance burden and a number of different financial institutions in different jurisdictions. New technologies and new business models could be used to address some of these frictions. While there are clearly potential efficiency gains from addressing some of these gaps, there are reasons for regulators to keep an eye on developments that might result in inefficient outcomes. Some of these arise from the existence of network effects. A very large network that incorporates payments as one part of its services might be able to lock in the payments business, even if it is more costly than alternatives, because customers are unwilling to leave the ecosystem. The trend towards embedding payments in apps or other devices could also lead to inefficient outcomes. While automated payments are likely to be convenient for consumers and merchants, they might also make it more difficult for alternative payment methods to compete and reduce the sensitivity of users to changes in the relative prices of payment instruments. Security With increasing commercialisation of consumer data, interest in people’s personal banking data (including payments) is likely to grow. For example, it has been suggested that if individuals could easily and securely share their personal banking information (while retaining ownership of the data), new services could be developed to facilitate personalised financial services. More generally, the advent of ‘big data’ analytics to generate insights into behaviours of individual consumers has increased interest in access to data on consumer payments behaviour. But with more data being stored and shared, data security (and cybersecurity more generally) will be important ongoing issues for the industry and for regulators. Incumbent financial institutions invest a lot in securing their customers’ data and in managing fraud in payment systems. Mostly they do this without the need for regulators to be involved because it is in their interests to ensure that they maintain the trust of their customers. But with new participants and new technologies, there is a risk that security vulnerabilities and opportunities for fraud will arise. The strength of the system is only as good as its weakest link so it is essential that all participants in payment systems and the financial system more broadly manage and mitigate these risks. Regulators may have a role to play in encouraging the adoption of minimum standards. Resilience The final area I want to focus on is resilience of payment systems. Traditionally, central banks and regulators have paid a lot of attention to the resilience of high-value payment systems because of the systemic disruption that would likely occur if such systems were to suffer from an outage. High-value payment systems are therefore subject to high standards of operational resilience. 4/5 BIS central bankers' speeches Retail payment systems have not usually been required to meet similarly high standards. But, with electronic payments becoming increasingly important, the resilience of the electronic retail payment systems is becoming quite critical to the smooth functioning of economies. With people carrying less cash, an outage in a retail payment system can mean that customers can’t undertake transactions. In Australia, for example, an outage at a major bank recently meant that its merchant customers had to turn customers away if they didn’t have cash (and many didn’t). These sorts of outages disrupt commerce and erode trust of consumers in payment systems. Regulators are therefore starting to focus on the operational risks associated with retail payment systems and whether the operators and the participants are meeting appropriately high standards of resilience. Conclusion There is a lot of change happening in retail payments and it is happening quickly. Financial technology is facilitating the development of new payment products and the entry of new participants, and potentially transforming the customer experience. It has the potential to enhance competition and increase efficiency in the payments system. Recognising this, regulators in Australia and other countries are encouraging innovation. Nevertheless, regulators need to keep up with this fast changing world and the implications for efficiency, and safety of the payments system. 5/5 BIS central bankers' speeches | reserve bank of australia | 2,018 | 7 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Anika Foundation Luncheon supported by NAB and the ABE, Sydney, 8 August 2018. | 8/8/2018 Demographic Change and Recent Monetary Policy | Speeches | RBA Speech Demographic Change and Recent Monetary Policy Philip Lowe [ * ] Governor Address to Anika Foundation Luncheon supported by NAB and the ABE Sydney – 8 August 2018 It is a pleasure to be able to speak at the Anika Foundation lunch for a second time. As the father of three teenage children I know how important the work of the foundation is. Thank you all very much for your support. Today, I would like to talk about a long-run topic and a short-run topic. The long-run topic is Australia's demography and the short-run topic is current monetary policy in Australia. These might seem to be unrelated topics. But at the RBA, we are very aware that our decisions about interest rates are not made in a vacuum – that they are influenced by structural developments in our economy. And one of these important structural factors is changes in our demography. Indeed, Australia's demographic profile is more positive than those of many other countries. It is one of the factors that provides a basis for optimism about the future of our economy. Many countries are rightly concerned about their population dynamics, their ageing workforces and their rapidly rising old-age dependency ratios. We, too, need to keep an eye on these issues, but we are in a better position than many others. This, in part, reflects policy decisions, including about the level and composition of immigration, and retirement income policy. I would like to take this opportunity to talk about these issues, before turning to monetary policy. Population Dynamics According to the latest estimates, there are now 25 million people living in Australia. Over the past decade, our population has grown at an annual rate of more than 1½ per cent. This is faster than in previous decades and it is also noticeably faster than population growth in most other advanced economies (Graph 1). Over the past decade, most countries have experienced average annual population growth of less than 1 per cent and a number of countries have experienced stagnant or declining populations. This is an important difference, with Australia's faster population growth being https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-08.html 1/18 8/8/2018 Demographic Change and Recent Monetary Policy | Speeches | RBA one of the reasons our economy has experienced higher average growth than many other advanced economies. Graph 1 The increase in Australia's population growth over the past decade is largely due to increased immigration; the rate of natural increase has not changed that much (Graph 2). Over recent times, net overseas migration has, on average, added around 1 per cent to our population each year. The increase from natural sources has averaged around 0.7 per cent per year. https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-08.html 2/18 8/8/2018 Demographic Change and Recent Monetary Policy | Speeches | RBA Graph 2 There has been a reasonable amount of year-to-year variation in net overseas migration. Migration increased sharply at the height of the resources boom when demand for skilled labour was very strong, and then subsequently declined as the mining investment boom came to an end. In this way, migration has helped our economy adjust to large swings in the demand for labour. It has also helped address some particular skills shortages. A second factor that accounts for the step-up in the level of migration and the year-to-year variation is a marked increase in the number of overseas students studying in Australia and changes in the policies around student visas. There are currently more than 500,000 overseas students studying in Australia. Over recent times, it has been common for around one-sixth of foreign students to stay and live and work in Australia after completing their studies. [1] This has boosted our population. It has also boosted the nation's human capital. People living in Australia who were born overseas are more likely than the average Australian to have a post-secondary school qualification (Graph 3). We also benefit from stronger overseas connections when foreign students return home after studying in Australia. https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-08.html 3/18 8/8/2018 Demographic Change and Recent Monetary Policy | Speeches | RBA Graph 3 The effects of faster population growth on our economy and society are complex and they are widely debated. As a number of commentators have noted, population growth has put pressure on our infrastructure. As a country, we were slow to increase investment in infrastructure to meet the needs of our more rapidly growing population. Investment in this area has now picked up, particularly in transport, which, in time, will help alleviate some of the pressures. We were also slow to increase the rate of home building in response to the faster population growth. Indeed, it took the better part of a decade for this adjustment to take place (Graph 4). This slow adjustment is one of the factors that contributed to the large increases in housing prices in some of our cities over recent times. The adjustment, though, has now taken place, with growth in the number of dwellings exceeding growth in the population over the past four years. https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-08.html 4/18 8/8/2018 Demographic Change and Recent Monetary Policy | Speeches | RBA Graph 4 I have spoken about these adjustments on previous occasions. Rather than cover this material again, I would like to focus on something that receives less attention, but is no less important – that is, how the changes in our population dynamics have affected some of Australia's key demographic indicators. Of particular importance is the fact that, on average, new migrants to Australia are younger than the resident population. Workers coming to Australia tend to be relatively young and so too, obviously, are most students. The median age of new migrants is between 20 and 25, which is more than 10 years younger than the median age of the resident population. Over the past five years, over 80 per cent of net overseas migration has been accounted for by people under the age of 35 (Graph 5). https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-08.html 5/18 8/8/2018 Demographic Change and Recent Monetary Policy | Speeches | RBA Graph 5 This inflow of younger people through immigration has significantly reduced the rate of population ageing in Australia. The median age of Australians is currently 37. Back in 2002, Australia was expected to age quite quickly, with the median age projected to increase significantly to over 45 by 2040 (Graph 6). But after a decade of increased immigration of younger people, the latest estimate is that the median age in 2040 will be around only 40 years. This is a big change in a relatively short period of time, and reminds us that demographic trends are not set in stone. https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-08.html 6/18 8/8/2018 Demographic Change and Recent Monetary Policy | Speeches | RBA Graph 6 It is useful to put this change in an international context. To do this, the RBA's staff has examined demographic trends and projections over the next quarter of a century for 37 advanced economies using UN data. [2] This next graph shows four key demographic variables for Australia and the range of outcomes across these countries (Graph 7). Australia stands out in a number of dimensions: First, our median age of 37 makes Australia one of the youngest countries among the advanced economies. We are also ageing more slowly than most other countries, which means that we are projected to stay relatively young. This is different from the earlier projections, under which we were expected to move to the middle of the pack. Second, we have a higher fertility rate than most advanced economies. Australians tend to have larger families than those in many other countries. Third, our average life expectancy is at the higher end of the range, and is expected to continue to rise. Fourth, the old-age dependency ratio is rising, but less quickly than in most other countries. Our relative youth and higher fertility rates mean that the dependency ratio is expected to remain lower than elsewhere over the next generation. Beyond that, on current projections, it is then expected to increase quite significantly. https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-08.html 7/18 8/8/2018 Demographic Change and Recent Monetary Policy | Speeches | RBA Graph 7 So, in summary, we are better placed than many other countries. The movement to Australia of large numbers of young people over the past decade has changed our demographic profile in a positive way. This has implications for future economic growth and the pressures on government budgets. This immigration has also boosted the nation's human capital. Ageing and Labour Force Participation I would now like to turn to some of the implications for labour force participation of our changing demographics. While we remain a relatively young country, we are still ageing. Even with the large increase in relatively young migrants, the share of the Australian population aged 15–64 is declining, after increasing for many years (Graph 8). This decline is projected to continue for at least a generation, reflecting a combination of the ongoing transition of baby boomers into retirement ages, lower fertility rates and increased life expectancy. By 2040, around 20 per cent of the population is expected to be over 65, compared with 15 per cent currently. https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-08.html 8/18 8/8/2018 Demographic Change and Recent Monetary Policy | Speeches | RBA Graph 8 All else equal, as the population ages, the proportion of people who are working could be expected to decline. But all else is not equal. In Australia, we are seeing shifts in behaviour that have, to date, more than offset the effects of ageing on labour supply. In particular, the participation rates for men and women aged over 55 have increased significantly over the past two decades or so (Graph 9). https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-08.html 9/18 8/8/2018 Demographic Change and Recent Monetary Policy | Speeches | RBA Graph 9 This increase in the number of older Australians and the rise in their labour force participation means that nearly one in five employees are aged over 55 years. This compares with less than one in 10 in the 1980s and 1990s (Graph 10). https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-08.html 10/18 8/8/2018 Demographic Change and Recent Monetary Policy | Speeches | RBA Graph 10 There are a range of factors that are at work here. One is the improvement in health outcomes for older people. One way of measuring this improvement is through the responses to an Australian Bureau of Statistics (ABS) survey in which individuals are asked to assess whether they have a health impairment that restricts their everyday activities (Graph 11). Over the past decade and a half there has been a significant decline in the share of people over 55 reporting that they have such an impairment. This improvement in health is allowing people to stay in the workforce longer. Greater acceptance of flexible work practices is also supporting this change. https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-08.html 11/18 8/8/2018 Demographic Change and Recent Monetary Policy | Speeches | RBA Graph 11 A related development is the ongoing shift in economic activity towards service industries, which tend to be less physically demanding on the body. On average, labourers have one of the youngest retirement ages and managers and professionals have the oldest retirement ages (Graph 12). As the type of work we do changes, it seems that more of us are in a position to spend more years working. https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-08.html 12/18 8/8/2018 Demographic Change and Recent Monetary Policy | Speeches | RBA Graph 12 Another factor that has encouraged increased participation by older workers is the changes to retirement income policies. In another ABS survey, the most common reason cited by retirees for their decision to retire is eligibility for superannuation and/or the age pension. The importance of this reason has increased through time, perhaps because other factors – such as health – have become less binding. It seems reasonable to suggest then that the increase in the pension eligibility ages, particularly for women, and the increase in the preservation age for those with superannuation are both likely to have boosted labour force participation. A third set of factors is related to other financial considerations. For some people, increased life expectancy could be expected to lead to delayed retirement because of the need to increase savings to finance a longer life. A loss of wealth during the global financial crisis is likely to have had the same effect. Another financial consideration influencing retirement decisions is the tendency for people to carry debt later in life (Graph 13). The causation here, though, runs both ways. An expectation that one will work for longer makes it possible to carry debt for longer. But for other people, the tendency to buy homes later in life and the fact that the real value of debt erodes more slowly than it used to, is likely to see them stay in the workforce longer. https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-08.html 13/18 8/8/2018 Demographic Change and Recent Monetary Policy | Speeches | RBA Graph 13 Finally, the increased participation of older women is also an extension of the ongoing increase in female labour force participation across nearly all age groups that has been boosting labour supply in Australia for many decades (Graph 14). This shift has been encouraged by policy changes related to parental leave and child care, and the increased prevalence of flexible and part-time work. Changing societal attitudes and increased time spent in education have also played a role. As a result, the labour force participation rates of younger women no longer display such a pronounced dip as they progress through their child-bearing years, because fewer leave the labour force entirely when they have children, although their hours worked do still show a dip. https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-08.html 14/18 8/8/2018 Demographic Change and Recent Monetary Policy | Speeches | RBA Graph 14 So, together, better health outcomes, changes in the nature of work and retirement income policies, financial incentives and the general trend towards greater female participation in the labour force are all boosting the participation rate for older Australians. The overall picture is one of constructive adjustment to our changing demographics. This is another illustration of the flexibility of the Australian economy. As our population continues to age, further adjustment is likely to be needed. But as I spoke about earlier, Australia is better placed to deal with population ageing than most other advanced economies. The Near-term Outlook and Monetary Policy I would now like to shorten my gaze a little and turn to the near-term outlook for the Australian economy and the implications for monetary policy. The RBA will be releasing its latest forecasts for the economy on Friday. The outlook for GDP growth is little changed from that we have had for some time. Our central scenario remains for growth in the Australian economy to average a bit above 3 per cent in 2018 and 2019. The latest data have been consistent with this. We also still expect the unemployment rate to move lower over time and to reach 5 per cent at some point over the next few years. An unemployment rate of 5 per cent is the conventional estimate of full employment in Australia, but it is possible that we could go lower than this on a sustained basis. Time will tell. https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-08.html 15/18 8/8/2018 Demographic Change and Recent Monetary Policy | Speeches | RBA In terms of inflation, the latest data were in line with our expectations. Over the year to June, headline inflation was 2.1 per cent and, in underlying terms, inflation was close to 2 per cent. Both measures are higher than the average of recent years. Over the forecast period, we expect inflation to increase further to be close to 2½ per cent in 2020. In the short term, though, we would not be surprised if headline inflation dipped a little, reflecting declines in some administered prices in the September quarter. Electricity prices in some cities have declined recently after earlier large increases, and changes in government policy are likely to result in a decline in child care prices as recorded in the CPI. There have also been changes to some state government programs that are expected to lead to lower measured prices for some services. Together, these changes mean that our forecast for headline inflation for 2018 is now 1¾ per cent. Looking beyond these short-run dynamics, inflation is still expected to rise as the economy moves closer to full employment. The labour market is gradually tightening and it is reasonable to expect that this will lead to a lift in both wages growth and inflation. This tightening of the labour market is evident in the steady increase in job vacancies, with the number of vacancies, as a share of the labour force, at the highest level in many years (Graph 15). It is also evident in the increase in the number of firms reporting that it is difficult to find workers with the necessary skills. As expected, the tighter labour market is leading to higher wage outcomes in certain pockets of the labour market. Over time, we expect that this will become a more general story, although this is going to take some time. Graph 15 https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-08.html 16/18 8/8/2018 Demographic Change and Recent Monetary Policy | Speeches | RBA In terms of the financial risks facing the economy, things have also been broadly moving in the right direction. For a number of years, risks were rising due to the nexus of high and rising levels of debt and escalating housing prices. Over the past year, though, housing price declines in the largest cities have reversed a small part of the earlier gains. Borrowing by investors has also slowed considerably, largely because of reduced demand by investors. There has also been a tightening of credit standards. While banks are competing strongly for customers with low credit risk, their appetite to lend to riskier borrowers has lessened a bit. Some of the non-bank lenders are providing credit to these borrowers. This change in financial trends has helped reduce the build-up of risk. It is helpful that this change is taking place at a time when the world economy is growing strongly, the unemployment rate is trending lower and the economy is recording good growth. This is assisting with the adjustment and means that, notwithstanding the changes in the housing market, we still expect consumption growth of around 3 per cent over each of the next couple of years. We do, though, need to keep a close eye on the housing market and housing finance. So, in summary, we see reasonable prospects that the economy will record good growth, the unemployment rate will come down gradually and that inflation will increase over time. This is a favourable outlook. If this is how things evolve, you could expect the next move in interest rates to be up, not down. As the economy strengthens and income growth and inflation lift, it would be natural for interest rates to return towards more normal levels. The timing of any future change in interest rates is dependent upon the speed of the progress that is made in reducing the unemployment rate and having inflation return to around the midpoint of the target range on a sustained basis. If we were to make faster progress than we currently expect, any future increase in interest rates is likely to be earlier. Conversely, slower progress would likely see a longer period without an adjustment. For the time being, the Reserve Bank Board's judgement remains that the best course is to maintain the cash rate at its current level. Given that the progress in reducing unemployment and lifting inflation is expected to be only gradual, the Board does not see a strong case for a near-term adjustment in monetary policy. The Board is seeking to be a source of confidence and stability to support the progress that the Australian economy is making. Thank you for listening and I welcome your questions. https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-08.html 17/18 8/8/2018 Demographic Change and Recent Monetary Policy | Speeches | RBA Endnotes [*] I would like to thank Andrea Brischetto, Merylin Coombs and Angus Moore for assistance in the preparation of this talk. The Treasury and the Department of Home Affairs (2018), ‘Shaping a Nation’, Treasury Research Institute External Papers, April. Brown A and R Guttmann (2017), ‘Ageing and Labour Supply in Advanced Economies’, RBA 37-45; United Nations, Department of Social Affairs, Population Division (2017), . 2017 Revision, Volume 1: Comprehensive Tables Bulletin, December, pp World Population Prospects: The © Reserve Bank of Australia, 2001–2018. All rights reserved. https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-08.html 18/18 | reserve bank of australia | 2,018 | 8 |
Speech by Ms Luci Ellis, Assistant Governor (Economic) of the Reserve Bank of Australia, at the Infrastructure Partnerships Australia (IPA) Leaders' Luncheon, Sydney, 15 June 2018. | 6/15/2018 How Infrastructure Fits In | Speeches | RBA Speech How Infrastructure Fits In Luci Ellis [ * ] Assistant Governor (Economic) Speech at the Infrastructure Partnerships Australia (IPA) Leaders' Luncheon Sydney – 15 June 2018 I'm grateful for the opportunity to speak to you today, and conscious of the infrastructure expertise in the room. There wouldn't be anything I could add to what you know about project design, selection or funding. What I would like to do today is place infrastructure in a broader context. Specifically, I plan to talk about the role of infrastructure from the perspective of someone involved in macroeconomic policy: the policy challenges and opportunities, the work of the G20 and role of infrastructure as not just an engine of growth but, more importantly, an enabler of growth. What Is Infrastructure? Before getting into that, it's useful to define what we are talking about. When macroeconomists think about infrastructure, we think about the capital goods that provide public services. They are shared facilities that help economies function well. These include the – that is, the things produced by the construction industry that, unlike buildings, don't have roofs. But there are also many other shared facilities that promote a well-functioning economy and society. One example of those other important pieces of infrastructure is the New Payments Platform that was launched recently. There are also important social infrastructures such as our legal system, or our frameworks for safeguarding children. But for the purposes of my talk, I will focus on the things that are tangible. structures Within this class of tangible physical infrastructure, we can think of various kinds of physical assets. There is transport infrastructure, utilities providing electricity, gas and water, and communications infrastructure. Within each of these groups there are ‘hubs’ or centres, such as airports and railway stations for transport, power stations and reservoirs providing utilities, or telephone exchanges and satellites facilitating communication. Also within each group are ‘paths’ or distribution networks, such as the road and rail networks, power lines and telecommunications networks. https://www.rba.gov.au/speeches/2018/sp-ag-2018-06-15.html 1/8 6/15/2018 How Infrastructure Fits In | Speeches | RBA As you all well know, infrastructure of this kind can be provided by either the private or public sectors. The public sector might be involved for a number of reasons. One is that it is generally accepted that there are social benefits to providing these kinds of assets that are not fully captured by a profit-making provider. Without some provision by the state, such infrastructure will be underprovided. Another is the network nature of these facilities. Where there is a network, there is an element of monopoly power, and thus often a role for state regulation if not actually state ownership. At the very least, someone needs to set the rules of the game, whether that is the side of the road we drive on or the protocols used in telecommunications. Despite the role of the state in the provision and management of these types of infrastructure, they are not ‘public goods’ in the textbook sense. Textbook public goods are non-rival and nonexcludable: their benefits aren't diminished by an extra person enjoying them and, in any case, you can't prevent people from having those benefits. Clean air and a defence force fall into this category. By contrast, physical infrastructure can clearly suffer from congestion. It is also conceptually possible to exclude free riders from the use of the infrastructure, though this is more easily achieved in some cases than others. It is from these characteristics – congestion, excludability and the underlying monopoly network – that most of the policy challenges around infrastructure arise. What Policy Challenges Does Infrastructure Pose? Much like any business decision faced by private firms, decisions about infrastructure involve a lot of uncertainty. Businesses grapple with these questions every day. Should we build it? Is the market big enough? Where should we build it? What design and methods should we use? What price should we set? It is tempting to think that physical infrastructure is no different. Many of the questions are the same. But there are differences, and the policy challenges around infrastructure stem from that. Firstly, infrastructure can be very long-lived, which compounds the uncertainty about future usage rates and congestion. Secondly, the network element of the infrastructure makes it especially difficult to forecast market size. Thirdly, the social benefits that spill over to the broader economy are harder to quantify than a forecast revenue stream. All countries face the same challenges of providing enough infrastructure in the right places to serve the needs of their populations. So it is no surprise that infrastructure has been a recurring topic in the deliberations and work of the G20 group of major economies. Australia elevated the topic further during its presidency year in 2014. This year, the Argentine presidency has also included it as one of its key priorities and has re-convened the G20 Infrastructure Working Group, which met in Sydney earlier this month. One typical challenge is risk management. Infrastructure risk takes many forms. There's the risk that the project is not built efficiently, that investors are unwilling, that demand is too high – leading to congestion – or not high enough. There are risks that revenue can't be collected as intended. There are risks that the construction isn't resilient to natural disasters or just ordinary wear and tear. Another typical challenge is financing. Most infrastructure assets cost a lot upfront to build, and their monetary return – if any – is only realised over a long period. This can still be an attractive payoff https://www.rba.gov.au/speeches/2018/sp-ag-2018-06-15.html 2/8 6/15/2018 How Infrastructure Fits In | Speeches | RBA structure for private investors, depending on how the project is structured. Ensuring private sector participation in infrastructure finance has therefore been a priority of the G20. A common thread in these challenges is that the nature of the risks and funding issues are very different in the ‘build phase’ than in the ‘run phase’, once the infrastructure is being used. This is true of any large construction project and, similarly, one solution can be to have different actors involved in the two stages. What Policies Might Lessen These Challenges? The good news is that, if we face common challenges, the solutions are also likely to be common. We can learn from each other. So there is value in sharing information about best practice across countries. For example, during Australia's G20 presidency in 2014, a Global Infrastructure Hub (GI Hub) was announced, with an aim of, among other things, sharing guidance on best practices. If you think about it, the principles for designing a good road network or locating a railway line don't really change according to where you live. There will be differences relating to legal frameworks or other national specifics, but most of what constitutes best practice will be universal. To lessen the financing challenge, G20 authorities have been focusing on initiatives that can make infrastructure an attractive asset class. [2] There is plenty of private sector financing looking for the stable long-term cash flows that certain kinds of infrastructure assets can provide, once they are built. The question is how to bring that financing to the projects that need it, especially in emerging market economies where the need seems to be greatest. Different countries have approached this topic differently (Chong and Poole 2013). The report ‘Roadmap to infrastructure as an asset class’, [3] which G20 Finance Ministers and Governors endorsed in March, proposed several initiatives that should help, including to: enhance project preparation so that projects are more ‘bankable’ align the risk of projects to the risk profile of investors increase the data available on projects promote quality infrastructure and good governance improve local currency capital markets in emerging markets explore the creation of standardised contracts for activities such as financing and risk sharing. Some of these initiatives can work as collaborative efforts with the private sector. Others, such as aligning risks, may require more effective use of credit enhancement from the public sector or from supranational agencies, such as the multilateral development banks (MDBs). This is seen as a way of ‘crowding in’ private finance rather than have the MDBs fund the project themselves. Here's where the Australian experience might be instructive. As a central banker, I can look around the world and see that most countries have settled on the idea of having a specialist, independent agency to carry out the kinds of responsibilities that central banks usually have, such as setting monetary policy or running the payments system. The same is true for many kinds of financial https://www.rba.gov.au/speeches/2018/sp-ag-2018-06-15.html 3/8 6/15/2018 How Infrastructure Fits In | Speeches | RBA regulation. It is less common to have an autonomous agency involved in analysing and assessing microeconomic policy. But in Australia, we do have something like that in the Productivity Commission. And similarly we have an independent statutory authority for assessing and prioritising infrastructure projects, Infrastructure Australia. As a non-specialist it is not possible for me to quantify what difference this makes. But if common frameworks and rigorous, pre-emptive analysis help – and I believe they do – then Australia's experience will surely be instructive for other economies wanting to improve their infrastructure. What Is the Current State of Play in Australia? In comparison to some countries, international research suggests that Australia is fairly well served by its current infrastructure. [4] But with a strongly growing population, we face a challenge of ensuring that the stock of infrastructure keeps pace with expanding needs. Utilities such as electricity and water, as well as transport links, need ongoing investment to accommodate a rising population. This challenge has clearly been recognised and, over recent years, governments at both the state and federal level have been increasing infrastructure investment. As can be seen from this graph, public investment in communications infrastructure has increased with the rollout of the NBN. Transport infrastructure – road and rail – has increased even more sharply and is back close to the share of GDP it represented in the years immediately after the global financial crisis. Graph 1 https://www.rba.gov.au/speeches/2018/sp-ag-2018-06-15.html 4/8 6/15/2018 How Infrastructure Fits In | Speeches | RBA The recent federal budget foreshadowed additional infrastructure spending. More broadly, investment by the federal government is projected to increase over coming years. Most of the infrastructure spend is by state governments, however. This has already increased noticeably, particularly in the south-eastern states, and according to state budgets it is projected to increase further in the next couple of years. Much of this work is in urban transport projects, both road and rail. Graph 2 Another area of infrastructure attracting substantial investment at the moment is renewable energy. The value of renewable generation projects slated for the next year or so is similar to the average of recent years' investment in electricity generation, distribution and transmission, a much broader total set of activities. Most of the investment in renewables is by the private sector. These projects have become more attractive lately as the cost of the underlying technology has fallen. At the same time, the costs of fossil-based inputs to existing generation methods has risen, and so has the price of electricity. So renewable energy projects are becoming increasingly commercially viable. As such, it is an area where the private sector can provide the infrastructure. And that is indeed what we are seeing. A range of data sources on both capital expenditure and financing show greatly increased activity recently (Graph 3). A few years ago, much of the https://www.rba.gov.au/speeches/2018/sp-ag-2018-06-15.html 5/8 6/15/2018 How Infrastructure Fits In | Speeches | RBA investment in renewables was in small-scale rooftop solar. More recently, as the economics of these projects has changed, we are seeing more large-scale solar and wind projects being financed and built. Graph 3 As I mentioned earlier, the risks and challenges of the build phase are very different from those in the run phase. There will be some areas, like renewables, where the private sector will be involved in both phases. In others, the execution and governance risks in the build phase don't match investors' desired risk profiles, but the revenue from the operation phase can do so. These kinds of projects will be good candidates for private ownership once construction is complete; some state governments are recycling the revenue from those sales to fund new infrastructure. And finally, there are projects where the social benefits are not easily captured as cash flow. It is important that these kinds of projects are not under-provided, just because they would not be profitable for the private sector to run. Regardless of the exact approach to funding and management of construction, infrastructure investment can involve significant spillover benefits to the rest of the economy. The Bank has discussed these recently, and they bear repeating (RBA 2018). The direct spillovers derive from the incomes earned by the workers and firms doing the work; most of these projects are built by the private sector on behalf of the public sector. This income gets spent or invested, which in turn generates income for someone else and so on. At a time such as now, when there is still spare capacity in the economy, this ‘fiscal multiplier’ can result in overall demand rising by considerably more than the original spend on the project. https://www.rba.gov.au/speeches/2018/sp-ag-2018-06-15.html 6/8 6/15/2018 How Infrastructure Fits In | Speeches | RBA More broadly, and over a longer horizon, the economy benefits from a larger capital stock and the productivity benefits of infrastructure of this type. These are often hard to quantify even after the fact, but some examples might include: new export businesses enabled by the construction or expansion of an airport; higher productivity of logistics firms if their vehicles spend less time in traffic; and better health outcomes from reduced accident rates when roads are made safer. It is these benefits that are worth focusing on, more than the raw contribution of the building work to GDP growth. As I've emphasised on an earlier occasion, it isn't helpful to think of infrastructure as a new ‘engine of growth’, receiving the handover from the mining investment boom and, later, the apartment building boom (Ellis 2017). By its nature, infrastructure is justified by its contribution to the public good. It is not so much an engine of growth as an enabler of growth. But for this to be true, projects need to be rigorously assessed, carefully designed and appropriately timed. And for that to be possible, it helps if practitioners can learn from each other, for example through forums such as this one and, internationally, the initiatives of the G20. Thank you for your time. https://www.rba.gov.au/speeches/2018/sp-ag-2018-06-15.html 7/8 6/15/2018 How Infrastructure Fits In | Speeches | RBA Endnotes [*] Thanks to Ashwin Clarke, Rachel Adeney and Tomas Cokis for assistance with elements of this talk. Some important economic infrastructure, like the internet, has been able to expand and develop via cooperative governance and standard-setting by industry bodies with voluntary membership. But the role of public telecommunications networks and government-funded universities and other bodies in these areas should not be ignored. The Australian Treasury co-chairs the group designing and implementing these initiatives. See Group of Twenty (2018). See McKinsey Global Institute (2016). Bibliography Chong S and E Poole (2013), ‘Financing Infrastructure: A Spectrum of Country Approaches PDF ’, RBA pp 65–76. Bulletin, September, Ellis L (2017), ‘Where is the Growth Going to Come From?’, Stan Kelly Lecture, University of Melbourne, Melbourne, 15 November. Group of Twenty (2018), ‘Roadmap to Infrastructure as an Asset Class’, Report to the G20 Ministers and Governors. Available at <https://www.g20.org/sites/default/files/documentos_producidos/roadmap_to_infrastructure_as_an_asset_class_argentina_ presidency_0.pdf>. McKinsey Global Institute (2016), ‘Bridging Global Infrastructure Gaps’, June. Available at <https://www.mckinsey.com/~/media/McKinsey/Industries/Capital%20Projects%20and%20Infrastructure/Our%20Insights/ Bridging%20global%20infrastructure%20gaps/Bridging-Global-Infrastructure-Gaps-Full-report-June-2016.ashx>. RBA (2018), ‘Box C: Spillovers from Public Investment’, Statement on Monetary Policy, February, pp 40–42. © Reserve Bank of Australia, 2001–2018. All rights reserved. https://www.rba.gov.au/speeches/2018/sp-ag-2018-06-15.html 8/8 | reserve bank of australia | 2,018 | 8 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Australian Industry Group, Melbourne, 13 June 2018. | 13/06/2018 Productivity, Wages and Prosperity | Speeches | RBA Speech Productivity, Wages and Prosperity Philip Lowe [ * ] Governor Address to Australian Industry Group Melbourne – 13 June 2018 I would like to thank Australian Industry Group (Ai Group) for the invitation to speak at this lunch today. I have participated in many Ai Group events over the years and I have always valued hearing from your members, so it is a pleasure to be here in Melbourne today. The title I have chosen for my remarks this afternoon is ‘Productivity, Wages and Prosperity’. I know that these three issues are important to your members and they are also important to the broader Australian community. Australians enjoy a level of economic prosperity that few other people in the world enjoy. Per capita incomes here are high and so, too, is wealth per capita. We have also avoided bouts of high unemployment for over a quarter of a century now. Our banking system is strong, we have worldclass natural resources and Australians have access to high-quality health care and education. So there is much for us to feel fortunate about. The question is how do we sustain this prosperity? This is an important question to be asking. At the moment, there is unease in parts of the community about the future of work, about competition from overseas and about the implications of technology – all issues that I know the members of Ai Group are dealing with every day. For others in our community, these concerns are being brought into sharp focus by unusually slow growth in wages. As we address these important issues, we also need to keep focused on the critical task of raising national productivity. After all, lifting productivity is the key to building on our current prosperity and ensuring sustained growth in wages and incomes. There is no shortage of good ideas to consider here. http://www.rba.gov.au/speeches/2018/sp-gov-2018-06-13.html 1/15 13/06/2018 Productivity, Wages and Prosperity | Speeches | RBA My remarks today will be in four parts. First, I will briefly cover the recent economic data. Then, with that context, I will talk about some of the reasons why wages growth has been as low as it has. I will then turn to productivity growth. Finally, I will say a few words about the recent monetary policy decisions by the Reserve Bank Board. The Recent Economic Data Last week's national accounts contained positive news about the Australian economy. Over the past year, GDP rose by 3.1 per cent, which is a bit stronger than we were expecting (Graph 1). It is consistent, though, with the RBA's central scenario for the Australian economy to grow more strongly this year and next than it has over recent years. Graph 1 One pleasing feature of the national accounts was the ongoing rise in investment. Non-mining business investment increased by 10 per cent over the past year (Graph 2). This lift is consistent with current business conditions, which, as measured by Ai Group's own survey, are at the highest level in many years. Investment is also being boosted by increased spending on infrastructure, including in the areas of transport and renewable energy. http://www.rba.gov.au/speeches/2018/sp-gov-2018-06-13.html 2/15 13/06/2018 Productivity, Wages and Prosperity | Speeches | RBA Graph 2 One area that we continue to watch carefully is consumption growth. Over the year, household consumption rose by 2.9 per cent. This is a reasonable outcome, although growth in the March quarter was on the soft side. Stronger employment growth has contributed to a pick-up in wagerelated income and this is helping to support spending. At the same time, though, the level of household debt remains very high and the housing markets in Sydney and Melbourne are going through a period of adjustment, following the earlier very large increases in prices. Credit standards are also being tightened further. So we are paying close attention to household finances. On the international front, economic conditions remain strong. The US and Japanese labour markets are quite tight and Asia, including China, is benefiting from the global upswing in trade and investment. At the same time, though, recent developments have increased some tail risks. One of these is political developments in Italy, which have again put the spotlight on the debt dynamics and underlying tensions in the euro area. Another potential source of a financial shock is the increasing strains in several emerging market economies – including Argentina, Brazil and Turkey. And finally, there is the ongoing risk of an escalation in trade tensions sparked by the policies of the US administration. So, against what remains a reasonably positive international backdrop, these are some of the areas to keep an eye on. http://www.rba.gov.au/speeches/2018/sp-gov-2018-06-13.html 3/15 13/06/2018 Productivity, Wages and Prosperity | Speeches | RBA Wages I would now like to turn to an issue that has received a lot of attention lately; that is wages growth. Over recent times, wages growth around the 2 per cent mark has become the norm in Australia. Some time back, the norm was more like 3 to 4 per cent. This downward shift in the rate of wages growth is clearly evident in the wage price index as well as in the more volatile measure of average hourly earnings in the national accounts (Graph 3). Graph 3 There are both cyclical and structural explanations for why this change has taken place. From the cyclical perspective, there is still spare capacity in the labour market. The unemployment rate has been around 5½ per cent for a year now (Graph 4). While we can't be definitive about what constitutes full employment, most conventional estimates for Australia are that it means an unemployment rate of around 5 per cent. It is possible, though, that we could do better than this, especially if we approach the 5 per cent mark at a steady pace, rather than too quickly. Indeed, in a number of other countries, estimates of the unemployment rate associated with full employment are being revised lower as wage increases remain subdued at low rates of unemployment. We have an open mind as to whether this might turn out to be the case here in Australia too. Time will tell. http://www.rba.gov.au/speeches/2018/sp-gov-2018-06-13.html 4/15 13/06/2018 Productivity, Wages and Prosperity | Speeches | RBA Graph 4 Broader measures of underutilisation suggest another source of spare capacity in the labour market. Currently, around one-third of workers work part time, with most of these people wanting to work part time for personal reasons. However, of those working part time, around one-quarter would like to work more hours than they do; on average, they are seeking an extra two days a week. If we account for this, these extra hours are equivalent to around 3 per cent of the labour force. This suggests an overall labour underutilisation rate of 8¾ per cent, compared with the 5½ per cent traditional unemployment rate measure based on the number of unemployed people. Recent experience also reminds us of another important source of labour supply; that is, higher labour force participation (Graph 5). As we have seen over recent times, when the jobs are there, people stay in the workforce longer and others, who had not been looking for jobs, start looking. So the supply side of the labour market is quite flexible, even more so than we expected. http://www.rba.gov.au/speeches/2018/sp-gov-2018-06-13.html 5/15 13/06/2018 Productivity, Wages and Prosperity | Speeches | RBA Graph 5 Another cyclical element that has affected average hourly earnings over recent years is the decline in very highly paid jobs in the resources sector as the boom in mining investment wound down. It looks, though, that this compositional shift has now largely run its course. These various factors go some way to explaining the low wages growth over recent times. When there is spare capacity in the labour market, it is understandable that wages growth is slow. Yet, alone, these cyclical factors don't fully explain what is going on. Some structural factors also appear to be at work, with perhaps the most important of these related to competition and technology. I will come back to this in a moment. The idea that structural factors are at work is supported by this next graph, which shows the wage price index and the responses to the NAB business survey where firms are asked whether the availability of labour is a constraint on output (Graph 6). While there is still spare capacity in the labour market, firms are finding it more difficult to find suitable workers. Yet despite this difficulty, wages growth has not responded in the way that it once did. http://www.rba.gov.au/speeches/2018/sp-gov-2018-06-13.html 6/15 13/06/2018 Productivity, Wages and Prosperity | Speeches | RBA Graph 6 A similar pattern is evident overseas. This next graph shows wages growth in the United States and the euro area as well as survey-based measures of labour market tightness (similar to those in the NAB survey) (Graph 7). In both economies, wages growth has picked up in response to tighter labour markets, but the response is not as large as it has been in the past. http://www.rba.gov.au/speeches/2018/sp-gov-2018-06-13.html 7/15 13/06/2018 Productivity, Wages and Prosperity | Speeches | RBA Graph 7 We are still trying to understand fully why things look different in so many countries and how persistent this will be. Part of the story is likely to be changes in the bargaining power of workers and an increase in the supply of workers as the global economy becomes increasingly integrated. But another important part of the story lies in the nature of recent technological progress. There are a couple of aspects of this progress that are worth pointing out. One is that it has been heavily focused on software and information technology, rather than installing new and better machines – or on intangible capital rather than physical capital. The second is that the dispersion of technology and productivity between leading and lagging firms has increased, perhaps because of the uneven ability of firms to innovate and use the new technologies. The OECD has done some very interesting work documenting this increasing productivity gap. Both of these aspects of technological progress are affecting wage dynamics. The returns to those who can develop and best use information technology have increased strongly. These returns, though, are often highly concentrated in a few firms and in only certain segments of the labour market. At the same time, the firms that are not able to innovate and take advantage of new technologies as quickly are slipping behind and they feel under pressure. As a way of remaining competitive, many of these firms are responding by having a very strong focus on cost control. In many cases this translates into a focus on controlling labour costs. This cost-control mentality does not make for an environment where firms are willing to pay larger wage increases. http://www.rba.gov.au/speeches/2018/sp-gov-2018-06-13.html 8/15 13/06/2018 Productivity, Wages and Prosperity | Speeches | RBA Over time, we can expect the diffusion of new technology to take place. This is what the historical record suggests. I am optimistic that this diffusion will boost aggregate productivity and lift our real wages and incomes. Advances in information technology, in artificial intelligence and in machine learning have the potential to reshape our economies profoundly and lift average living standards in ways that are difficult to envisage today. But the adoption and the diffusion of these new technologies is a gradual process; it takes time. While it is taking place, the benefits of new technologies are accruing unevenly across the community. In my view, this is one of the key structural factors at work. Whatever weight one places on these various factors constraining wages growth, it is clear that the slow growth in wages is affecting our economy. On the positive side of the ledger, it is one of the factors that has helped boost employment growth over recent times. Of course, there are other effects as well. One is that the low growth in wages is contributing to low rates of inflation in Australia. Indeed, if wages growth were to continue at around its current rate for an extended period, it is unlikely that the rate of inflation would average around the midpoint of the inflation target in the period ahead. Wages growth of 2 per cent and reasonable labour productivity growth are unlikely to make for 2½ per cent inflation on a sustained basis. Another consequence is that real debt burdens stay higher for longer. Many people who borrowed expected their incomes to grow at something like the old rate rather than the current rate. With their expectations not being realised, the real value of the debt stays higher than they expected and this is likely to affect their spending decisions. And beyond these purely economic effects, the slow wages growth is diminishing our sense of shared prosperity. If this remains the case, it can make needed economic reforms more difficult. Given these various effects, some pick-up in wages growth would be a welcome development. It would help deliver a rate of inflation consistent with the target, it would help with the debt situation and it would add to our sense of shared prosperity. In my judgement, a return, over time, to a world where wage increases started with a 3 rather than a 2 is both possible and desirable. To be clear, this is not a call for a sudden jump in wages growth from current rates to 3 point something. Rather, we will be better off if this increase takes place steadily over time as the economy improves. There are some signs that we are starting to move in this direction, but it is likely to be a gradual process. Labour markets in most parts of the country have tightened over the past year. One piece of evidence in support of this is the responses to the NAB survey I showed earlier. There has been a sharp increase in the share of firms reporting the availability of labour as a constraint (Graph 6). The only other time in the past 25 years where this share has been as high as it is now was in the early http://www.rba.gov.au/speeches/2018/sp-gov-2018-06-13.html 9/15 13/06/2018 Productivity, Wages and Prosperity | Speeches | RBA stages of the resources boom. These survey results are consistent with what the RBA is hearing through our own business liaison program. One explanation for why firms are reporting that it is hard to find workers with the necessary skills is that the very high focus on cost control over recent times has led to reduced work-related training. With the labour market now tightening, we are perhaps starting to pay the price for this. On a more positive note, a number of businesses and industry associations are now starting to address the skills shortage. Some businesses also tell us that another factor that has made it more difficult to find workers with the necessary skills is the tightening of visa requirements. It's reasonable to expect that as the labour market tightens, wages growth will pick up. The laws of supply and demand still work. Consistent with this, we hear reports through our liaison program of wages increasing more quickly in areas where there are capacity constraints, although these reports are still not very common. As part of our liaison program we also ask firms about their expectations for wages growth over the next year: whether it will be lower, higher or about the same as the recent past. The results are shown in this next graph (Graph 8). There are now more firms expecting a pick-up in wages growth and fewer firms expecting a decline compared with recent years. Graph 8 http://www.rba.gov.au/speeches/2018/sp-gov-2018-06-13.html 10/15 13/06/2018 Productivity, Wages and Prosperity | Speeches | RBA So it is reasonable to expect growth in wages to pick up from here. To repeat the point, though, this pick-up is expected to be only gradual given both the spare capacity that still exists in our labour market and the structural factors at work. Productivity This is an appropriate segue to the issue of productivity. The best outcome is one in which a pick-up in wages growth is accompanied by stronger growth in labour productivity. That's because, ultimately, the basis for sustained growth in real wages is that we become more productive as a nation. The recent productivity data are difficult to interpret. Despite a positive outcome in the most recent quarter, there has been no net increase in measured labour productivity over the past two years. Over the past couple of years, output growth has been subdued, but employment growth has been strong. In other words, measured labour productivity growth has been weak (Graph 9). However, if we take a slightly longer period – say since the end of 2010 – labour productivity growth has been better, averaging 1.4 per cent per year, which is a reasonable estimate of the rate of productivity growth we could expect over the medium term. This outcome has been boosted by stronger labour productivity in the mining sector as new production comes on stream after the investment boom. It may be that the current lull in productivity growth is just noise in the data, which is quite common, but it may also be a sign of something more persistent. Again, time will tell. http://www.rba.gov.au/speeches/2018/sp-gov-2018-06-13.html 11/15 13/06/2018 Productivity, Wages and Prosperity | Speeches | RBA Graph 9 In trying to understand recent trends, it is useful to examine what has been happening in the broad industry groups: goods-related industries, business services and household services (Graph 10). Employment growth has been especially strong in household services over recent times, yet measured productivity growth in this area of the economy has been quite weak. Output per hour worked in this set of industries is only 4 per cent higher than it was in 2010. In contrast, over this period, output per hour worked is up 13 to 16 per cent in the other industry groups. This is quite a different picture. http://www.rba.gov.au/speeches/2018/sp-gov-2018-06-13.html 12/15 13/06/2018 Productivity, Wages and Prosperity | Speeches | RBA Graph 10 Almost 40 per cent of the workforce currently works in household services, so the weak productivity growth here is weighing on the outcome for the economy as a whole. It is possible that part of the story is the difficulty of measuring output in some service industries. Even so, last year's ‘Shifting the Dial’ report by the Productivity Commission highlighted some of the steps we could take to boost productivity in the delivery of services. One of these steps is ensuring a strong ongoing focus on training, education and the accumulation of human capital. As I have spoken about on previous occasions, our national comparative advantage will increasingly be built on the quality of our ideas and our human capital. This means that a continued focus on education and research is important. Investment in human capital also helps with two of the issues that I touched on earlier: the diffusion of new technologies and emerging skills shortages. One explanation for the widening gap between leading and laggard firms is the difficulty of employing new technologies. Successfully using these technologies requires both the right management capability and technical skills. Both of these can be difficult to acquire. It seems reasonable, then, to suggest that investment in human capital can both lift the rate of technical progress and accelerate its diffusion. It is therefore an important part of addressing the slow wages growth in many advanced economies, including Australia. Another way of encouraging the more rapid diffusion of technology is ensuring that there is strong competition in our economy. There are many other elements of the productivity debate that are also important. I don't plan to expand on them today, but the list of areas is well known. It includes: the design of the tax system; http://www.rba.gov.au/speeches/2018/sp-gov-2018-06-13.html 13/15 13/06/2018 Productivity, Wages and Prosperity | Speeches | RBA the provision and pricing of infrastructure; the way we finance innovation and new businesses; and our business culture around innovation, risk and entrepreneurship. We need to keep all these areas on the radars of both government and business if we are to build on the prosperity that we currently enjoy. Monetary Policy I would like to close with a few words on monetary policy. At its meeting last week, the Reserve Bank Board again held the cash rate steady at 1½ per cent, where it has been since August 2016. Subsequent to the Board meeting, the national accounts provided confirmation that the Australian economy is moving in the right direction. If this continues to be the case, it is likely that the next move in interest rates will be up, not down. It is, however, important to remember that the environment in which interest rates are increasing is also likely to be one in which people's incomes are growing more quickly than they are now. This will help. Any increase in interest rates, however, still looks to be some time away. The Board will want to have reasonable confidence that inflation is picking up to be consistent with the medium-term target and that slack in the labour market is lessening. At this stage, a sustained pick-up in inflation to around the midpoint of the target range is likely to require faster wages growth than we are currently experiencing. There are reasonable grounds to expect that this increase in wages growth will occur. But for the reasons I have spoken about today, this increase is likely to be only gradual. Given this, there is not a strong case for a near-term adjustment in monetary policy. With things moving in the right direction, the Board's view is that by holding rates steady, we can help promote a sense of stability and confidence. We hope that this helps Australians make the decisions that can help build the future prosperity of the country that we are so fortunate to live in. Thank you for listening. I am happy to answer your questions. Endnotes [*] I would like to thank Andrea Brischetto and Geoff Weir (a visiting scholar to the Reserve Bank) for assistance in the preparation of this talk. Andrews D, C Criscuolo and P Gal (2015), ‘Frontier Firms, Technology Diffusion and Public Policy: Micro Evidence from OECD Countries’, OECD Productivity Working Papers No 2. Available at <https://www.oecd.org/eco/growth/Frontier-Firms-Technology-Diffusion-and-Public-Policy-Micro-Evidence-fromOECD-Countries.pdf>. Productivity Commission (2017), ‘Shifting the Dial: 5 Year Productivity Review’, report No. 84, August. Available at <https://www.pc.gov.au/inquiries/completed/productivity-review/report/productivity-review.pdf>. © Reserve Bank of Australia, 2001–2018. All rights reserved. http://www.rba.gov.au/speeches/2018/sp-gov-2018-06-13.html 14/15 13/06/2018 Productivity, Wages and Prosperity | Speeches | RBA http://www.rba.gov.au/speeches/2018/sp-gov-2018-06-13.html 15/15 | reserve bank of australia | 2,018 | 8 |
Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 17 August 2018. | Philip Lowe: Opening statement to the House of Representatives Standing Committee on Economics Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 17 August 2018. * * * Chair Members of the Committee Thank you for the opportunity to appear before the Committee today. These hearings are an important part of the accountability process for the Reserve Bank of Australia. As usual, my colleagues and I will do our best to answer your questions. Since we last met, the Australian economy has continued to move in the right direction. According to the most recent data, GDP growth is 3.1 per cent, inflation is around 2 per cent and the unemployment rate is now below 5½ per cent. In the broad sweep of our economic history, these are a pretty good set of numbers. We would, of course, like them to be better – we are still short of full employment and we would like to be more confident that inflation will be sustained at a level consistent with the target. But if things work out as expected, we are likely to make further gradual progress on both fronts over the next couple of years. The Australian economy looks to have grown strongly over the first half of 2018. GDP increased by 1 per cent in the March quarter and a reasonable increase is expected in the June quarter. Business conditions are positive and we are in the midst of an upswing in non-mining business investment. Increased spending on infrastructure is also helping. Resource exports are also increasing strongly as new capacity comes on stream, particularly for LNG. One important offsetting factor is the drought in eastern Australia. While the prices of some farm products are currently quite high, the dry conditions will limit farm production. I thought it might be useful to make some introductory remarks on four topics the Reserve Bank Board has devoted considerable attention to over recent times: the global outlook; household debt and the housing market; wages growth; and the outlook for inflation. The global outlook remains positive, although a number of risks have increased. The advanced economies are growing faster than trend and unemployment rates are at multi-decade lows in some countries. A gradual pick-up in wages growth is also now taking place. As is appropriate, the considerable monetary stimulus that has been in place in the United States is being steadily withdrawn. At the same, though, official interest rates in the euro area, Japan, Sweden and Switzerland are still negative, more than a decade after the onset of the financial crisis. In China, growth has slowed a little. The authorities have responded to this, although they also face the challenge of addressing risks in the financial system. There are a few uncertainties that are worth highlighting. One is the possibility of an escalation in global trade tensions. The measures announced so far are unlikely to derail the global expansion. Even so, in some countries, businesses are delaying investment because of the additional uncertainty. It is possible that this becomes a more general story. If this were to occur, this could be the channel through which the trade tensions sap the current positive momentum in the global economy. Another uncertainty is the possibility of a larger-than-expected pick-up in inflation in the United States. The US economy is experiencing a sizeable fiscal stimulus at a time of limited spare capacity, so growth there could surprise on the upside. At the same time, financial markets 1/4 BIS central bankers' speeches remain relaxed about the implications of this for inflation. I am less relaxed: it is highly unusual to have such stimulatory fiscal policy when the economy is already operating at a very high level of capacity. One can’t rule out the possibility that the Federal Reserve will have to withdraw monetary accommodation more quickly than currently projected, with possibly disruptive consequences in financial markets. A third set of global risks originate from a number of individual economies with country-specific structural and/or institutional vulnerabilities, including Argentina, Brazil, Italy and Turkey. Over the past month there have been episodes of market volatility associated with each of these countries. We are watching developments closely as a further escalation of problems could be a catalyst for a period of increased stress in the global financial markets. The second issue is the housing market and household debt. The housing markets in Sydney and Melbourne have clearly slowed and prices are coming down. While this has concerned some people, we need to keep things in perspective. Not so long ago, there was concern in the community about rapidly rising housing prices and debt and declining housing affordability. These earlier trends were not sustainable and were posing a medium-term risk to our economy. So a pull-back is a welcome development and can put the market on a more sustainable footing. It is good news that this adjustment is taking place at a time when global growth is strong, the labour market is positive and interest rates are low. All these things are helping with the adjustment. We are nevertheless continuing to keep a close eye on housing market developments across the country. The slowing in the housing market has reduced the demand for credit by investors. There has also been some tightening in the supply of credit, partly in response to the Royal Commission, although the main story is one of reduced demand. The average variable interest rate paid by borrowers has declined further over the past six months, to be about 10 basis points lower than a year ago. You would not have expected to have seen this if supply constraints were the main reason for slower credit growth. A third issue that the Board has focused on recently is growth of wages. As I have discussed previously, a lift in aggregate wages growth would be a welcome development from several perspectives. It would contribute to inflation being closer to the midpoint of the inflation target. Stronger income growth would also help in the context of high levels of household debt. It would also be of benefit to government finances and more generally would strengthen our sense of shared prosperity. And, to the extent that stronger wages growth is backed by stronger productivity growth, it would boost our real incomes. We had another reading on the Wage Price Index a couple of days ago, which showed a welcome uptick. Over the past year, the Wage Price Index increased by 2.1 per cent and the broader measure, which captures bonuses, increased by 2.5 per cent. These figures are both up from a year ago. This week, we also received employment data for the month of July. While the month-to-month employment data are volatile, the unemployment rate has fallen to 5.3 per cent, which is the lowest it has been for some years. Taken together, these data are consistent with our view that wages growth and inflation will pick up gradually over the next couple of years as the labour market continues to tighten. This tightening is evident in a number of indicators. The number of job vacancies, as a share of the labour force, is at a record high. Firms are reporting that it is harder to find workers with the necessary skills, and survey-based measures of hiring intentions remain positive. In our liaison program we also hear reports of larger wage increases for certain occupations where workers with the necessary skills are in short supply. We expect that we will hear more such reports over time. Even so, the pick-up in wages growth is still expected to be fairly gradual. We still have some 2/4 BIS central bankers' speeches spare capacity in the labour market, including part-time workers who would like more hours. There are also structural factors at work, arising from technology and competition that we have discussed at previous hearings. The fourth and related issue is the outlook for inflation. The CPI inflation rate – at 2.1 per cent – is higher than it was a couple of years ago, but still below the medium-term average. Strong competition in retailing from new entrants is holding down the prices of many goods and low wage increases are holding down the prices of many services. Rent inflation is also at a very low level. Working in the other direction over the past year has been higher prices for electricity, fuel and tobacco. We are expecting inflation to move gradually higher over the next couple of years as the economy strengthens. We remain committed to achieving an average rate of inflation over time of between 2 and 3 per cent. In the short term, though, we are expecting the headline rate of inflation to dip a little in the September quarter. Utility prices have declined recently in some cities and policy changes are likely to reduce the measured price of child care. There have also been some policy changes at the state government level that will reduce other measured prices. Collectively, these changes will help with cost-of-living pressures and free up income to spend on other things. From this perspective, these changes are good news. So these are some of the main issues we have been working our way through. As you are aware, the Reserve Bank Board has held the cash rate steady at 1½ per cent since August 2016. This setting of monetary policy is helping support economic growth, allowing for further progress to be made in reducing the unemployment rate and returning inflation towards the midpoint of the target range. We have not sought to fine-tune outcomes, but rather to be a source of stability and confidence as the economy moves along this path. For most of this year, I have emphasised three points in communication about monetary policy. The first is that things are moving in the right direction. We are making progress towards full employment and having inflation return to around the midpoint of the target range, and further progress is expected. The second point is that if we continue to make progress, you could expect the next move in interest rates to be up. With the central scenario being for the economy to continue on its recent track, it is more likely that the next move in interest rates will be an increase, not a decrease. The last increase in the cash rate was back in late 2010, so an increase, when it occurs, will represent a significant change for many people. It is important to remember, though, that higher interest rates will be accompanied by faster growth in incomes than we have seen over recent times. In this sense, it will be a sign that things are returning to normal. Of course, higher rates will also be welcomed by many depositors, who have been earning low rates of returns on their savings over recent times. The third point is that because the progress that is being made is gradual, and is expected to remain so, there is not a strong case for a near-term adjustment in interest rates. The Board’s view is that it is likely that we will hold steady for a while yet. It is likely to be some time before we are at full employment and the inflation rate is comfortably within the target range on a sustained basis. We are prepared to maintain the current monetary policy stance until these benchmarks are more clearly in sight. 3/4 BIS central bankers' speeches So these are our three recent messages on monetary policy. On other matters, we are planning to release the upgraded $50 banknote in October. The new note will have the same high-tech security features as the new $5 and $10 notes. All up, there are around 700 million $50 notes on issue – that’s around 28 per person – so it is a big logistical exercise. You may have read in the press that there has been an industrial dispute at Note Printing Australia, which manufactures Australia’s banknotes in Craigieburn, Melbourne. I am pleased to be able to report that an in principle agreement on a new enterprise bargaining agreement was reached earlier this week and that we have sufficient notes to launch the new $50 in October as planned. Finally, at previous hearings we have spoken about the New Payments Platform – the new payments system that allows Australians to easily make information-rich, real-time, 24/7 payments to each other, without having to know BSB and account numbers. Since the system was launched in February, 1.8 million Australians have registered a PayID – usually their mobile phone number – that can be used easily to address payments in the new system. The take-up of the system has, however, been less than earlier industry projections. This partly reflects the fact that a number of the major banks have been slow to make the new system available to their customers. They are now making it available, so we expect take-up to increase. Interestingly, many of the smaller financial institutions have done a better job, with more than 50 of them ready from day one. Despite the relatively slow start, we still expect that the new system will provide the bedrock upon which further innovation in Australia’s payment system will be built. The Payments System Board is keeping a close eye on access arrangements so that those with new ideas and better ways of doing things can use the new system. Thank you. My colleagues and I are happy to answer your questions. 4/4 BIS central bankers' speeches | reserve bank of australia | 2,018 | 8 |
Remarks by Ms Luci Ellis, Assistant Governor (Economic) of the Reserve Bank of Australia, at the Australian National University, Canberra, 17 August 2018. | ON LAGS Luci Ellis Assistant Governor (Economic) Remarks at the Australian National University Canberra – 17 August 2018 ON LAGS I’d like to thank the Australian National University for providing the opportunity to speak to you tonight. ANU is one of my three alma maters, and I’m pleased to be able to engage once again with the university community. It’s important that central banks and the academic community collaborate. We can learn a lot from each other. I’m conscious that this talk was originally scheduled to take place almost exactly a year ago, but I had to cancel due to illness. That seems especially pertinent on this occasion, because my topic tonight is lags. By choosing this topic, I hope to encourage those of you who engage in economic analysis of any kind, and the broader academic community, to think carefully about time, and in particular, about how the passage of time is built into your analysis. I want to talk about lags: where they come from; how they might change; and what they might be telling us. This is more than just an academic point about what our models should look like, though. Understanding lags is central to day-to-day analysis and interpretation of economic developments. As such, they are central to our work in economic policy. Before I get to that, I’d like to make some brief remarks about the current situation. We released the Statement on Monetary Policy last week, and earlier today the Governor and some others of us appeared before the House of Representatives Standing Committee on Economics. I don’t have anything new to add but thought it would be worth summarising the main messages from the Statement and the testimony. Unemployment is still a bit higher than our estimates of the rate consistent with full employment. Inflation is still a bit low. It is therefore appropriate that monetary policy should be supporting the economy right now. But the Australian economy is growing a bit above trend, which has helped the progress on getting unemployment down and seeing inflation return closer to the midpoint of the Bank’s target. The world economy is continuing to expand at a good rate and that is also helping. We expect further progress on both the inflation and unemployment fronts over the period ahead. If things turn out broadly as we expect, it is therefore more likely that the next move in the cash rate will be up than down. That progress on getting unemployment down and inflation up is likely to be only gradual, however. So any increase is still likely to be some time away. That’s been the story for a while, and these remain the key messages about the policy outlook, as the Governor explained earlier today. Of course, there are a number of risks that need to be kept in mind. Trade tensions have increased in recent months, which could worsen the investment climate as well as directly limiting global trade and growth. Conditions in a few emerging markets 1 of 12 ON LAGS have worsened for country-specific reasons. The Chinese authorities are balancing the need to support growth with the need to reduce financial risk. It is hard to predict how that balance plays out in their macro policy settings in the short term, and how this will affect growth in China. The outcome will be directly relevant to the prices paid for Australia’s bulk commodity exports, as will be global energy demand more generally. It can’t be ruled out that certain commodity prices, and thus Australia’s terms of trade, remain higher for longer than we expect. That would be a positive income boost if it happened. Another risk to the upside is that the US economy is currently seeing significant fiscal stimulus at a time when there is already not much spare capacity. So it can’t be ruled out that global growth and inflation turn out to be a bit stronger than we currently expect. In those circumstances, policy rates in the United States might rise a bit faster than some people expect. Domestically, we are alert to the risks that high household debt could pose for household spending, especially if other negative events should occur. We are also mindful that, as the labour market tightens, wages growth could be slow to pick up in earnest. This has been the pattern in some other countries where unemployment rates are already very low. Among the questions we have been grappling with lately are: how low the unemployment rate needs to go before wages growth picks up more emphatically; how quickly wages growth will respond to tighter conditions; and how much it will pick up. Fundamentally these are questions about distinguishing between structural change and lags. This brings me to my topic tonight. What Lags Are A lag occurs in any instance where time passes between when an activity is initiated and when that activity has its impact. Almost all economic phenomena involve lags. Not all of these lags are significant, of course. The time taken to make a hamburger doesn’t matter that much for economic outcomes. The time taken to build a house is rather more important. But even lags that are short individually can impose significant costs if they occur frequently. For example, tender times – the time needed to pay and, where relevant, receive change – are a non-trivial share of the cost of making payments (Stewart et al 2014). Waiting time is a cost, and can affect people’s choices. In thinking about lags, I have found it useful to categorise them into three types, which I will discuss in turn: Process lags Stock–flow lags, and Learning lags. 2 of 12 ON LAGS Process lags A process lag is the time taken for any readily defined production process. Think of laying a brick or baking a cake. It involves a more or less predictable delay, and its outcome is unambiguous. The brick gets laid or it doesn’t. (The cake might or might not turn out as you expect, but you have a cake.) One important but underappreciated example of a process lag is the time required to make a decision. By this I mainly mean the formal processes and governance that organisations place around decision-making. Some of this might involve information gathering or other analysis, to know what decision to make. But even with all the facts in front of you, there are lags involved in any formal decision process. Documents must be prepared, meetings convened, review processes completed. Good governance takes resources; it also takes time. Decision lags underlie an aspect of economic policymaking that is often taught to undergraduates. They account for an important difference between monetary and fiscal policies as tools for macroeconomic demand management. Monetary policy changes, we were all taught, can be enacted more quickly. The decision lag was shorter. But that change might take longer to affect the economy. The ‘long and variable lags’ of monetary policy are those after the decision is taken and enacted. Fiscal policy changes can have more immediate effect, but the decision lag is longer. Parliament must vote on the government’s budget. Other decision processes might be needed before funds are finally disbursed or spent. These can also take some time. Many other decision lags can be relevant to our analysis of the economy. Consider the approval processes for building projects, or for loans. Most companies have formal decision processes for allocating budget to particular investment projects, based on a written business case. Tender processes for awarding contracts and application processes for hiring workers involve lags arising from the search process, which is a process lag in itself. But in the end, there’s a decision, which also involves a lag. It should be clear by now that time is an input into almost every economic activity. Certainly anything that involves a labour input involves a time input. Often we oversimplify or ignore the resulting process lags in our models, for example by thinking of everything in discrete time with quite long discrete periods. But those process lags are there. The existence of process lags has a number of implications. These go beyond the standard lag assumptions in our models’ production functions. One is that for every production process with a material process lag, there is an ‘in-process’ state. Some of these provide important, additional information on the state of the economy. The stock of construction projects approved or commenced, but not completed, tells us a lot about near-term future construction activity. The number of job vacancies – the in-progress state between deciding to hire and actually hiring – tells us a lot about the state of the labour market. 3 of 12 ON LAGS A second important implication of process lags is that hog cycles can arise. It takes time to fatten a hog, or build a building, or ship something from far away. In the interim, prices can fluctuate significantly. Too many economic models forget about these dynamics. But the short-term fluctuations can matter a lot, on our way to the long-term. Stock–flow lags The second kind of lag – stock–flow lags – also produces hog cycles, for slightly different reasons. These lags are the inherent implication of past activity having long-lived consequences. They can be seen in the property market, in the shipping fleet – indeed in most classes of capital goods. Because these products are longlived, the increment to the stock in any one year is small. And because of that, the response of the stock is usually quite sluggish. Price cycles can therefore arise. I have spoken about these kinds of hog cycles before in the context of property markets (Ellis 2015). More generally, stock–flow lags by definition have long-lived consequences. Past decisions affect outcomes far into the future. Because of this, they create an option value of waiting. Economic theory has long allowed for this in models of investment, for example. Vintage capital, s–S pricing and many other mechanisms all arise from this type of lag. I don’t have much to add to that already rich literature tonight. But I would reiterate a point I’ve made before (Ellis 2014): if you aren’t taking stocks and flows seriously, you probably don’t have a realistic model of the economy. Learning lags The third type of lag that I identify, I’ve loosely termed ‘learning lags’. This is the time taken to effect an intellectual change in a person or group of people. Think of the time taken to draw a conclusion, develop a skill, or detect a structural change. This type of lag is similar to the process lags I have already spoken about. But it has a number of important differences. I think these differences are central to many of the economic uncertainties that central banks must grapple with. Firstly, the time taken is inherently uncertain. People’s learning styles and development rates differ. And some people are just more decisive than others. Secondly, and perhaps more importantly, the input to the process can be noisy and uncertain. Think of the example of detecting and concluding that a structural change has occurred in the economy. That’s a signal extraction problem. How long it takes before you can conclude that a change has occurred depends on many things: the noisiness of the data, the signal extraction technologies you have available – even the strength of your priors versus your willingness to change your view. That can differ depending on individual psychology or organisational culture. It also means that the results of a learning process might not be replicable across people, time or circumstances. 4 of 12 ON LAGS Thirdly, and related to the last point: the output of the process can be uncertain. You don’t know what conclusion you will draw until you’ve drawn it. You don’t know how much skill you will build up until you have done the training. Building on all that, we can also see that micro learning lags lead to macro learning lags. Micro learning lags are when individual actors in the economy take uncertain amounts of time to learn about changes in their circumstances, before they can respond to those changes. Because of that, noise and uncertainty arise in the lags we see in macroeconomic developments. So it takes time to learn about changes in the economy – the macro learning lags. These macro learning lags could be as simple as the time it takes to be confident that growth has picked up, for example. Was it a change in trend or just one quarter’s noise? This isn’t always easy to know. Detecting structural change in the economy is even more difficult. It depends on the variability of those learning-and-response processes at the micro level. One might think that the presence of variable lags would make observers more reluctant to conclude the economic structures have changed. In fact, it seems the opposite is true. Too often we see confident pronouncements that things are now different. In fact, often those observers just needed to be a little more patient, before the normal patterns reasserted themselves. A typical example has occurred after most of the recessions in industrialised countries over the last several decades. Compared with earlier recessions in the post-war period, those since the early 1990s have tended to involve more financial sector distress. The uncertainty this engenders – or perhaps simply the balance sheet distress – changes the nature of the recovery. In particular, it tends to make the subsequent pick-up in employment quite drawn out. We therefore start to see claims of “jobless recoveries” or “skills mismatch”. It is often assumed that there has been a structural change in the economy to which workers are not able to adapt. But in reality the labour market does start to pick up, eventually. It just takes longer than some of these observers seem to have expected. The economic structure and skills requirements aren’t changing in any unusual way. It was just that the lags had lengthened. Or maybe, they hadn’t lengthened. People just forgot that the lags are there. Three Important Lags in Australia I’d like to illustrate these different types of lags with some examples that have been important to economic developments in Australia in recent years. Perhaps the best example of a process lag is the multiyear boom in mining investment. Largely spurred by the increased demand for commodities in China, earlier this century mining firms decided to expand production capacity for coal, iron ore and LNG here in Australia. It would have taken some time for these firms to make those decisions. More importantly, it took several years for each of these projects to be built. 5 of 12 ON LAGS The effect of the resulting process lags is clear in this graph (Graph 1). The lags involved in decision-making and project preparation meant that this investment took a while to ramp up. And the process lag to completion of these projects has taken many years; for LNG, there is still a bit more to go. Graph 1 Mining Investment $b $b Chain volume* % % Work yet to be done Per cent of quarterly GDP RBA estimates Sources: ABS; RBA As a result, the ramp-up of resource exports flowing from this decision was also quite lagged (Graph 2). For coal and iron ore, the process is more or less complete. But for LNG, again, some of the new production capacity is still to come on line. Graph 2 Resource Export Volumes Selected commodities, constant 2015/16 prices $b $b Forecasts* Iron ore Coal LNG 12 / 13 14 / 15 16 / 17 18 / 19 20 / 21 Based on DOIIS projections Sources: ABS; DOIIS; RBA More recently, there have been announcements of new mining projects. Most of these are ‘sustaining investment’, that is, the investment you need to do to keep production at its current level (Jenner et al 2018). However, there are a couple of coal projects underway and one planned LNG expansion that involve increases in productive capacity. These projects have in part been a response to stronger demand – and thus higher prices – for these key commodities than some observers might have expected a couple of years ago. But again, it takes a while before this addition to capacity comes on line. 6 of 12 ON LAGS It is typical to use property as an example of a stock–flow lag. The flow of new construction is small relative to the stock already existing. That flow supply is determined in part by the price, and thus the profit to be made from the construction project. But it is the balance of supply of and demand for the stock that determines prices. Even without the process lags involved in construction, it would therefore take a while for any supply response to bring prices down. I’d like to emphasise a different example tonight, though, because it highlights how simple lags can sometimes be misinterpreted as something else. It also shows how the existence of stock–flow lags means that cyclical developments can have longterm consequences. That example is long-term unemployment. Data on unemployment durations first became regularly available in the early 1990s recession. You can see how, at the beginning of this graph, the rate of people unemployed for more than three months but less than a year (‘medium-term unemployment’), and the long-term unemployment rate – people unemployed for more than a year – were still rising even after short-term unemployment peaked. Both these rates start rising around the time that unemployment overall starts rising. This is because the stock of unemployed starts to rise partly because the flow back into employment slows down. This affects people who are already unemployed. But unemployment also rises because some previously employed people lose their jobs. This is especially relevant in recessions when many workers are laid off. So of course there is a process lag: it takes more than a year before someone who previously had a job becomes long-term unemployed, just by definition. This is why long-term unemployment continues to rise even after the layoffs decline to more normal rates. You can also see this effect during the smaller increases in overall unemployment in the late 1990s and in 2001. A recovering economy, solid employment growth, but rising long-term unemployment: it would have been tempting to misinterpret this as a structural problem. Indeed, many did so at the time. But that probably is not what was going on. What this shows is the effect on a stock – unemployment – when the economic decision – to hire or lay off workers – is a flow in and out of that stock. Graph 3 Unemployment Rates* % % Short-term (<13 weeks) Medium-term (13–52 weeks) Long-term (>52 weeks) Seasonally adjusted by RBA Sources: ABS; RBA 7 of 12 ON LAGS Once unemployment starts to decline, the stock–flow lag becomes more relevant. Consider that, if the flow out of unemployment back into employment declines for a period, a stock of unemployed people can build up. Even if that flow returns to more normal levels in the subsequent recovery, it can take a long time for that stock to return to low levels. That is exactly what we saw after the 1990s recession. It took 15 years from the peak, before long-term unemployment finally troughed, at a bit above ½ per cent of the labour force. Again, this should not be interpreted as a structural deterioration in the performance of the labour market. It just took a long time to work down that stock of unemployment. More recently, the end of the mining investment boom in 2013 induced a period of slower growth and softer labour market conditions. As a result, both medium-term and long-term unemployment increased for a time. They are currently a little below their peaks in 2015, but only a little. As an aside, you might have noticed the sharp move down in the latest data for medium-term unemployment. One should never make too much of one month’s figures. It’s hard to know whether it will persist, or whether it’s a result of the vagaries of our seasonal adjustment process.1 And it’s a good example of the signal extraction problem that gives rise to learning lags in economic policymaking. An important lesson here is that, most of the time in an expansion, growth at socalled ‘potential’ is not enough. There is a stock of unemployment that needs to be worked down. That means that an above-average flow out of unemployment back into employment is needed. And that is one reason why macro policy might need to be supportive of growth for an extended period during an expansion. A natural question to ask is why one wouldn’t seek to run the economy even faster, to open that spigot back into paid employment even wider and get long-term unemployment down sooner. It’s a legitimate question. In essence it depends on how quickly unemployed people can be matched with vacant jobs. It is possible that there are limits to the efficiency of the labour market’s ability to do that matching. Job search involves process lags, such as the window of time that an employer chooses to receive applications, as well as the decision lag involved in selection. So beyond some point, running the economy faster might not open the spigot that much wider. There is also the question of how much faster the economy could be induced to run at all. For the economies most affected by the financial crisis (by which I don’t mean Australia), that might also have had its limits. Banks’ credit supply had been weakened and existing spare capacity reduced firms’ need to invest. At the same time, during this period, it was not always the case that the various arms of macroeconomic policy in these countries were all pulling in the same direction. The ABS only publishes seasonally adjusted data for some categories of unemployment by duration. The figures shown here have been seasonally adjusted by RBA staff. 8 of 12 ON LAGS In the Australian context, as the Bank has explained on several occasions, there have instead been concerns regarding a different stock–flow dynamic. One key way expansionary monetary policy works is by getting people to borrow more and spend. Lower interest rates also reduce the servicing burden on existing debt, which can free up some cash to spend more. Overall, though, we would ordinarily expect debt to rise when monetary policy is boosting growth. When household debt is high, it poses some risks. In particular, it could make household spending and well-being less resilient to shocks, including individual-specific outcomes. So the question then arises: what is the appropriate balance between the risk of higher debt and the benefits of the hoped-for faster decline in unemployment? In part, this depends on whether a particular level of interest rates induces households to keep increasing debt indefinitely, or whether debt instead accumulates up to some point, or some relativity to income, and no further. The experience of recent decades, and the arithmetic of debt-servicing burdens, suggests the latter.2 But it is hard to be certain. Another question to ask when weighing up this balance is whether the question of how low unemployment can go depends on how fast you are getting there. It’s usually assumed that there is a level of unemployment, below which wages growth starts to pick up. This is sometimes called the ‘full employment’ rate of unemployment. A more technically correct, but less attractive, name is the ‘nonaccelerating inflation rate of unemployment’, or NAIRU.3 In some other countries, unemployment has fallen well below previous estimates of the NAIRU before wages growth actually started to pick up. As a result, more recent NAIRU estimates have tended to be revised down. That brings me to two examples of a learning lag that I consider to be particularly relevant to the current situation. The first is the simple one that it might just take a while before firms start to realise how hard it is to find suitable labour, and decide to offer higher wages. So it could be that it takes a little while for wages to pick up once unemployment has fallen below the NAIRU. If so, it would mean that NAIRU hasn’t really moved in these countries, and the revisions we see are just an artefact of the way this unobservable variable is measured. If that is what is going on, then this mechanism would also be relevant in Australia. As the Bank has explained on several occasions recently, although there appears to still be a deal of spare capacity in the labour market, many firms are reporting that they are finding it hard to recruit suitably skilled workers. Some of these issues are industry-specific. For example, we hear from contacts in our liaison program that it is particularly difficult to recruit certain kinds of specialists in construction and IT, as well as local workers into hospitality roles in regional areas, where foreign workers on short-term visas had previously been more easily recruited. But so far, wages growth is not picking up much even in these areas, despite scattered reports This is the implication of RBA (2003). Strictly speaking, it’s the non-accelerating wages growth rate of unemployment, but ‘NAWGRU’ has not caught on. 9 of 12 ON LAGS of high wage offers in some cases. It could be that, after a period of realisation and learning, we will see wages growth pick up more emphatically in these areas. But there is another kind of learning lag that might also be driving the outcomes we see. It might be that employers are learning that their definition of ‘suitable labour’ can change. After a long period where there is plenty of unemployed labour, employers get used to being able to pick and choose. As the labour market begins to tighten, they have to start looking at people who are less credentialed or who have less prior experience. And they have to start looking at the way they organise the work in their firm, and maybe investing in productivity-enhancing innovation. And if they do that, suddenly previously ‘unsuitable’ workers start looking a lot more ‘suitable’. Productivity isn’t something an individual has handed to them at birth. Different people have different skills and experience which affects their productivity in a given context. But the context of how work is organised and supported with capital is crucially important. If this is true, then a period where the labour market tightens gradually, and not in every area at once, could induce firms to realise that workers are more ‘suitable’ than they previously assumed. And if they realise that before they start resorting to paying higher wages, the result is that unemployment can fall further before wages start to rise. In other words, the NAIRU falls. And if that is what is happening, it means that learning lags can induce path-dependence in the macroeconomy, in a particularly consequential way. How Lags Change and Why That Can Matter Most lags can change in duration. Some are more stable than others. Policymakers need to be alert to which lags can shift, and be ready to detect those shifts. It should be obvious that technological change, by increasing productivity, often reduces process lags. Changes in rates of obsolescence or physical depreciation can change stock–flow lags. And as technology makes more information available more frequently, we might expect that learning lags could speed up. This particular implication is not guaranteed, though. Sometimes more information just adds noise. I shall talk more about that in a moment. Some lags, especially decision lags, depend on legal and social processes. So they can change, if those responsible for those processes desire it. A good example here is the streamlining of building approval processes in some jurisdictions over recent years. Decision processes can also slow down, if more and more rigorous governance is being demanded, whether by external parties or the decision-makers themselves. Whatever the reason for it, a change in the length of lags can have huge economic implications. For the hog cycle examples, price dynamics can change noticeably. And where a shorter lag comes from increased productivity and therefore lower cost, we can see marked changes in relative prices. 10 of 12 ON LAGS There can also be big social implications from a change in lags. Probably the best example is the enormous decline in the cost of recording and transmitting information over the centuries. Ideas, good and bad, can now reach the whole world in seconds. In past centuries, each new copy of a text was done by hand and could take months. The result is more information to more people, not all of it better information. What it Means for Monetary Policy I’ve already referenced the long and variable lags of monetary policy. I would like to draw out three more general implications of lags for monetary policy making. First, most forecasts leverage known process lags. For example, we use building approvals to help forecast residential construction. Stock–flow lags are also important, but in my view these are often underappreciated in many forecasting models. Second, the lags from monetary policy to macroeconomic effects are primarily learning lags. That is why they are variable, as well as long. People take time to realise that demand has increased enough that it’s worth hiring a new employee. Likewise people take time to decide that demand has increased enough to be worth changing their prices. The time taken will depend on many factors. For example, the lags to changing prices are determined by things such as the pricing models prevailing in that industry, menu costs, and the level of competition, which determines the cost of getting a pricing decision ‘wrong’. Third, both the learning lags involved in noticing stronger demand and the decision lags involved in responding to stronger demand depend in part on the stories we tell ourselves – our narratives and beliefs. That’s because these help determine how readily we update our hypotheses, and change our minds. This raises the question of whether better macroeconomic outcomes can be achieved by telling ourselves better stories – more accurate stories, and stories that are more consistent with each other. I believe this supports the case for fulsome and frequent communication by the central bank. Many researchers have focused on the role of central banks’ public commitments to a nominal anchor such as an inflation target, to help coordinate expectations around that target. Others have focused on central bank communication as a signal of future central bank actions, which other economic actors can respond to. I can’t help thinking that the case goes beyond that. When a central bank explains publicly how it interprets economic developments, it creates a public good. Putting out a view gives everyone something to compare with their own expectations. So by sharing the results of its efforts publicly, perhaps central banks can help everyone learn a little faster, just as we learn from comparing our views to those of other observers. 11 of 12 ON LAGS To conclude, lags pervade economic activities. They matter. As researchers, and as policymakers, we need to understand when lags are important, and develop techniques to detect when those lags are changing. The passage of time needs to be taken seriously in economic inquiry. So I’ll take no more of yours tonight, and thank you for listening. Bibliography Ellis L (2014), ‘Future Directions in Financial Stability Analysis: Learning from Others, Learning from the Past’, Address to the Paul Woolley Centre for the Study of Capital Market Dysfunctionality Conference, Sydney, 9 October. Ellis L (2015), ‘Property Markets and Financial Stability: What We Know So Far’, University of New South Wales (UNSW) Real Estate Symposium 2015, Sydney, 8 September. Jenner K, A Walker, C Close and T Saunders (2018), ‘Mining Investment Beyond the Boom’, RBA Reserve Bank Bulletin, March. RBA (2003), ‘Household Debt: What the Data Show’, Reserve Bank Bulletin, March, pp 1–11. Stewart C, I Chan, C Ossolinski, D Halperin and P Ryan (2014), ‘The Evolution of Payment Costs in Australia’, RBA Research Discussion Paper No 14. 12 of 12 | reserve bank of australia | 2,018 | 8 |
Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the breakfast event to launch ASIC's National Financial Capability Strategy 2018, Canberra, 21 August 2018. | Philip Lowe: Remarks - launch of ASIC's National Financial Capability Strategy 2018 Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the breakfast event to launch ASIC's National Financial Capability Strategy 2018, Canberra, 21 August 2018. * * * I am very pleased to be here to participate in the launch of the National Financial Capability Strategy. All of us have to make choices about money every day. Do I spend, or save? If I spend, what do I buy and how do I pay for it? If I save, where should I invest; how much risk should I take? If I borrow, how much should I borrow and how quickly should I pay it back? In many ways these choices have become more complicated over time. We have more options than ever before – which is good – but these options can be bewildering. It is fair to say that many people find it hard to navigate their way through the myriad of possibilities out there. But we all do need to find a way to navigate through these choices. We all need to plan. For our own sake, and that of our families, we need to do this as well as we can. If we go in the wrong direction, it can have a major effect on our families and our welfare, perhaps for years. So it is really important we make well-informed financial decisions. And, we can all do with a bit of help to make sure we are going in the right direction. The strategy that is being launched today can provide that help by providing education, information and support for Australians as they manage and make decisions about their money, and plan and save for the future. I would like to congratulate the government and ASIC for the work they have done in putting this strategy together. At the Reserve Bank of Australia, we are also trying to play our part. As Australia’s central bank, the RBA has a very strong interest in people being in control of their financial lives and making well-informed choices. I say this from the perspective of the individual and the economy as a whole. At the individual level, each of us will be better placed in our lives if we make good financial choices. And at the collective level, the financial choices that the 25 million of us make about how much we spend, save and borrow can have a major bearing on the health of the overall economy. If enough of us make risky or bad choices, the whole community can eventually feel the effects. So it matters a lot. One of the things the RBA seeks to do is to provide balanced analysis about the economy and the financial system and where the risks lie. We hope that this helps people make informed decisions about their finances. We also have a public education program that is aligned with the school curriculum. As part of this, we are devoting significant resources to helping support the teaching of economics and finance in our schools. People can also visit the Reserve Bank’s Museum, where they can learn about Australia’s banknotes and economics more generally. The Bank has also been a partner in the recent upgrading of Australia’s payment system, which is allowing you to make more timely payments. For many Australians, their biggest single financial decision is whether or not to borrow to buy a home. It is an important decision, one that can have a major bearing on your finances for years to come. I am not allowed to give financial advice, but I would like to make four brief points that we should all keep in mind. The first is that interest rates go up and down. It is nearly eight years since the previous increase in interest rates by the RBA. This means that many borrowers have never experienced a rise in official interest rates. They have mostly 1/2 BIS central bankers' speeches experienced lower rates. At some point this will change. Over recent times the Australian economy has been improving. This is good news. If we continue on this current improving track, as we expect we will, it is likely that the next move in official interest rates will be up, not down. This will not be welcomed by some, but it would be a sign that things are returning to normal. My advice here is to make sure your finances can withstand a lift in interest rates. The second point is that housing prices don’t always go up; like interest rates, they go up and down. We are seeing an example of this in Sydney and Melbourne at the moment. And most of our cities have seen falls in housing prices at some point over the past decade. While I would expect housing prices to trend higher over time as our incomes increase, there is no guarantee that your home will be worth more tomorrow than it is today. So plan accordingly. The third point is closely related. Make sure you build adequate financial buffers into your plans. Things don’t always turn out as we expect. So for most of us, having a buffer against the unexpected makes a lot of sense. We all need to prepare for that rainy day. It rarely makes sense to take all the credit that you are offered, whether on a credit card or when you apply for a loan. Many Australians with mortgages find the best way of building buffers is to put any spare money into their offset account. This makes a lot of sense. My fourth and final point is to shop around and don’t be shy to ask for a better deal; whether for your mortgage, your electricity contract or your phone plan. There are very good deals out there if you look. We can all play a role in making our markets more competitive by being smart and informed in our choices. Again, I am pleased to be here at the launch of this important strategy. Congratulations to those who have worked so hard to put it together. Thank you. 2/2 BIS central bankers' speeches | reserve bank of australia | 2,018 | 8 |
Address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at The Economic Society of Australia (QLD) Business Lunch, Brisbane, 22 August 2018. | 22/08/2018 Low Inflation | Speeches | RBA Speech Low Inflation Guy Debelle [ * ] Deputy Governor Address at The Economic Society of Australia (QLD) Business Lunch Brisbane – 22 August 2018 The inflation rate is currently just over 2 per cent (Graph 1). This is consistent with the inflation target for the Reserve Bank agreed between the Governor and the Treasurer. However, that follows a period where inflation has been a little below target for a number of quarters. While inflation has averaged 2½ per cent since the inflation target was introduced, over the past three years it has averaged 1.8 per cent (Table 1). http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 1/23 22/08/2018 Low Inflation | Speeches | RBA Graph 1 How broad based has the recent decline in inflation been? In 2016, only around one-quarter of the CPI basket had an inflation rate of above 2.5 per cent. [1] In the June quarter this had risen but only to 40 per cent. To look at it another way, in recent quarters around 80 per cent of the basket had an inflation rate below its inflation-targeting average (Graph 2). http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 2/23 22/08/2018 Low Inflation | Speeches | RBA Graph 2 There are a number of macroeconomic forces at work that have contributed to these outcomes, but today I am going to focus on some of the individual price developments that underpin the aggregate inflation outcome. [2] I will examine pricing dynamics at a more disaggregated level and how these dynamics have changed in recent years. An understanding of these changing dynamics and what might be behind them is useful in assessing the outlook for inflation. Important drivers of recent lower outcomes include competition in the retail sector, historically low increases in rents, low wages growth and slower growth in some administered prices. http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 3/23 22/08/2018 Low Inflation | Speeches | RBA Table 1: Inflation by Component(a) Effective weight Average since 1993 Average since 2015 1.2 −0.1 0.1 2.4 3.2 2.7 2.3 −0.8 −0.1 1.1 1.6 −0.5 AVC and telecommunications equipment −2.8 −4.7 Housing(d) 3.0 1.9 3.5 2.9 2.2 2.8 0.7 2.2 Administered prices 4.4 3.8 Utilities Education Health Other administered 4.5 5.1 4.3 4.0 4.2 3.2 4.0 3.6 Market services(e) 2.9 2.0 Tobacco 8.4 13.9 Automotive fuel 3.3 6.7 Holiday travel and accommodation 2.2 0.8 Headline CPI(f) 2.5 1.8 Trimmed mean(f) 2.6 1.8 Retail Consumer durables(b) Food(c) Fruit and vegetables Alcoholic drinks Non-alcoholic drinks New dwelling purchase Rents Dwelling maintenance and repair (a) Adjusted for the tax changes of 1999-2000 (b) Excludes audio, visual and computing equipment (c) Excludes fruit, vegetables, meals out and takeaway food (d) Excludes administered prices (e) Excludes domestic travel and telecommunications equipment and services (f) Excludes interest charges and indirect deposit and loan facilities Sources: ABS; RBA http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 4/23 22/08/2018 Low Inflation | Speeches | RBA Retail One of the factors having a significant impact on inflation outcomes in recent years has been increased competition in the retail sector. Prices of many retail items have been steady or falling over recent years. Since 2015, retail prices have on average. The price of the typical food basket declined has not increased all that much over the past 10 years, while the prices of consumer durable items such as fridges and furniture (adjusted for improvements in the quality of the goods) have not changed noticeably over the past 25 years (Graph 3). Most notably, the prices of audiovisual equipment have declined by 90 per cent over the past 25 years (see below). In the case of consumer durables and audiovisual equipment, technological improvement has clearly been an important factor, but competition in the retail sector has also played a significant role. Graph 3 One way of illustrating the effect of competition on retail prices is by examining the changing dynamics of exchange rate pass-through. That is, the way that changes in the exchange rate affect price changes for retail items. http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 5/23 22/08/2018 Low Inflation | Speeches | RBA Graph 4 illustrates that changes in the exchange rate typically pass through quickly to import prices for retail goods. That is, the prices of imported goods at the docks tend to move very much in line with movements in the exchange rate (first-stage pass-through). When the exchange rate depreciates, these at-the-dock prices increase. This relationship hasn't changed much over the past 25 years. In the two decades up to 2010, these changes in import prices at the docks tended to be passed on to the retail prices faced by consumers. However, over the past decade or so there has been a shift in these pricing dynamics for retail goods. Graph 4 While slower growth in consumer spending over this time frame compared with the earlier period has probably played a role in explaining retailers' reluctance to pass on higher import prices, it is the http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 6/23 22/08/2018 Low Inflation | Speeches | RBA structural changes underway in the retail sector that are putting downward pressure on prices. One aspect of this is that the internet, and technology more generally, have meant that foreign retailers can now compete with local retailers for online shopping, which is a small but rapidly growing part of the retail market. In June, online sales made up around 5 per cent of total retail trade according to the Australian Bureau of Statistics (ABS); however, the value of online sales has grown by 50 per cent over the past year. This competitive pressure is not confined to online market share, with a number of large foreign retailers also setting up ‘bricks and mortar’ retail operations in Australia. In addition to the direct competition from this source, there is also greater information about prices, which has allowed households to comparison-shop more easily and negotiate greater discounts off listed prices. Competition is not directly observable, but we can look at some proxies for it to assess how it has changed. Two proxies for competition are mark-ups and margins. Mark-ups measure the ratio of a firm's sale price to its marginal cost (i.e. the cost of supplying one more unit of the good) (Graph 5). Net margins capture the ratio of prices to the average cost of production (Graph 6). When competition increases, this is likely to put downward pressure on mark-ups and margins. Graph 5 http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 7/23 22/08/2018 Low Inflation | Speeches | RBA Graph 6 Both of these proxies show some evidence of increased competition. Measures of retail mark-ups constructed using the firm-level Business Longitudinal Analysis Data Environment (BLADE) database peaked in 2011/12, and have generally declined since then. [3] While these data are only available until 2014/15, more timely data on retail net margins show a similar story, with net margins for food and other retailers declining over the past few years. Companies have responded to the increased competition by reducing their costs and improving their productivity. This has been evident in the retailers themselves as well as their supply chains. This has put further downward pressure on prices. Labour productivity growth in the retail sector has averaged 3½ per cent since 2010, quite a lot faster than that in the economy as a whole (although growth hasn't obviously picked up in recent years as it grew at a similar fast pace in the five years prior to 2010). How retail competition plays out over the period ahead is one of the uncertainties for the Bank's inflation forecast. There have already been foreign entrants into many parts of the retail sector in recent years, which have driven down margins in the sector. But there are other entrants who are only just establishing their foothold, which suggests that they, at least, regard the current level of http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 8/23 22/08/2018 Low Inflation | Speeches | RBA margins as still quite attractive, notwithstanding the decline over recent years. Our expectation is that these forces still have some way to run. In contrast, there is some prospect that the effect of margin compression on the rate of food price inflation could be near an end. Recent commentary by market analysts suggests that the transition by some supermarkets to ‘every day low price’ strategies may have run its course. Furthermore, in coming quarters food prices are going to be affected by the severe drought in some parts of the country. Based on what happened in previous droughts, we expect meat prices to decline initially as slaughter rates increase, but then to rise beyond that. The impact on fruit and vegetables prices is less clear. It is worth noting that the ABS now uses scanner data and is better able to capture ‘low-level substitution bias’ in the CPI than in the past – i.e., if households shift away from more expensive drought-affected foods to other foods. This would mitigate the impact of the drought on inflation. Technology Beyond the effect of technology in contributing to greater price transparency and facilitating increased competition in the retail sector, it has obviously had a direct effect on the prices of a number of retail goods, most obviously audiovisual and communication goods such as TVs, computers and phones. One thing that may not be apparent is that statistical measures of inflation are adjusted for changes in quality where possible. Advances in technology often improve the quality of products across a number of different dimensions and the ABS aim to capture this in their measure of inflation. Smartphones and tablets are a good example: changes to processing speed, data storage, camera quality, etc. have all contributed to measured declines in the prices of computers and phones (Graph 7). However, households may not necessarily see that prices of these goods have declined over time when purchasing these products, particularly if they do not value or use all the services that are bundled into their computer or phone. [4] The retail price may remain relatively constant, but the product you are getting for that price is much better quality. This shows up as a decline in the price in the CPI. http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 9/23 22/08/2018 Low Inflation | Speeches | RBA Graph 7 As I mentioned earlier, the prices of audio, visual and computing equipment (adjusted for quality change) have been falling steadily over the past 25 years. More recently, the prices of mobile phone handsets and plans have also fallen after the ABS updated its methodology for measuring the prices of these items. As a result, the rate of decline in this group of items has picked up to be closer to 5 per cent per annum, which by itself has taken around 0.2 percentage points off CPI inflation each year. Price measurement when there is technological change is a long-standing challenge for statisticians. There is the challenge of appropriately capturing changes in quality and there is also the challenge of ensuring that the weights used to aggregate the prices of the various goods and services appropriately reflect households' expenditure patterns. For example, it may take some time for new goods and services to be included in the CPI basket. More generally, there is the issue of ensuring that the CPI appropriately takes account of changing expenditure patterns in response to movements in relative prices. The ABS has recently begun updating its CPI weights to reflect changing household expenditure patterns on a more frequent basis, which should reduce the size of this ‘substitution bias’ in the future. http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 10/23 22/08/2018 Low Inflation | Speeches | RBA Housing The cost of housing services has a large weight in the CPI, with the weight about equally split between the cost of building a new home and the cost of renting (Graph 8). There have been quite divergent dynamics in each of these two components in recent years. Graph 8 New dwelling costs New dwelling cost inflation, which has an 8 per cent weight in the CPI basket, has tended to move closely with the residential building cycle over time (Graph 9). [6] However, despite the historically high level of activity in housing construction over recent years, new dwelling cost inflation has been running at a bit below its long-run average. During the late 2000s, new dwelling cost inflation was higher than it is currently because the residential construction sector was competing for materials and labour with the resources sector in the midst of its investment boom. This competition for inputs has clearly abated. Wages growth in housing construction has been generally contained except for some particular skills such as bricklayers, in part because workers have been moving from the resources sector as projects there finished and also reflecting the general slow pace of wages growth in the economy. Reports from liaison suggest that competition for inputs between public infrastructure projects and high-rise residential developments has put some upward pressure on new http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 11/23 22/08/2018 Low Inflation | Speeches | RBA dwelling cost inflation in Sydney and Melbourne. This includes competition for labour such as engineers and project managers, as well as competition for materials such as concrete. Liaison contacts suggest that firms have also been able to limit cost inflation by switching to lower-cost building materials. Graph 9 Rents The pace of rent inflation has been falling since 2008, and year-ended rent inflation is around its lowest level since the mid 1990s. This has been a considerable drag on inflation: rental inflation was nearly 3 percentage points lower per annum in the past three years than in the previous twenty, which has reduced aggregate inflation by nearly 0.2 percentage points per annum in recent years. The decline in rent inflation can be attributed to a mix of supply and demand side developments. As mentioned, housing construction activity has grown strongly in recent years, which has increased the supply of rental properties. Growth in the housing stock has outstripped population growth since 2014, which put downward pressure on rents. [7] Furthermore, rents are changed relatively infrequently and can be indexed to CPI inflation, so there is a self-reinforcing dynamic to this too. http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 12/23 22/08/2018 Low Inflation | Speeches | RBA The national rent inflation series masks considerable variation across capital cities. Rent inflation has been much lower in Perth than in other capital cities in recent years, indeed rents have been falling in Perth at quite a rapid rate for a number of years. The vacancy rate in Perth – that is, the share of properties that are vacant and available to rent – has more than doubled since 2008. But slower growth in rents is not just a Perth story. Rent inflation in Sydney and Melbourne has slowed considerably in recent years reflecting the substantial additions to the dwelling stock in these cities, and notwithstanding the faster population growth, particularly in Melbourne. Rents are flat in Brisbane and Adelaide. Only in Hobart are rents growing at a high rate. We expect the pace of rent inflation to increase gradually over the next couple of years. The vacancy rate has declined over the last year, and newly advertised rent growth has increased. However, it will take some time for the flow of new rents to materially affect the stock of rents captured in the CPI. Graph 10 http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 13/23 22/08/2018 Low Inflation | Speeches | RBA Graph 11 Service Inflation Services make up over one-third of the CPI basket and can be split into two broad categories. The first is what can be described as market services. These are services for which pricing tends to be market-based. This includes household services such as hairdressing, financial services, and meals out & takeaway. The prices of market services are generally driven by domestic factors such as wages, commercial rents and utility prices. There is little or no competition from imports and they are not affected by movements in the exchange rate. The second category is administered prices. These are the services for which prices are at least partly regulated, or for which the public sector is a significant provider. This includes services such as health, education and child care. It also includes utilities, which I will talk about separately. Market services Labour costs comprise about 40 per cent of final market services prices, which means that wages growth is a key determinant of the pace of market services inflation. Market services inflation and wages growth were both growing strongly in the run-up to the terms of trade peak in 2011 (Graph 12). More recently, wages growth has been subdued, and this has been a significant factor contributing to the slower pace of market services inflation. http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 14/23 22/08/2018 Low Inflation | Speeches | RBA Graph 12 There have also been a number of idiosyncratic developments that have weighed on market services inflation in recent quarters. This includes the removal of some ATM withdrawal fees in September 2017, the introduction of a CTP green slip refund scheme in New South Wales in December 2017, and the introduction of the Active Kids sports participation program in New South Wales in January 2018. Notwithstanding these one-off developments, the outlook for market services inflation is intrinsically related to the outlook for wages. The Bank's forecast is that, as the labour market continues to tighten, wages growth should gradually pick up, and along with that we would expect market services inflation to also increase. However, as we have noted on a number of occasions, there is considerable uncertainty about the extent of unutilised capacity in the labour market and how quickly a reduction in spare capacity would translate into higher wage and price inflation. It is possible that the unemployment rate could fall faster than expected and wages growth could pick up more strongly as a result. Alternatively, it is possible that the flow of new workers into the labour force could continue to be stronger than usual, so that unemployment declines more slowly than we expect and wage pressures could take longer to emerge. http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 15/23 22/08/2018 Low Inflation | Speeches | RBA Administered prices Administered prices have generally risen at a faster rate than other prices for the past couple of decades. One reason is that demand for administered items has grown particularly strongly over time, and is relatively insensitive to the business cycle (Graph 13; Graph 14). For example, demand for health services has increased as the population has aged and as we have become wealthier. The share of children in formal child care has also increased markedly. Another reason is that growth in unit labour costs has been a little higher in administered services than in other industries. Graph 13 http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 16/23 22/08/2018 Low Inflation | Speeches | RBA Graph 14 While administered services inflation continues to exceed the rate of inflation in other items, it has slowed since 2012. This has been broad based across the various administered components. Education inflation is noticeably below its inflation-targeting average. In recent years, several state government initiatives have been introduced that have weighed on education inflation. These include initiatives to freeze TAFE fees and lower the cost of preschool education. Annual increases in school and tertiary education fees have been lower than usual, since some fees are indexed to wages growth and CPI inflation, both of which are subdued. Health inflation has also been lower in recent years, although it is still one of the categories with the highest rates of inflation (Graph 15). At around 4 per cent, the most recent increase in health insurance premiums was the lowest average increase in more than 15 years. http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 17/23 22/08/2018 Low Inflation | Speeches | RBA Graph 15 The pace of child care inflation has also declined in recent years. On a quarter-to-quarter basis, child care inflation tends to be affected by changes in the fees that are charged by child care centres. However, many families also receive child care benefits from the government, and changes in the level of these payments are factored into the measurement of child care inflation. The last time that the child care payment system changed noticeably was in the September quarter 2008, when the child care rebate was increased to cover 50 per cent of out-of-pocket costs. It had previously only covered 30 per cent of costs. The net effect of this change was measured deflation in child care prices of over 20 per cent in that quarter. Looking ahead, as we discussed in the recent Statement on Monetary Policy, there are a number of developments in some of these prices, which have resulted in the Bank lowering its forecast for inflation in the current (September) quarter. The education component is expected to be lower over the next few quarters because of initiatives in a couple of states to make vocational education more affordable. The recent changes to the child care benefits system that came into force on 1 July lead us to expect that the cost of child care will fall in the September quarter. However, there is considerable uncertainty around what the magnitude of this decline will be. There is also uncertainty around whether the changes will affect measured inflation in subsequent quarters. For example, child care inflation has historically increased in the March quarter since this is when families have typically reached the caps on their benefit payments. Under the new system, many families will no longer be http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 18/23 22/08/2018 Low Inflation | Speeches | RBA limited by these caps, which means that child care prices could also fall in the March quarter next year. These identifiable prices changes are likely to result in a lower inflation outcome in the September quarter, although it is possible that there are other offsetting movements in other prices that are not as apparent at this stage. We expect these price changes to be mostly confined to the September quarter but there might be further declines in administered prices in subsequent quarters because of other government initiatives to reduce cost-of-living pressures. At the same time, it is worth bearing in mind that such price changes do also boost household purchasing power. This will boost spending on other goods and services potentially leading to higher prices elsewhere. Utilities Utility prices have risen at a faster rate than other prices for the past couple of decades, including large rises in electricity and gas prices in 2017 (Graph 16). Graph 16 http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 19/23 22/08/2018 Low Inflation | Speeches | RBA The recent Australian Competition and Consumer Commission (ACCC) report into retail energy pricing outlined the factors contributing to this outcome. [8] The ACCC highlighted significant overinvestment in state-owned networks in some states and that networks have recouped the cost of this over-investment from customers. Meanwhile, the supply and demand balance within the wholesale market has tightened following the retirement of some coal-fired generation capacity. High prices have also led households to increasingly make use of solar panels and energy efficient appliances, which has reduced demand for energy from the National Electricity Market. Gas generation has become an increasingly important source of energy, but the cost of this gas has increased dramatically alongside an increase in exports and domestic restrictions on further exploration. The ACCC also identified some elements of the energy market's structure that have contributed to higher bills for customers. High and rising prices are usually a signal to market participants to invest in additional supply. However, the payoff period for new energy generation assets is long, and uncertainty around energy policy has contributed to significant underinvestment in new supply. As a result of these factors, wholesale energy prices increased markedly over the course of 2016 and 2017. Higher wholesale prices led to an increase in electricity and gas inflation, since wholesale market costs account for around 30 to 40 per cent of consumers' electricity bills. However, these dynamics have changed quite markedly. Wholesale electricity prices have declined from their recent peak and the large volume of new renewable energy generation expected to come on line may put further downward pressure on wholesale prices (Graph 17). The recent decline in wholesale prices and an increase in competition amongst energy retailers has seen a decline in market offer prices in many states. Furthermore, many energy retailers have indicated that they will not be changing their standing offer prices in the September quarter, while others have indicated that they will be lowering their prices. As a result, we expect utility prices to decline in the coming quarters. How this plays out over the period ahead is another significant uncertainty for the Bank's inflation forecast. http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 20/23 22/08/2018 Low Inflation | Speeches | RBA Graph 17 Tobacco Finally, I will briefly touch on the contribution of tobacco prices to inflation. Unlike most of the other components of the CPI I have talked about, tobacco prices have been rising at an historically fast pace. Rising tobacco prices have been the single largest contributor to headline inflation for some time now (Graph 18). In fact, higher tobacco prices contributed 0.6 percentage points to headline inflation over the year to June 2018. The high rate of tobacco inflation reflects the introduction of a new indexation regime in December 2013, which was to see the tobacco excise increase by 12.5 per cent per year above average earnings. This regime, which was originally legislated for four years, was subsequently extended out to 2020. http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 21/23 22/08/2018 Low Inflation | Speeches | RBA Graph 18 Conclusion In conclusion, I have discussed some of the dynamics that have contributed to the lower inflation outcomes in recent years. These include increased competition in the retail sector, historically low rental growth, the slow pace of wages growth and developments in some administered prices. Utilities prices have been boosting inflation for a number of years but are now expected to reduce it in the period ahead. Our current forecast for inflation is broadly unchanged from earlier forecasts. We did revise down our expectation for inflation in the current quarter for reasons I have just discussed. Beyond the September quarter, we continue to expect inflation to be around 2¼ per cent over the next couple of years as above-trend GDP growth reduces spare capacity in the labour market and there is an associated pick-up in wages growth. We expect most of these other forces that have contributed to the recent low rate of inflation to abate but there is uncertainty about how much longer they will persist. We would like to be more confident that inflation will be sustained at a rate consistent with the target. That said, the Australian economy remains on the path it has been for at least the past year and a half. Although inflation is likely to be a bit lower in the near term, this http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html is expected to be temporary. 22/23 22/08/2018 Low Inflation | Speeches | RBA Further gradual progress on both lowering unemployment and bringing inflation closer to the midpoint of the target is expected over coming years. The current accommodative stance of monetary policy will assist this outcome. Endnotes [*] Thanks to Natasha Cassidy, Jonathan Hambur and Mike Read for their assistance. The Consumer Price Index (CPI) captures changes in the prices of the basket of goods and services that are consumed by households. Each individual item is categorised into one of around 90 expenditure classes. In deciding what goods and services to include in the CPI basket and what their weights should be, the ABS uses information about how much – and on what – households in Australia spend their income. These expenditure weights will now be updated on an annual basis. For more information, see RBA (Reserve Bank of Australia) (2017), ‘Box D: Updated Weights for the Consumer Price Index’, , November, pp 60–63. Statement on Monetary Policy Over the longer term, in principle, the inflation rate should be determined by macroeconomic forces and shouldn't be affected by relative price movements. But over shorter horizons, individual price movements can have a large impact. A fall in the price of one good should boost household spending power and demand for other goods and services boosting their price, but this can take some time to play out. The results of these studies are based, in part, on ABR data supplied by the Registrar to the ABS under and tax data supplied by the ATO to the ABS under the . https://www.rba.gov.au/disclaimer/blade-disclaimer.html See Jacobs D, D Perera and T Williams (2014), ‘Inflation and the Cost of Living’, RBA discussion of these issues. RBA (2017), ‘Box D: Updated Weights for the Consumer Price Index’, pp 60–63. New dwelling cost inflation is measured as the cost of newly built owner-occupied housing, excluding the value of the land. The price of established dwellings has no direct influence on CPI inflation. Though this came after a period of time where the growth in the housing stock lagged that of the population, which likely boosted rents. ACCC (2018), ‘Restoring electricity affordability and Australia’s competitive advantage', Retail Electricity Pricing Inquiry – Final Report, June. System (Australian Business Number) Act 1999 Administration Act 1953 A New Tax Taxation Bulletin, pp 33–46 for a Statement on Monetary Policy, November, © Reserve Bank of Australia, 2001–2018. All rights reserved. http://www.rba.gov.au/speeches/2018/sp-dg-2018-08-22.html 23/23 | reserve bank of australia | 2,018 | 8 |
Speech by Mr Lindsay Boulton, Assistant Governor (Business Services) of the Reserve Bank of Australia, to the Business Banking Summit 2018, Sydney, 23 August 2018. | 23/08/2018 The Reserve Bank's Government Banking Business | Speeches | RBA Speech The Reserve Bank's Government Banking Business Lindsay Boulton [ * ] Assistant Governor, Business Services Business Banking Summit 2018 Sydney – 23 August 2018 Introduction Thank you to the RFi Group for the invitation to speak to the 2018 Global Business Banking Summit. A key theme this year is the role that technology plays in servicing business banking customers. Few would disagree that technology plays a significant role. Its role, though, has changed over the past decade or so from supporting the provision of business services to also being a source of competitive difference. The change is particularly evident in payments, where advances in digital technologies and greater connectivity between networks are driving innovation in products and increased competition. I would like to talk today about the banking services that the Reserve Bank provides the Australian Government as a business banking customer, highlighting the role that technology has played in an arrangement that is unique as far as government banking is concerned. I would also like to mention a couple of new payment-related services underpinned by advances in payments technology and how they may benefit business customers, including the government. Let me start with some background on the Reserve Bank's banking services to set the scene. Background There are two components to the banking services that the Reserve Bank provides the Australian Government. The first is a core banking facility directed at maintaining a core group of accounts that the government is legally required to hold at the Reserve Bank. Maintaining central government core accounts is a service that almost all central banks provide, though arrangements vary from country to country. https://www.rba.gov.au/speeches/2018/sp-ag-2018-08-23.html 1/7 23/08/2018 The Reserve Bank's Government Banking Business | Speeches | RBA The second component is a transactional banking facility. This is an account and transaction service available to government agencies to assist in undertaking their policy responsibilities and day-to-day operating expenses. Unlike core banking, transactional banking is not a service universally provided by central banks. In some countries it is the sole responsibility of the central bank, while in others government agencies must purchase these services under competitive pricing arrangements from commercial banks. Arrangements in Australia are a unique mix of the two. While the Reserve Bank has authority to provide transactional banking services to the government under its charter, it competes with commercial banks under government competition policy to do so, submitting bids at tenders conducted by the agencies themselves. The Bank must cost and price its transactional banking services as a business that stands alone from its other activities, including its core banking service, and meet a prescribed minimum annual return on capital. The minimum is equivalent to the 10-year government bond yield plus a margin for risk of a few hundred basis points. These arrangements have been in place since the late 1990s. Their objective has been to ensure, through competition, that government agencies get value for money for their transactional banking business as well as access to innovations in payments products. At the same time, maintaining core accounts at the Reserve Bank means that the government's core balances are not exposed to overnight credit risk and that the Reserve Bank can meet its responsibility to manage the impact of the government's daily cash transactions on banking system liquidity. Allowing the Reserve Bank to provide transactional banking services to government agencies also provides a way for agencies to avoid conflicts that might arise between their policy responsibilities and their banking arrangements if they were to bank with a commercial bank. Although it is unique for a central bank to compete to provide banking services to their central government, the Reserve Bank has been awarded business in three-quarters of the tenders for government banking business in which it has participated over the past 15 years and, reflecting a focus on meeting customer needs, more than doubled its available range of banking services (see Graph). https://www.rba.gov.au/speeches/2018/sp-ag-2018-08-23.html 2/7 23/08/2018 The Reserve Bank's Government Banking Business | Speeches | RBA Graph Customer numbers have also risen steadily. The Reserve Bank now has just under 100 government agency customers making in aggregate some $1 trillion in transactions annually. Importantly, the customer base includes the largest spending and collection agencies – the Department of Human Services (DHS) and the Australian Taxation Office – which, together, comprise a significant share of the Bank's customer business. The Bank has also met its minimum benchmark rate of return in line with the government's competitive neutrality guidelines. Role of Technology Several factors have contributed to these outcomes. One of these is the productivity of the Bank's service. As a rough measure, the number of Reserve Bank staff directly involved in providing transactional banking services to government customers has remained largely unchanged over the past 15 years (see Table) while, at the same time, the annual volume of customer transactions has risen by around 3¼ per cent per year. https://www.rba.gov.au/speeches/2018/sp-ag-2018-08-23.html 3/7 23/08/2018 The Reserve Bank's Government Banking Business | Speeches | RBA Table: Transactions and Employment Average Annual Growth since 2004/05 (%) RBA's Transactional Banking Volumes 3.2 Banking Sector Payment Volumes 5.3 Real GDP 2.8 RBA Banking Staff 0.1 Banking and Finance Sector Employment Total Employment Source: RBA, ABS Another factor is the Bank's preparedness to contract and partner with third parties to provide specific payment services. In most instances, the Bank has done this to take advantage of a vendor's broader customer base. In other words, we have tapped economies of scale where, because of our customers' relatively low transaction volumes, it would not have been cost effective for us to provide a service using only our own resources. In these instances, too, our customers have generally preferred to deal with the Reserve Bank as a single provider of a bundle of payment services sourced from different providers rather than deal separately with each provider. Payment card acquiring services, for which costs are typically quite large, are an example of this. Of course, a key factor, which, incidentally, has also underpinned our productivity, has been the application of payments technologies. To give just a few examples: online gateways have allowed the Bank to offer a virtual shopfront for receiving payments to the government without the cost of a physical branch network; increased network connectivity has meant that we can lodge the government's overseas pension payments directly into automated clearing houses in other countries rather than issue foreign currency cheques or money orders; and greater processing capacity and system resilience means that we can now process certain government payments with a tolerance of no more than 20 minutes of system downtime per year. Not surprisingly, we now invest more in technology. The share of information technology in the total cost of the Bank's transactional banking business is now around 50 per cent compared with 25 per cent around 15 years ago. Of course, developments in payments technology are ongoing. I would like to focus on three in particular because of their near-term potential for business banking customers: The New Payments Platform, known simply as NPP; open banking; and digital identity, which is still on the drawing board. All have benefits for business banking customers, including the government. New Payments Platform Launched in February, the NPP has been a collaborative effort over several years by a number of financial institutions, including the Reserve Bank. It enables individuals and businesses to make and receive payments in real time, 24 hours a day, 365 days of the year, and to send more complete https://www.rba.gov.au/speeches/2018/sp-ag-2018-08-23.html 4/7 23/08/2018 The Reserve Bank's Government Banking Business | Speeches | RBA remittance information with payments. It also allows payments to be sent via a simple address, such as a mobile phone number. Reflecting its complexity, the platform is still ramping up and additional services will come on line over the next few years. As far as the government's services are concerned, it will allow the government to make emergency payments at any time to assist individuals and households in distress. DHS currently makes in excess of 1,000 emergency payments each day across the country, more in the immediate wake of a natural disaster. Until now, given restrictions in the payments system, funds could only be fast tracked to recipients' bank accounts during business hours on Australia's south-eastern seaboard. NPP, instead, allows these payments to be made quickly at any time. The government's systems will communicate directly and securely with the Reserve Bank's, providing the government with certainty within seconds as to whether a payment has successfully reached a payee's bank account. Similarly, the new platform allows payments by the government to be made on their scheduled dates, even if this occurs on a public holiday. NPP also offers advantages for the government in the way its account funding arrangements are administered. Significantly, it will allow the government to undertake ‘just-in-time’ funding. Under protocols administered by the Department of Finance, balances needed by government agencies to fulfil their responsibilities are swept between agencies' transaction accounts and the government's core accounts at the Reserve Bank on a daily basis, with agencies required to provide up to 24 hours' notice for funds to be swept to transaction accounts. Under NPP, agencies could receive funding from the core accounts on the day they prepare the payments and, once received, make the payments in real time. Potential exists in these arrangements to minimise balances held in agencies' transaction accounts and, as a result, reduce the government's net funding costs. Taking this further, it may be possible, in time, for government to dispense with agencies' transactions accounts and the associated daily sweep, allowing agencies to draw their daily spending requirements directly from the government's core accounts at the Reserve Bank. This could offer savings by avoiding fees currently applied on existing transaction accounts as well as increase administrative efficiency. Finally, the ability to send more complete remittance information with a payment could reduce costs for Australian businesses making payments to the government by including remittance information within the payment message rather than sending the information via a separate channel. It could also reduce the amount of back office work required by government agencies in trying to align payments with relevant information. Open banking The government announced in May that it accepted the recommendations of a review into the design, operating model and regulatory framework for open banking in Australia, and will implement them in stages over the next few years. [3] Like NPP, open banking represents a significant advance in banking arrangements, giving consumers of banking and financial services the right to access and https://www.rba.gov.au/speeches/2018/sp-ag-2018-08-23.html 5/7 23/08/2018 The Reserve Bank's Government Banking Business | Speeches | RBA share their banking data with third parties, including other payment service providers. The changes will increase competition for services. The Reserve Bank, as a banking service provider, will be participating in the open banking arrangements and is already considering ways by which our customers, along with third parties, can access their own banking data, consistent with the recommendations in the review. It is, of course, a decision for government agencies as to how they will utilise open banking. As with any new service offering, the Reserve Bank is consulting its customers with regard to the potential advantages for their business. At the very least, government agencies may use open access arrangements to centralise the collection of their banking data, particularly where they hold accounts at more than one financial institution. This would help to streamline the flow of their banking data to their financial management systems and provide better reporting for analytical purposes. Whatever the case, the Reserve Bank, as a service provider, intends to play a role as a holder of data that government agencies can access from services currently provided by the Reserve Bank and as a receiver of data from commercial providers of banking services to government agencies. This would reduce reporting and analysis costs for the government as well as for the institution from which the data is sourced. Digital identity The NPP and open banking are just two developments that offer significant benefits for business banking customers. As new payment services emerge, it will be important to manage the risks, particularly the risk of fraud and identity theft. Already in Australia, annual losses arising from payment card fraud amount to around $600 million, much of which comes from online payments where the card is not physically present. The ability for individuals representing either themselves or their organisations to properly and reliably identify themselves online is essential for security as we increasingly move to online transactions. This is the case irrespective of whether the transaction is finance based, a licence application, a health insurance claim, or an application for some form of government assistance, to name just a few potential use cases. The Australian Payments Council is currently underway with a program of work that will lead to the development and implementation of a digital identity framework in Australia. A focus of the Council's work is developing a framework that will support the creation of portable digital identities. In other words, a single framework that can be used by different organisations to verify and authenticate identity at the time transactions are taking place. This does not necessarily mean that the underlying identity system is owned and operated by a single entity, but that there is interoperability between identity services and a common set of rules by which identities are lodged, verified, authenticated, and shared. It is intended that the framework will extend beyond payments and financial services to include retail, government and the telecommunications sectors. The Reserve Bank, through its membership of the Council, is supporting the Council's work. Whatever form it finally takes, it is important that the work to develop the framework is coordinated. https://www.rba.gov.au/speeches/2018/sp-ag-2018-08-23.html 6/7 23/08/2018 The Reserve Bank's Government Banking Business | Speeches | RBA The benefits will not be fully realised if each identity service provider goes it alone, developing their own identity services with different standards, separate and unconnected to each other. This would likely result in inefficiencies, requiring individuals and organisations to maintain identities with different providers for different purposes, and leave security gaps. Summing Up In finishing, I would reiterate that technology has become a source of competitive difference in the payments industry over the past decade or so. The application of payments technology has certainly allowed the Reserve Bank to compete for the government's transactional banking business, delivering value for money services while, at the same time, allowing the Bank to perform its traditional role of banker to the government. There will, of course, be more developments and further advances. The NPP, open banking, and digital identity are just three examples of technology supporting the provision of services while being a potential source of competition and innovation. It is the Bank's intention to continue providing its government banking customers with the services it needs, to make new products and services available where they offer a benefit to our business customers, and to do so in a way that is secure, reliable and provides value for money. Endnotes [*] My thanks to Stephanie Connors (RBA) and Victoria Richardson (Australian Payments Network) for their contribution to this speech. The Reserve Bank's authority to provide banking services is set out in the . The Act empowers the Bank to act as banker to the Commonwealth insofar as the Commonwealth requires the Bank to do so. The term ‘agencies’ refers to corporate and non-corporate Commonwealth entities as defined under the The term is used here for ease of expression. However, only non-corporate Commonwealth entities, which includes most government departments, are subject to the sweep arrangements. The review was commissioned by the Treasurer in mid-2017. The Final Report – which included 50 recommendations – was delivered to the government in early 2018. See Australian Treasury (2018), ‘Review into Open Banking in Australia’, Final Report, February. Data sourced from Australian Payments Network Fraud Statistics (2018), . Available at <https://www.auspaynet.com.au/resources/fraud-statistics/July-2016-June-2017>. Figures updated as at April 2018. Reserve Bank Act Governance Performance and Accountability Act (2013). Public Payment Fraud Statistics Jul 16 – Jun 17 © Reserve Bank of Australia, 2001–2018. All rights reserved. https://www.rba.gov.au/speeches/2018/sp-ag-2018-08-23.html 7/7 | reserve bank of australia | 2,018 | 8 |
Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Reserve Bank Board Dinner, Perth, 4 September 2018. | Philip Lowe: Remarks at Reserve Bank Board Dinner Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Reserve Bank Board Dinner, Perth, 4 September 2018. * * * Good evening. On behalf of the Reserve Bank Board I would like to warmly welcome you to this community dinner. It is very good to be in Perth again. The Board met this morning at our office on St Georges Terrace. This dinner is an opportunity for us to hear directly from you about how things are going in Western Australia. So thank you for joining us. As you have probably already heard, the Board left the cash rate unchanged at 1.5 per cent at its meeting this morning. I doubt that this decision surprised anybody. The cash rate has been at 1.5 per cent for more than two years now and the Board expects it to remain there for a while yet. Lest you think that keeping interest rates unchanged for an extended period means that life at the Reserve Bank of Australia must be very quiet, we are always closely tracking domestic and international developments and we have other important responsibilities that don't attract the same spotlight as our monthly interest rate decisions. The RBA is responsible for the issuing of Australia's banknotes. We are currently undertaking a major upgrade of our notes to protect against counterfeiters. All up, there are 1.6 billion individual banknotes on issue – that's an average of around 65 notes for each of the 25 million people in Australia. Despite the growth of tap-and-go and other forms of electronic payments, the value of notes on issue as a share of GDP is the highest in more than five decades. This highlights the continued importance of banknotes as a store of value as well as a payment mechanism. So the upgrade of the notes is a major logistical exercise. The RBA is also the banker for the Australian Government. We operate the government's core accounts and we are the transactional banker for many government departments. So if you get a Medicare or tax refund, it comes from the government's accounts at the RBA. We operate the core of Australia's payments system. The way that money moves from one bank to another is through the accounts that financial institutions hold at the RBA. In addition, we operate a key part of the infrastructure supporting Australia's new payments system, generally referred to as ‘the NPP’. This system allows you to move money between bank accounts in real time on a 24/7 basis using an easily remembered ‘PayID’, such as a mobile number, to address the payment. BSBs and account numbers can still be used, but if you have not already done so, I encourage you to contact your bank to register a PayID, which makes it easier to use the new system. The RBA also regulates key parts of Australia's financial market infrastructure, including the central counterparties at the ASX. In addition, we have broad responsibilities to promote competition, efficiency and stability in Australia's payments system. As a result of decisions of the Bank's Payments System Board there have been significant changes to the ATM and debit and credit card systems over recent times. The RBA also operates in financial markets every day to ensure the system as a whole has adequate liquidity. We also have a broad responsibility for financial stability, including acting as the lender of last resort in a financial crisis to provide liquidity to solvent institutions. Finally, we manage Australia's foreign exchange reserves. These are all important functions that we carry out in the public interest. They are all critical to the 1/4 BIS central bankers' speeches functioning of our successful modern economy and financial system. I can assure you, we take these responsibilities very seriously. This means that even when interest rates are being held steady, we have a lot of things on our plate. But it is interest rates that mainly keep us in the news. At its meeting this morning, the Board's assessment was that the Australian economy is moving in the right direction. Over the past year, GDP increased by 3.1 per cent and inflation was around 2 per cent. The unemployment rate is currently 5.3 per cent, which is the lowest it has been in nearly six years. In the broad sweep of our history, these are a pretty positive set of numbers. We will get another reading on the pulse of the economy tomorrow with the release of the June quarter national accounts. We are expecting that this will confirm that over the first half of 2018, the economy expanded at a faster than trend pace, making inroads into spare capacity. Our central scenario is that economic growth this year and next will be a bit above 3 per cent, which should see the unemployment rate come down further. So things are moving in the right direction. One of the factors helping us is that the global economy is expanding quite strongly. Many of the advanced economies are growing quite strongly and unemployment rates in a number of them are at multi-decade lows. The Chinese economy is also growing solidly, although the pace of growth has slowed, partly as a result of efforts to put the financial sector on a more sustainable footing. The United States is most advanced in the process of monetary policy normalisation. This has led to a broad-based appreciation of the US dollar this year. As a consequence, the Australian dollar has depreciated. If sustained, this could be expected to improve the outlook for both inflation and growth. Notwithstanding the positive global picture, there are a number of international uncertainties that we are monitoring closely. One is the possibility of an escalation in the current trade disputes. If this were to happen, it would materially affect trade flows and investment plans around the world. As a country that has benefited greatly from an open rules-based international system, Australia has a strong interest in this not happening. Another uncertainty we are watching closely is the possibility of a material lift in inflation in the United States. The United States is experiencing a large fiscal stimulus at a time when the economy is at full employment and is growing quickly. This is an unusual combination to say the very least. Past experience suggests that it could lead to inflation increasing significantly. Financial markets are, however, heavily discounting this possibility, which means that if it did take place it would come as quite a surprise, with repercussions for markets and the real economy. We are also monitoring carefully the financial and economic problems in a number of emerging market economies with structural or institutional weaknesses, including Turkey, Brazil and Argentina. If these problems were to escalate, they could put strains on parts of the global financial system. So these are some of the international issues we are keeping an eye on at the moment. Domestically, the Board is closely monitoring housing markets across the country and trends in housing finance. Housing credit growth has slowed, which, from a medium-term perspective, is a positive development. Our assessment is that this slowing largely reflects reduced demand for credit by investors, although there has been some tightening in the supply of credit as well. With housing prices falling in a number of cities, largely due to a shift in the underlying fundamentals, investors no longer find it as attractive to invest in residential property as they once did. This is a normal part of the cycle. While credit standards have been tightened, mortgage credit remains readily available. 2/4 BIS central bankers' speeches I would note that some banks have increased their mortgage rates recently in response to somewhat higher interest rates in short-term wholesale markets. A much less remarked upon fact is that the average mortgage rate paid in Australia has fallen since August last year, as lenders have increased their discounts. I encourage anyone with a mortgage to shop around: there are some very good offerings out there. We can all play a role in promoting strong competition in our financial sector by shopping around and taking advantage of the good deals that are out there. Another set of issues that the Board continues to pay close attention to is the outlook for wages growth and inflation. Wages growth has been quite low recently. For some time my view has been that some increase in aggregate wages growth would be a welcome development, especially if it is backed by stronger productivity growth. Many business people that I speak to recognise that a pick-up in overall wages growth would be a positive development from a macro perspective, although not from the perspective of their individual business. So there is a tension there. Our expectation is that wages growth will pick up from here, but the pick-up is likely to be only gradual. Firms are currently reporting a record number of job vacancies and increasingly telling us that it is hard to find workers with the right skills. One way of dealing with this increasing tightness in the labour market is, of course, to lift wages. We expect that as this happens, inflation will also lift towards the midpoint of the medium-term inflation target, although this, too, is likely to be a gradual process. Against this background, this morning the Board again decided to keep the cash rate steady at 1.5 per cent. We are seeking to be a source of stability and confidence, as further progress is made towards full employment and having inflation return to around the midpoint of the target range. As that progress is made, you could expect the next move in interest rates to be up, not down. This would be a sign that overall economic conditions are returning to normal and would take place against the backdrop of stronger growth in household income. But any move still seems some way off, given the gradual nature of the progress expected on unemployment and inflation. At this morning's meeting, as well as a thorough review of the international and Australian economies, we had a detailed discussion on the Western Australian economy. We pay close attention to what is going on here: Western Australia accounts for a little over 14 per cent of Australian GDP and 35 per cent of our exports, so it is important. Reflecting this, this is my third trip to, and public speech in, Perth in the past year. This morning we heard that while the Western Australian economy is still feeling the effects of a decline in the level of mining investment, there are some positive signs. The level of mining investment has further to fall as some large liquefied natural gas projects are completed. But elsewhere in the resources sector things are looking brighter. Sustaining capital expenditure, particularly in the iron ore sector, is picking up with positive spillover effects. Higher prices for a number of minerals have also led to increased exploration activity, including for gold and lithium, and an expansion of some existing mines is taking place. For the first time in a number of years, we are hearing reports through our liaison program in Western Australia that it is difficult for firms to find workers with the right skills, including project engineers and related occupations. Business conditions – as measured by surveys – have also risen significantly and are now above average. At our meeting, we also discussed the population dynamics here in Western Australia. At the peak of the resources boom, annual population growth reached almost 3½ per cent, which is very fast. People moved here from overseas and from the rest of Australia to meet the needs of your rapidly growing economy. In contrast, over the past year, population growth has slowed sharply, to around ¾ per cent, which is almost the slowest of any state in the country. There is now a considerable net flow of people from Western Australia to the eastern states. This change in population dynamics has had a significant effect on housing markets in Western 3/4 BIS central bankers' speeches Australia. The earlier strong growth in population contributed to a sharp rise in housing prices and rents, and then a bit later to a surge in housing construction. With the resources boom now in the past, some of the earlier increases in prices and rents have been reversed and residential construction activity has been low. Western Australia has seen this type of cycle before, and I expect it will see it again at some point in the future. Our liaison, though, suggests that a stabilisation of conditions is in prospect. If so, this should help support consumer confidence and household spending and reinforce the recent more positive news from the resources sector. Finally, as I mentioned earlier, we are currently upgrading Australia's banknotes. I am pleased to be able to announce that the new $50 note will be released on 18 October. We are proud to have a prominent West Australian on this note – Edith Cowan – as well as the Aboriginal writer and inventor David Unaipon. The redesigned $50 note celebrates the fact that Edith Cowan was the very first female member of an Australian Parliament. The microtext on the note will include an extract from her first speech to the Western Australian Parliament. When the note is released, those of you with great eyesight might be able to read this microtext without a microscope. But for those who will struggle to read it, I would like to quote a little from the text. In 1921 Edith Cowan said: I stand here to-day in the unique position of being the first woman in an Australian Parliament… If men and women can work for the same state side by side and represent all the different sections of the community… I cannot doubt that we should do very much better work in the community than was ever done before. Nearly one hundred years on, this sentiment is just as relevant as it was back in 1921. We are proud to have this text on the new $50 note and to recognise Edith Cowan's achievement. The note will also have a seating plan of today's Western Australian Legislative Assembly. It will also recognise Edith Cowan's lifelong advocacy of women. Western Australia's official bird emblem – the iconic black swan – will also appear on the note a number of times. If the note is tilted you will be able to see the colour of the swan change and its wings move. So I am sure that people here in Western Australia will feel a great affinity for the note and enjoy spending it. Once again, thank you for joining us and please enjoy the evening. 4/4 BIS central bankers' speeches | reserve bank of australia | 2,018 | 9 |
Speech by Ms Michele Bullock, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Ai Group lunch, Albury-Wodonga, 10 September 2018. | 10/09/2018 The Evolution of Household Sector Risks | Speeches | RBA Speech The Evolution of Household Sector Risks Michele Bullock [ * ] Assistant Governor, Financial System Ai Group Albury – 10 September 2018 Thank you for the invitation to speak at this Ai Group lunch. It is great to be back in regional Australia. I am responsible for the area of the Bank that focuses on financial stability. So my remarks today are going to cover one of the financial risks we have been focusing on over recent years – the high level of household debt in Australia. Household debt has been rising for a number of decades. How much of a concern is this? I am going to talk through the evolution of the current debt situation and how we see the current risks. Given that I am in Albury-Wodonga, I will finish with a few comments on housing markets and debt in regional Australia. Household debt in Australia has been rising relative to income for the past 30 years (Graph 1). This graph shows the total household debt-to-income for Australia from the early 1990s until this year. Over that time it has risen from around 70 per cent to around 190 per cent. There are three distinct periods. The first, from the early 1990s until the mid-2000s, saw the debt-to-income ratio more than double to 160 per cent. Then there was a period from around 2007 to 2013 when the ratio remained fairly steady at 160 per cent. Finally, since 2013, the debt-to-income ratio has been rising again, reaching 190 per cent by 2018. https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-10.html 1/13 10/09/2018 The Evolution of Household Sector Risks | Speeches | RBA Graph 1 Australia has not been unique in seeing debt-to-income ratios rise. The median debt-to-income ratio for a range of developed economies has also risen over the past 30 years. But the Australian debt-toincome ratio has risen more sharply. In fact, Australia has moved from having a debt-to-income ratio lower than around two thirds of countries in the sample to being in a group of countries that have debt-to-income ratios in the top quarter of the sample. This suggests that there are both international and domestic factors at play when it comes to debt-to-income ratios. There are two key international factors that have tended to increase the ability of households in developed countries, including Australia, to take on debt over the past few decades. The first is the structural decline in the level of nominal interest rates over this period, partly reflecting a decline in inflation but also a decline in bank interest rate margins as a result of financial innovation and competition. With lower interest payments, borrowers could service a larger loan. The second is deregulation of the financial sector. Through this period, the constraints on banks' lending were eased significantly, allowing credit constrained customers to access finance and banks to expand their provision of credit. But as noted, in Australia the household debt-to-income ratio has increased more than for many other countries. The increase in household debt over the past few decades has been largely due to a rise in mortgage debt. And an important reason for the high level of mortgage debt in Australia is that the rental stock is mostly owned by households. Australians borrow not only to finance their own homes but also to invest in housing as an asset. This is different to many other countries where a significant proportion of the rental stock is owned by corporations or cooperatives (Graph 2). This https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-10.html 2/13 10/09/2018 The Evolution of Household Sector Risks | Speeches | RBA graph shows for a number of countries the share of dwellings owned by households on the bottom axis and the average household debt-to-income ratio on the vertical axis. There is a clear tendency for countries where more of the housing stock is owned by households to have a higher household debt-to income-ratio. Graph 2 Potential vulnerabilities This high level of household debt relative to income raises two potential vulnerabilities. First, because mortgage lending is such an important part of bank balance sheets in Australia, any difficulties in the residential mortgage market could translate to credit quality issues for banks (Graph 3). And since all of the banks have very similar balance sheet structures, a problem for one is likely a problem for all. This graph shows the share of banks' domestic credit as a share of total credit over the past couple of decades. Australian banks have substantially increased their exposure to housing over this period and housing credit now accounts for over 60 per cent of banks' loans. So the Australian banking system is potentially very exposed to a decline in credit quality of outstanding mortgages. https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-10.html 3/13 10/09/2018 The Evolution of Household Sector Risks | Speeches | RBA Graph 3 The risk that difficulties in the residential real estate market translate into stability issues for the financial institutions, however, appears to be currently low. The Australian banks are well capitalised following a substantial strengthening of their capital positions over the past decade. While lending standards were not bad to begin with, they have nevertheless tightened over the past few years on two fronts. The Australian Prudential Regulation Authority (APRA) has pushed banks to more strictly apply their own lending standards. And APRA has also encouraged banks to limit higher risk lending. Lending at high loan-to-valuation ratios has declined as a share of total loans, providing protection against a decline in housing prices for both banks and households. And for loans that continue to be originated at high loan-to-valuation ratios, the use of lenders' mortgage insurance protects financial institutions from the risk that borrowers are unable to repay their loans. Overall, arrears rates on housing loans remain very low. But the second potential vulnerability – from high household indebtedness – is that if there were an adverse shock to the economy, households could find themselves struggling to meet the repayments on these high levels of debt. If they have little savings, they might need to reduce consumption in order to meet loan repayments or, more extreme, sell their houses or default on their loans. This could have adverse effects on the real economy – for example, in the form of lower economic growth, higher unemployment and falling house prices – which could, in turn, amplify the negative shock. So what do the data tell us about the ability of households to service their debt? This graph shows the ratio of household mortgage debt to income (a subset of the previous graph on household total https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-10.html 4/13 10/09/2018 The Evolution of Household Sector Risks | Speeches | RBA debt) on the left hand panel and various serviceability metrics on the right hand panel (Graph 4). The mortgage debt-to-income ratio shows the same pattern as total household debt-to-income – rising up until the mid-2000s then steadying for a few years before increasing again from around 2013. The dashed line represents the total mortgage debt less balances in ‘offset’ accounts. This shows that taking into account these ‘buffers’, the debt-to-income ratio has still risen, although not by as much. So households in aggregate have some ability to absorb some increase in required repayments. Graph 4 In terms of serviceability, interest payments as a share of income rose sharply from the late 1990s until the mid-2000s reflecting both the rise in debt outstanding as well as increases in interest rates. Interest payments as a share of disposable income doubled over this period. Since the mid-2000s, however, interest payments as a share of income have declined as the effect of declines in interest rates have more than offset the effect of higher levels of debt. Indeed even total scheduled payments, which includes principal repayments, are lower than they were in the mid-2000s, as the rise in scheduled principal as a result of larger loans was more than offset by the decline in interest payments. https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-10.html 5/13 10/09/2018 The Evolution of Household Sector Risks | Speeches | RBA The risks nevertheless remain high and it is possible that the aggregate picture is obscuring rising vulnerabilities for certain types of households. Interest payments have been rising as a share of income in recent months, reflecting increases in interest rates for some borrowers, particularly those with investor and interest-only loans. Scheduled principal repayments have also continued to rise with the shift towards principal-and-interest, rather than interest-only, loans. There are therefore no doubt some households that are feeling the pressure of high debt levels. But there are a number of reasons why the situation is not as severe as these numbers suggest. First, the economy is growing above trend and unemployment is coming down. While incomes are still growing slowly, good employment prospects will continue to support households meeting their repayment obligations. Second, as noted earlier, households have taken the opportunity over the past decade to build prepayments in offset accounts and redraw facilities. In fact, despite the continuing rise in scheduled repayments, actual repayments relative to income have remained quite steady as the level of unscheduled repayments of principal has declined and offset the rise in scheduled repayments. Third, as noted earlier, lending standards have improved over the past few years, resulting in an improvement in the average quality of both banks' and households' balance sheets. Much slower growth in investor lending, and declining shares of interest-only and high-loanto-valuation lending have also helped to reduce the riskiness of new lending. And at the insistence of the regulator, banks have been tightening their serviceability assessments. In addition, strong housing price growth in many regions over recent years will have lowered loan-to-valuation ratios for many borrowers. As noted earlier, arrears rates remain very low. The discussion above has focussed on the average borrower but what about the marginal borrower? For example, will the tightening standards result in some households being constrained in the amount they can borrow with flow-on effects to the housing market and the economy? Our analysis suggests that while we should remain alert to this possibility, it seems unlikely to result in a widespread credit crunch. The main reason is that most households do not borrow the maximum amount anyway so will not be constrained by the tighter standards. While the changes to lending standards have tended to reduce maximum loan sizes, this has primarily affected the riskiest borrowers who seek to borrow very close to the maximum loan size and this is a very small group. Most borrowers will still be able to take out the same sized loan. It has also been suggested that the expiry of interest-only loan terms will result in financial stress as households have to refinance into principal-and-interest loans that require higher repayments. Again, this is worth watching, but borrowers have been transitioning loans from interest-only to principaland-interest for the past couple of years without signs of widespread stress. Our data suggest that most borrowers will either be able to meet these higher repayments, refinance their loans with a new lender, or extend their interest-only terms for long enough to enable to them to resolve their situation. There appears to be only a relatively small share of borrowers that are finding it hard to service a principal-and-interest loan, which is to be expected given that over recent years, serviceability assessments for these loans have been based on the borrower's ability to make principal-and-interest repayments. So far, the evidence suggests that the transition of loans from interest-only to principal-and-interest repayments is not having a significant lasting effect on banks' housing loan arrears rates. https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-10.html 6/13 10/09/2018 The Evolution of Household Sector Risks | Speeches | RBA The distribution of household debt So far, I have focussed on data for the household sector as a whole. But an important aspect of considering the risks inherent in household debt is the distribution of that debt. If most of the debt is held by households with lower or less stable income for example, it will be more risky than if a substantial amount of the debt is held by households with higher or more stable income. In this respect, the data suggest that we can have some comfort. This graph shows the shares of household debt held by income quintiles – the bottom 20 per cent of incomes, the next 20 per cent and so on up to the top 20 per cent of incomes (Graph 5). And it shows how these shares have changed from the early 2000s until 2015, the latest period for which the data are available. Around 40 per cent of household debt is held by households that are in the top 20 per cent of the income distribution and this share has remained fairly steady for the past 20 years. Furthermore, households in the second highest quintile account for a further 25 per cent of the debt. So in total two-thirds of the debt is held by households in the top 40 per cent of the income distribution. Nevertheless, around 15 per cent of the debt is held by households in the lowest two income quintiles. Whether or not this presents risks is not clear. Retirees are typically captured in these lower income brackets and if this debt is connected with investment property from which they are earning income, it may not be particularly risky. Graph 5 https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-10.html 7/13 10/09/2018 The Evolution of Household Sector Risks | Speeches | RBA Another potential source of risk in the distribution of debt is the age of the head of the household. As noted, a regular, stable income is important for servicing debt so people in the middle stages of their careers typically have better capacity to take on and service debt. The next graph shows the shares of debt for various age groups for owner occupiers, and how they have moved over the past couple of decades (Graph 6). Graph 6 Households in which the head is between the ages of 35 and 54 account for around 60 per cent of the debt. But there does appear over time to be a tendency for a higher share of owner occupier debt to be held by older age groups. In part, the growing share reflects structural factors like lower interest rates. More importantly, it is not clear whether the higher share of debt increases the risk that these households will experience financial stress. On the one hand, it might indicate that in recent years, people have been unable to pay down their debt by the time they retire. If they continue to have large amounts of debt at the end of their working life, they might therefore be vulnerable. On the other hand, people are now remaining in the workforce for longer, possibly a response to better health and increasing life expectancies. They also hold more assets in superannuation and have more investment properties. This improves their ability to continue to service higher debt. And there is no particular indication that older people have higher debt-toincome or debt servicing ratios than younger workers. https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-10.html 8/13 10/09/2018 The Evolution of Household Sector Risks | Speeches | RBA So while the economy wide household debt-to-income ratio is high and rising, the distribution of that debt suggests that a large proportion of it is held by households that have the ability to service it. It nevertheless bears watching. Regional dimensions I thought I would finish off with some remarks about regional versus metropolitan differences. From a financial stability perspective, we are mainly focussed on the economy as a whole. But we still need to be alert to pockets of risk that have the potential to spill over more broadly. These risks may have important regional dimensions, particularly to the extent that individual regions have less diversified industrial structures and are thus more vulnerable to idiosyncratic shocks. One recent example has been the impact of the downturn in the mining sector on economic conditions in Western Australia, and the subsequent deterioration in the health of household balance sheets and banks' asset quality. The potential for the drought in eastern Australia to result in household financial stress is another. Data limitations make it difficult to drill down too far into particular regions. So I am going to focus here on a general distinction between metropolitan areas and the rest of Australia. As noted above, there tends to be a relationship between debt and housing prices. As housing prices rise, people need to borrow more to purchase a home and with more ability to borrow, people can bid up the prices of housing. So one place to look for a metro/regional distinction might be housing prices. While there is clearly a difference in the absolute level of housing prices in cities and regional areas, over the long sweep, movements in housing prices in the regions have pretty much kept up with those in capital cities (Graph 7). This graph shows an index of housing prices for each of the states broken down into capital city and rest of the state. While there are periods where growth in housing prices diverge, most obviously in NSW and Victoria in recent years, they follow a very similar pattern. This partly reflects the fact that some cities that are close to the capitals tend to experience similar movements in house prices as the capitals. https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-10.html 9/13 10/09/2018 The Evolution of Household Sector Risks | Speeches | RBA Graph 7 What about housing debt in regional areas? The data suggest that the incidence of household indebtedness is broadly similar in the capital cities and in the regions (Graph 8). In 2015, the latest year for which we have data, around 50 per cent of regional households were in debt compared with around 45 per cent of households in capital cities. But in previous years this was reversed. At a broad level, the proportion of households in debt seems fairly similar. https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-10.html 10/13 10/09/2018 The Evolution of Household Sector Risks | Speeches | RBA Graph 8 Incomes and housing prices tend to be lower on average in regional areas than cities so we might expect debt to also be lower. But how do debt-to-income ratios compare? This next graph shows debt-to-income ratios for cities and regional areas at various points over the past 15 years (Graph 9). In general, average debt-to-income ratios for indebted households in capital cities tend to be a bit higher than those for indebted households in regional Australia. But it is not a huge difference and it mostly reflects the fact that people with the highest incomes – and therefore, higher capacity to manage higher debt-to-income ratios – tend to be more concentrated in cities. In general, it seems that regional households' appetite for debt is very similar to that of their city counterparts. https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-10.html 11/13 10/09/2018 The Evolution of Household Sector Risks | Speeches | RBA Graph 9 Conclusion Household debt in Australia has risen substantially relative to income over the past few decades and is now at a high level relative to international peers. This raises potential vulnerabilities in both bank and household balance sheets. While the risks are high, there are a number of factors that suggest widespread financial stress among households is not imminent. It is nevertheless an area that we continue to monitor closely. Thank you again for the opportunity to talk to you today. I look forward to your questions. Endnotes [*] I would like to thank Michelle Wright, Alex Fritsche and Michael Pope for assistance in the preparation of this talk. © Reserve Bank of Australia, 2001–2018. All rights reserved. https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-10.html 12/13 10/09/2018 The Evolution of Household Sector Risks | Speeches | RBA https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-10.html 13/13 | reserve bank of australia | 2,018 | 9 |
Remarks by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Reserve Bank's Topical Talks Event for Educators, Sydney, 19 September 2018. | 20/09/2018 Money – Born of Credit? | Speeches | RBA Speech Money – Born of Credit? Christopher Kent [ * ] Assistant Governor (Financial Markets) Remarks at the Reserve Bank's Topical Talks Event for Educators Sydney – 19 September 2018 Most of us would put cold hard cash at the top of our list when we think of money. Others would include funds they have on deposit at a bank. Some might contemplate broader measures of their wealth. Historians would be tempted to tell us about the role of precious metals, coins, salt, shells and even rum when the topic of money is raised. When thinking about the role that money plays in an economy, economics teachers and academics might educate us about money multipliers, the velocity of money and money demand and supply functions. Keen students of episodes of high inflation would discuss Milton Friedman and the notion that inflation is ‘always and everywhere’ a monetary phenomenon. Given this, concerned citizens might be worried about what they see as the ability of private banks to create money via the extension of credit, seemingly at will. While there are many interesting aspects of money, today I want to focus on the questions of how money is created and how money relates to lending or credit. Along the way, I'll also review what's been happening to both money and credit in Australia over recent decades. The process of money creation is often subject to a degree of confusion, in part because the explanation draws upon a combination of disciplines – accounting, banking and economics. What Is Money? It is relatively standard practice to define money according to its ability to do each of the following three things: money can be used for transactions – it facilitates the exchange of goods, services or assets thereby avoiding the substantial costs associated with barter money is a store of value – it's worth does not fluctuate wildly, nor does it degrade rapidly over time, and https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-19.html 1/16 20/09/2018 Money – Born of Credit? | Speeches | RBA money acts as a commonly accepted unit of account – it provides a convenient means of comparing the value of a range of different goods, services or assets. Banknotes and coins – otherwise known as currency – satisfy each of these functions. Currency long ago pushed aside other physical forms of money. Currently, there is around $75 billion of currency in circulation in Australia (outside of the banking system). However, despite its usefulness, currency represents only a small share of money in modern economies. Most money consists of deposits in banks, building societies and credit unions (simply referred to here as banks). Just as I can pay for my morning coffee using currency, I can also transfer funds in my bank deposit to the café's account. In either case, the café owner receives a liquid store of value which they are confident will be accepted by others. Not all bank deposits are equally liquid – for instance, it can take some time to gain access to funds in a term deposit. For this reason, it is common to construct a range of different ‘monetary aggregates’, from the more liquid narrower forms of money – such as M1, which includes currency and current deposits at banks – to ‘broad money’, which also captures less liquid deposits and other financial products that share the characteristics of money discussed earlier (Table 1; Graph 1); for example, broad money includes certificates of deposit or short-term debt securities. For convenience, in what follows I'm going to focus on broad money. Table 1: Monetary Aggregates Measure Description(a) Currency Notes and coins held by the private non-bank sector Money base Currency + banks' holdings of notes and coins + deposits of banks with the Reserve Bank + other Reserve Bank liabilities to the private non-bank sector M1 Currency + current (cheque) deposits of the private non-bank sector at banks M3 M1 + all other deposits of the private sector at banks (including certificates of deposit) except deposits of authorised deposit-taking institutions (ADIs) + all deposits of the private non-ADI sector at credit unions and building societies (CUBS) Broad money M3 + other deposit-like borrowings of all financial intermediaries (AFIs) from the non-AFI private sector (such as short-term debt securities) (a) These descriptions abstract from some detail. See the Financial Aggregates release for more information. https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-19.html 2/16 20/09/2018 Money – Born of Credit? | Speeches | RBA Graph 1 Broad money represents a relatively liquid form of wealth held by Australian households and businesses. It includes currency, deposits and deposit-like products. [1] Unlike ancient forms of physical money – think shells or gold found in the natural environment – these are liabilities issued by authorised deposit-taking institutions (ADIs) and other financial intermediaries. [2] Broad money in Australia is currently around $2 trillion or 115 per cent of the value of annual economic output as measured by nominal GDP; most of that is in the form of banking deposits. Over the past decade, the share of broad money represented by term and other bank deposits has increased in importance at the expense of holdings of current deposits and other borrowings from the private sector. How Is Money ‘Created’? Australia's banknotes are produced by the Reserve Bank of Australia and account for most (about 95 per cent) of the value of Australian currency. The rest is accounted for by coins produced by the Royal Australian Mint. Banks purchase banknotes from the Reserve Bank as required to meet demand from their customers and, in turn, the Reserve Bank ensures that it has sufficient banknotes on hand to meet that demand. Previous research by the Reserve Bank points to a number of drivers of demand for banknotes. The most important is the size of the economy. [3] This is consistent with people holding some fraction of their income in this most liquid form of money in order to undertake transactions. [4] Some share of demand is also accounted for by the desire for a liquid store of wealth. The value of banknotes in circulation as a share of nominal GDP has actually increased over recent years (to around 4 per cent), which suggests that this source of demand has grown strongly. https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-19.html 3/16 20/09/2018 Money – Born of Credit? | Speeches | RBA This increase has been observed in a range of countries and is consistent with the low level of interest rates, which has reduced the opportunity cost of holding money (compared with holding interest-bearing deposits). When customers withdraw currency from an ATM or a bank branch, the value of their deposit holdings declines and the value of their currency holdings increases. The stock of broad money, however, is unchanged. As I mentioned earlier, the vast bulk of broad money consists of bank deposits. These banking liabilities are created when an Australian household or business has funds credited to their deposit account at an Australian bank. One way this can occur, for example, is when a business deposits currency it has earned with its bank. Again, such transactions add to deposits but do not create money because the bank customer is simply exchanging one type of money (currency) for another (a deposit). Money can be created, however, when financial intermediaries make loans. Accordingly, the concepts of money and credit are closely linked in a modern economy, albeit not one for one. When a bank extends a loan, it makes money available to the borrower, for example, to buy a car, a house or equipment for a business. The bank may credit the deposit account of the borrower, who withdraws the funds to make their purchase. Alternatively, the bank may directly credit the deposit account of the seller on behalf of the borrower. In either case, the loaned funds will tend to find their way into a deposit somewhere in the banking system. This process adds to the supply of money. If I stopped here, you might be left with the impression that the process of lending allows the banking system to create endless quantities of money at no cost. However, the process of money creation is constrained in numerous ways and depends on the behaviour of borrowers, banks and regulators, as well as the stance of monetary policy. In the first instance, the process of money creation requires a willing borrower. That demand will depend, among other things, on prevailing interest rates as well as broader economic conditions. Other things equal, lower interest rates or stronger overall economic conditions will tend to support the demand for credit, and . vice versa The bank then has to be willing and able to issue the loan: It has to satisfy itself that the borrower can service the loan. The bank must maintain a sufficient share of its assets in liquid form to meet any drawdowns relating to the new loan, as well as meeting any withdrawals from existing depositors. Otherwise, the bank runs the risk of failing to meet its obligations when they fall due. The bank's loans and other assets need to be backed by adequate capital. Capital is needed to absorb unexpected losses arising from defaults or other sources of variation in the value of assets. The interest rates charged on loans must cover expected losses on the loan portfolio, as well as the costs of deposits and other sources of funding. Revenues from loans and other assets will also https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-19.html 4/16 20/09/2018 Money – Born of Credit? | Speeches | RBA have to cover the operating costs of the bank, while allowing it to earn a profit so that shareholders can earn a reasonable return on the bank's capital. All of these considerations imply that money creation occurs at some cost, which serves to constrain the extent of lending. These constraints are reinforced by regulatory requirements for liquidity, capital adequacy and lending standards set by the Australian Prudential Regulation Authority. Other things equal, anything that reduces the willingness or ability of banks to make loans can be expected to result in lower growth of (system-wide) money. It's also worth emphasising that the process of money creation is not the result of the actions of any single bank – rather, the banking system as a whole acts to create money. A single bank may make loans by drawing on its liquid assets, yet not receive the corresponding deposits created in return. Before extending further loans, that bank would need to raise funds in other ways – for example, by issuing debt or equity securities or by waiting for its deposits and liquid assets to rise via other means. Graph 2 illustrates how the process of money creation can work. It shows an example of an increase in loans of $100 billion. However, the increase in loans in this case leads to an increase in deposits of $60 billion; in other words, the changes are not one for one. This is because there are other sources of funding besides deposits – and indeed, loans are not the only assets held by banks. In the example shown, other funding comes from issuance of debt and equity. The shares from different sources are in line with the actual funding behaviour of the banking system over recent years (Graph 3). https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-19.html 5/16 20/09/2018 Money – Born of Credit? | Speeches | RBA Graph 2 https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-19.html 6/16 20/09/2018 Money – Born of Credit? | Speeches | RBA Graph 3 In summary, changes in the stock of broad money are the result of a myriad of decisions, including those of banks, their borrowers, creditors and shareholders. And these decisions take place within the framework of a range of regulatory and institutional arrangements. It is worth noting that the Reserve Bank does not target a particular level or growth rate of money (although it has done so under a previous monetary policy regime). [7] Instead, the Reserve Bank has some influence on the money stock via the effect of its interest rate target for the overnight cash rate on other interest rates in the economy. These in turn affect the cost of borrowing and economic conditions more generally. Ultimately, borrowing and lending decisions – and thus the creation of money – are constrained by the need for prudent banking behaviour, the budget constraints of borrowers and the profitability of lenders. One final word on the creation of money is that as fun as it is to teach students about traditional money multipliers, I don't find them to be a very helpful way of thinking about the process. In Australia, simple regulatory regimes – which had earlier required banks to hold a minimum share of their deposits as reserves with the Reserve Bank – have been replaced with modern prudential regulation and market discipline. Again, the demand for and supply of credit is the real driver of money. That point can be reinforced by examining the behaviour of credit and money over time. What Has Money Been Doing and Why? https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-19.html 7/16 20/09/2018 Money – Born of Credit? | Speeches | RBA Given that money is used for transactional purposes and as a store of value, it makes sense that most of the time it would at least keep pace with growth in the value of nominal spending. Indeed, in Australia it has grown faster than that over the past 40 years, roughly doubling as a share of nominal GDP (Graph 4). Growth of credit has been stronger still, roughly tripling as a share of nominal GDP, from under 50 per cent in the early 1980s to over 150 per cent currently. A closer look at the banks' balance sheets shows how these changes have occurred. Graph 4 In 1980, Australian banks held more than 80 per cent of their liabilities as deposits (worth around $47 billion at the time) (Graph 5). This deposit base was more than sufficient to fund loans of about 60 per cent of assets (worth $34 billion). The majority of the remaining assets were held in the form of securities (mostly government bonds). https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-19.html 8/16 20/09/2018 Money – Born of Credit? | Speeches | RBA Graph 5 As banks grew through the next four decades or so, there was a marked change in the composition of their balance sheets. These changes reflected choices by both banks and the private sector and were strongly influenced by the deregulation of the financial system. In particular, constraints on banks' business activities were progressively removed in the 1970s and early 1980s (for example, the interest rates they could charge and pay, their product offerings, lending volumes and their asset holdings). This was associated with significant changes in banks' abilities to attract and use different funding sources to support balance sheet growth. [9] By the early 1990s, Australians' demand for credit from banks became larger than the sum of all of their deposits. Following a period of slower growth around the early 1990s recession, credit growth picked up again and continued to grow much more quickly than money. To enable this, a greater proportion of bank funding during this period was drawn from sources other than deposits. Much of it owed to an increase in the issuance of debt securities, which was supported, in part, by a strong appetite from non-residents for Australian bank debt. These trends continued until the global financial crisis. Following the crisis, credit growth fell for a while (reflecting a decline in both the supply of and demand for credit). At the same time, the stock of (broad) money increased noticeably, rising by around $1.1 trillion dollars, from around 80 per cent of GDP in 2007 to around 115 per cent in 2018. This strong growth reflected a sharp increase in the share of funding sourced from deposits at the expense of short-term debt securities, consistent with https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-19.html 9/16 20/09/2018 Money – Born of Credit? | Speeches | RBA banks seeking more stable funding. Meanwhile, households and businesses increased the share of their assets held in the form of deposits. While loans have grown dramatically in nominal terms, to around $2.6 trillion today, the share of loans on banks' balance sheets is the same as it was in 1980 (Graph 6). [10] In contrast, and notwithstanding the increase in deposits since the global financial crisis, the share of deposits has declined over the past 40 years from above 80 per cent to around 50 per cent of banks' balance sheets. [11] Currently, a sizeable share of banks' liabilities is in the form of bonds on issue – a source of funding that was less important in 1980. [12] Banks also have a much larger share of ‘other liabilities’ (such as those to non-residents and related parties, which are not included in domestic monetary aggregates). Graph 6 Looking back, it is clear that there have been many instances of sustained gaps between the growth of deposits – and broad money more generally – and the growth of credit (Graph 7). While broad money growth outpaced credit growth for most of the period since the financial crisis, this was not the experience of the two decades or more prior to the crisis, when credit typically outpaced broad money. https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-19.html 10/16 20/09/2018 Money – Born of Credit? | Speeches | RBA Graph 7 This long history suggests that we should not be concerned about a so called deposit ‘funding gap’. Some commentators have suggested that the recent decline in the growth rate of money has left banks with insufficient deposit funding to support credit growth. According to this hypothesis, banks have been forced to seek other forms of funding, including from short-term money markets, which, so the argument goes, can help to explain the notable rise in rates in those markets in recent months. What are we to make of this hypothesis? First, such a gap between the growth of deposits and credit has been commonplace over recent decades – and conditions in short-term money markets were benign through much of those earlier episodes. Second, loans are not the only assets on banks' balance sheets; indeed, in recent quarters, growth in these other assets has been particularly slow – slower than both credit and deposits (Graph 8). So deposit growth has more than matched the growth in total assets. https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-19.html 11/16 20/09/2018 Money – Born of Credit? | Speeches | RBA Graph 8 Third, if some banks really did have insufficient deposit funding, we would expect to see them competing more vigorously for deposits by raising interest rates on those products. But retail deposit rates have been flat to down over the past year (Graph 9). https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-19.html 12/16 20/09/2018 Money – Born of Credit? | Speeches | RBA Graph 9 In short, there is little evidence that there is any relationship between the slowing of deposit growth and recent funding pressures in short-term money markets. More generally, given my earlier discussion about the extension of credit leading to the creation of banking system deposits, worrying about slower deposit growth impinging on the banking system's ability to generate credit is putting the cart before the horse. What Can Money or Credit Tell Us about Broader Economic Developments? Given this discussion, it is worth asking whether the behaviour of money can tell us anything useful about broader economic developments and, if so, is it more or less useful than the behaviour of credit? I'm going to address these questions in a very narrow way by examining whether the growth of broad money or credit provides any useful statistical information about the growth of nominal GDP. Because data for money and credit are available about five weeks ahead of the quarterly GDP release, we can examine whether growth in the current quarter of these series provides any additional information about the likely outcome for nominal GDP this quarter. This exercise is intended to merely determine whether money or credit are useful indicators of GDP. It is not https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-19.html 13/16 20/09/2018 Money – Born of Credit? | Speeches | RBA intended to demonstrate whether a causal link exists between money or credit and GDP. (Indeed it is possible that the direction of causation runs in either or both, directions.) I start with a simple model of quarterly nominal GDP growth as a function of recent lags of nominal GDP growth (Model 1 in Table 2). The model is estimated over the inflation-targeting period. This simple model is not particularly useful; lags of nominal GDP growth explain only about 8 per cent of the variation in the current growth of nominal GDP. But it gives us a useful baseline for comparison. Table 2: Simple Models of Nominal GDP Growth(a) March quarter 1993 – June quarter 2018 Constant GDP growth(b) Model 1 Model 2 Model 3 Model 4 1.14** 0.85** 0.88** 0.70** 0.21 0.04 −0.06 −0.08 Broad money growth(c) 0.26* Credit growth(c) R-squared Adjusted R-squared 0.08 0.04 0.15 0.07 0.16 0.31** 0.25** 0.17 0.09 0.22 0.10 (a) Quarterly data; ** indicates statistical significance at the 5 per cent level; * indicates statistical significance at the 10 per cent level (b) Coefficient presented is the sum of the coefficients on the past four lags of quarterly nominal GDP growth; statistical significance is based on a joint significance test for these coefficients (c) Coefficients presented are the sum of the coefficients on the current and past four lags of quarterly broad money or credit growth; statistical significance is based on joint significance tests for these coefficients Sources: ABS, RBA Adding current and past lags of money growth to the baseline model doesn't improve its performance much; the sum of the coefficients on the money terms are statistically significant, but only at a 10 per cent level (Model 2). Similarly, adding current and past lags of credit growth improves the model's explanatory power only slightly; however, the sum of coefficients on the credit terms are statistically significant at the 5 per cent level (Model 3). Interestingly, if both money and credit terms are included at the same time, only credit growth is statistically significant (Model 4). This suggests that credit growth is a marginally more useful statistical indicator of the growth of economic activity than money growth; again, I should stress that the contribution of the credit variable to the model in terms of its additional explanatory power is very modest. Conclusion Currency in circulation has increased as a share of nominal GDP – indeed it's as high as it's been in many decades. But the increase in money, which includes bank deposits, has been even greater over the same period. That increase has been driven by the extension of credit, which depends on the decisions of borrowers and lenders. Banks have been able to fund that additional credit via growth in other sources of funding, including debt securities and equity. The recognition that deposits are created by the banking system via the extension of credit suggests that we should not be concerned about the banking system facing a deposit funding gap. Moreover, it is consistent with simple https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-19.html 14/16 20/09/2018 Money – Born of Credit? | Speeches | RBA empirical analysis that suggests that credit is a marginally more useful indicator of the near-term growth in the value of economic activity than money. References Battellino R (2007), ‘Australia’s Experience with Financial Deregulation', Address to China Australia Governance Program, Melbourne, 16 July. Battellino R and N McMillan (1989), ‘Changes in the Behaviour of Banks and Their Implications for Financial Aggregates’, RBA Research Discussion Paper No 8904. Black S, J Kirkwood, A Rai and T Williams (2012), ‘A History of Australian Corporate Bonds’, RBA Research Discussion Paper No 2012-09. Bullock M (2018), ‘The Evolution of Household Sector Risks’, Remarks to Ai Group, Albury, 10 September. Doherty E, B Jackman and E Perry (forthcoming), ‘Money in the Australian Economy’, RBA Bulletin, September. Flannigan G and A Staib (2017), ‘The Growing Demand for Cash’, RBA 63–74. Bulletin, September, pp Flannigan G and S Parsons (2018), ‘High-denomination Banknotes in Circulation: A Crosscountry Analysis’, RBA , March. Bulletin The Grenville S (1991), ‘The Evolution of Financial Deregulation’, in I Macfarlane (ed), , Proceedings of a Conference, Reserve Bank of Australia, Deregulation of Financial Intermediaries Sydney, pp 3–35. Macfarlane I (1998), ‘Australian Monetary Policy in the Last Quarter of the Twentieth Century’, Shann Memorial Lecture, University of Western Australia, Perth, 15 September. Endnotes [*] I would like to thank Emma Doherty, Ben Jackman and Emily Perry for their excellent assistance in helping to prepare these remarks. Indeed, I draw heavily on their work: Doherty, Jackman & Perry (forthcoming). Holdings of these forms of money by the government, residents of other countries and financial intermediaries that issue deposits or similar products are generally excluded from broad money. Considerations such as data availability mean that there are some exceptions to this general rule. ‘Other financial intermediaries’ includes registered financial corporations (RFCs) and cash management trusts. Growth in nominal GDP will reflect growth in real per capita income, population growth and inflation. Other determinants include interest rates and access to the payment system. See Flannigan and Staib (2017) for more details. https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-19.html 15/16 20/09/2018 Money – Born of Credit? | Speeches | RBA Survey data indicate that the share of payments made with cash continues to fall. See Flannigan and Staib for a discussion of the different types of demand for currency. Also, Flannigan and Parsons (2018) provide a crosscountry perspective on the increase in the number of high-denomination banknotes in circulation. Doherty (forthcoming) contains a highly stylised example that demonstrates how liquidity and capital considerations can affect the decision to extend a loan. In the same way that extending loans can create deposits, repayment of loans can extinguish deposits. For example, if the funds credited to the seller's bank account above are used to repay an existing loan, the (systemwide) deposit base will remain as it was prior to this series of transactions. Other transactions of financial intermediaries can also create or extinguish deposits and therefore money. For example, when a bank issues a bond or equity, it receives payment, which is typically from the buyer's deposit account, thereby decreasing the stock of money. The reverse occurs when the principal of the bond is repaid, or in the case of the bank buying back its equity. Macfarlane (1998) provides a summary of the evolution of the RBA's approach to monetary policy in the last quarter of the twentieth century. Banking regulation from this period required banks to maintain sizeable holdings of certain types of assets. For more information see Battellino and McMillan (1989). See Grenville (1991), Battellino & McMillan (1989) and Battellino (2007) for further details. Note that ‘loans’ on bank balance sheets here is distinct from ‘credit’ in the financial aggregates, which is a slightly broader measure. Graph 3 shows that banks' deposits are around 60 per cent of liabilities, which are a subset of total liabilities on banks' balance sheets – excluding those not used for funding. There are also some conceptual differences in the definition of deposits used. See Black, Kirkwood, Rai and Williams (2012). See RBA (2018), ‘Domestic Financial Conditions’, , August, pp 39–50 for a summary of recent conditions in short-term money markets and a discussion of factors contributing to elevated short-term money market rates. Two caveats regarding the interpretation of these simple modelling results are in order. First, it is possible that the statistical relationship between credit and GDP growth reflects the effect of some omitted factor — perhaps an indicator of overall financial conditions, such as interest rates for example. Second, this exercise is not intended to capture a potential role for credit in determining the longer-term economic outlook. For instance, the Council of Financial Regulators has identified growing economic risks relating to the high level of indebtedness among Australian households. For a recent discussion of these risks, see Bullock (2018). Taking account of such relationships is beyond the scope of my simple exercise. et al funding Statement on Monetary Policy © Reserve Bank of Australia, 2001–2018. All rights reserved. https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-19.html 16/16 | reserve bank of australia | 2,018 | 9 |
Plenary session address by Ms Luci Ellis, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Melbourne Institute Outlook Conference, Melbourne, 11 October 2018. | 10/11/2018 Supporting Growth in the Short Run and the Long Run | Speeches | RBA Speech Supporting Growth in the Short Run and the Long Run Luci Ellis [ * ] Assistant Governor (Economic) Plenary Session Address to the Melbourne Institute Outlook Conference Melbourne – 11 October 2018 I'd like to thank the organisers of this conference for inviting me to participate in this session. It is truly an honour to be included in this roster of speakers. The topic for this session is a broad one: how do we support growth? As the extended form of the topic indicates, there are many considerations that need to be taken into account. In the time available I can only do justice to a few of those considerations. In these opening remarks, I'd like to focus on the issue of the time horizon. The question of how public policy can support growth depends in part on whether we are talking about the short run or the long run. In the Short Run In the short run, supporting growth implies a role for macroeconomic policy, both fiscal and monetary. Australia has achieved its record of economic expansion in part because macroeconomic policy has, by design, supported growth when needed. This has helped us avoid the serious downturns that can do so much damage, even long after they have ended. In Australia, the role played by macro policy is informed by longstanding frameworks that govern its conduct. In the case of monetary policy, that framework is the medium-term inflation target that was adopted a quarter-century ago. This framework inherently points policy in the direction of supporting growth when that is needed, because demand would otherwise be insufficient. Of course, there are other considerations, including debt and asset prices as highlighted in the session title. But the Bank's will be released tomorrow, and it will cover those issues in far more detail than is possible the time available today. The basic message for policy is still to support demand when it would otherwise be insufficient to absorb spare capacity. Financial Stability Review https://www.rba.gov.au/speeches/2018/sp-ag-2018-10-11.html 1/6 10/11/2018 Supporting Growth in the Short Run and the Long Run | Speeches | RBA Spare capacity in the economy, as there has been in recent years, tends to put downward pressure on inflation. To avoid inflation getting too low, monetary policy therefore needs to be set at an expansionary level, supporting growth so that inflation either does not depart too far from target, or returns to target in cases where it has already moved. That is how an inflation target works, and it would do so even if the Reserve Bank's legislated mandate was expressed solely in terms of price stability. But the mandate in our Act also encompasses full employment and the welfare of the Australian people. These things are not in conflict with an inflation target. Rather, they inform how that inflation-targeting regime operates day-to-day. They are relevant to the choices made about how quickly to return to target. The role of an inflation-targeting regime for monetary policy in supporting growth can be well illustrated by events in the Australian economy over the past decade or so. During the build phase of the mining investment boom, there was a great call on Australia's production capacity to get all the new mines built. This meant that, unlike many other countries, Australia reached a point of having little spare capacity quite soon after the Global Financial Crisis peaked. So there was a period where it was appropriate to set the cash rate a bit higher than the levels reached in the immediate aftermath of the crisis. Since the peak of the mining boom, though, it has been appropriate to cushion the drag on growth as the terms of trade and mining investment declined. That is one of the reasons why monetary policy has been set to support growth in recent years. We expect mining investment to bottom out in coming quarters, as the last of the large LNG expansion projects completes. After that, it will probably increase a little, as resource firms invest to maintain their production capacity at current levels. The scale of that ‘sustaining investment’ is nothing like that of the boom of the past decade or so. But the important point is that mining investment will no longer be dragging on growth. While there is spare capacity remaining, it is important for policy to support above-trend growth and work that spare capacity down. This raises the question of what trend might be and how we would know. Just waiting until you see wages growth or inflation pick up would leave policymakers in the dark about how quickly they are moving towards their goals, or even if they are doing so at all. Instead people use a range of different rules of thumb to assess how growth is tracking relative to trend, or ‘potential growth’. Some of these are trickier to use in practice than others. For example, some estimates hinge on an estimate of feasible productivity growth. But these will be subject to the risks that historical relationships no longer apply, or that productivity (which is not directly observable) is just plain mismeasured for a period. A measure of trend constructed in this way is okay to use as cross-check, but I wouldn't want to rely on that as my only guide. The labour market is, by contrast, a source of pragmatic and accessible signals of where growth is relative to trend. If employment is growing faster than the working-age population, and the unemployment rate is coming down, those are pretty good signs that the economy is running faster than ‘trend’. It can take a while for spare capacity to be absorbed. Therefore policy settings might need to be expansionary for a number of years. So it is natural to want to ask whether extended periods of expansionary monetary policy might lead to unintended consequences. The consequences for asset https://www.rba.gov.au/speeches/2018/sp-ag-2018-10-11.html 2/6 10/11/2018 Supporting Growth in the Short Run and the Long Run | Speeches | RBA prices and financial stability have been dealt with at length elsewhere, including in the Stability Review as I have already mentioned. Financial Another aspect of expansionary policy that has raised concerns in some quarters is the distributional effect. Other central banks have looked into this (for example see, Ampudia et al (2018), Bunn, Pugh and Yeates (2018) and Colciago, Samarina and de Haan (2018)). That is understandable, because they had set interest rates at much lower levels than seen in Australia, and in some cases also expanded their balance sheets with asset purchases. The findings of that research is that the first-order effect of expansionary monetary policy is to put more people in jobs who wouldn't have had one otherwise. This tends to benefit households at the lower end of the income distribution more than those whose incomes are already high. For wealth, there are a number of effects that offset one another, so the net effect on summary measures of the wealth distribution tend to be small. While lower interest rates and asset purchases do tend to support asset prices, and higher equity prices tend to benefit higher-wealth households, higher housing prices tend to have the largest effect on households in the middle of the wealth distribution. The effect of asset price increases are also greatest for people with a bit of leverage against their asset holdings; they tend not to be those with the highest wealth. In the Long Run In the short run, then, the answer is clear. It is the job of macro policy to support growth by encouraging sufficient demand to employ our nation's productive resources. But this leaves open the bigger question of how we ensure our living standards continue to increase in the longer run. That is not so much an issue of helping the economy grow faster than trend when there is spare capacity. Rather it is a separate question of how fast trend can be. Having low and stable inflation is helpful because it can create a more predictable investment climate. But beyond that effect, monetary policy doesn't have much effect on the feasible trend rate of growth. There are many drivers of long-run productivity growth, but monetary policy would be way down that long list. Its role is more in the short run than the long run. Of course, there could also be synergies and linkages between the short run and the long run if there is path dependence. If short-run prosperity helps create the conditions for even more long-run prosperity, that is even more reason to ensure that policy supports growth. We are seeing an example of this in Japan at the moment. There, unemployment is so low and the labour market is so tight, that firms are investing rapidly in labour-saving technology. That will boost productivity in the longer run. Contrast that with the productivity malaise that can set in following a period of contraction or stagnation. People's skills atrophy – or are assumed to – through lack of use. Firms don't invest to expand production when sales aren't growing. And a kind of ‘scarcity mentality’ can take hold, where risks are not taken and opportunities are missed. Scarcity mentality is all about hunkering down and defending what you have. So it's easy to see how that could get in the way of the processes needed to support growth in the long run. Firms might https://www.rba.gov.au/speeches/2018/sp-ag-2018-10-11.html 3/6 10/11/2018 Supporting Growth in the Short Run and the Long Run | Speeches | RBA become less willing to innovate and invest, in case the new venture doesn't pan out. People might become less willing to switch jobs, in case the new role isn't really better than the old one. If living standards are to rise, it needs to be possible to produce more with the same resources. The good news is that this means better jobs at better firms. But getting there requires making changes and taking risks. It also requires firms to become better, more productive firms, so they can offer those better, higher-paying jobs. And it requires workers to have the confidence to take those jobs, rather than always stick with what they have. For this reason, it is significant that job turnover is not particularly high in Australia at present, and that average tenure in a job has been rising. It's worth considering what a productive firm looks like, because not all firms are the same. Some of the latest research on growth highlights the role of differences between firms in creating prosperity (Andrews, Criscuolo and Gal 2015). The evidence both in Australia and abroad is that productivity varies widely across firms, even within the same narrowly-defined industry. Firms that are highly productive – so-called ‘superstar firms’ – tend to grow faster, grow employment faster, and pay better than firms that are a long way from the frontier of productivity (Autor do show that better firms do offer better jobs. et al 2017). So the data But there is a concern here. Because these ‘superstar’ firms are more productive than average, they gain market share at the expense of less-productive competitors. The leading firms could start moving further and further ahead of the pack. The firms that lag behind would then find it harder and harder to catch up. The result could be that markets become more concentrated. The market leader begins to reap monopoly profits, which isn't good for consumers and might not be good for long-run innovation and welfare. Must laggard firms always lag? Could they instead catch up to today's superstars? It depends what determines which firms are leaders and which firms lag. Perhaps this dispersion has something to do with the distribution of management ability. If so, it's not set in concrete, either at the firm level or more generally. (That said, raising the bar on management skills in an organisation can be difficult and isn't always successful.) Another reason for the dispersion in productivity between firms might be that the lagging firms are not adopting latest technologies in the way that the ‘superstars’ are. Whether this is a universal pattern, or something specific to current conditions is not yet known. It is also not yet settled whether this pattern applies in Australia; the existing research focused on other countries. But if this ‘superstar’ pattern has instead only arisen recently, it could be something to do with the nature of current technological developments and their ease of adoption. While some observers have dubbed the current technological wave a ‘fourth industrial revolution’, innovations like machine learning and artificial intelligence seem to have a very different character to previous general-purpose technologies. Prior waves of innovation in general-purpose technologies, such as the Industrial Revolution, electricity and the previous computing revolution, all had a ‘democratising’ character, in the sense that the new technology could be operated by less-skilled workers than the technology it replaced. https://www.rba.gov.au/speeches/2018/sp-ag-2018-10-11.html 4/6 10/11/2018 Supporting Growth in the Short Run and the Long Run | Speeches | RBA This wasn't always benign, as the child factory workers who replaced artisan weavers during the Industrial Revolution could attest. But it did set these technologies up for widespread adoption. The most recent technological wave seems to have a different character, so it might not be so pervasive in the end. Using machine learning and other emerging techniques to automate routine business processes seems to involve specialist skills and, often, PhD-level training in statistics or computer science. These skills are much rarer and take longer to develop than those required for the jobs that are thereby replaced. That doesn't mean it's impossible, but it could take a long time. If leading-edge technologies are currently unusually costly or difficult to adopt, they become a kind of barrier to entry protecting the firms that are already using those technologies. In that sense, they are a particular case of the more general barriers to entry, that advantage incumbent firms and industries over challengers. [2] That is a concern, because contestability of markets is another essential element for long-run growth and prosperity. Laggard firms will never catch up, and will never become those better firms offering better jobs, if they have no chance of contesting the market or fully competing within it. And if incumbents never face rivals, they are more likely to become complacent. Innovation could slow down, and growth in living standards with it. All of this comes back to the question of where growth comes from, and the answer is it comes from all of us. Growth is not something that is bestowed upon a nation by external forces. And though domestic institutions matter, neither is growth in the long run something that governments can bestow upon society. Instead it's about the myriad of individual decisions within firms and other organisations to find better ways of doing things. An important question is how we as a society support and enable those decisions. But more important is whether we actually make them. Thank you for your time. Bibliography Ampudia M, D Georgarakos, J Slacalek, O Tristani, P Vermeulen and G Violante (2018), ‘Monetary Policy and Household Inequality’, European Central Bank Working Paper Series No 2170. Andrews D, C Criscuolo and PN Gal (2015), ‘Frontier Firms, technology diffusion and public policy: Micro evidence from OECD economies’, OECD: The Future of Productivity: Main Background Papers. Autor D, D Dorn, LF Katz, C Patterson and J Van Reenan (2017), ‘The Fall of the Labor Share and the Rise of Superstar Firms’, NBER Working Paper 23396. Bunn P, A Pugh and C Yeates (2018), ‘The distributional impact of monetary policy easing in the UK between 2008 and 2014’, Bank of England Staff Working Paper No 720. Colciago A, A Samarina and J de Haan (2018), ‘Central bank policies and income and wealth inequality: A survey’, DNB Working Paper No 594. Endnotes [*] My thanks to Iris Day for her assistance in preparing this talk. https://www.rba.gov.au/speeches/2018/sp-ag-2018-10-11.html 5/6 10/11/2018 Supporting Growth in the Short Run and the Long Run | Speeches | RBA A better analogy for the current technological wave, in the sense that it emphasised higher-skilled roles, might be containerisation in the transport industry. This raised productivity by replacing raw physical labour and drawing on machine operation and load optimisation skills, but was not the kind of general-purpose technology represented by steam power, electricity or general computation. My thanks to Merylin Coombs for pointing out this similarity. This type of barrier to entry is also separate from the network externalities that can be important in technology industries. © Reserve Bank of Australia, 2001–2018. All rights reserved. https://www.rba.gov.au/speeches/2018/sp-ag-2018-10-11.html 6/6 | reserve bank of australia | 2,018 | 10 |
Address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the Citi 10th Annual Australia and New Zealand Investment Conference, Sydney, 17 October 2018. | 10/17/2018 The State of the Labour Market | Speeches | RBA Speech The State of the Labour Market Guy Debelle [ * ] Deputy Governor Citi 10th Annual Australia and New Zealand Investment Conference Sydney – 17 October 2018 Over the past year, there have been welcome developments in the Australian labour market. Employment has grown strongly, the participation rate is close to its highest level on record and the unemployment rate has declined to be at a six-year low. This is consistent with the above-trend GDP growth in the economy. Despite these improvements, there is still spare capacity in the labour market. Unemployment is higher than is desirable and a number of workers would like to work more hours than are currently on offer. This is a large part of the explanation for the low wages growth in Statement on Monetary Policy recent years. As detailed in our most recent , we anticipate that GDP will continue to grow above trend over the next few years, which will see the unemployment rate decline further. This in turn should see wages growth pick up, providing a welcome boost to household incomes. The dynamics at play in the labour market are important considerations for monetary policy. Full employment is an objective for the RBA in and of itself, and the state of the labour market has a significant influence on the achievement of the RBA's inflation target. Today, I will look at the labour market from a number of different angles. I will begin with the recent employment data, then discuss unemployment and wages before turning to the outlook for the labour market. In analysing the labour market it is important to not get hung up on one month's data. The standard error on the change in employment each month is around ±30,000. [1] Rather, it is more useful to look at the trends in the various labour market data, check that these are consistent and identify, and hopefully resolve, any anomalies. Employment Employment has grown by 2½ per cent over the past year (Graph 1). This is at the high end of historical outcomes and above the growth in the working-age population (around 1½ per cent https://www.rba.gov.au/speeches/2018/sp-dg-2018-10-17.html 1/13 10/17/2018 The State of the Labour Market | Speeches | RBA currently). Over two-thirds of the increase in employment over the past two years has been in fulltime work. Despite this, part-time employment as a share of total employment remains close to historical highs at around one-third of employment. Quite a lot is often made of the full- versus part-time distinction, often with the unstated presumption that full-time jobs are better than part-time jobs. But of the one-third of the workforce which works part-time, three-quarters of them do so because that's what they want. Some of them do want to work more hours, but generally more hours in a part-time job. They don't want a fulltime job. The important issue is whether there are enough jobs generating enough hours that people want to work. Graph 1 At the same time as there has been above-average employment growth, the participation rate has increased and is now close to its record high. Movements in the participation rate have been highly correlated with employment growth for some time (though this doesn't have to be the case). I will invoke Chris Caton in noting that you should always avoid statements like: if the participation rate hadn't increased, the unemployment rate would have been lower. Both the rise in the participation rate and the lower unemployment rate increase labour utilisation and reduce the amount of spare capacity in the labour market. The rise in the participation rate has both structural and cyclical elements. Some part of the rise is occurring because each generation of women is participating more in the labour force than previous https://www.rba.gov.au/speeches/2018/sp-dg-2018-10-17.html 2/13 10/17/2018 The State of the Labour Market | Speeches | RBA cohorts did at the same age. Some of it is because more people have joined (or deferred leaving) the labour force over recent years as employment opportunities have improved. [2] In particular, the participation rates of older workers and females have increased notably in recent years. Where Has the Jobs Growth Been? Employment growth has been strong over the past year. What sectors of the economy have underpinned this strong growth? There are two ways of looking at this. First, there is the Labour Force Survey, which asks households which industry they work in. Second, there are the labour account data, which incorporate employment information from businesses. It is similar to the payrolls data in the US. According to the Labour Force Survey, the industries that have contributed the most to employment growth over the past two years are health care & social assistance, construction and (perhaps more surprisingly) manufacturing (Graph 2): The increase in health-related jobs reflects both longer-term trends, such as the ageing of the population, as well as the rollout of the National Disability Insurance scheme over the past couple of years. Construction employment is close to 10 per cent of total employment, and this is around its highest share of employment since the 1920s. Construction employment has been supported by the large amount of activity in residential and infrastructure construction, particularly in the eastern states. More recently, there has been a noteworthy increase in manufacturing employment. This is a result of export demand for high-quality food and beverage products, demand for manufactured goods from mining-related activity as well as the high levels of residential and infrastructure construction. This more recent pick-up in manufacturing employment takes it back to its level around 2011. Professional, scientific and technical (PST) services employment has also grown strongly over the past year, driven by computer system design and management consulting. https://www.rba.gov.au/speeches/2018/sp-dg-2018-10-17.html 3/13 10/17/2018 The State of the Labour Market | Speeches | RBA Graph 2 The labour account data provide an alternative perspective on where the jobs growth has been. For example, businesses report that the number of jobs in construction has not increased anywhere near the extent that households have reported over recent years. This may be because construction workers hired or contracted out by labour hire or business services companies will not be recorded as construction workers in the labour account. Similarly, in answering a household survey, someone working for a professional services company who is deployed to a bank may think of themselves as working in the finance sector rather than in professional services. There is no ‘right’ way of measuring this. It depends on who you ask and what question you are trying to answer. What sorts of jobs have been created in terms of pay? Drawing on the data from the (more than) 450 occupations tracked by the ABS, our assessment is that employment growth has been reasonably evenly distributed across pay levels over the recent period. There has been relatively strong employment growth in occupations with above-average rates of pay, such as jobs within health care, IT and engineering. But within the household services sector, employment growth has been strongest in occupations with below-average wages. These include bar attendants & baristas, waiters, child carers and aged & disabled carers. It is also difficult to get a good read on the prevalence of ‘gig economy’ jobs. The share of people working as independent contractors has declined a little over the past decade, the share of people working casual jobs is also little changed. The labour account data reports information on workers with more than one job. It suggests that secondary jobs – i.e. filled by people who also have a https://www.rba.gov.au/speeches/2018/sp-dg-2018-10-17.html 4/13 10/17/2018 The State of the Labour Market | Speeches | RBA primary job – account for around 6 per cent of total jobs, which hasn't changed much over the past five years. Unemployment The aggregate unemployment rate has fallen over 1 percentage point since its recent peak in October 2014 and is now at its lowest level in six years. It has fallen from its peak across all states and territories. Recently, we have seen strong declines in the unemployment rates of Victoria and South Australia (Graph 3). In trend terms, my home state of South Australia has the third lowest unemployment rate for the first time since 2012 and its unemployment rate has fallen over 2 percentage points since its most recent peak. Graph 3 The recent decline in the unemployment rate has also been broad based across all age groups in the economy. The unemployment rate of younger people (15–24 year olds) has recorded the sharpest fall over the past year (Graph 4). The youth unemployment rate tends to be more sensitive to economic conditions than the unemployment rate of other age groups. Despite this, the share of younger part-time workers who want to work more hours than they currently do remains high. Furthermore, the share of 20–24 year olds that are neither engaged in employment nor full-time education or training remains higher than it was a decade ago. https://www.rba.gov.au/speeches/2018/sp-dg-2018-10-17.html 5/13 10/17/2018 The State of the Labour Market | Speeches | RBA Graph 4 Looking at the duration of unemployment, the median duration of unemployment has declined over the past year to be around 15 weeks. There has been a noteworthy decline recently in those who have been unemployed for a year or less. However, the unemployment rate has not fallen for those who have been unemployed for over one year (Graph 5), remaining at around 1¼ per cent of the labour force. This is concerning given the adverse social and economic consequences that arise from long-term unemployment. That said, generally a sustained improvement in the economy does result, in time, in a decline in the average duration of unemployment. https://www.rba.gov.au/speeches/2018/sp-dg-2018-10-17.html 6/13 10/17/2018 The State of the Labour Market | Speeches | RBA Graph 5 At 5.3 per cent, the unemployment rate is above our estimates of the NAIRU. We also closely monitor broader measures of underutilisation. [6] In that regard, here are some useful facts to keep in mind: around one-quarter of part-time workers are actively looking to work more hours than they currently do; on average they are seeking to work an extra two days a week. When combined with the number of hours of work that the unemployed are seeking, this gives a labour underutilisation rate of around 8½ per cent (Graph 6). While the underemployment rate has trended higher over time alongside the increasing prevalence of part-time work, movements in the unemployment rate remain the dominant driver of movements in the broader underutilisation rate. Hence, I still view the unemployment rate as the most useful summary indicator of the state of the labour market. https://www.rba.gov.au/speeches/2018/sp-dg-2018-10-17.html 7/13 10/17/2018 The State of the Labour Market | Speeches | RBA Graph 6 Wages Given this spare capacity in the labour market, wages growth has been subdued. The RBA monitors a range of available measures of labour costs as they each capture a slightly different concept of wages growth. The wage price index (WPI) measures the change in the average hourly wage rate for a given job compared to the same job in the previous period (excluding any changes to the nature of the job). In contrast, the national accounts measure of average earnings per hour (AENA) and average weekly full-time ordinary time earnings (AWOTE) are broader in scope in that they measure the average wage bill. They embody changes to the composition of the labour force (for example, the movement of people in and out of higher-paying jobs in mining-related industries). AENA also includes non-wage payments such as allowances, superannuation and redundancy payments. These measures tend to be more volatile than the WPI, but better capture any inflationary pressure stemming from labour costs. On any of the measures, wages growth has been low over the last few years (Graph 7). One of the factors contributing to this is the low level of voluntary job turnover. Workers tend to choose to leave their job for a better job – be it in conditions or pay. The fact that little of this is occurring is likely to be contributing to the subdued wages growth. Recently, some of our liaison contacts are now reporting that turnover is increasing. https://www.rba.gov.au/speeches/2018/sp-dg-2018-10-17.html 8/13 10/17/2018 The State of the Labour Market | Speeches | RBA Graph 7 Also, as the labour market has tightened, businesses are finding ways to retain some of their employees without raising wages for everyone. Many businesses in our liaison program report that they are linking wages growth outcomes to individual performance, which provides employers the flexibility to reward and retain strong performers and valued skill sets while keeping average wages growth contained. The use of bonuses, especially to retain key staff, is also prevalent, which doesn't permanently raise labour costs. Some firms are attempting to retain staff by using non-wage incentives, including flexible work arrangements, shares, subsidised gym memberships, development opportunities and additional annual leave. All of the wage measures indicate that a slight pick-up in growth has occurred recently. This increase has been broad based across most industries, although it has been modest in all cases (Graph 8). We are anticipating that wages growth will continue to pick up gradually as the unemployment rate declines and the adjustment following the end of the mining boom is close to running its course. There are a few other factors that are likely to contribute to this. Around one-quarter of all employees will have received a 3.5 per cent pay rise following the increase in national minimum and award wages on July 1. For some retail and public sector employees, we are also seeing some new enterprise bargaining agreements signed following a lengthy period where wages had been frozen. https://www.rba.gov.au/speeches/2018/sp-dg-2018-10-17.html 9/13 10/17/2018 The State of the Labour Market | Speeches | RBA Graph 8 Where to from Here? Our outlook for the labour market is based on our outlook for the economy as a whole but also by a number of useful leading indicators. While there is always uncertainty around our forecasts, there are currently conflicting signals from the various measures of labour demand. Job vacancies data and business survey hiring intentions have recorded strong growth this year, but there has been little growth in the job advertisements data (Graph 9). While divergences in the signal from various activity indicators are not unusual, the divergence between vacancies and job advertisements (as a share of the labour force) has been steadily increasing over recent years. This in part reflects changes in the way that businesses recruit and workers search for jobs. [7] For example, the job advertisements data capture the main online recruitment websites, but they are not picking up newer recruitment sites or the use of social media sites, such as LinkedIn, so the usefulness of this series may be declining. Large corporations are also maintaining ‘expression of interest’ registers on their own websites, which reduces their need to advertise to fill a vacancy. Taking all of the information from these various indicators together suggests that employment is likely to grow a bit above its long-term average over the next six months. This is consistent with our forecast that GDP will also grow a bit above trend. https://www.rba.gov.au/speeches/2018/sp-dg-2018-10-17.html 10/13 10/17/2018 The State of the Labour Market | Speeches | RBA Graph 9 Empirically, there is a negative relationship between the number of job vacancies and the number of unemployed persons; when demand for labour is strong the number of vacancies will generally rise, which leads to a reduction in the unemployment rate as those vacancies are filled. This relationship is depicted as the Beveridge Curve [8] , and this negative relationship has held over long periods of time and is observed in the data in other countries. Over the past few years, there has been a large increase in vacancies but only a small decline in the unemployment rate to date (Graph 10). That is, firms are hiring fewer workers per job opening or vacancy than has been typical – suggesting a possible shifting to the right of the Beveridge Curve. A possible explanation for this would be an increasing skill mismatch between unemployed workers and available jobs. Structural changes in the labour market as a result of changes to participation, technological change or those stemming from a shock such as the mining boom can contribute to a mismatch. Lower mobility, either geographical or at the job level, can also reduce the ability of firms to find the appropriate worker. This last explanation seems unlikely given the relatively large net interstate migration flows we have seen as conditions in the state labour markets have varied, most notably the large flows in and then subsequently out of Western Australia. Finally, it may reflect underinvestment in training over recent years, including in technical skills. That said, the vacancy rate is currently at its highest relative to the size of the labour force. That too is a very positive signal for the labour market outlook. https://www.rba.gov.au/speeches/2018/sp-dg-2018-10-17.html 11/13 10/17/2018 The State of the Labour Market | Speeches | RBA Graph 10 Conclusion To sum up, the labour market is in pretty good shape: employment growth is above average, the participation rate is at a high level, the vacancy rate is at an all-time high and the unemployment rate is falling. However, the long-term unemployment rate has been little changed of late and wages growth remains low. The near-term indicators suggest demand for labour remains above average and the expected growth in the economy over the next few years should gradually reduce the spare capacity in the labour market. As we have stated many times, we expect that will lead to a gradual increase in wages growth and, in turn, inflation. There are a number of uncertainties around the extent and timing of the decline in the unemployment rate and the pick-up in wages growth. The recent international experience indicates that the unemployment rate could decline further than historical experience would suggest before we see a material increase in wages growth. But against this, further increases in labour demand may be met more from the pool of unemployed rather than from people not currently in the labour force. That is, the unemployment rate may decline faster than we expect, rather than the participation rate increase further. https://www.rba.gov.au/speeches/2018/sp-dg-2018-10-17.html 12/13 10/17/2018 The State of the Labour Market | Speeches | RBA Endnotes [*] Thanks to Blair Chapman and Natasha Cassidy for their extensive help with this. The standard error is not large relative to the level of employment, but it is for the monthly change. See Evans E, A Moore and D Rees (2018), ‘The Cyclical Behaviour of Labour Force Participation’, RBA September. The Australian labour account balances information on jobs sourced from businesses and households; as such, it provides estimates of the number of jobs, people, hours worked and labour income in each industry. Conceptually the labour account is designed to be consistent with the national accounts data. In a welcome development, the ABS is also starting to release datasets that match administrative data and ABS survey data such as Business Longitudinal Analysis Data Environment (BLADE). These datasets should enhance our analysis of the labour market. For a more comprehensive discussion of labour market outcomes for the young, see Dhillon Z and N Cassidy (2018), ‘Labour Market Outcomes for Younger People, RBA , June. See Ellis L (2018), ‘On Lags’, Sir Leslie Melville Memorial Lecture, Australian National University, Canberra, 17 August. A recent speech by my colleague Alex Heath looked at the increase in labour market flexibility over recent decades, and the impact this might have on our understanding of spare capacity. See Heath A (2018), ‘The Evolving Labour Market’, Business Educators Australasia 2018 Biennial Conference, Canberra, 5 October. See Edwards K and L Gustafsson (2013), ‘Indicators of Labour Demand PDF ’, RBA Janet Yellen once referred to the Beveridge Curve as the ‘neglected stepsister of macroeconomics’. I recall sitting in lectures by Olivier Blanchard and Peter Diamond as they developed their work on the Beveridge Curve and job matching. They noted that, although the Beveridge Curve ‘has very much played second fiddle’ to the Phillips Curve, it conceptually comes first and contains essential information about the functioning of the labour market and the shocks that affect it. Bulletin, Bulletin Bulletin, September, pp 1–11. © Reserve Bank of Australia, 2001–2018. All rights reserved. https://www.rba.gov.au/speeches/2018/sp-dg-2018-10-17.html 13/13 | reserve bank of australia | 2,018 | 10 |
Remarks by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the Walkley Business Journalism Award, The Walkley Foundation, Sydney, 22 October 2018. | Guy Debelle: Remarks - The Walkley Business Journalism Award Remarks by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the Walkley Business Journalism Award, The Walkley Foundation, Sydney, 22 October 2018. * * * Thank you very much for the invitation to be here. The financial media is very important to the Reserve Bank, playing a critical role in helping us communicate our message to the public. Today I am going to talk about the challenges that uncertainty causes journalists as well as policymakers. I will draw on Charles Manski, Nate Silver and Philip Tetlock and repeat the warning of the first of these: ‘Beware the Lure of Incredible Certitude’.1 What does Manski mean? He means try to avoid presenting point predictions and estimates without conveying any sense of the uncertainty around them. This is hard because as Manski notes, ‘the public, impatient for solutions to its pressing concerns, rewards those who offer simple analyses leading to unequivocal policy recommendations’. Should we be giving the people what they want? Can they handle the truth? Or in this case, can they handle the fact that we don’t really know the whole truth? To channel Mulder and Scully, the truth is out there, but its whereabouts are unknown. We are always making decisions under uncertainty. Uncertainty is unavoidable. Sometimes the uncertainty isn’t that important and we can ignore it. But a lot of the time, it is important and we can’t ignore it. So what do we do? We estimate. As Philip Tetlock said in his great book Superforecasting, ‘estimating is what you do when you do not know’. Given we are in a world of probabilistic statements, how do we assess them? How do we hold those who make these statements to account? Probabilistic statements should be falsifiable and they should be verifiable. They need a time frame and they need some numbers. They should avoid phrases like ‘x has a significant chance of happening’. Or ‘there is a possibility of x happening’. Significant and possible can mean anything. Pin people down; get them to commit! If instead we have a statement such as ‘x has a one in three chance of happening in the next two years’, we can work out that it is less likely to occur than something that has a 50/50 chance of happening. But if the event does actually happen in the prescribed time frame, which forecast was more accurate? Unfortunately that’s hard to assess. In the end, track records built up over time can help you sort out luck from skill. Time frames help here too. Beware the ‘I told you so’ forecaster. Put a prediction out there without any expiry date and many years down the track when the event actually happens then ‘I told you so’. Pick the one in 100 event that no one saw coming. Was the forecaster really good? Or were they the monkey that wrote Hamlet? Closely related to ‘I told you so’ is ‘just wait, it’s still coming'. Tetlock highlights an example from 2012 when a bunch of luminaries wrote a petition that quantitative easing (QE) in the US would generate high inflation and currency debasement. Six years down the track, inflation in the US is struggling to stay above 2 per cent. But without a time limit on the prediction, they might one day claim to be right. To be a useful prediction, it needs some time frame and some probability of occurrence. The best Australian example of this might be a housing market crash. 1/2 BIS central bankers' speeches Ideally the probability of something occurring gets updated through time as new information comes to hand so you can say whether it is getting more or less likely. This is the Bayesian approach that underpins Nate Silver and the Fivethirtyeight team’s approach to prediction described in Nate’s book The Signal and the Noise. Continually update your assessment of likely outcomes as new information comes in. Journalists (and policymakers) need to filter and clarify. Filtering all the predictions out there is hard. Clarifying what they actually mean is hard. How do you assess the validity of the claims? Should you assess them or just report them? How much editorial input should you bring to bear? What is the motivation of those making the claims? Are they rewarded by the headline or the click? Are you reporting the story that will deliver the best headline, the most quotable quote or are you reporting the more boring, more likely outcome? To give an example, often the most accurate statement about why the stock market rose today is that it occurred for any one of a hundred different reasons, or for a mix of all of them.2 Or my favourite explanation: because there were more buyers than sellers. Not as punchy as ‘the market rose today because Carlton won the premiership’. All that said, people need to be informed of the tail outcomes, but not bombarded with them. I know that bad news sells but a continual reporting of possible tail events conveys the sense that these events are more likely than they really are. Downside risks are easy to articulate, particularly if they are bad, even if they are very low probability. I’m not arguing that we all should be Pollyannas, but at the same time we seem to have a surplus of Cassandras. There are so many black swans identified each day that we may as well all be living in Perth. I will finish using the employment numbers as an example of the challenges of reporting on economic data accurately. Each month the point estimates are dutifully reported. But that’s what they are: point estimates. The ABS provides a band of uncertainty around those estimates, which is ±30,000. Not so large a forecast error in terms of the level of employment, but it is large in terms of the monthly changes. Do you report the full range of this uncertainty? On this, Manski cites LBJ, ‘Ranges are for cattle. Give me a number’. So what is the signal versus the noise in each monthly release? You need to filter and clarify. Maybe use the trend, though trends are generally slow to pick turning points, just like a lot of forecasters. You can bring other information to bear, cross-validate, consistency check. So it is definitely a challenge for business journalists to convey uncertainty to the public, just as it is a challenge for us policymakers to make decisions under uncertainty. That is the challenge, but a challenge neither of us can ignore. 1 Manksi C (2018), ‘The Lure of Incredible Certitude’, available at <www.nber.org/papers/w24905>, NBER Working Paper No 24905; Nate Silver (2012), The Signal and the Noise, Penguin; Tetlock P and D Gardner (2015), Superforecasting: The Art and Science of Prediction, Crown Publishing, New York. 2 Tetlock p 57. 2/2 BIS central bankers' speeches | reserve bank of australia | 2,018 | 10 |
Speech by Ms Michele Bullock, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the 10th Annual Commonwealth Bank Global Markets Conference, Sydney, 30 October 2018. | null | reserve bank of australia | 2,018 | 11 |
Remarks by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the FINSIA Signature Event "The Regulators", Melbourne, 15 November 2018. | null | reserve bank of australia | 2,018 | 11 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the CEDA Annual Dinner, Melbourne, 20 November 2018. | Philip Lowe: Trust and prosperity Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the CEDA Annual Dinner, Melbourne, 20 November 2018. * * * I would like to thank Andrea Brischetto for assistance in the preparation of this talk. Thank you for the invitation to address CEDA's annual dinner. It has become a tradition at these dinners for the Governor of the RBA to talk about how we secure Australia's continued economic prosperity. I would like to continue that tradition tonight. My focus is going to be on the importance of trust as an essential building block of economic prosperity. This focus is a bit different from the normal turf of economists: things like productivity, investment and capital accumulation. Of course, we need to keep a close eye on these issues, but in doing so we should not lose sight of the fact that our economy, and our society, works best when there are high levels of trust. And those in whom trust has been placed need to do their best to be worthy of that trust. There is an element of trust in all economic transactions. Without it, commerce can't flourish. But the nature of trust in our society is changing. We can all think of recent examples where trust in our institutions and organisations has been severely tarnished. At the same time, changes in technology mean that we are increasingly trusting the wisdom of the crowd on our preferred online platforms, rather than our traditional institutions. As some have argued, trust is now more likely to be distributed, rather than to flow vertically from our institutions. This is a significant change. But regardless of how that trust is earned and retained, we all have a strong interest in living in a high-trust society. I would like to use this theme of trust to talk about three broad issues this evening. The first is the role of trust in finance. The second is the importance of the community having trust that living standards will improve over time. And the third is trust in institutions. Here, naturally enough, I will focus on the central bank and the importance of accountability and transparency. In this context I will end with a few words about current monetary policy. Trust in Finance Finance is all about trust. When a deposit is placed in a bank, we trust it will be repaid. We also trust financial institutions to invest our hard-earned savings for us. And we trust them to provide us with sound advice. Without this trust, the financial system cannot operate properly and the economy cannot prosper. As the first line of the Banking and Finance Oath says: ‘Trust is the foundation of my profession’.1 I encourage everybody in the finance sector to read this oath regularly and to live by it. Australia's banks have a strong record of being worthy of the trust that is placed in them to repay deposits. The last bank failure in Australia that resulted in a loss to depositors was almost 90 years ago, back in 1931, and it was a very small bank and depositors lost only a small fraction of their deposits.2 This is a positive record that few countries can match. This strength was apparent during the financial crisis a decade ago and has served Australia well. The Australian 1 / 11 BIS central bankers' speeches banks are strongly capitalised and have considerable liquidity buffers. On the whole, they have also managed credit risk effectively, reporting few problem loans by global standards. This means that we can have a high level of trust in the ability of Australia's banks to repay depositors. Indeed, our strong and stable banking system is one of the Australian economy's strengths. It is in other areas, though, where trust has been strained. It is clear that the behaviours highlighted by the Royal Commission have dented the community's trust in parts of our financial sector. The case studies used by the Commission have put the spotlight on three important issues: 1. the inadequate way in which banks have dealt with conflict of interest issues; 2. the way that poorly designed incentive systems can distort behaviour – promoting a sales culture at the expense of a service culture, and promoting the short term at the expense of the long term; and 3. the fact that the consequences for not doing the right thing have, in some cases, been too light. Strengthening trust in our financial institutions requires all three issues to be addressed. Central to this task is creating a strong culture of service within Australia's financial institutions. Too often our financial institutions prioritised sales over service. Correcting this starts with the system of internal reward established by the board and management. The vast bulk of the people who work for Australia's financial institutions do want to do the right thing, and they do want to serve their customers as best they can. But, like everybody else, they respond to the incentives they face. If they are rewarded on sales or short-term objectives, it should not come as a great surprise that that's what they prioritise. So establishing the right incentives is key. One of the things that influences incentives is the consequences and penalties that apply when something goes wrong. Strong penalties can play an important role in incentivising good behaviour, and this is an area we should be looking at. But we do need to get the balance right as there can be unintended consequences. In my view, it is worth making a distinction between the penalties that apply for poor conduct and those that apply for making loans that ultimately cannot be repaid. On conduct issues, we should set our expectations and standards high, and if they are not met the penalties should be firm. On lending, matters are more complex. Even when banks lend responsibly, a percentage of borrowers will end up in financial strife and be unable to meet their obligations. We need banks to be prepared to make loans in the full expectation that some borrowers will not be able to pay them back. Banks need to take risk and manage that risk well. If they become afraid to lend simply because of the consequences of making a loan that goes bad, our economy will suffer. So a balance needs to be struck here. More broadly, having clear lines of accountability can help build trust. The Banking Executive Accountability Regime (BEAR) is helpful here. This regime is, however, largely limited to authorised deposit-taking institutions and to prudential matters. It is worth thinking about how the same focus on accountability can be applied to a broader range of financial services and to conduct issues as well. As we do this, though, we should not lose sight of the fact that it is the banks' boards and management that are ultimately responsible for the choices that banks make. It is unrealistic to expect that an appropriate culture can be created through regulation and penalties. Creating the right culture is a core responsibility of boards and management. Changes that are now taking place within the financial sector should, over time, help restore trust, although it is likely to be a gradual process. The Royal Commission will have recommendations that should assist with this. One thing that would help is for financial 2 / 11 BIS central bankers' speeches institutions to have a long-term focus and reflect that in their internal incentives. Managing to short-term targets might boost the share price for a while, but this short-termism can weaken the long-term franchise value of the bank. We have seen evidence of this recently. I would argue that the franchise value is more likely to be maximised if our financial institutions have a long-term perspective, treat their customers well, reward loyalty rather than take advantage of it, and invest in systems and technology that deliver world-class financial services for Australians. Doing this would not only be good for bank shareholders, but also for the broader community. Trust That Living Standards Will Improve over Time I would now like to turn to a slightly different concept of trust, but one that is no less important: that is, the community's trust that real living standards will improve over time. On many accounts, the Australian economy has performed very well over recent times. Over the past year it has grown by close to 3½ per cent, inflation has been low and stable at around 2 per cent, employment has grown quite strongly and we are getting closer to full employment (Graph 1). Business conditions are positive and government finances have improved and are in reasonable shape. There is a lot of investment in infrastructure taking place and the number of job vacancies is at a record high. So, overall, it is quite a positive picture. Yet, despite how often this story is told, not everybody shares this positive assessment. 3 / 11 BIS central bankers' speeches This next graph helps explain why this is so (Graph 2). It shows how average hourly earnings in Australia, adjusted for inflation, have changed over time. The picture is pretty clear. Over the period from 1995 to 2012, we witnessed a substantial lift in real hourly earnings; on average real wages increased by almost 2 per cent per year. This occurred alongside inflation averaging around the midpoint of the 2–3 per cent target range and strong growth in corporate profits. Since 2012, though, it has been a different story: over these six years, there has been little change in average real hourly earnings. The wage increases that have occurred have been broadly matched by inflation. This is quite a change and it is having significant effects. On the positive side, flat real wages have supported the substantial gains in employment that we have seen. So they have benefited many people. At the same time, though, flat real wages are diminishing our sense of shared prosperity. The lack of real wage growth is one of the reasons why some in our community question whether they are benefiting from our economic success. This is not a uniquely Australian story. A similar thing has happened across most of the advanced economies. As a result, too many citizens around the world have diminished trust in the idea that the policies that have underpinned growth over the past 30 years are working for 4 / 11 BIS central bankers' speeches them. They feel more uncertain about the future and, in some countries, are also having to deal with very high housing prices. This unease is despite unemployment rates in many advanced economies being the lowest in many decades. The diminished trust in the idea that living standards will continue to improve is a major economic, social and political issue. It underlies some of the political changes we are seeing around the world. It is also making it harder to implement needed economic reform. It is in our collective interest that this trust is restored. This is a challenging task, but it is not an impossible one. Part of the solution is for the labour market to tighten further and for this to lead to a pick-up in household income growth. The current setting of monetary policy is encouraging this. As the labour market has tightened in Australia over the past year, there has been a modest lift in wages growth. We received further confirmation of this last week with the publication of the wage price index. The RBA also continues to hear reports of larger wage rises in areas where there is strong demand for labour and workers are in short supply. We expect to hear more such reports over time. From a longer-term perspective, another part of the solution is to boost our productivity. The factors that are contributing to flat real wages for many workers are complex, but many of them are linked to globalisation and technology. The best way of dealing with this is not to ignore these forces, but to do what we can to capitalise on them. This means government and business having a sharp focus on the question of how we can best flourish in this world of global markets and continuing improvements in technology. An important part of the answer must be investment in education and skills, and in research and development. We need to be thinking long term here. Realistically, more investment in human capital will not make much difference to real wages this year or next. But over the next decade or two, it is crucial to raising real wages and living standards. Increasingly, our prosperity rests on the ideas that we have, how we can take advantage of those ideas, and how we can capitalise on new technologies. This means that having a strong culture of innovation in our businesses is important. With the right investments, Australians can enjoy high and rising real wages in a highly competitive and technically sophisticated world. There are other elements to lifting productivity: the design of our tax system, the quality and pricing of our infrastructure and the strength of competition in our markets. The key point here is that raising productivity and ensuring a strong economy will, over time, help deal with the diminished trust that people have in the idea that their real living standards will improve. We all have a strong interest in that trust being restored. Without it, a lot of things become more difficult. Trust in the Central Bank I would now like to turn to a third aspect of trust – that is trust in public institutions. One of Australia's strengths is that we have strong and stable public institutions. We can sometimes take this for granted. But strong public institutions are one of the foundations upon which our economic prosperity is built. They help support the public's trust in the development and implementation of economic policy, and in the fair and effective administration of laws and regulation. They can also help society balance some of the difficult trade-offs that we sometimes face. I hope you see the Reserve Bank of Australia as one of those institutions. We have been entrusted with important responsibilities by the Australian parliament and the government: determining Australia's monetary policy; issuing Australia's currency; operating the core of Australia's payment system; acting as the banker for the Australian Government; and having broad responsibilities for financial stability and for competition, efficiency and stability in the 5 / 11 BIS central bankers' speeches Australian payments system. As we carry out these responsibilities, I am very conscious that as central bankers we are unelected officials acting on the public's behalf. Reflecting this, the first of our internal values at the RBA is to act in the public interest. We work hard to be worthy of the trust that has been placed in us. We seek to do this by speaking and acting independently, consistent with our mandate, by being analytical and pragmatic in our approach to policy and by being accountable and transparent. One element of transparency is the release of minutes on monetary policy shortly after each monthly board meeting. The latest minutes were released this morning. These contain our assessment that the Australian economy has been doing well recently. It is growing a bit faster than average, the unemployment rate is trending lower and inflation is low and stable. We expect this to continue for a while yet. This is evident in this next chart, which shows our central forecasts of GDP growth and inflation over the next few years (Graph 3). Growth this year and next is expected to exceed 3 per cent, before easing in 2020 as the boost from the large increase in liquefied natural gas exports tapers off. Inflation is expected to pick up gradually, but to remain low. The graph also shows the range of uncertainty, based on historical experience. While the public focus is normally on the central scenario, it is important to recall that the range of possible outcomes is quite large. 6 / 11 BIS central bankers' speeches As the minutes discuss, one of the current sources of uncertainty is the pace of growth in consumer spending. Over the past couple of years, consumer spending has been growing reasonably firmly and faster than disposable income. Our central scenario is for household spending to continue growing at around its current rate and for income growth to pick up to be in line with spending growth. But there are conflicting forces at work. The strong employment growth is positive for income and consumption growth. But working in the other direction are flat real wages at a time when debt levels are high and housing prices are falling in our largest cities. We are continuing to assess the balance of these forces. As we do this, we are watching the housing market closely. There has recently been considerable public attention paid to declining housing prices in Sydney and Melbourne. It is important to remember that these declines come after very large run-ups in housing prices in these two cities, which made purchasing a home difficult for a significant number of people (Graph 4). It is also worth pointing out that this adjustment is taking place against the backdrop of a strong world economy, a positive Australian economy, low unemployment, low interest rates, strong population growth and only limited pockets of excess housing supply. This is a reasonably favourable backdrop against which to be having an adjustment in the housing market. But we do need to watch things closely. 7 / 11 BIS central bankers' speeches The minutes also report that the Board evaluated the forecasts made by the Bank this time last year. The Board does this type of evaluation exercise annually. Over the past year, the economy performed more strongly than expected a year ago and the unemployment rate came down by more than expected. At the same time, though, the stronger growth and labour market did not translate into more inflation; wages growth and inflation turned out to be pretty close to expectations.The fact that growth was stronger than expected is largely accounted for by a positive surprise on both mining and non-mining investment. The terms of trade were also stronger than expected, which, combined with a lower exchange rate, helped too. The positive story for non-mining investment can be seen in this next graph, which shows the Bank's successive forecasts over the years as well as the actual outcomes – the black line (Graph 5). For a number of years we were forecasting a lift in investment that did not come. During this period of flat business investment, Glenn Stevens gave speeches bemoaning the lack of animal spirits in the business community. But over the past couple of years, things finally turned around. The long-forecast pick-up in investment finally arrived and it has been stronger than expected. We expect this upswing in investment to continue for a while yet. 8 / 11 BIS central bankers' speeches The fact that growth was stronger than expected is largely accounted for by a positive surprise on both mining and non-mining investment. The terms of trade were also stronger than expected, which, combined with a lower exchange rate, helped too. The positive story for non-mining investment can be seen in this next graph, which shows the Bank's successive forecasts over the years as well as the actual outcomes – the black line (Graph 5). For a number of years we were forecasting a lift in investment that did not come. During this period of flat business investment, Glenn Stevens gave speeches bemoaning the lack of animal spirits in the business community. But over the past couple of years, things finally turned around. The long-forecast pick-up in investment finally arrived and it has been stronger than expected. We expect this upswing in investment to continue for a while yet. 9 / 11 BIS central bankers' speeches In the context of its forecast evaluation, the Board at its recent meeting also reviewed the various arguments that have been made by commentators for alternative courses of monetary policy. The timing of this review has no particular policy significance. It is good practice to consider the issues and arguments from all angles, and we do this as part of our regular processes. As you know, following its deliberations at the November meeting, the Board again decided to maintain the cash rate at 1.5 per cent, where it has been since August 2016. The central messages also remain the same. First, the economy is moving in the right direction and further progress is expected in lowering unemployment and having inflation consistent with the target. Second, the probability of an increase in interest rates is higher than the probability of a decrease. If the economy continues to move along the expected path, then at some point it will be appropriate to raise interest rates. This will be in the context of an improving economy and 10 / 11 BIS central bankers' speeches stronger growth in household incomes. Third, the Board does not see a strong case for a near-term change in interest rates. There is a reasonable probability that the current setting of monetary policy will be maintained for a while yet. This reflects the fact that the expected progress on our goals for unemployment and inflation is likely to be gradual. The Board's view is that it is appropriate to maintain the current setting of policy while this progress is made. Thank you for listening. I look forward to your questions. 1 See the Banking and Finance Oath website at <www.thebfo.org/home>. 2 The Primary Producers Bank was wound up in 1931. The bank accounted for less than 0.5 per cent of Australian banks’ deposits at the time, and the bank’s customers lost just 1.25 per cent of their deposits. See Fitz-Gibbon B and M Gizycki (2001), ‘AHistory of Last-resort Lending and Other Support for Troubled Financial Institutions in Australia’, RBA Research Discussion Paper No 2001–07. 11 / 11 BIS central bankers' speeches | reserve bank of australia | 2,018 | 11 |
Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the 2018 Australian Payment Summit, Sydney, 26 November 2018. | Philip Lowe: A journey towards a near cashless payments system Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the 2018 Australian Payment Summit, Sydney, 26 November 2018. * * * I would like to thank David Emery and Tony Richards for assistance in the preparation of this talk. Thank you for the opportunity to address the Australian Payment Summit. The world of payments has become increasingly exciting, so it is very good to be here today to share in that excitement. This morning I would like to speak about the shift towards electronic payments; or as the title of my remarks says, the journey towards a near cashless payments system. For some decades, people have been speculating that we might one day go cashless – that we would no longer be using banknotes for regular payments and that almost all payments would be electronic. So far, this speculation has been exactly that – speculation. But it looks like a turning point has been reached. It is now easier than it has been to conceive of a world in which banknotes are used for relatively few payments; that cash becomes a niche payment instrument. Given this, I would like to structure my remarks around three broad points. The first is that the shift to electronic payments is occurring quite quickly and it is likely to continue. This shift is a positive development that should promote our collective welfare. The second is that if we are to realise the benefits of moving to a near cashless payments system, the electronic system needs to offer the functionality, safety and reliability that people require. People need to have confidence that the electronic payment system will be operating when they want to make their payments and that it will deliver the payment services that they need. The third point is that as we undertake this journey towards a near cashless payment system, there will be a greater focus on the cost of electronic payments. If almost all payments are electronic, then the cost of making these payments matters more than it used to. The electronic system needs to be as efficient as it can be and to be characterised by strong competition. In my view, there is further work to be done here. 1. The Shift to Electronic Payments The Reserve Bank conducts regular surveys of how Australians make their payments. The next survey will be undertaken in 2019. Until then, perhaps the best illustration of the declining use of cash for transactions is the sharp decline in the number and value of cash withdrawals through ATMs (Graph 1). Around the turn of decade, Australians went to an ATM, on average, around 40 times per year. Today, we go to an ATM around 25 times a year and the downward trend is likely to continue. 1 / 14 BIS central bankers' speeches At the same time as the use of cash for payments has been declining, the number of electronic transactions has been growing strongly (Graph 2). Today, Australians make, on average, nearly 500 electronic payments a year, up from around 100 per year around the turn of the century. 2 / 14 BIS central bankers' speeches New payment technologies are being developed that will further encourage this shift to electronic payments. Perhaps the most significant of these is the New Payments Platform, which has made it possible for people to make real-time person-to-person payments without using banknotes. A range of payment apps are also under development that would have the same effect. So the direction of change is clear. There also continues to be a decline in the use of cheques (Graph 3).1 In the mid 1990s, Australians, on average, made around 45 cheque payments per year. Today, we make around three per person. Given this trend is likely to continue, it will be appropriate at some point to wind up the cheque system, given the high fixed costs involved in operating the system. We have not reached that point yet, but it may not be too far away. Before we do, it is important that alternative payment methods are available. Progress has been made on this front, but more is required. 3 / 14 BIS central bankers' speeches It is worth pointing out that despite the decline in cash use, the value of banknotes on issue, relative to the size of the economy, is close to the highest it has been in fifty years. For every Australian there are currently around thirty $50 and fourteen $100 banknotes on issue (Graph 4). 4 / 14 BIS central bankers' speeches So there is an apparent paradox between the declining use of cash and the rising value of banknotes on issue. The main explanation is that some people, including non-residents, choose to hold a share of their wealth in Australian banknotes. The opportunity cost of doing this is less than it used to be because of the low level of interest rates. While it is difficult to predict the future, I expect that banknotes will remain part of our payments system for some time to come. In some situations, paying with banknotes is quicker and more convenient than paying electronically, although this advantage is less than it once was. Some people also simply prefer paying in cash – our 2016 survey indicated that around 14 per cent of Australians had a preference for using cash as a budgeting tool. Banknotes also allow payments to be made anonymously in a way that is not possible in systems that leave an electronic fingerprint. This privacy aspect is valued by some people. In some circumstances this desire for privacy is entirely legitimate, but in others it has more to do with tax evasion and illegal activities. Perhaps a more important source of ongoing demand is the fact that using cash does not require the internet to be up, electricity to be working and the banks’ systems to be operational. Banknotes are therefore an important emergency or back-up payment instrument. They are 5 / 14 BIS central bankers' speeches particularly useful in the event of natural disasters or failure of the electronic system. Perhaps one day the various systems will be so reliable that a backup will not be needed, but that day still seems some way off. Overall, the shift to electronic payments that is occurring makes a lot of sense – it is similar to other aspects of our lives where things that used to be physical have been supplemented with, or replaced by, technology. This shift is likely to promote our collective welfare. I say that even though the Reserve Bank is the producer of banknotes and earns significant income, or as it’s known, seigniorage, for the taxpayer from their use. The greater use of electronic payments can bring efficiency benefits, with lower costs and more functionality and choice for users. One example of this is the reduced tender time involved in card transactions due to contactless technology. There are also non-trivial production and distribution costs involved in the cash system. Some of these are fixed costs, so the average cost of cash transactions is likely to rise as the volume of cash transactions falls. Looking ahead, there is also more limited scope for fundamental innovation in the cash system compared with the scope for dynamic innovation in electronic payments. So this journey is in our national interest. 2. Functionality, Safety and Reliability I would now like to discuss three interrelated factors that will influence how quickly we undertake that journey. These are: the functionality offered by the electronic system; the safety of that system, and the reliability of that system. The other factor that is also relevant is cost, and I will touch on this a little later. Functionality The rapid adoption of contactless payments in Australia shows that Australians change how they pay quite quickly when new functionality is offered. Contactless card payments were slow to take off but once critical mass was established, they grew very quickly. In our 2013 consumer payment study they accounted for around over 20 per cent of point of sale card payments; three years later they accounted for over 60 per cent. So the functionality of the electronic payments system is key. The development of the electronic payment system took a major step forward earlier this year with the launch of the New Payments Platform (NPP). This system allows people to make payments 24 hours a day, 7 days a week, using just a simple identifier such as a mobile phone number or an email address. It also allows a lot of information to accompany the payment. I expect that over time this extra functionality will further reduce the use of cash in the economy and also improve the efficiency of the electronic system. The number of transactions through the NPP is steadily increasing (Graph 5). After a relatively low-key start, there are now around 400,000 NPP transactions per day. Over 2 million PayIDs have also been registered, and we expect further growth as the banks continue to roll out services to their customers. 6 / 14 BIS central bankers' speeches The concept behind the NPP is that so-called ‘overlay’ services are developed, and that these overlay services offer new functionality that utilise the real time capability of the NPP. The first overlay service provides for a basic account-to-account payment. Among the subsequently planned overlay services are ones that will allow someone to send a request to pay, perhaps to a friend for their share of a meal out. Another overlay service would allow a link to a document to be sent with a payment; this could be a payslip or a detailed record of the transaction. It was originally anticipated that these two overlay services would be up and running not long after the NPP launch. Unfortunately, this timeline has slipped. A number of the major banks have also been slower than was originally expected to roll out NPP functionality to their entire customer bases. This is in contrast to the capability offered by smaller financial institutions, which from Day 1 were able to provide their customers with NPP services. Given the slow pace of roll-out by the banks, and the prospect of delays for additional overlay services, I recently wrote to the major banks on behalf of the Payments System Board seeking updated timelines and a commitment that these timelines will be satisfied. It is important that these commitments are met. It is worth observing that in other countries where banks have been slow to develop payment applications that meet the needs of the public, other possibilities emerge. China is perhaps the best example of this, with the emergence of QR-code-based payments. I expect that the NPP infrastructure will be the backbone of our electronic payments system for many years to come. 7 / 14 BIS central bankers' speeches But for this to be the case, the system will need to provide the functionality that people require, and it will need to do this on a timely basis. There are a range of fintech firms that are excited by the capabilities offered by the NPP and the potential for it to be used for innovative payment solutions. In October, the RBA issued a consultation paper seeking views on the functionality and access arrangements for the NPP. In particular we are interested in views on whether the various ways of accessing the NPP, and their various technical and eligibility requirements, are adequate for different business models. A topic that I get asked about from time to time is whether the functionality of the electronic system would be enhanced by the RBA issuing an electronic version of the Australian dollar, an eAUD. I spoke about this issue at this conference last year, concluding that we did not see a public policy case for moving in this direction at the time. In particular, it is not clear that RBAissued electronic banknotes would provide something that account-to-account transfers through the banking system do not, particularly with the emergence of the NPP. Another important consideration was the implications for financial stability. A year on, our views have not changed. Security A second important influence on the rate at which we shift to a more electronic payments system is the public’s confidence in the security of the system. Given this, a recent focus of the Payments System Board has been the high and increasing level of fraud in card-not-present transactions (Graph 6). Card-not-present fraud rose by 15 per cent in 2017 and now represents 87 per cent of total scheme card fraud losses.2 In contrast, the industry has had successes in addressing card-present fraud, with the introduction of chip technology and the switch to PINs. Despite this, growth in e-commerce activity has provided new opportunities for would-be fraudsters. 8 / 14 BIS central bankers' speeches The Payments System Board identified the rise in card-not-present fraud as a priority for the industry. In August this year, the Board was pleased to welcome AusPayNet’s publication of a draft industry framework to mitigate card-not-present fraud, and supports continued collaboration on this issue. A separate but not unrelated priority for the industry is to progress work on digital identity. This is another area where barriers to effective coordination can arise. I am pleased that AusPayNet is undertaking work here, under the auspices of the Australian Payments Council. Digital identity is likely to become increasingly important as more and more activity takes place online. The RBA is highly supportive of industry collaboration on this issue and views it as important that substantive progress is made. More broadly, individuals, businesses, governments and financial institutions all need to be aware of cyber risks. In the RBA’s most recent Financial Stability Review we noted the increasing sophistication of cyber attacks and that regulatory authorities have increased their focus on cyber issues. 9 / 14 BIS central bankers' speeches Reliability A third factor is the confidence that people have that they will be able to use the electronic system when they need to make their payments. As I noted earlier, people will still want to hold and use banknotes if they can’t be sure that the electronic system will be available when they need it. In our consumer payments survey in 2016, we asked people about why they held cash in places outside of their wallet. The most common response, from nearly half of respondents, was that it was for emergency transaction needs. Over recent times, there have been a number of serious operational incidents that have interrupted the payments system. On some occasions these have been caused by problems with the telecommunications companies and at other times by problems at the banks. An operational incident at the RBA in August as a result of problems with a routine fire test also saw a number of RBA core systems unavailable for some hours, including the Fast Settlement Service supporting the NPP. We all need to do better here. As we rely less on cash, outages affecting retail transactions can have a significant impact on businesses and individuals. So continued effort needs to be made by all participants in the payments system to reduce operational problems. If this does not happen, then it is possible that the Payments System Board could consider setting some standards. 3. Increased focus on Cost and Competition My third broad point is about the cost of electronic payments and the importance of competition. As we move to a predominantly electronic world, there will be more focus on the cost of operating the electronic payments systems and how those costs are allocated between those making and receiving payments. Looking forward, I expect that over time the cost of electronic payments will decline further, due to both advances in technology and economies of scale. Even so, there are significant costs to operate the electronic systems, including costs for front- and back-end systems to maintain accounts, and to deliver functionality and convenience to users, as well as costs in preventing fraud and ensuring resilience. How these costs are managed and who pays for them will have a significant bearing on the efficiency of the overall system. In terms of card payments, merchants in Australia currently pay less than merchants in many other countries. The comparison with the United States is particularly stark (Graph 7). For credit cards, Australian merchants, on average, pay 0.8 per cent of the transaction value for Mastercard/Visa transactions. In the United States the figure is much higher at around 2.2 per cent. There are also differences in the cost of debit cards and American Express cards between the two countries. 10 / 14 BIS central bankers' speeches The main reason for the lower merchant costs in Australia is our lower interchange fees. These fees were reduced in Australia as a result of regulation by the Reserve Bank commencing in 2003. The RBA’s reforms reduced average interchange fees in the Mastercard and Visa systems by around 45 basis points. This has been reflected in merchant service fees; indeed, these merchant fees have fallen by somewhat more than the cuts to interchange, likely reflecting an increased focus on card acceptance costs by merchants (Graph 8). In addition, as a result of competitive pressure, including from the removal of no-surcharge rules, fees on American Express and Diners Club have also fallen over time. 11 / 14 BIS central bankers' speeches Notwithstanding the reduction in interchange fees, these fees still represent, on average, around 60 per cent of the total merchant service fee on credit cards. So they remain an important part of the total cost to merchants. Conversely, these fees mean that the cardholder’s bank gets paid each time the card is used. This has meant that the cost to consumers of using these cards is often low; in some cases, cardholders are actually subsidised to use their card, through reward points and/or interest-free credit. The subsidy is provided by the cardholder’s bank, but ultimately paid for by the merchant. The close link between interchange and merchant costs means that there continues to be significant focus on interchange and its implications for the distribution of costs between merchants and consumers. For example, there have been recent recommendations from the Black Economy Taskforce and the Productivity Commission for the Reserve Bank to consider regulatory action to lower, or even ban, interchange fees. The Payments System Board will again examine the arguments for lower interchange fees when it next conducts a formal review of the card payments system. On the competition front, one area that merits close attention is the market for acquiring services. This has come into sharper focus as a result of concerns about the costs to merchants in the debit card system, where most cards allow for transactions to be processed by either of the two networks enabled on the card. The longstanding view of the Payments System 12 / 14 BIS central bankers' speeches Board has been that merchants should at least have the choice of sending the debit payment through the lower cost system, whether that be eftpos or the international scheme. For merchants to be able to do this though, acquirers need to offer terminals and technical systems enabled to allow least-cost routing. Some acquirers have already completed the necessary work and are attracting new merchants. Others, including the major banks, made commitments earlier in the year regarding the timetable for this work to be completed. Partly on the basis of those commitments, the Payments System Board made a decision not to regulate. Since then, I regret to say there has been slippage by some, who have cited technical problems. It is important that the banks get back on track here. A failure to deliver on commitments or to provide the payment services that the community needs will inevitably lead to calls for further regulation. 4. Looking ahead Looking beyond interchange and acquiring competition, new technologies open up the prospect of new payment options developing. Recently, there has been much discussion on the role that so-called ‘Big Tech’ firms might eventually play. These firms have potential advantages over existing providers of payments services. In some cases, their technology and systems are more flexible, they have a greater ability to use and process information, they have well established networks which they can leverage and they are often better at interacting with their users and customers. Given this, one scenario is that these firms become significant players in the payments industry. They might be able to do this through developing new payment applications that provide a commercial return, not through charging for payment services, but by commercialising the value of the information that they obtain as a byproduct of offering these services. If this scenario were to play out, it could significantly change the payments landscape, providing both merchants and consumers new payment options at low monetary cost. At the same time though it would raise a number of important issues related to data privacy, ownership and security. The probability of Big Tech firms entering the payments arena is higher if merchants and consumers feel that the existing payment systems do not offer them the services they need and/or the prices that are being charged are too high. As I noted earlier, where banks have been slow to respond, other payment applications have emerged. This scenario highlights a broader point. The way that people are charged for payments is complex and is changing: among other things, it is influenced by interchange fees, how the value of information is commercialised, and commercial pressures on banks. It is difficult to predict how things will ultimately play out, but these are issues the Payments System Board continues to keep a close eye on. 5. Summing Up To conclude, I expect the shift to electronic payments will continue. The issues of functionality, security and reliability, and cost are central to the development of the system. The Payments System Board will be keeping a close eye on these issues. While I have talked about a near cashless payments system, I want to emphasise that we don’t yet envisage a world without banknotes. The RBA is committed to providing cash consistent with demand by users and to support its distribution. Our development of the Next Generation Banknote series is a clear commitment to ensuring that cash continues to have public confidence and to meet the needs of the community. The launch of the NPP this year was a big step forward for the industry and a credit to all of the staff at participating organisations who worked hard over the life of the project to bring it to 13 / 14 BIS central bankers' speeches fruition. As I mentioned, there are some key things that need to be done for the full benefits of the NPP to be available to end-users, but I am optimistic that these can be achieved and this new infrastructure can provide great functionality for Australia. 1 For a more detailed discussion of cheques, see Tellez (2017), ‘The Ongoing Decline of the Cheque System’, RBA Bulletin, June. 2 Fraud statistics are published every half-year by Australian Payments System Limited (AusPayNet) (2018), Fraud Statistics, 22 November 2018. available at <www.auspaynet.com.au/resources/fraud-statistics>, 14 / 14 accessed BIS central bankers' speeches | reserve bank of australia | 2,018 | 11 |
Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Australian Securitisation Forum Conference, Sydney, 26 November 2018. | Christopher Kent: Securitisation and the housing market Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Australian Securitisation Forum Conference, Sydney, 26 November 2018. * * * I thank Emma Doherty, Kate Fernandes and Eden Hatzvi for invaluable assistance in preparing these remarks. Introduction Good afternoon, and thank you to the Australian Securitisation Forum for their invitation. It’s a pleasure to be here. Today I’ll provide an update on developments in the markets for housing and housing credit. These markets are closely related and both are of considerable interest to those that issue and those that invest in Australian residential mortgage-backed securities (RMBS). Along the way, I’ll make use of data on residential mortgages from RMBS that are eligible for repurchase operations with the Reserve Bank.1 Among other things, these data are a useful source of timely information on interest rates actually paid, loan by loan. As I’ll demonstrate, this allows us to infer something about shifts in the supply of, and demand for, housing credit, thereby shedding some light on the different forces driving these markets. With this background in mind, I’ll also review some recent developments in the RMBS market. And I’ll finish by taking the opportunity to emphasise that RMBS issuers and investors should be prepared for any future changes in the use and availability of benchmark interest rates. Interactions between the housing market and the market for housing credit As highlighted recently in a speech by the Deputy Governor, the markets for housing and housing credit are going through a period of significant adjustment.2 After years of strong growth, housing prices have been declining nationally, driven by falls in Melbourne and Sydney over the past year. Also, there has been a noticeable decline in investor credit growth and an easing in owneroccupier credit growth. The cycles in the growth of overall housing prices and investor credit have moved together quite closely over the past few years (Graph 1). 1 / 16 BIS central bankers' speeches Underpinning these changes, there have been shifts in the demand for, and supply of housing, as well as in the demand for, and supply of, housing credit. Credit supply affecting housing demand The links between these two markets run in both directions, from housing credit to the housing market, and from the housing market to housing credit. Of late, the story more commonly told, though, is that a tightening in the supply of credit over recent years has impinged on the demand for housing. This story is certainly the more apparent one in terms of its causes and effects. In particular, the measures implemented by regulators over recent years to address the risks associated with some forms of housing lending have worked to mitigate those risks and they have also led to a noticeable slowing of investor credit. This, in turn, has contributed to a decline in the demand for housing. 2 / 16 BIS central bankers' speeches Again, these links have been discussed by Guy Debelle and are well-documented in the Bank’s latest Financial Stability Review (FSR).3 In late 2014, the Australian Prudential Regulation Authority (APRA) set a benchmark for investor lending growth at each bank of no more than 10 per cent per annum (Graph 2).4 Then in March 2017, APRA announced it would require interest-only loans – which are disproportionately used by investors – to be less than 30 per cent of each bank’s new lending. Over the same period, several other measures were implemented, including to tighten up the ways in which banks assessed the ability of borrowers to service their loans, and to limit the share of loans that constituted a large portion of the value of the property being purchased. Banks responded to these requirements in two key ways. First, for some years now they have been tightening lending standards, thereby reducing the availability of credit to higher-risk borrowers. Second, banks raised interest rates for new and existing borrowers, first on investor loans from 2015, and then on interest-only loans in 2017 (Graph 3). In other words, the banks tightened the supply of credit, most notably for investors. 3 / 16 BIS central bankers' speeches The FSR presents estimates of the effect of APRA’s first round of regulatory changes from late 2014. The key conclusions of that analysis are that, with the introduction of the 10 per cent investor credit growth benchmark: the composition of new lending shifted away from investors and towards owner-occupiers, with little change in overall housing loan growth; and housing prices have grown more slowly in regions with higher shares of investor-owned properties. So, that’s the story that emphasises the effect of prudential measures on the supply of credit. And, in turn, the effect of tighter credit supply on the demand for housing. Housing market developments affecting investor demand I now want to draw your attention to the story less often told about the important causal link going in the other direction. In particular, the correction in the housing market over the past year or so appears to have been impinging on the demand for credit. There are a number of reasons for the ongoing adjustment in housing prices: the aforementioned reduction in the supply of credit; the large increase in the supply of new housing associated with the high levels of housing 4 / 16 BIS central bankers' speeches construction in Brisbane, Melbourne and Sydney; weaker demand from foreign buyers due to stricter enforcement of Chinese capital controls and various policy measures in Australia (many of which were implemented by various state governments) that have made it more costly for foreign residents to purchase and hold housing; and last, but by no means least, the very substantial growth in housing prices over a long period, which had pushed housing prices to record levels as a share of household incomes and raised the prospects for a correction. In support of this last point, I note that housing prices in Melbourne and Sydney (which had increased by 55 and 75 per cent respectively since 2012) are currently experiencing larger declines than in Brisbane (where housing prices had risen 20 per cent from 2012 to the recent peak; Graph 4).5 It is also worth noting that housing prices are currently rising in Adelaide and Hobart. In addition, in Melbourne and Sydney house prices had run up further than apartment prices, and it is now house prices that have declined the most.6 While there may have been numerous causal factors, after a period of slowing housing price growth, more recently it is clear that housing prices are in decline in a number of major markets. 5 / 16 BIS central bankers' speeches This dynamic would have weighed heavily on the minds of buyers; particularly investors whose only motivation for buying is the return on the asset. An expectation of even a modest capital loss provides a strong incentive for them to delay buying a property, particularly in an environment of relatively low rental yields. But how can we assess the role of factors affecting credit supply versus those affecting credit demand? Changes in the price of credit – that is, interest rates – can help. Other things equal, a fall in the supply of credit relative to demand can be expected to be associated with higher interest rates on housing loans. In contrast, a fall in the demand for credit (relative to supply) should be associated with a decline in interest rates. Just to be clear, I’m talking about the credit supply and demand curves shifting inwards. The former, by itself, reduces quantities while prices rise as the equilibrium shifts up along the demand curve. The latter, by itself, reduces quantities but decreases prices as the equilibrium shifts down along the supply curve. So what’s happened to the interest rates borrowers are actually paying? The Securitisation Dataset provides estimates for both owner-occupiers and investors. There has been a modest broad-based decline in outstanding mortgage rates in the Securitisation Dataset over the year to August (Graph 5). This suggests that banks were responding to weakness in credit demand by competing more vigorously to provide loans to highquality borrowers. Indeed, looking just at new loans there is some evidence that average variable interest rates declined by more for investors than owner-occupiers, which is consistent with a noticeable decline in the demand for investor credit. 6 / 16 BIS central bankers' speeches However, compositional changes might also explain why there was a slight decline in interest rates over this period. In particular, the tightening in lending standards has helped to shift the profile of loans away from higher-risk borrowers. This shift would have contributed to the decline in average interest rates paid as better quality borrowers tend to get loans at lower rates. However, it turns out that rates have declined over this period even within the set of low-risk borrowers – for example, those with low loan-to-valuation ratios (LVRs) (Graph 6). So the decline in average rates paid has been driven by factors other than just compositional changes.7 7 / 16 BIS central bankers' speeches While banks began the process of tightening lending standards from around 2015, over the past year or so they have extended these efforts by applying greater rigour to their assessments of the ability of prospective borrowers to service loans. For example, banks have been assessing borrowers’ expenditures more thoroughly, which is likely to have contributed to reductions in the maximum loan sizes offered to borrowers.8 Notwithstanding these changes, there are two other pieces of evidence that suggest that factors other than just a tightening in constraints on the supply-side have been affecting housing credit and housing market developments over the past year or so: First, the majority of borrowers had earlier chosen to borrow much less than the maximum amounts offered by lenders. Hence, reductions in the sizes of maximum loans on offer over the past year does not imply one-for-one reduction in credit actually extended.9 Second, given that owner-occupiers have lower incomes on average than investors, they are likely to have faced noticeable reductions in maximum loan sizes as a result of the recent tightening in serviceability practices. However, owner-occupier credit growth has remained notably higher than investor credit growth. 8 / 16 BIS central bankers' speeches In summary, weakness in credit demand – stemming from the dynamics in the housing market – has been a significant development over the past year or so. This is not to say that ongoing weakness of credit supply has not also been at work since then, but that credit supply is not the only part of the story. Broader developments in the securitisation market So far I have focused on the prudentially regulated banks. While the non-banks still only account for a modest share of outstanding mortgages, the sector has experienced very strong growth over recent years and is an important source of competition for the banks. The RMBS market is a major source of funding for the non-bank providers of residential mortgages, and so RMBS issuance provides an indication of the recent growth in this sector. Last year, RMBS issuance was at its highest level since the global financial crisis. Non-banks’ issuance was in line with the high levels issued by this sector in the mid-2000s (Graph 7). In 2018, RMBS issuance in aggregate has been lower, but this has been largely been driven by decreased issuance by banks. Non-banks, by contrast, are continuing to issue close to $4 billion of RMBS per quarter. This high volume of RMBS issuance by non-banks is consistent with a sizeable increase in their mortgage lending. This is an unsurprising consequence of the tighter supervision and regulation of mortgage lending by banks. This is not to say that non-banks are unregulated. They operate 9 / 16 BIS central bankers' speeches under a licensing regime managed by the Australian Securities and Investments Commission. And, as my colleague Michele Bullock mentioned recently, the members of the Council of Financial Regulators (which includes the Reserve Bank, APRA and ASIC) are monitoring the growth of the non-bank lenders for possible emerging financial stability risks.10 The Reserve Bank’s liaison indicates that non-banks have been lending to some borrowers who may otherwise have obtained credit from banks in the absence of the regulatory measures. Consistent with this, the Securitisation Dataset shows that a rising share of non-bank lending has been to investors. Indeed, there has been at least a five-percentage-point increase in the share of investor loans across all outstanding non-bank deals in the Securitisation Dataset over the past two-and-a-half years (Graph 8).11 This is in contrast to the share of total bank loans to investors, which has been declining over that period. Similarly, the share of non-bank loans that are on an interest-only basis has been stable over the past couple of years, whereas the share of bank loans that are interest-only has declined significantly over the same period. 10 / 16 BIS central bankers' speeches The increase in the share of investor housing in deals issued by non-banks is one of the few noticeable changes in the composition of the collateral underpinning RMBS in the past couple of years. Indeed, for deals by non-banks the share of loans with riskier characteristics such as high LVRs or self-employed borrowers has been little changed. One of the other changes to loan pools in new deals is a fall in seasoning (i.e. the age of loans when the deal is launched). This has been most pronounced for non-banks (Graph 9). It is consistent with non-banks writing a lot more loans. Hence, warehouses of their loans are reaching desired issuance sizes more quickly. Despite the pull-back in RMBS issuance by the major banks over recent years, the broader stock of asset-backed securities (ABS) on issue increased by around $20 billion over the past 18 months, after remaining broadly stable for the previous 5 years (Graph 10; in addition to RMBS, ABS cover other assets such as car loans and credit card receivables). Demand for these additional asset-backed securities has been driven by non-residents. 11 / 16 BIS central bankers' speeches As well as a shift in the composition of investors in ABS, we have observed some changes in deal structures over recent years. Of particular note, the average number of tranches per deal has increased from around four to eight (Graph 11). The increase has been broad-based across different types of issuers. This general trend covers deals with a greater number of tranches with differing levels of subordination, as well as deals where the top tranche is split into a number of individual tranches with different characteristics but equal subordination. 12 / 16 BIS central bankers' speeches We have also seen what might be termed greater ‘specialisation’ of individual tranches. For instance, in recent years the use of one or more tranches with less common features – such as foreign currency, short term or green features – has increased. 12 This increased specialisation is consistent with issuers addressing the needs of different types of investors. All of these developments point to the evolution of the Australian securitisation market over the past few years, with non-bank issuers playing an increasingly important role and non-resident investors taking an increasing share of issuance. Benchmark interest rates, RMBS pricing and funding costs The increase in bank bill swap (BBSW) rates in early 2018 has led to a modest rise in the funding costs of both banks and non-banks.13 However, the increase in overall funding costs has been a bit greater for non-bank issuers than for banks. This is because banks have a sizeable proportion of their liabilities – such as retail deposits – that do not reprice in line with BBSW rates. Also, the bulk of non-banks’ loans are funded via RMBS issuance, and the cost of issuance has risen by a bit more than BBSW rates (Graph 12). The premium over the BBSW benchmark rate has risen to the level of two years ago. At the margin, these changes mean that 13 / 16 BIS central bankers' speeches non-bank issuers are not able to compete as aggressively on price for new borrowers as banks than was the case a year ago. Most lenders have passed through modest increases in their funding costs to borrowers over the past few months. Despite these increases, competition for new loans remains strong, and interest rates for new loans are still well below outstanding rates. So credit supply is available to good quality borrowers on good terms and there is a strong financial incentive to shop around. Interest Rate Benchmarks for the Securitisation Market One final point I’d like to make on pricing, is that RMBS issuers and investors should be considering the implications of developments in interest rate benchmarks. In light of the issues around benchmarks such as LIBOR (the London Inter-Bank Offered Rate), substantial efforts have been made to reform these benchmarks to support the smooth functioning of the financial system. BBSW rates are important Australian dollar interest rate benchmarks, and the 1-month BBSW 14 / 16 BIS central bankers' speeches rate is frequently used in the securitisation market. We have worked closely with the ASX and market participants to ensure that BBSW rates are anchored as much as possible to transactions in the underlying bank bill market. However, the most robust tenors are 6-month and 3-month BBSW, which are the points at which banks frequently issue bills to investors. In contrast, the liquidity of the 1-month BBSW market is lower than it once was. This is mainly due to the introduction of liquidity standards that reduced the incentive for banks to issue very shortterm paper. Given this, RMBS issuers should consider using alternative benchmarks.14 One option would be to reference 3- or 6-month BBSW rates for new RMBS issues. Another option is the cash rate, which is the (near) risk-free benchmark published by the Reserve Bank.15 Given the underlying exposure in RMBS is to mortgages rather than banks, it could make more sense to price these securities at a spread to the cash rate rather than to BBSW rates, which incorporate bank credit risk. Issuers and investors globally, including in Australia, should also be prepared for a scenario where a benchmark they are using ceases to be published. In such an event, users would have to rely on the fall-back provisions in their contracts. However, for many products – including RMBS – the existing fall-back provisions would be cumbersome to apply and could generate significant market disruption. This is most urgent for market participants using LIBOR, since the regulators are only supporting LIBOR until the end of 2021. While we expect that BBSW will remain a robust benchmark, it is prudent for users of BBSW to also have robust fall-backs in place. The International Swaps and Derivatives Association (ISDA) recently conducted a consultation on how to make contracts more robust. We would expect Australian market participants to adopt more robust fall-backs in their contracts following this process. Conclusion As the housing market undergoes a period of adjustment, it is useful to have an understanding of some of the drivers at play. Much attention has been given to the effect of prudential measures in dampening the supply of credit and how this has affected the housing market. However, it is also important to acknowledge causation going in the other direction, whereby the softer housing market has led to weakness in credit demand. My assessment is that the slowing in housing credit growth over the past year or so is due to both a tightening in the supply of credit and weaker demand for credit. Within that environment, lenders are competing vigorously for highquality borrowers. Developments in the RMBS market are consistent with non-bank lenders providing an extra source of supply. While non-banks remain small as a share of total housing lending, developments over the past couple of years show that the sector continues to evolve. The recent increase in issuance spreads may provide some slight headwinds for the sector; however, spreads remain below their levels in early 2016. Finally, I would urge both issuers and investors to be responsive to the forces affecting benchmarks used to price RBMS and to focus on preparing for the use of alternative benchmarks. 1 Since mid 2015, the Reserve Bank has required that detailed information about asset-backed securities and their underlying assets be reported to the Bank in order for these securities to be eligible as collateral for transactions with the Bank. The collection of these data allows the Bank to manage its actual and contingent exposure to these securities. The Bank also requires some data to be made available to permitted data users with the aim of enhancing market transparency. The database contains information on approximately 1.6 million housing loans, or roughly one-quarter of those outstanding. Across many, although not all, dimensions the database is reasonably representative of the broader mortgage market; see the forthcoming RBABulletin article by Fernandes and Jones. 15 / 16 BIS central bankers' speeches 2 Debelle G (2018), ‘Assessing the Effects of Housing Lending Policy Measures’, Speech at FINSIA Signature Event: The Regulators, Melbourne, 15 November. 3 See RBA (Reserve Bank of Australia) (2018), Financial Stability Review, October. 4 I use the term ‘banks’ loosely to include all authorised deposit-taking institutions (ADIs). For details on the investor lending growth benchmark see APRA (Australian Prudential Regulation Authority) (2014), ‘APRA Outlines Further Steps to Reinforce Sound Residential Mortgage Lending Practices’, Media Release No 14.30, 9 December. 5 Note that housing prices in Melbourne and Sydney remain 50 and 60 per cent higher than in 2012, respectively. 6 The data in Graph 4 only partially capture off-the-plan sales of apartments. Nonetheless, to the extent that such apartments are relatively close substitutes for existing apartments, the prices for apartments shown should be broadly representative of all apartments. 7 The shift from interest-only payments to principal-and-interest payments is another compositional change that may have contributed to a reduction in the average interest rates paid over this period. However, interest rates also declined within the set of interest-only and principal-and-interest loans, for both owner-occupiers and investors. 8 See RBA (2018), Household and Business Finances, Financial Stability Review, October. 9 See RBA (2018), ‘Box B: The Impact of Lending Standards on Loan Sizes’, Financial Stability Review, October. 10 Bullock M (2018), “Building Financial Sector Resilience: A Decade Long Transition”, 10th Annual Commonwealth Bank Global Markets Conference, Sydney, 30 October 2018. 11 While, as I note below, the average seasoning of loans in non-banks’ new RMBS deals has fallen in recent years, the data on non-banks’ securitised loans remain a less reliable indicator of recent lending activity. 12 Atypical RMBS tranche (or note) will pay a floating interest rate with principal returned on a ‘pass-through’ basis as payments are received (subject to the payment profile specified in the RMBS deal documentation). A shortterm tranche is one that is structured to receive sufficient principal payments such that its weighted average life is less than or equal to one year. A ‘green’ tranche indicates that a sufficient share of mortgages in the pool involves housing that meets certain energy efficiency or low carbon criteria for residential buildings. 13 See RBA (2018), Domestic Financial Conditions, Statement on Monetary Policy, August for more detail on the effect of higher BBSW rates on banks’ funding costs. 14 This point was raised in a speech by Guy Debelle several years ago: Debelle G (2015), ‘Benchmarks’, Speech at the Bloomberg Summit, Sydney, 18 November. 15 For further details, see Debelle G (2018), ‘Interest Rate Benchmark Reform’, Keynote at ISDAForum, Sydney, 15 May, and Alim S and E Connolly (2018), ‘ Interest Rate Benchmarks for the Australian Dollar’, RBA Bulletin, September. 16 / 16 BIS central bankers' speeches | reserve bank of australia | 2,018 | 11 |
Address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, to the Australian Business Economists Annual Dinner, Sydney, 6 December 2018. | 12/6/2018 Lessons and Questions from the GFC | Speeches | RBA Speech Lessons and Questions from the GFC Guy Debelle [ * ] Deputy Governor Address to the Australian Business Economists Annual Dinner Sydney – 6 December 2018 It is now just over 10 years since the date that people most associate with the Global Financial Crisis (GFC), namely 15 September, the day that Lehman Brothers filed for bankruptcy. [1] There have been quite a number of articles written in recent months looking back at that time and the period leading up to it. [2] It is interesting to read the differing perspectives on the same set of events, especially those that recount events that I had a ringside seat at, or was even in the ring itself. As I have said recently, it's a bit like the standard line about the sixties, those who can remember the GFC probably weren't there. The sleep-deprived haze that was pervasive at the time affects the memory. Critical decisions were made under extreme duress and fatigue, particularly in the US, which by and large stack up well with the passage of time. Today I am not going to give another detailed account of what happened. I will talk about some of the events, but the main thing I intend to do is to talk about some of the lessons learned and relearned from the crisis. This list of lessons is by no means comprehensive. I will also discuss some questions that arise from the crisis that remain unresolved, at least in my mind. They are questions which I think should be a focus of the economics profession. Answering them will help guide policymakers should they be faced with similar situations to the one we confronted in 2008. I am going to talk about both macro and finance today. Some events can be seen through mostly a macro lens with finance playing a lesser role (the seventies in Australia is an example), some events can be seen with the spotlight on finance with macro as a sideshow (e.g., the dotcom bubble). I don't think it is possible to look at the GFC and talk about one without the other. It is clearly important to integrate finance into macroeconomic analysis. Indeed, the failure to do that is a criticism that is often levelled at central banks and the macroeconomic profession in the aftermath of the crisis. I think this criticism is overstated. One obvious counter example is the work https://www.rba.gov.au/speeches/2018/sp-dg-2018-12-06.html 1/13 12/6/2018 Lessons and Questions from the GFC | Speeches | RBA of Ben Bernanke himself on the Great Depression, Japan and the financial accelerator. His large body of work very much informed the Fed's actions during the GFC. How should this integration occur? Should finance be built directly into the models that inform (though do not dictate) policymaking decisions? There is a body of work directed at that goal currently underway. [3] Building finance into macro models is one approach but by no means the only one. At the very least though, macroeconomics should have an understanding of finance and vice versa. Macroeconomics is like the model of the engine, finance is the oil that lubricates the engine. One can understand how the engine works without really needing to worry about the oil, as long as the oil is flowing. But at least a basic understanding of the plumbing is useful when the oil dries up. The key lesson that comes from the crisis that I will highlight today is leverage really matters. Leverage significantly magnifies the effect of any shock that hits the economy. Leverage might not start the fire, but it will pour petrol on a burning platform. At the same time, you need to keep the credit flowing to prevent the economy from seizing up. Ballad of a Thin Man Something's happening here but you don't know what it is, do you Mr Jones? That is the Dylan version of the question Queen Elizabeth posed: why didn't anybody see this coming? There were those who saw the storm clouds on the horizon. Michael Lewis wrote a book about some of them. Though often the storm didn't quite take the form these people were expecting. Very few appreciated the extent of the financial interconnectedness and what that implied. For example, one common prediction was there would be a US dollar crisis with consequent calamity, but, in the event, the US dollar appreciated through the crisis. Looking back on how financial markets reacted through 2007, the onset of the crisis is often dated from BNP Paribas shutting three funds with subprime mortgage exposure on 9 August. That caused a short-lived wobble in equity markets, but after that it was onwards and upwards for much of the rest of the year, with the equity market peaking in November. The equity market was the lens through which the public saw events unfold. So by that metric, 2007 was fairly benign. Macroeconomists generally looked at what was unfolding in the US housing market and expected that its spillover to the rest of the economy would be contained. The slowdown would be mild and, to an extent, welcome in containing the inflationary pressures that had been building. But the fixed income market took fright and got more and more scared through 2007. Uncertainty increased about the quality and value of asset-backed securities and the assets that underpinned them. There was further uncertainty about whose books these assets resided on, generating a marked rise in counterparty risk aversion amongst financial institutions. That is, institutions became less willing to lend to each other, both because of concerns about the financial strength of the counterparty as well as a desire to hoard any available liquidity, should they themselves need it. The indicator of the tension in fixed income markets is the LIBOR/OIS spread (BBSW/OIS here in Australia), which summarises the unfolding of the crisis well (Graph 1). https://www.rba.gov.au/speeches/2018/sp-dg-2018-12-06.html 2/13 12/6/2018 Lessons and Questions from the GFC | Speeches | RBA Graph 1 These tensions continued to increase with a rolling series of flare-ups, including notably the rescue of Bear Stearns by JP Morgan in March 2008. By this stage, these concerns were increasingly reflected in the equity market too. GDP growth in a number of economies started to slow, but it was not until the fourth quarter 2008 when the economic forces took hold with a vengeance. Lehmans filed on the Monday morning Australian time. It is interesting to look back at the time. That day was a relatively quiet one in financial markets. Lehmans wasn't the turning point. The actual zenith of the crisis was still to come in the following weeks. AIG, the poster child of financial connectedness, was rescued. TARP was rejected by Congress and then passed after financial tumult broke out. The prime mutual fund Reserve broke the buck. Washington Mutual failed. Markets were driven by fear, with huge swings in prices. Many of these swings occurred late in the New York trading day, which was early in the Australian day. The correlation between the Australian dollar and the US equity markets through those periods was indicative of the extremely high degree of co-movement across all markets. Markets regularly recorded ‘25 standard deviation events’ in the words of then Goldmans CFO David Viniar. These sorts of events are only supposed to be happening once in the lifetime of the universe, which says something about the risk models that were being used at the time. My recollection of the worst of it was in the early hours of Saturday morning 11 October after we had been intervening in the foreign exchange market through the Friday evening to provide liquidity into https://www.rba.gov.au/speeches/2018/sp-dg-2018-12-06.html 3/13 12/6/2018 Lessons and Questions from the GFC | Speeches | RBA an almost completely illiquid market. Talking on the phone to the RBA desk in New York, they reported that US Treasuries, the most liquid market in the world, had effectively seized up. It is worth recounting this, just to recall how dislocative and disruptive these developments were. It was really not clear how this was going to end, except badly. The fourth quarter of 2008 was bad. Global GDP declined by 1.5 per cent. GDP in the US fell by 2.2 per cent. In Australia, GDP contracted by 0.5 per cent (Graph 2). The impact was particularly severe in global trade, which collapsed as trade finance dried up because of extreme counterparty risk aversion (Graph 3). Companies and banks were unwilling to accept the guarantee of another bank that underpinned the trade lines of credit. They had little confidence they were going to be paid. Graph 2 https://www.rba.gov.au/speeches/2018/sp-dg-2018-12-06.html 4/13 12/6/2018 Lessons and Questions from the GFC | Speeches | RBA Graph 3 The breadth and depth of the impact was remarkable. Output fell by more in the Great Depression, but the Great Depression was not synchronised nor as widespread as this was. These macroeconomic and financial developments very much underpin the nature of the global policy response, both monetary and fiscal. There was a fiscal response in many (though not all) countries, buttressed by the G20 leaders meeting in April 2009. Central banks responded by reducing policy rates rapidly to very low levels. Some of these actions were coordinated in a hitherto unprecedented manner. Central bank balance sheets expanded rapidly (Graph 4). The re-intermediation by central banks mitigated the withdrawal of intermediation by the banking sector. A part of that increase in the balance sheet addressed the large counterparty risk aversion. Central banks were willing to stand between institutions that were unwilling to deal with each other, as well as accommodate the rapid increase in demand for liquidity. That large increase in central bank balance sheets mitigated the large contraction in the financial sector, which goes a long way to explaining why it has still yet to lead to a marked rise in inflation, despite this being foreshadowed by a number of commentators over the past decade. https://www.rba.gov.au/speeches/2018/sp-dg-2018-12-06.html 5/13 12/6/2018 Lessons and Questions from the GFC | Speeches | RBA Graph 4 The central bank actions were designed to alleviate the credit crunch. An alphabet soup of programs was implemented in the US to address the dysfunction in a number of markets, [5] with similar programs in other countries. The aim was to keep the credit flowing and limit the need for fire sales wherever possible. An important motivation for this first phase of quantitative easing (QE) in the US and elsewhere was addressing the market dysfunction. Indeed, for a time, the Fed characterised it as credit easing. This first phase of QE was particularly effective. My view is that subsequent phases of QE had diminishing returns, though I acknowledge that much of the empirical evidence tends not to find that. A question worth considering about QE is: if QE was effective on the way in, then surely there must be a large degree of symmetry? Hence we should expect to see similar but opposite effects on the way out. If there were diminishing returns to QE, then it might take a little while before we see the full impact of the reduction in the Fed's balance sheet that is currently underway, but the effect should grow over time. Turning to Australia, why did Australia come through the crisis better than many other countries? There were a number of contributing factors. [6] Good luck certainly played a role. But the policy actions made an important contribution too. Monetary policy was eased rapidly. The Australian banking system was much less affected by the problems bedevilling banking systems in other countries (partly through good luck). This meant that the transmission of the significant easing in monetary policy to the economy worked pretty much as normal. The exchange rate depreciation https://www.rba.gov.au/speeches/2018/sp-dg-2018-12-06.html 6/13 12/6/2018 Lessons and Questions from the GFC | Speeches | RBA combined with the fact that the Australian economy could adapt flexibly to the depreciation were beneficial. Fiscal stimulus in Australia in my view was absolutely necessary and was a critical factor behind Australia's good economic outcomes. [7] While one can argue about the exact nature of the implementation, the fact that it was designed to take effect quickly was vital in the circumstances: ‘go hard, go early, go to households’ as Ken Henry put it. China was certainly a major contributor to Australia's resiliency. But it is important to remember that China's strong growth at the time was a direct consequence of their large fiscal stimulus. Hence it seems inconsistent to me to argue that China ‘saved’ Australia, as a result of its fiscal stimulus, while simultaneously dismissing the direct impact of fiscal stimulus here in Australia. What lessons did we learn (and relearn) from this experience? Policy capacity matters, both monetary and fiscal. Fiscal space is really important. We still have that in Australia. It is less clear there is fiscal capacity in some other countries. Monetary capacity matters too. The Reserve Bank has repeatedly said that our expectation is that the next move in monetary policy is more likely up than down, though it is some way off. But should that turn out not to be the case, there is still scope for further reductions in the policy rate. It is the level of interest rates that matters and they can still move lower. We have also been able to examine the experience of others with other tools of monetary policy and have learned from that. Hopefully, we won't ever have to put that learning into practice. QE is a policy option in Australia, should it be required. There are less government bonds here, which may make QE more effective. But most of the traction in terms of borrowing rates in Australia is at the short end of the curve rather than the longer end of the curve, which might reduce the effectiveness of QE. The RBA's balance sheet can also expand to help reduce upward pressure on funding, if necessary, as occurred in 2008. Finally, the floating exchange rate matters and remains an important shock absorber for the Australian economy. Everything Flows I will now step into the plumbing and talk briefly about the lessons learned on liquidity provision and other measures undertaken to keep financial markets functioning as best as possible. The RBA's balance sheet expanded in Australia for a number of reasons. [9] Exchange settlement balances at the RBA increased as banks' preference for liquidity increased. We were able to accommodate this in our daily market operations. Part of the increased demand for liquidity arose from the large rise in counterparty risk aversion that I referred to earlier. We also offered more repos at longer terms to our counterparties, which saw our domestic repo book approximately double in size and the average maturity increase from 20 days to four months. This helped to provide some additional certainty to funding and mitigate some of the upward pressure on bank funding costs. The balance sheet of the central bank, and that of the public sector more generally, has the capacity to intertemporally smooth more than any other balance sheet in the economy, be it financial https://www.rba.gov.au/speeches/2018/sp-dg-2018-12-06.html 7/13 12/6/2018 Lessons and Questions from the GFC | Speeches | RBA institutions, corporates or households. The capacity to do this is particularly important when you are dealing with a systemic risk event, as was the case in the GFC. The central bank can intermediate extreme counterparty risk, functioning as much as intermediary of last resort as lender of last resort. Another example of this was the provision of the FX swap lines. [10] These facilities were introduced to address the global shortage of US dollars (outside the US), which was causing a substantial dislocation in swap markets. In our case, we were able to intermediate the provision of US dollars into the Asian time zone, where this shortage was particularly acute. By the end of the trading day in the US, these shortages had often abated. Note that the swap lines were not about providing US dollars to the Australian banks to meet US dollar obligations. The Australian banks were predominantly funding Australian dollar assets (the hedges on their US dollar borrowing provided them with the US dollars as these matured). They needed Australian dollars rather than US dollars. On 12 October, the Australian Government introduced a guarantee on wholesale debt and deposits. This followed on from the introduction of the guarantee in Ireland on 30 September. With the guarantee in place in many other countries, Australian banks would have been at a significant disadvantage in terms of funding costs without the guarantee. In addition, the guarantee allowed the banks to access another group of investors who had an appetite for sovereign credit but not bank credit. It is interesting to consider the question of how much the guarantee addressed the issue of quantity or price. There was a period of time where debt markets were closed at any price in the last quarter of 2008. But at some point it became more an issue of price rather than quantity. As an indication of the price that might have had to be paid, Goldmans issued a bond around this time at a spread of 500 basis points. It is also worth noting that short-term funding continued to be issued by the Australian banks without the need for a guarantee. Both the RBA operations and the government's funding guarantee were priced such that usage would decline as market conditions improved, and, indeed, that is what happened. The many Fed facilities introduced to address market dysfunction were priced the same way. That is an important lesson which has been around since the time of Bagehot. These facilities were introduced to facilitate the flow of credit to the real economy at a reasonable price and, in some cases, alleviate the need for asset fire sales, which have the capacity to tip markets and the economy into a worse equilibrium. It is also worth noting that the depreciation of the exchange rate also helped out on the funding side. With a lower exchange rate, a given amount of $US funding translates into more Australian dollars to fund Australian dollar assets. Unlike in some other countries, the maturity-matched hedging of the banks' offshore funding meant there was no issue of currency mismatch. Indeed the CSAs (Credit Support Annexes) associated with those hedges actually provided a short-term source of additional funding. Finally, the similarity of the business models of the Australian banks was probably beneficial in the GFC. There was not much to differentiate between them, which meant that the counterparty uncertainty present in other banking systems was nowhere near as prevalent here. https://www.rba.gov.au/speeches/2018/sp-dg-2018-12-06.html 8/13 12/6/2018 Lessons and Questions from the GFC | Speeches | RBA The Australian banks' similarity is not so obviously beneficial in the current circumstance. Their similar behaviour and similar reaction functions to events such as falling house prices run the risk of amplifying the downturn in the housing market. The crisis very much demonstrated the critical importance of keeping the lending flowing. The lesson is that countries that did that fared better than countries that didn't. That lesson is relevant to the situation today in Australia, where there is a risk that a reduced appetite to lend will overly curtail borrowing with consequent effects for the Australian economy. Karma Police After the crisis has come the regulatory response, coordinated by the Financial Stability Board (FSB). [13] In the banking space, the regulation has included: 1. The Basel capital standards have required the banks to hold more capital thereby reducing leverage. 2. The Liquidity Coverage Ratio (LCR) had addressed liquidity/runnable funding. 3. The Net Stable Funding Ratio (NFSR) has addressed funding mismatch/maturity transformation. 4. The Volcker rule (in the US), and increased balance sheet costs more generally, have reduced banks' capacity to provide services such as market-making and repo in other jurisdictions. The first of these has clearly reduced the leverage in the core banking system. Some argue that the leverage should be reduced further (see below), but unambiguously banks hold more capital than they did pre-crisis. The enhanced liquidity regulation in Australia has been in place since the beginning of 2015, and its effects have been present even before then as the banks adjusted their funding and assets to meet the new requirements. In other parts of the world, I think the effect of the liquidity regulation has been diluted by the large liquidity provided by the greatly expanded central bank balance sheets. As the Fed balance sheet is shrinking, it is likely that the liquidity regulation will start to bite more in the US. Indeed it is possible we are starting to see some effects now, not necessarily in aggregate, but in particular parts of the money markets. As important as the liquidity regulation is, in my view, asset quality matters more than funding in the end. [14] If asset quality remains sound, as a creditor of the bank, I should be confident of being repaid. An example of this is to compare the German domestic banks and the Australian banks. The German banks were predominantly deposit funded. However, with relatively low returns on offer in Germany, they sought out higher-yielding assets offshore including RMBS (residential mortgagebacked securities) and CDOs (collateralised debt obligation) in the US. In contrast, the Australian banks utilised more wholesale funding but were able to earn high returns on their domestic Australian assets. During the crisis, the German banks were faced with much greater asset quality issues than the Australian banks. They had $US asset positions that were difficult to fund in the market, notwithstanding the fact that their funding (in euros) is regarded as more stable. https://www.rba.gov.au/speeches/2018/sp-dg-2018-12-06.html 9/13 12/6/2018 Lessons and Questions from the GFC | Speeches | RBA One (intended) impact of the Volcker rule and similar regulations is that banks have retreated from their former role as market makers and risk warehousers. This was by design, to ensure that the core part of the intermediation process would not be affected by concerns about the quality of assets on their books accumulated through these activities, particularly given the difficulty in distinguishing between risk warehousing and speculation (which can be observationally equivalent). What does this imply for market dynamics? It is distributing the risk from the banking sector to real money such as asset managers. That is fine in principle, as asset managers have more capacity to absorb and manage the risk with less disruption to the real economy. But it still remains an open question as to how quickly people with deployable capital respond to dislocations in market prices, given that the banks play a considerably smaller role. That said, one should be careful not to look at the past with rose-coloured glasses. Banks didn't rush in to catch a falling knife when asset prices were falling. Liquidity pockets occurred at least as much in the past, with one good example being the frequency of large big figure movements in foreign exchange rates. Bid-ask spreads used to widen a lot in the past too. The ultimate widening in bid-ask spread back then was not to answer the phone. In addition, the market liquidity provision mechanism is now more machines and less people. The shape of liquidity has changed and with it market dynamics in a stress environment. The potential volatility of markets has increased (even though actual volatility has generally been low). In such circumstances, some have talked about central banks acting as market-maker of last resort, stepping in to provide liquidity in a dislocated market (like foreign exchange intervention). This is an interesting question to consider. I think it is a mischaracterisation to call this market-making. It is more likely the central bank will be the buyer of last resort. It may well be some time before the central bank can sell on the asset at a reasonable price. This might well be justified to prevent firesale dynamics taking hold, but it should be recognised for what it is, which is not market-making. The potential implications for central bank balance sheets also need to be thought through. One lesson from any number of crises past is that it is almost inevitable the next crises will originate somewhere different. The inevitability of this in part arises because of the reforms introduced to address the sources of the previous crisis. So where might one possible location of the next crisis lie? To me, one possibility is that it will involve central counterparties (CCPs). They have a high degree of interconnectedness, considerably greater than before, and very much sit at the heart of the financial system today. Their resilience is of first order importance, as they potentially constitute single points of failure. Much has been done to increase their resilience, recovery planning and resolvability already, including by my colleagues at the RBA. The FSB has a work program to address CCP issues, but it remains a work in progress. How Much Is Enough? Finally, I will pose a critical, but unresolved, question: what is the right amount of leverage in the system? When is there too much? https://www.rba.gov.au/speeches/2018/sp-dg-2018-12-06.html 10/13 12/6/2018 Lessons and Questions from the GFC | Speeches | RBA Leverage was at the heart of the GFC. Leverage in the banking system and highly leveraged nonbank institutions like Bear Stearns and Lehmans played a fundamental role in significantly amplifying the crisis. Excess leverage in housing sectors, such as those in the US, Ireland and Spain, was incredibly damaging. This has led to the long-lived effects we still see today, both economic and political. But we still don't really have a great handle on what level of leverage is dangerously excessive for governments, households, banks and corporates. This surely is a major challenge for the economics profession to address. As I said earlier, banks have increased capital and reduced leverage. But those such as Anat Admati still make the argument that further reduction in leverage is necessary. In terms of government, public debt is sustainable until it is not. It is not at all clear whether there is a threshold of sustainability. We have seen crises erupt at very different levels of public debt. Public debt in Japan is currently at 240 per cent of GDP, but there has not been a crisis. We have seen other countries have debt crises at considerably lower levels of debt to GDP. The market can turn on these countries very quickly. We do know that unhedged borrowing in foreign currency significantly increases the vulnerability. And, relatedly, the European situation highlights the issues that arise when the government doing the borrowing and the central bank are part of the same currency union but not the same country. On the private sector side, what are the appropriate metrics? Corporate debt sustainability is assessed in terms of debt to equity ratios or serviceability. It is probably the form of debt about which we have the best understanding of sustainability. But what about household debt? Debt to income is commonly used, but that is dividing a stock by a flow, a metric not commonly used for corporates. We can look at household leverage, but that is very much dependent on the value of the denominator, house prices in this case, and we know they can decline quite rapidly. Serviceability can be a useful metric, but we don't have a good sense of sustainability at the aggregate level. [16] The quality and distribution of household debt matters as well as the level. The policy measures implemented in Australia over recent years have been aimed at improving the quality, and hence sustainability, of household debt. While acknowledging that household debt is higher in Australia than many other countries, there is little to form a strong conclusion about how much is too much. How much debt is enough and how to best manage the risks are two of the large questions remaining unanswered, ten years after the GFC. History Never Repeats? To conclude, the GFC provided many lessons, some old, some new. One of the main lessons was an old one: leverage matters. https://www.rba.gov.au/speeches/2018/sp-dg-2018-12-06.html 11/13 12/6/2018 Lessons and Questions from the GFC | Speeches | RBA Leverage can turn a manageable macroeconomic event into a very hard to manage crisis. The regulatory response has been aimed at addressing this by reducing the leverage in the core of the financial system, while being mindful that the risk and leverage is not excessively relocated elsewhere. The second lesson is that timely policy responses are effective. In a crisis, go fast and go hard. Don't die wondering. The third lesson is that the plumbing can sometimes really matter. Keep the credit pipes flowing. Fourth, targeted policy responses/interventions are effective. Use Bagehot pricing, where these interventions are priced to work in bad times but not in the good times. But the questions of how much debt is enough and how much is too much remain unresolved. The lessons learned from the GFC will be useful, provided they are not forgotten. But there will be new challenges ahead and the source of the next crisis will probably be different. History does not repeat itself but it often rhymes. Endnotes [*] Thanks to Lara Pendle and Christian Vallence for their assistance. Particular thanks to James Aitken, Morten Bech, Ulrich Bindseil, Matt Boge, Jean Pierre Danthine, Bill Dudley, Paul Fisher, Trish Mosser, Hiroshi Nakaso, Francesco Papadia, Simon Potter, Roberto Schiavi, Chris Ryan, Brian Sack, Chris Salmon and James Whitelaw as well as other members of the BIS Markets Committee for many helpful conversations over the past decade. The GFC playlist for this speech is Bob Dylan, Teenage Fanclub, Radiohead, You Am I, Split Enz. The label ‘GFC’ was an export from Australia to the rest of the world. Luckily we did not import the Great Recession to balance the trade ledger. Brookings provide a comprehensive summary of accounts from a US perspective: Brookings (2018), ‘Day 1: Responding to the Global Financial Crisis’, Bookings.edu site, 11 September. Available at <https://www.brookings.edu/events/day-1-responding-to-the-global-financial-crisis/>. See also Shin HS (2018), ‘Reflections on the Lehman collapse, 10 years later’, Speech at the Bank for International Settlements, 17 September. One example that has already borne some fruit is the work of Simon Gilchrist in succinctly including the financial channel in macro models via credit spreads: Faust J, S Gilchrist, JH Wright and E Zakrajsek (2013), ‘Credit Spreads as Predictors of Real-Time Economic Activity: A Bayesian Model-Averaging Approach’, , MIT Press, 95(5), pp 1501–1519, December. Statistics The Review of Economics and Leaders of the Group of Twenty (2009), ‘London Summit – Leaders’ Statement', 2 April. Available at <https://www.imf.org/external/np/sec/pr/2009/pdf/g20_040209.pdf>. Logan L, W Nelson, P Parkinson (2018), ‘Responding to the Global Financial Crisis What We Did and Why We Did It: Novel Lender of Last Resort Programs’, Brookings preliminary discussion draft. Available at <https://www.brookings.edu/wp-content/uploads/2018/08/02-Novel-LOLR-Prelim-Disc-Draft-2018.09.11.pdf>. Kearns J, ‘Lessons from the financial crisis: an Australian perspective’, in J Braude, Z Eckstein, S Fischer and K Flug (eds), , 2011, MIT press, pp 245-68. The Great Recession: lessons for central bankers https://www.rba.gov.au/speeches/2018/sp-dg-2018-12-06.html 12/13 12/6/2018 Lessons and Questions from the GFC | Speeches | RBA Hence I would endorse the assessment of Treasury on the effectiveness of these actions https://treasury.gov.au/speech/the-return-of-fiscal-policy/. See also <https://treasury.gov.au/speech/the-9th-caixinsummit-global-challenges-global-solutions/>. Debelle G (2008), ‘Market Operations in the Past Year’, Speech at the 2008 FTA Congress, Melbourne, 31 October. Debelle G (2010), ‘The Evolving Financial Situation’, Speech at the Women in Finance Lunch, Sydney, 16 February. [10] Sheets N, E Truman, C Lowery (2018), ‘Responding to the Global Financial Crisis What We Did and Why We Did It. The Federal Reserve’s Swap Lines: Lender of Last Resort on a Global Scale'. Brookings preliminary discussion draft available at <https://www.brookings.edu/wp-content/uploads/2018/08/14-B-International-Swaps-Prelim-Disc-Draft2018.09.11.pdf>. [11] Debelle G (2013), ‘Remarks on Liquidity’, Address to the Australasian Finance and Banking Conference, Sydney, 17 December. See also Carlson M and M Macchiavelli (2018), ‘Emergency Collateral Upgrades’, Finance and Economics Discussion Series No 2018–078. [12] Margin was posted by the banks' swap counterparties as the exchange rate depreciated. This was in the form of cash or a cash equivalent. This was another way in which the exchange rate was an automatic stabiliser. [13] See FSB (2014), ‘Overview of Progress in the Implementation of the G20 Recommendations for Strengthening, Financial Stability’, Report of the Financial Stability Board to G20 Leaders, November. Available at <http://www.fsb.org/wp-content/uploads/Overview-of-Progress-in-the-Implementation-of-the-G20Recommendations-for-Strengthening-Financial-Stability.pdf>. [14] Debelle G (2011), ‘Collateral, Funding and Liquidity’, Address to Conference on Systemic Risk, Basel III, Financial Stability and Regulation, Sydney, 28 June. , [15] Admati R, P DeMarzo, M Hellwig and P Pfleiderer(2018) ‘The Leverage Ratchet Effect’, available at <https://www.gsb.stanford.edu/faculty-research/publications/leverage-ratchet-effect>, February, 73(1), pp 145–198. The Journal of Finance, [16] Debelle G (2004), ‘Macroeconomic Implications of Rising Household Debt’, available at <https://www.bis.org/publ/work153.htm>,, BIS Working Papers, No 153, 1 June. [17] Debelle G (2018), ‘Assessing the Effects of Housing Lending Policy Measures’, Remarks at FINSIA Signature Event: The Regulators, Melbourne, 15 November. [18] One part of the explanation for the relatively high level of household debt in Australia is that the household sector owns the rental stock, where in other countries it is often owned by corporations. See Bullock M (2018), ‘The Evolution of Household Sector Risks’, Speech at Ali Group, Albury, 10 September. © Reserve Bank of Australia, 2001–2018. All rights reserved. https://www.rba.gov.au/speeches/2018/sp-dg-2018-12-06.html 13/13 | reserve bank of australia | 2,018 | 12 |
Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at a Bloomberg event, Sydney, 10 December 2018. | 12/10/2018 US Monetary Policy and Australian Financial Conditions | Speeches | RBA Speech US Monetary Policy and Australian Financial Conditions Christopher Kent [ * ] Assistant Governor (Financial Markets) The Bloomberg Address Sydney – 10 December 2018 Introduction Thank you for the opportunity to speak at this Bloomberg event today. I'd like to address some issues about how monetary policy decisions taken elsewhere influence interest rates here in Australia. Australia is a small open economy that is influenced by developments in the rest of the world. Financial conditions here can be affected by changes in monetary policy settings elsewhere, most particularly in the United States given its importance for global capital markets. However, Australia retains a substantial degree of monetary policy autonomy by virtue of its floating exchange rate. In other words, a change in policy rates elsewhere need not mechanically feed through to Australian interest rates. While Australian banks raise significant amounts of funding in offshore markets, they are able to insulate themselves – and by extension Australian borrowers – from changes in interest rates in other jurisdictions. Just before delving into the details, some context is in order. First, Australian banks have long borrowed in wholesale markets, including those offshore. However, they do so much less than used to be the case (Graph 1). [1] For a number of reasons, domestically sourced deposits have become an increasingly large share of overall funding for banks. https://www.rba.gov.au/speeches/2018/sp-ag-2018-12-10.html 1/10 12/10/2018 US Monetary Policy and Australian Financial Conditions | Speeches | RBA Graph 1 Second, to the extent that Australian banks have continued to tap offshore wholesale markets, it is worth reflecting on some of the characteristics of this borrowing. For instance, some banking sectors around the world borrow in US dollars in order to fund their portfolios of US dollar assets. [3] This can leave them vulnerable to intermittent spikes in US interest rates. However, this is generally not the case for Australian banks. Rather, a good deal of the borrowing by Australian banks in US dollars reflects the choice of the banks to diversify their funding base in what are deep, liquid capital markets. By implication, if the costs in the offshore US dollar funding market increased noticeably relative to the home market, then Australian banks can pursue other options. They might opt to issue a little less in the US market for a time, switching to other markets or even issuing less offshore. They are not ‘forced’ to acquire US dollars at any price, as some other banks may be. Another important feature of this offshore funding, as I will address in detail in a moment, is that the banks are not exposed to exchange rate risks as they hedge their borrowings denominated in foreign currencies. Independence – It's an Australian Dollar Thing As you are well aware, the US Federal Reserve has been raising its policy rate in recent years, and interest rates in the United States are now higher than in Australia. These developments reflect differences in spare capacity and inflation: unemployment in the United States is at very low levels, inflation is at the Fed's target and inflationary pressures appear to be building. Since August 2016 – the last time the Reserve Bank changed its cash rate target – the Federal Reserve has raised its https://www.rba.gov.au/speeches/2018/sp-ag-2018-12-10.html 2/10 12/10/2018 US Monetary Policy and Australian Financial Conditions | Speeches | RBA policy rate seven times, by 175 basis points in total (Graph 2). Yet while Australian banks raise around 15 per cent of their funding in US dollars, interest rates paid by Australian borrowers since then have been little changed. Graph 2 How is it that interest rates for Australian borrowers have been so stable, despite Australian banks having borrowed some US$500 billion in the US capital markets, in US dollars, paying US dollar interest rates? The answer lies in the hedging practices of the Australian financial sector. As I'll demonstrate, Australian banks use hedging markets to convert their US interest rate obligations into Australian ones. The Australian banks fund their Australian dollar assets via a number of different sources. Some of their funds are obtained in US dollars from US wholesale markets. In order to extend these USD funds to Australian residents, they convert the US dollars they have borrowed into Australian dollars soon after the securities are issued in the US. On the surface it would appear that such transactions could give rise to substantial foreign exchange and interest rate risks for Australian banks given that: 1. the banks must repay the principal amount of the security at maturity in US dollars. So an appreciation of the US dollar increases the cost of repaying the loan in Australian dollar terms; and https://www.rba.gov.au/speeches/2018/sp-ag-2018-12-10.html 3/10 12/10/2018 US Monetary Policy and Australian Financial Conditions | Speeches | RBA 2. the banks must meet their periodic coupon (interest) payments in US dollars, which are tied to US interest rates (either immediately if the security has a floating interest rate, or when the security matures and is re-financed). So a rise in US interest rates (or an appreciation of the US dollar) would increase interest costs for Australian banks that extend loans to Australian borrowers. However, it is standard practice for Australian banks to eliminate, or at least substantially reduce, these risks. They can do this using a derivative instrument known as a cross-currency basis swap. Such instruments are – when used appropriately – a relatively cost effective way of transferring risks to parties with the appetite and capacity to bear them. Simply put, cross-currency basis swaps allow parties to ‘swap’ interest rate streams in one currency for another. They consist of three components (Figure 1): 1. first, the Australian bank raises US dollars in the US wholesale markets. Next, the Australian bank and its swap counterparty exchange principal amounts at current spot exchange rates; that is, the Australian bank ‘swaps’ the US dollars it has just borrowed and receives Australian dollars in return. It can then extend Australian dollar loans to Australian borrowers; 2. over the life of the swap, the Australian bank and its swap counterparty exchange a stream of interest payments in one currency for a stream of interest receipts in the other. In this case, the Australian bank pays an Australian dollar interest rate to the swap counterparty and receives a US dollar interest rate in return. The Australian bank can use the interest payments from Australian borrowers to meet the interest payments to the swap counterparty, and it can pass the interest received from the swap counterparty onto its bondholders; 3. At maturity of the swap, the Australian bank and its swap counterparty re-exchange principal amounts at the original exchange rate. The Australian bank can then repay its bond holders. In effect, the Australian bank has converted its US dollar, US interest rate obligations into Australian dollar, Australian interest rate obligations. https://www.rba.gov.au/speeches/2018/sp-ag-2018-12-10.html 4/10 12/10/2018 US Monetary Policy and Australian Financial Conditions | Speeches | RBA Figure 1 An analogy related to housing can help to further the intuition here. Imagine a Bloomberg employee who owns an apartment in New York but has accepted a temporary job in Sydney. She fully expects to return to New York and wishes to keep her property, and she does not wish to purchase a property in Sydney. The obvious solution here is for her to receive rent on her New York property and use it to pay her US dollar mortgage. Meanwhile, she can rent an apartment in Sydney using her Australian dollar income. In other words, our relocating worker can temporarily swap one asset for another. As a result, she can reduce the risks associated with servicing a US mortgage with an Australian dollar income. As I mentioned earlier, it is common practice for Australian banks to hedge their foreign currency borrowings with derivatives to insulate themselves and their Australian borrowers from fluctuations in foreign exchange rates and interest rates. The most recent survey of hedging practices showed that around 85 per cent of banks' foreign currency liabilities were hedged (Graph 3). Also, the maturities of the derivatives used were well matched to the maturities of the underlying debt securities. [5] This means that banks were not exposed to foreign currency or foreign interest rate risk for the life of their underlying exposures. By matching maturities, banks also avoided the risk that they might not be able to obtain replacement derivatives at some point in the future (so called roll-over risk). https://www.rba.gov.au/speeches/2018/sp-ag-2018-12-10.html 5/10 12/10/2018 US Monetary Policy and Australian Financial Conditions | Speeches | RBA Graph 3 For the very small share of liabilities that are not hedged with derivatives, there is almost always an offsetting high quality liquid asset denominated in the same foreign currency of a similar maturity, such as US Treasury Securities or deposits at the US Federal Reserve. Taken together, these derivative hedges and natural hedges mean than Australian banks have only a very small net foreign currency and foreign interest rate exposure overall (Graph 4). https://www.rba.gov.au/speeches/2018/sp-ag-2018-12-10.html 6/10 12/10/2018 US Monetary Policy and Australian Financial Conditions | Speeches | RBA Graph 4 So who is bearing the risk? Despite Australia's external net debt position, in net terms Australian residents have passed on – for a cost, as we shall see – key risks associated with their foreign currency liabilities to foreign residents. Australian residents have found enough non-residents willing to lend them Australian dollars and to receive an Australian interest rate to extinguish their foreign currency liabilities. As a result, Australians are net of foreign currency assets, not borrowers. [6] Collectively, Australians have used hedging markets and natural hedges to (more than) eliminate their exchangerate exposures associated with raising funds in offshore markets. owners Australians' ability to find non-residents willing to assume Australian dollar and Australian interest rate risks is a reflection of the willingness of non-residents to invest in Australian dollar assets. This in turn reflects Australia's status as a country that has long had strong and credible institutions, a high credit rating and mature and liquid capital markets. The willingness of these non-resident counterparties to assume these risks via a direct exposure to Australia's banking system – sometimes for as long as thirty years – reflects the fact that Australia's banks are well-capitalised and maintain high credit ratings. In short, Australians have found a source of finance unavailable domestically (at as reasonable a price), and non-residents have found an asset that suits their portfolio needs. Since there are no free lunches in financial markets, there is the question of the cost for Australian banks to cover these arrangements. One part of this cost is known as the basis. https://www.rba.gov.au/speeches/2018/sp-ag-2018-12-10.html 7/10 12/10/2018 US Monetary Policy and Australian Financial Conditions | Speeches | RBA An imperfect world Some swap counterparties have an inherent reason to enter into swap transactions with Australian banks. In other words, such exposures actually help them to manage their own risks. Non-residents that issue Australian dollar debt – in the so called Kangaroo bond market – are a case in point. These issuers raise Australian dollars to fund foreign currency assets they hold outside of Australia. This makes them natural counterparts to Australian banks wanting to hedge their foreign currency exposures. Similarly, Australian residents invest in offshore assets. To the extent that they want to hedge the associated exchange rate exposures, they too would be natural counterparties for the Australian banks. However, it turns out that these natural counterparties do not have sufficient hedging needs to meet all of the Australian dollar demands of the Australian banks. So in order to induce a sufficient supply of Australian dollars into the foreign exchange swap market, Australian banks pay an additional premium to their swap counterparts on top of the Australian dollar interest rate. This premium, or hedging cost, is known as the basis. Simply put, the basis is the price that induces sufficient supply to clear the foreign exchange swap market. Since the start of the decade, the basis has oscillated around 20 basis points per annum (Graph 5). Typically, though not always, the longer a bank wishes to borrow Australian dollars, the higher the premium it must pay over the Australian dollar interest rate. Graph 5 https://www.rba.gov.au/speeches/2018/sp-ag-2018-12-10.html 8/10 12/10/2018 US Monetary Policy and Australian Financial Conditions | Speeches | RBA You may be wondering why Australian banks are willing to pay this premium; why don't they instead only borrow Australian dollars in the Australian capital markets to meet their financing needs? In addition to the prudent desire to have a diversified funding base as I mentioned earlier, the short answer is that it may not be cost-effective to raise all their funding at home. What tends to happen is that banks – to the extent possible – seek to equalise the marginal cost of each unit of funding from different sources. If they were to obtain all of their funding at home, that would be likely to increase the cost of those funds relative to funds sourced from offshore. So the all-in-cost of the marginal Australian dollar from domestic sources will tend to be about the same as the marginal dollar obtained from offshore. Astute students of finance will also wonder why the basis is not arbitraged away. [8] The answer is that structural changes in financial markets have widened the scope for market prices to deviate from values that might prevail in a world of no ‘frictions’. This is consistent with the concept of ‘limits to arbitrage’ (which the academic community only started to re-engage with in the past couple of decades). Arbitrage typically requires the arbitrageur to enlarge their balance sheet and incur credit, mark-to-market and/or liquidity risk. As Claudio Borio of the BIS has noted: balance sheet space is rented, not free. And the cost of that rent has gone up. What about financial conditions more generally? None of this is to suggest that monetary policy settings in the United States (and elsewhere for that matter) have no impact on financial conditions here in Australia. But the link is neither direct nor mechanical. The primary channel through which foreign interest rates influence Australian conditions is through the exchange rate. An increase is policy rates elsewhere will, all else equal, tend to put downward pressure on the Australian dollar, because capital is likely to be attracted to the higher rates of return available abroad. A depreciation of the Australian dollar in turn will tend to enhance the competitiveness of our exporters, including those services priced in Australian dollars like tourism and education. Through various channels, exchange rate depreciation can also loosen financial conditions in Australia, which is not always the case in other countries, particularly those for which inflation expectations are not well anchored and where there are substantial foreign currency borrowings that are unhedged. Foreign monetary policy settings, particularly those in the United States, can also affect global risk premia. We are now approaching a period when US monetary policy is moving to a neutral stance. This follows a lengthy period of very easy monetary conditions, which may have encouraged investors to ‘search for yield’ to maintain nominal portfolio returns in an environment of low interest rates. The expectation of low and stable policy rates and inflation outcomes in turn compressed risk premia across a range of asset classes. In the period ahead, it seems plausible that term and credit risk premia will rise, which will increase costs for all borrowers, Australian banks included. https://www.rba.gov.au/speeches/2018/sp-ag-2018-12-10.html 9/10 12/10/2018 US Monetary Policy and Australian Financial Conditions | Speeches | RBA Conclusion Global developments undoubtedly influence Australian financial conditions. In particular, developments abroad can influence the value of the Australian dollar and affect global risk premia. But changes in monetary policy settings elsewhere need not, and do not, mechanically feed through to the funding costs of Australian banks, and hence their borrowers are insulated from such changes. Endnotes [*] I thank Christian Vallence for invaluable assistance in preparing these remarks. Kent, C (2018), ‘Some Features of the Australian Fixed Income Market’, Speech at the Australian Government Fixed Income Forum 2018, Tokyo, 6 June. See Debelle, G (2010), ‘Bank Funding and Capital Flows’, 23rd Australian Finance and Banking Conference, Sydney, 15 December. Also, Atkin T and B Cheung (2017), ‘How Have Australian Banks Responded to Tighter Capital and Liquidity Requirements?’, RBA Bulletin, June, pp41-50. Debelle, G (2018), ‘Lessons and Questions from the GFC’, Speech at the Australian Business Economists Annual Dinner, Sydney, 6 December. The maturity of the loans may be longer than that of the bond/swap, so a new bond/swap may be needed. Berger-Thomson, L and Chapman B (2017), ‘Foreign Currency Exposure and Hedging in Australia’, RBA December, pp 67-75. As a result, despite being a net debtor nation, Australia enjoys a transfer of financial wealth from abroad when the Australian dollar depreciates, other things equal. Debelle G (2017a), ‘How I Learned to Stop Worrying and Love the Basis’, Speech at the BIS Symposium: ‘CIP – RIP?’, Basel, 22 May. I direct you to any undergraduate finance textbook for a worked example that, under simplifying assumptions, demonstrates how to exploit the basis to earn a risk-free profit. Borio C et al (2016), ‘Covered Interest Parity Lost: Understanding the Cross-currency Basis’, September, pp 45 – 64. Available at <https://www.bis.org/publ/qtrpdf/r_qt1609e.pdf>. Kearns & Patel (2016), ‘Does the Financial Channel of Exchange Rates Offset the Trade Channel?’, , December, pp95–113. Available at <https://www.bis.org/publ/qtrpdf/r_qt1612i.pdf>. Review Bulletin, BIS Quarterly Review, BIS Quarterly © Reserve Bank of Australia, 2001–2018. All rights reserved. https://www.rba.gov.au/speeches/2018/sp-ag-2018-12-10.html 10/10 | reserve bank of australia | 2,018 | 12 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the National Press Club of Australia, Sydney, 6 February 2019. | Philip Lowe: The year ahead Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the National Press Club of Australia, Sydney, 6 February 2019. * * * I would like to thank Andrea Brischetto for assistance in the preparation of this talk. Thank you for the opportunity to address the National Press Club. It is an honour to have been invited. The media and the RBA have a special relationship. Most people in the community hear the RBA's messages through the media. You report on what we say, you filter it and you critique it. We also help you with your work. The RBA is a reliable source of information and analysis on issues that your audiences care about, including interest rates, housing prices and jobs. This means we have a strong mutual interest in understanding one another. I hope that today will help strengthen that understanding. This is my first public speech for 2019, so I would like to talk about the year ahead and some of the key issues that the RBA will be focusing on. I will first discuss the global economy and then turn to the Australian economy and particularly the outlook for household spending. I will finish with a few remarks on the outlook for monetary policy. At the outset, I want to emphasise that we don't have a crystal ball that allows us to see the future with certainty. I know many of you are looking for definitive answers to questions like, ‘Where will the cash rate be this time next year?’, ‘How much will housing prices fall?’, ‘When will wages growth reach 3 per cent?’. They are all good questions. The reality, though, is that the future is uncertain. None of us can say with certainty what will happen. What the RBA can do, though, is highlight the issues that are likely to shape the future, explain how we are thinking about those issues, and discuss how they fit into our decision-making framework. That is what I hope to do today. The Global Economy I will start with the global economy, because what happens overseas has a major bearing on what happens in Australia. My main point here is that while some of the downside risks have increased, the central scenario for the world economy still looks to be supportive of growth in Australia. It is worth recalling that 2018 was a good year for the world economy. Growth in the advanced economies was above trend in the first half of the year, unemployment rates reached their lowest levels in many decades, inflation was low and financial systems were stable (Graph 1). These are positive outcomes. We should not lose sight of this. Graph 1 1 / 13 BIS central bankers' speeches There was, though, a change in momentum in the global economy late in the year. This change was particularly evident in Europe and it was also evident in China. It has been widely reported in the media, but it is important to keep things in perspective. Some slowing in global growth was expected, given that labour markets are fairly tight and the policy tightening in the United States was aimed at achieving a more sustainable growth rate. So, I have been a little surprised at some of the reaction to the lowering of forecasts for global growth, which has been quite negative. We need to remember that the IMF's central forecast is still for the global economy to expand by 3.5 per cent in 2019 and by 3.6 per cent in 2020 (Graph 2). If achieved, these would be reasonable outcomes and not too different from the recent past. Graph 2 2 / 13 BIS central bankers' speeches What is of more concern, though, is the accumulation of downside risks. Many of these risks are related to political developments: the trade tensions between the United States and China; the Brexit issue; the rise of populism globally; and the reduced support from the United States for the liberal order that has supported the international system and contributed to a broad-based rise in living standards. One could add to this list the adjustments in China as the authorities rein in shadow financing. The origins of these diverse issues are complex, but there is a common economic element to some of them: that is, the extended period of little or no growth in real incomes for many people. In a number of countries, growth in real wages has been weak or negative for years. Advances in technology and greater competition as a result of globalisation also mean that many people worry about their own future and that of their children. Politicians, understandably, are responding to these concerns. Time will tell, though, whether the various responses help or not. I suspect that some of them will not. Over recent months, the accumulation of downside risks has been evident in business and consumer surveys. It was also evident in increased volatility in financial markets around the turn of the year, with declines in equity prices and an increase in credit spreads (Graph 3). Since then, though, markets have been more settled and some of the earlier decline in equity prices has been reversed. This has been partly on the back of a reassessment of the path of monetary policy in the United States, with markets no longer pricing in further increases in US interest rates. There has also been a noticeable fall in long-term government bond yields. 3 / 13 BIS central bankers' speeches Graph 3 The adjustments in financial markets over our summer sometimes generated reporting that, to me, seemed overly excitable. I lost count of how many times I read the words ‘crash’, ‘plunge’ and ‘dive’. Yet there is a positive side to some of these adjustments, which gets less reported on. The risks associated with stretched valuations in some equity markets have lessened. So, too, have concerns that very low credit spreads could lead to an excessive build-up of risk. And risks in many emerging market economies have also receded, helped by the lower global interest rates and lower oil prices. So it is important to look at the whole picture. For Australia, what happens in China is especially important. Growth there has slowed. From a medium-term perspective, this has a positive side, as it mainly reflects efforts to rein in risky financial practices and stabilise debt levels. But the slowing is probably faster than the government had hoped for, with the economy feeling the effects of the trade dispute with the United States and the squeezing of finance to the private sector. The authorities have responded by easing policy in some areas, but they are walking a fine line between supporting the economy and addressing the debt problem. There is also the question of how the economy responds to the policy easing. More broadly, we cannot insulate ourselves completely from the global risks, but keeping our house in order can go a long way to assist. Our floating exchange rate and the flexibility we have on both monetary and fiscal policies provide us with a degree of insulation. So, too, does our flexible labour market. Ensuring that we have predictable and consistent economic policies, credible public institutions and a reform agenda that supports a strong economy can also help in 4 / 13 BIS central bankers' speeches an uncertain world. The Domestic Outlook I would now like to turn to the outlook for the Australian economy. Much as is the case globally, the downside risks have increased, although we still expect the Australian economy to grow at a reasonable pace over the next couple of years. The Australian economy is benefiting from strong growth in infrastructure investment and an upswing in other areas of investment. The labour market is also strong, with many people finding jobs. This year, we will also benefit from a further boost to liquefied natural gas (LNG) exports. The lower exchange rate and a lift in some commodity prices are also assisting. Against this generally positive picture, the major domestic uncertainty is the strength of consumption and the housing market. We will be releasing a full updated set of forecasts in the Statement on Monetary Policy (SMP) on Friday. Close readers of the SMP will notice that we will now be publishing forecasts for a wider set of variables than has previously been the case.1 We hope that this helps people understand the various forces shaping the economy. Today, I can give you a summary of the key numbers. Our central forecast is for the Australian economy to expand by around 3 per cent over 2019 and 2¾ per cent over 2020 (Graph 4). For 2018, the outcome is expected to be a bit below 3 per cent. This type of growth should be sufficient to see further gradual progress in lowering unemployment. Graph 4 5 / 13 BIS central bankers' speeches These forecasts are lower than the ones we published three months ago. For 2018, the outcome is affected by the surprisingly soft GDP number in the September quarter and the ABS's downward revisions to estimates of growth earlier in the year. We are expecting a stronger GDP outcome in the December quarter, with other indicators of economic activity painting a stronger picture than suggested by the September quarter national accounts. For 2019 and 2020, the forecasts have been revised down by around ¼ percentage point, largely reflecting a modest downgrading of the outlook for household consumption and residential construction. I will talk more about this in a moment. The outlook for the labour market remains positive. The national unemployment rate currently stands at 5 per cent, the lowest in over seven years (Graph 5). In New South Wales and Victoria, the unemployment rate is around 4¼ per cent. You have to go back to the early 1970s to see sustained lower rates of unemployment in these two states. The forward-looking indicators of the labour market also remain positive. The number of job vacancies is at a record high and firms' hiring intentions remain strong. Our central scenario is that growth will be sufficient to see a modest further decline in unemployment to around 4¾ per cent over the next couple of years. Graph 5 6 / 13 BIS central bankers' speeches The other important element of the labour market is how fast wages are increasing. For some time, we have been expecting wages growth to pick up, but to do so gradually. The latest data are consistent with this, with a turning point now evident in the wage price index (Graph 6). Through our discussions with business we are also hearing more reports of firms finding it difficult to find workers with the necessary skills. In time, this should lead to larger wage rises. This would be a positive development. Graph 6 7 / 13 BIS central bankers' speeches Given this outlook, we continue to expect a gradual pick-up in underlying inflation as spare capacity in the economy diminishes (Graph 7). However, the lower forecast for growth means that this pick-up is expected to occur a bit later than we'd previously thought. Underlying inflation is now expected to increase to about 2 per cent later this year and to reach 2¼ per cent by the end of 2020. The latest CPI data were consistent with this outlook. The headline CPI number was, however, a bit lower than we had previously expected, reflecting the decline in petrol prices that started late last year. We expect headline inflation to decline further this year as the full effect of lower petrol prices shows up in the figures. Graph 7 8 / 13 BIS central bankers' speeches So that is the summary of the key numbers. As always, there is a range of uncertainties, many of which will be discussed in the SMP on Friday. Today, though, I would like to focus on the outlook for household spending, which is closely linked to the housing market and the prospects for growth in household income. Before I do that, I would like to touch on one related uncertainty that we have been paying attention to – that is the supply of credit. This is because a strong economy requires access to finance on reasonable terms. Over recent years there has been a needed tightening of credit standards. But the right balance needs to be struck. As lenders have sought to find that balance, we have had some concerns that the pendulum may have swung too far the other way, especially for small business. In that context, I welcome the report of the Royal Commission and the Government's response. The Commission's recommendations that bear on credit provision are balanced and sensible, and should remove some uncertainty. I also welcome the Commission's focus on: the importance of service – as opposed to sales – in the financial sector; the necessity of dealing properly with conflict of interest issues; and the importance of accountability when things go wrong. These are all issues I have spoken about on previous occasions. Addressing them is central to rebuilding the all-important trust in our financial system. 9 / 13 BIS central bankers' speeches Housing Prices and Household Income But back to household consumption and the housing market. You might recall that 18 months ago, one of the most talked about issues in the country was the high and rising cost of housing. This was understandable. In some of our cities, purchasing a home had become a very difficult stretch for many people, and this had become a major social issue. Today, the talk is about prices falling in our two largest cities. We have moved almost seamlessly from worrying that prices were going up, to worrying that they are going down. There is no single reason for this change, but, rather, it is the result of a number of factors coming together. One is that housing prices simply increased to the point in Sydney and Melbourne where demand tailed off, as purchasing a home had become very expensive and less attractive as an investment. A second is that the building boom over recent times significantly increased the supply of dwellings. It took a number of years before the rate of home construction picked up in response to faster population growth, but eventually it did pick up. This explains much of the cycle. A third factor is that the demand from overseas investors softened, partly in response to the Chinese authorities making it more difficult to move money out of China. And a fourth factor is that lending standards have been tightened and credit has become more difficult to obtain. Importantly, unlike most other housing price corrections, this one has not been associated with rising unemployment or higher interest rates. Instead, mainly structural factors – relating to the underlying balance of supply and demand – in our largest cities have been at work. The question is: what effect will this change have on household spending? Here, my earlier observation about not having a crystal ball is relevant. At this point, though, what we are seeing looks to be a manageable adjustment in the housing market. It is not expected to derail economic growth. The previous trends in debt and housing prices were becoming unsustainable and some correction was appropriate. We recognise that this correction will have an effect on parts of the economy. But our economy should be able to handle this, and it will put the housing market on a more sustainable footing. There are a few considerations here. The first is that the recent housing price declines follow very large increases in prices (Graph 8). Even after the recent declines in Sydney, prices are still 75 per cent higher over the decade. In Melbourne, they are 70 per cent higher. While the price falls are no doubt difficult for some, including people who purchased in the past couple of years, there are many people sitting on very significant capital gains and there are others who now will find it easier to purchase a home. And of course, in a number of cities and much of regional Australia, things have been more stable. Graph 8 10 / 13 BIS central bankers' speeches A second consideration is that most households do not change their consumption in response to short-term changes in their wealth. Sensibly, many people tend to take a longer-term perspective. During the recent upswing in housing prices, the strategy of borrowing against the extra equity in your home looked less sensible than it once was, especially as debt levels rose. Some home-owners also see themselves as being part of the ‘bank of mum and dad’. This meant that they refrained from spending the extra equity so that they were able to help their children purchase their own property. A third and perhaps the most important consideration, is that household income growth is expected to pick up and income growth usually matters more for consumption than changes in wealth. For some years, growth in nominal aggregate household income has been unusually slow, averaging just 2¾ per cent since 2016 (Graph 9). For some home-owners, rising housing prices have provided an offset to this, even though the effect may have been smaller than in the past. As a result, aggregate consumption has grown faster than income for the past few years. But a shift is now taking place. Over the next year, we are expecting a pick-up in household disposable income to provide a counterweight to the wealth effects of lower housing prices. Graph 9 11 / 13 BIS central bankers' speeches Labour market outcomes are key to this assessment. Continued employment growth and higher wages growth should boost disposable incomes. The announced tax cuts should also help here. In our central scenario, consumption is expected to grow at around 2¾ per cent over the next couple of years, broadly in line with expected growth in disposable income. This is a bit lower than our earlier forecast for consumption. There are, of course, other possible outcomes. Continued low income growth, together with falling housing prices, would be an unwelcome combination and would make for a softer outlook for the economy. Some Australian households have high levels of debt, so there is a degree of uncertainty about how they would respond to this combination. So we are monitoring things closely. The adjustment in the housing market is also affecting the economy through residential construction activity and the spending that occurs when people move homes. Residential construction activity is currently around its peak level and the large pipeline of approved projects is expected to support activity for a while. Developers, though, are finding it more difficult to sell apartments off the plan, and lenders are less willing to provide finance. Sales of new detached dwellings have also slowed. The central forecast is for dwelling investment to decline by about 10 per cent over the next two and a half years. Putting all this together, our economy is going through an adjustment following the turn in the 12 / 13 BIS central bankers' speeches housing markets in our largest cities. It is important that we keep this in perspective though. The correction in the housing market follows an extended period of strength. It is largely due to structural supply and demand factors, and is occurring against the backdrop of a robust economy and an expected pick-up in income growth. Our financial institutions are also in a strong position to deal with the adjustment. Indeed, lending standards were strengthened as the upswing went on. From this perspective, the adjustment in the housing market is manageable for the financial system and the economy. This adjustment will also help increase the affordability of housing for many people. Even so, given the uncertainties, we are paying very close attention to how things evolve. Monetary Policy This brings me to monetary policy. The cash rate has been held steady at 1½ per cent since August 2016. This setting has helped support the economy. The Reserve Bank Board has sought to be a source of stability and confidence while our economy adjusted to the end of the mining investment boom and responded to the shifting sands of the global economy. Over the past couple of years, economic conditions have been moving in the right direction. The labour market has strengthened, and the unemployment rate has fallen and a further decline is expected. Inflation is also above its earlier trough, although it has not changed much over the past year. Our expectation has been – and continues to be – that the tighter labour market and reduced spare capacity will see underlying inflation rise further towards the midpoint of the target range. Given this, we have maintained a steady setting of monetary policy while the labour market strengthens and inflation increases. Looking forward, there are scenarios where the next move in the cash rate is up and other scenarios where it is down. Over the past year, the next-move-is-up scenarios were more likely than the next-move-is-down scenarios. Today, the probabilities appear to be more evenly balanced. We will be monitoring developments in the labour market closely. If Australians are finding jobs and their wages are rising more quickly, it is reasonable to expect that inflation will rise and that it will be appropriate to lift the cash rate at some point. On the other hand, given the uncertainties, it is possible that the economy is softer than we expect, and that income and consumption growth disappoint. In the event of a sustained increase in the unemployment rate and a lack of further progress towards the inflation objective, lower interest rates might be appropriate at some point. We have the flexibility to do this if needed. The Board will continue to assess the outlook carefully. It does not see a strong case for a nearterm change in the cash rate. We are in the position of being able to maintain the current policy setting while we assess the shifts in the global economy and the strength of household spending. It has long been the Board's approach to avoid reacting to the high-frequency ebb and flow of news. Instead, we have sought to keep our eye on the medium term and put in place a setting of monetary policy that helps deliver on our objectives of full employment, an inflation rate that averages between 2 and 3 per cent, and financial stability. Thank you for listening. I look forward to answering your questions. 1 Forecasts will be published online for the various expenditure components of GDP as well as selected other variables. 13 / 13 BIS central bankers' speeches | reserve bank of australia | 2,019 | 2 |
Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the XE Breakfast Briefing, Melbourne, 15 February 2019. | Christopher Kent: Financial conditions and the Australian dollar recent developments Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the XE Breakfast Briefing, Melbourne, 15 February 2019. * * * I thank David Jacobs for excellent assistance in preparing these remarks. Introduction Thanks to XE for the opportunity to be here in Melbourne to speak to you. A lot has happened in financial markets globally and in Australia since late last year. I thought it would be helpful to summarise the key developments, including revisions to the global economic outlook, concerns about downside risks and changes to market expectations for monetary policy paths. I'd also like to discuss their implications for the Australian economy and the Australian dollar. But first, a brief caveat is in order on the topic of exchange rates. It's often said by Reserve Bank staff that we are not in the business of forecasting exchange rates. But, just as importantly, we also need to be humble when explaining the past behaviour of exchange rates. In that regard, it is worth recognising that models of exchange rates provide only rough estimates of the more enduring relationships. The International Backdrop After a lengthy period of relative stability, global financial markets have been more volatile over the past few months. The incoming data from around the end of 2018 was associated with a tightening in financial conditions: global equity prices declined; corporate credit spreads widened; issuance of corporate debt eased; and volatility picked up across most markets (Graph 1). And in the space of only a couple of months, the market's expectations for monetary policies changed markedly and there was a notable downward shift in yield curves. Graph 1 1 / 11 BIS central bankers' speeches What prompted these changes? In part, market participants reassessed their expectations for global growth. This reflected a run of data that was a bit weaker than had earlier been expected, particularly for the industrial sectors and trade. However, this was not true of all of the incoming data. Indeed, labour markets have remained in good health; the US labour market data of late have been especially strong. Moreover, labour market tightness is evident more broadly and wages growth is picking up in a range of advanced economies. Forecasts for growth of global economic activity have been revised lower, but only marginally. In late January, the IMF's forecasts for global growth were trimmed for 2019 and 2020, by 0.2 and 0.1 percentage points, respectively (Graph 2). Growth of Australia's major trading partners is expected to decline slightly in 2019 to around its historical average. It is also worth noting that at least some of this moderation in growth has been by design. Over the past year or more, policymakers in both China and the United States have sought to ensure that growth in their economies was placed on a more sustainable footing. Graph 2 2 / 11 BIS central bankers' speeches But that's a story about what is most likely to happen (the central tendency of the distribution of possible outcomes). Much of the market reaction of late has been prompted by greater concern about the potential for adverse, but less likely outcomes – the so called ‘downside risks’. From Australia's standpoint, at the top of the list of risks is the outlook for our largest trading partner, China. One concern relates to the extent and nature of leverage. The Chinese authorities had earlier moved to contain the growth in leverage, particularly where it was funded using so called ‘shadow financing’ channels. While proceeding broadly as intended, this earlier tightening in financial conditions has contributed to the slowing in Chinese economic activity. And yet leverage remains high and there is still much to do to ensure the soundness of the Chinese financial system. So the tension between sustaining growth and financial stability remains.1 While the authorities may want to help support growth of economic activity, they recognise that a broad-based easing of policies runs the risk of undoing what has been achieved with the deleveraging to date. Another concern for China is the adverse effects of trade tensions with the United States. The dispute is weighing on Chinese economic activity and trade. Softer demand from China has weighed on growth elsewhere in Asia, and the region would be relatively exposed to a more marked slowing in China if that was to occur. Consistent with the focus of global financial markets on downside risks, price adjustments have 3 / 11 BIS central bankers' speeches been in the form of a rise in risk premia in equity and corporate bond markets. In US equity markets, for instance, price declines in late 2018 were accompanied by only small downgrades to analysts' expectations for earnings growth over the medium term. This implies that the willingness of investors to pay for earnings declined materially (Graph 3). In other words, the equity risk premium went up.2 Similarly, in corporate bond markets, future default rates expected by analysts hardly moved over this period. And yet spreads widened sharply, reflecting an increase in credit risk premia. While early 2019 has seen a partial retracement of these moves, both equity and credit risk premia remain higher than a year ago. Graph 3 This rise in equity and credit risk premia follows an extended period where they had been unusually low, and even uncomfortably low, particularly in the United States. Some adjustment to these was inevitable, and welcome from the perspective of financial stability. While these premia remain a bit higher than a year ago, they are still not that high by historical standards. At the same time that markets became more concerned about downside risks to economic activity, they became less concerned about upside risks to inflation. Part of that reflected the revisions to the outlook for growth. But lower oil prices have had a significant effect on the nearterm outlook for inflation, and breakeven inflation expectations have shifted down accordingly. The combination of all of these changes – reduced expectations for growth and inflation, 4 / 11 BIS central bankers' speeches increased concerns about downside risks, and higher corporate risk premiums – has seen market participants revise down their expectations for the paths of monetary policy rates. Longerterm sovereign yields have also declined noticeably (Graph 4). Graph 4 The change in expectations for monetary policy has been most pronounced in the United States (Graph 5). As recently as December, market pricing implied an expectation that the US Federal Reserve would increase interest rates in 2019. Indeed, this was supported by the so-called ‘dots’, which show the median of individual Federal Open Market Committee (FOMC) members' projections of the most likely outcome. Currently, market pricing implies no increases in 2019 and even some chance of a reduction in the fed funds rate in 2020. Once again, the repricing appears to reflect concern over what could happen, as much as what is considered most likely to happen. One way to illustrate this is by examining the survey-based expectations of primary dealers in the US money market. These data show that primary dealers are increasingly concerned about the ‘tail risk’ that the fed funds rate will return to zero in the next few years. Nevertheless, their most likely forecast remains for further rate increases.3 Graph 5 5 / 11 BIS central bankers' speeches Central bank policy expectations have shifted elsewhere as well, although generally by less than in the United States (Graph 6). That difference is likely to have contributed to a depreciation of the US dollar after its trend appreciation last year. Graph 6 6 / 11 BIS central bankers' speeches I will return to foreign exchange markets in just a moment, but let me briefly take stock. The upshot of these recent developments is that global financial conditions have tightened a little. The cost for corporations to raise capital through equity and debt markets has increased a bit in the advanced economies. But overall conditions are not tight, with monetary policy rates still low (relative to most estimates of neutral) and government bond yields also low. Indeed, bond yields are generally lower than they have been for a couple of years. Implications for Australia Over recent months, developments in Australian financial markets have been similar in many respects to those offshore. Equity prices fell, credit spreads rose, and so did various measures of financial market volatility; although, some of the more pronounced moves seen late last year have been retraced in early 2019. These changes have again largely been a story of risk premia increasing from low levels and were associated with rising concerns about downside risks, both internationally and domestically. The outlook for the domestic economy has also shifted, and the Bank has revised down its forecasts for both growth and inflation. Our forecasts continue to project a further gradual reduction in spare capacity in the economy, with the unemployment rate trending lower. That should see wages growth pick up, although only gradually, and inflation is also expected to increase gradually. The Bank's Statement on Monetary Policy and the Governor's recent speech 7 / 11 BIS central bankers' speeches provided comprehensive updates to this picture.4 In response to this shift in the international and domestic outlooks, market expectations for the next move in the cash rate have switched signs: the markets have assessed that the next move is more likely to be down than up. That has been reflected in lower bond yields, alongside the effect of lower oil prices on market-implied inflation expectations. Two-year bond yields in Australia have tended to decline by a bit more than in many other major markets (Graph 7). Part of that change is somewhat mechanical given that in both Japan and the euro area policy rates are close to their effective lower bounds. This latest change in Australia's interest differential extends the trend decline that has been underway for five or more years. Graph 7 Over the past couple of months, the Australian dollar has depreciated by about 4 per cent on the basis of the trade-weighted index (TWI). This largely reflects the effect of the appreciation of the yen and the renminbi, which collectively comprise nearly 40 per cent of the TWI. The yen appreciation may have been driven by the tendency of Japanese investors to bring some of their funds back home during ‘risk-off’ periods in global financial markets. Graph 8 8 / 11 BIS central bankers' speeches The decline in Australian bond yields relative to other advanced economies is likely to have contributed somewhat to the modest depreciation of the Australian dollar of late (Graph 8). However, over much of the past 18 months or so, higher commodity prices appear to have worked to limit the extent of Australian dollar depreciation. 5 Indeed, commodity prices have increased noticeably of late. This largely reflects disruptions to supply, particularly of iron ore. In short, there are a number of forces affecting the Australian dollar, but they have been pulling in different directions. Accordingly, the Australian dollar remains within its relatively narrow range of the past few years. Having noted the low volatility of the exchange rate over recent years, I need to briefly touch on the recent flash event in currency markets that no doubt caught the attention of many of you in this room.6 On 3 January, in the span of a few minutes, a sharp appreciation in the yen against the US dollar quickly cascaded into the Australian dollar, which depreciated by up to 7 per cent against the yen (Graph 9). At the same time, bid-ask spreads had widened significantly. However, trading conditions quickly returned to normal and currencies largely retracted their earlier moves. Graph 9 9 / 11 BIS central bankers' speeches It is difficult to draw firm conclusions on the causes of such events, but as we outlined in the recent Statement on Monetary Policy, three factors are likely to have contributed. First, there was the liquidation of ‘carry-trade’ positions, notably from highly leveraged Japanese retail investor accounts. These appear to have been automatically triggered following the initial appreciation of the yen. Second, these liquidations occurred at a time when market liquidity was seasonally low, such that the foreign exchange market was more exposed to imbalances between buy and sell orders. Recent flash events have tended to occur around this same time of day, in between the close of US markets and the start of Asian trading. It was also early in the new year and a public holiday in Japan. Third, as in previous flash events, algorithmic trading strategies may have amplified the move, for example, by adding to demand to buy the yen as it appreciated. It is also difficult to be definitive about what restored orderly market functioning. Market contacts suggest that discretionary buying of Australian dollars by traditional market-making banks and institutional accounts helped to stabilise conditions and re-establish the process of price discovery. Ultimately, this event did not lead to wider disruption. But the growing list of such disorderly moves in key financial markets in recent years clearly bears close watching. Conclusion 10 / 11 BIS central bankers' speeches There have been modest revisions to the outlook for economic activity and inflation globally. Additionally, downside risks are attracting more attention, from both market participants and central banks. These changes have been accompanied by a rise in the markets' assessment of risks relating to the corporate sector – albeit from relatively low levels. There has also been a reassessment of the outlook for monetary policies, and interest rates have shifted down across the yield curve. The decline in sovereign yields has worked to partially offset the effect of higher risk premiums and so finance is still readily available to borrowers at relatively low rates. Broadly similar changes in economic and financial conditions have also occurred domestically. And while commodity prices have risen of late, Australia's terms of trade are still forecast to decline gradually over the next couple of years. Pulling all of this together, it is not so surprising then that the Australian dollar has depreciated a little over recent months. While the exchange rate is still within the relatively narrow range of the past few years, the recent depreciation is helpful at the margin given that there remains spare capacity in the economy and inflation remains below target. 1 See Lowe P (2018), ‘Australia’s Deepening Economic Relationship with China: Opportunities and Risks’, Address to the Australia-China Relations Institute, Sydney, 23 May. 2 It is also possible that investors viewed those forecasts as being too optimistic. While higher bond yields can also see investors apply a larger discount to future earnings, bond yields have declined in recent months. 3 The FOMC dots represent the median of FOMC members’ expectations of the most likely (modal) outcomes. In contrast, observed market prices reflect not the central scenario but rather a probability-weighted average of all expected outcomes (that is, the entire distribution). Because of this, tail risks can move market pricing, even if the most likely outcome has not changed in the eyes of market participants. 4 See Lowe P (2019), ‘The Year Ahead’, Address to the National Press Club of Australia, Sydney, 6 February. 5 For a description of the factors that influence the Australian dollar see, Chapman B, J Jääskelä and E Smith (2018), ‘A Forward-looking Model of the Australian Dollar ’, RBA Bulletin, December, viewed 13 February 2019. See also Hambur J, L Cockerell, C Potter, P Smith and M Wright (2015), ‘Modelling the Australian Dollar’, RBA Research Discussion Paper No 2015–12. 6 This event was covered in greater detail in the Bank’s recent Statement on Monetary Policy. See RBA (2019), ‘Box B: The Recent Japanese Yen Flash Event’, Statement on Monetary Policy, February, pp 24–27. 11 / 11 BIS central bankers' speeches | reserve bank of australia | 2,019 | 2 |
Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 22 February 2019. | Philip Lowe: Opening statement to the House of Representatives Standing Committee on Economics Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 22 February 2019. * * * Chair Members of the Committee My colleagues and I welcome this opportunity to share our views on the Australian economy and the RBA’s important policy responsibilities. These hearings are an essential part of the accountability process. Two weeks ago, we released our latest forecasts for the Australian economy. Our central scenario is for GDP growth of around 3 per cent this year and around 2¾ per cent in 2020. The outcome for the year just past is expected to be a bit below 3 per cent. These numbers are lower than the ones we were expecting at the time of the previous hearing in August. By contrast, the labour market outcomes have been better than we earlier expected. When we met six months ago, we were not anticipating the unemployment rate to reach 5 per cent until 2020, but it has already been around that level for some months. The number of jobs created has also exceeded our earlier expectations. We continue to expect the unemployment rate to move lower over the next couple of years to around 4¾ per cent. In terms of inflation, the recent outcomes have been a bit lower than we had been expecting. In the September quarter, childcare costs declined substantially due to government policy changes. And in the December quarter, petrol prices fell due to global developments, and a further decline is expected in the March quarter. In underlying terms, inflation is above its trough of a couple of years ago, but the pick-up is more gradual than we previously expected. By the end of 2020, inflation is forecast to reach 2¼ per cent. Putting this together, our central scenario for 2019 is for growth of around 3 per cent, inflation of around 2 per cent and unemployment of around 5 per cent. In the broad sweep of our economic history, this is not a bad set of numbers. Indeed, in many years in the past four decades we would have welcomed such an outcome. It is important that we do not lose sight of this. The economy is benefiting from increased spending on infrastructure and a pick-up in private investment as capacity utilisation has tightened. The strong growth in jobs is also supporting spending, as is the sustained low level of interest rates. Globally, the central scenario also remains a reasonable one. Inflation is low and unemployment in many advanced economies is the lowest in many decades. Recently, however, the focus has not been on this, but rather on the downgrading of forecasts for global growth by the International Monetary Fund and others. What sometimes gets lost, though, is that the latest forecast is for global growth to be around average, not below average. We need to remember that average growth at a time when unemployment is low is a reasonable outcome. What is of more concern is the accumulation of downside risks. There are two major areas of risk globally that the Reserve Bank Board has been keeping an especially close eye on. The first is what I will broadly label as political risk. Here the list includes: the trade and technology tensions between China and the United States; Brexit; the rise of populism; and 1/4 BIS central bankers' speeches strains in some western European economies. It is hard to be certain how these various issues will play out. But it is conceivable that one or more of these risks crystallises in a way that damages confidence and the global economy. It is, of course, also conceivable that political leaders respond to the mounting economic risks in a way that restores confidence. Time will tell. In working through the various possibilities, one issue that many people have focused on is the resilience of the global economy to a severe shock, whether it is generated in the political sphere or elsewhere. In many countries, both public and private debt levels are already very high. Real interest rates are also already very low. This means that there are fewer buffers in the global system than there once were. So there is less room to manoeuvre, although in a number of important dimensions the global financial system is more resilient than it used to be. The second international risk we are monitoring closely relates to the Chinese economy. Growth there has slowed, probably by more than the authorities had been expecting. The economy is feeling the effects of the tensions with the United States and the squeezing of finance to the private sector as the authorities seek to rein in non-bank financing. The authorities have responded by easing policy in some areas, but they are walking a fine line between supporting the economy in the near term and addressing the debt problem. Turning to the Australian economy, the Board has recently been paying particularly close attention to the strength of household spending and to developments in the housing market. Household consumption accounts for almost 60 per cent of total spending, so what happens on this front is important. Recently, determining the underlying strength of consumption has been complicated by volatility in the consumption data in the national accounts, as well as notable revisions to the history of both consumption and household income. On balance, though, the available data suggest that the underlying trend in consumption is softer than it earlier looked to be and this has affected the outlook for the economy. There are a couple of important considerations here. The first is the protracted period of relatively low growth in aggregate household income. The second is the decline in housing prices in our largest cities. Since 2016, aggregate household disposable income has grown at an average rate of around 2¾ per cent per year. This is down from an average of 6 per cent over the preceding decade. It is plausible that households have responded to this extended period of weaker income growth by progressively downgrading their spending plans. For many people, it has become harder to see the lower growth in income as just a short-term development that can be looked through. On this front, we are expecting better news ahead, with growth in disposable income forecast to increase. Wages are rising more quickly in almost all industries and in all states than they were a year ago. This is good news and we expect this gradual lift in wages growth to continue. Disposable income will also be boosted by the announced tax cuts. Faster income growth will support household spending. From a longer-term perspective, though, the key to boosting the real income of households is lifting productivity. I encourage you to keep examining ways to do this. Looking beyond income growth, developments in the housing market can also affect overall spending. Lower turnover means less of the spending that occurs when people move homes. Declining housing prices also make some people feel less wealthy, so they spend less, although this effect doesn’t look to be very large. Lower housing prices are also associated with less construction activity. So these are the areas we are keeping a close watch on. We do, though, need to keep things in perspective. The adjustments in the Sydney and Melbourne housing markets are occurring at a time of low unemployment, low interest rates and strong population growth. What we are witnessing is largely the working through of shifts in 2/4 BIS central bankers' speeches supply and demand for housing due to structural factors. In both markets it took a long time for supply to respond to faster population growth, so prices went up. And now that supply has responded, some of the earlier increase in prices has been reversed. I understand that these swings in housing prices are difficult for some in our community. We should, though, take some reassurance from the fact that our economy and our financial system are resilient. This adjustment in the housing market is not expected to derail the economy. It will put our housing markets on more sustainable footings and allow more people to purchase their own home. So there is a positive side too. I would now like to turn to monetary policy. The Reserve Bank Board has held the cash rate steady at 1½ per cent since August 2016. This is a stimulatory setting of monetary policy, which has helped support job creation and a gradual lift in inflation. When we met with the Committee six months ago, I said that if further progress on achieving our goals of full employment and returning inflation to target is made, you could expect the next move in interest rates to be up, rather than down. I also said that the Board did not see a strong case for a near-term adjustment in the cash rate, given that the progress towards our goals was expected to be only gradual. Today, the probability that the next move is up and the probability that it is down are more evenly balanced than they were six months ago. This shift largely reflects the change in the outlook for consumption that I have spoken about. It is important to point out that we are still expecting further progress towards our goals. The unemployment rate is forecast to decline further and inflation to increase, although only gradually. If we do make this progress, it remains the case that higher interest rates will be appropriate at some point. But it is also possible that the economy is softer than we expect and that progress towards our goals is limited. If there were to be a sustained increase in the unemployment rate and a lack of further progress towards the inflation objective, lower interest rates might be appropriate at some point. We have the flexibility to do this if needed. We are not on a predetermined course. The Board maintains its strong focus on the medium term and is seeking to be a source of stability and confidence. As was the case six months ago, it does not see a strong case for a near-term change in the cash rate. With monetary policy already providing considerable support to the Australian economy, it is appropriate to maintain the current policy setting while we assess developments. Much will depend on what happens in our labour market. I would like to turn to some other issues now. Some years ago, this Committee held extensive hearings into the foreign bribery issues at Note Printing Australia (NPA) and Securency. The legal proceedings against former employees of these companies were finally completed last November. As a result, the Supreme Court of Victoria lifted longstanding suppression orders. This allowed the RBA to disclose that in 2011 NPA and Securency entered guilty pleas to charges of conspiracy to bribe foreign officials between 1999 and 2004. We were also able to disclose that the two companies paid substantial fines and penalties, including under proceeds of crime legislation. The Reserve Bank has sought to deal with this difficult matter as openly and transparently as possible. The corrupt and unethical behaviour that was uncovered runs counter to everything that we stand for. A number of years ago, we sold our half share in Securency, the manufacturer of the polymer material the notes are printed on. Securency is now owned by a Canadian firm. NPA remains a fully owned subsidiary of the RBA and it prints Australia’s banknotes in Melbourne. The company 3/4 BIS central bankers' speeches has undergone a top-to-bottom overhaul of its governance arrangements and its business practices. I am confident that the company is operating to the very high standards that we demand and that it will continue to do so. On a more positive front, over recent months, NPA has been printing Australia’s new $20 banknote. We are today releasing the design of the new note and it will be issued into circulation in October. It will have the same world-leading security features as the other new notes. It will also have three raised bumps along each edge to assist people who are blind or have low vision. The new $20 note will continue to recognise two significant Australians: Mary Reibey and the Reverend John Flynn. Mary Reibey was a remarkable woman. She arrived in the colony of New South Wales in 1792 as a 15-year-old convict. Then, through hard work and determination, she rose to become one of the colony’s most successful entrepreneurs. And John Flynn is best known for establishing what we know today as the Royal Flying Doctor Service. This service has helped countless Australians and is now the largest aero-medical service in the world. We are very proud to celebrate the enterprise and ingenuity of these two Australians on the $20 note. The Reserve Bank also continues to work on the upgrading of Australia’s electronic payments system. We want to see a system that is reliable, secure and efficient, and meets the needs of Australians. It is one year now since the New Payments Platform (NPP) was launched. Over 2½ million Australians have registered PayIDs and the banks are progressively adding functionality to the system. Many people are already benefiting from faster and more flexible payments. We have, however, been disappointed that some of the major banks have not met the originally agreed timelines. This delay has, regrettably, slowed the pace of innovation in the overall system, given the substantial network effects that exist in payment systems. Late last year, I wrote to the CEOs of the major banks on behalf of the Payments System Board expressing our concerns and seeking a commitment that the updated timelines will be satisfied. It is important that these commitments are met. Notwithstanding these delays, I remain confident that the NPP will provide the backbone for substantial innovation in Australia’s payment system for years to come. Thank you very much. My colleagues and I are here to answer your questions. 4/4 BIS central bankers' speeches | reserve bank of australia | 2,019 | 2 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the AFR Business Summit, Sydney, 6 March 2019. | 3/7/2019 The Housing Market and the Economy | Speeches | RBA Speech The Housing Market and the Economy Philip Lowe [ * ] Governor Address to the AFR Business Summit Sydney – 6 March 2019 Thank you for the invitation to address this year's AFR Business Summit. It is good to be back here again. As you would be aware, the Reserve Bank Board met yesterday and left the cash rate unchanged at 1.5 per cent. I would like to use this opportunity to highlight some of the issues we discussed at the meeting. Before I do that, though, I would like to focus on the housing market and its implications for the economy. Readers of the monetary policy minutes would have noticed that at its February meeting the Board discussed a special paper taking a deep dive into this topic. My remarks today draw from that paper. I will first focus on the current state of the housing market. Then, I will discuss the main drivers of recent movements in housing prices, before turning to the implications for the broader economy and the financial system. The Current State of the Housing Market Australians watch housing markets intensely, perhaps more so than citizens of any other country. Over the five years to late 2017, they saw nationwide housing prices increase by almost 50 per cent (Graph 1). Since then, prices have fallen by 9 per cent, bringing them back to their level in mid 2016. https://www.rba.gov.au/speeches/2019/sp-gov-2019-03-06.html 1/18 3/7/2019 The Housing Market and the Economy | Speeches | RBA Graph 1 Declines of this magnitude are unusual, but they are not unprecedented. In 2008 and 2010, prices fell by a similar amount, as they did on two occasions in the 1980s. In the 1980s, the rate of CPI inflation was higher than it is now, so in inflation-adjusted terms, the declines then were larger than the current one. These nationwide figures mask considerable variation across the country (Graph 2). The run-up in prices over recent years was most pronounced in Sydney and Melbourne, so it is not surprising that the declines over the past year have also been largest in these two cities. In Perth and Darwin, the housing markets have been weak for some time, affected by the swings in population and income associated with the mining boom. By contrast, the housing market in Hobart has been strong recently. In Adelaide, Brisbane, Canberra and many parts of regional Australia, conditions have been more stable. Given these contrasting experiences, it is pretty clear that there is no such thing as housing market. What we have is a series of separate, but interconnected, markets. Australian https://www.rba.gov.au/speeches/2019/sp-gov-2019-03-06.html the 2/18 3/7/2019 The Housing Market and the Economy | Speeches | RBA Graph 2 Another important window into housing markets is provided by rental markets. Over recent times, the nationwide measure of rent inflation has been running at a bit less than 1 per cent, the lowest in three decades (Graph 3). As with housing prices, there is a lot of variation across the country. Rents have been falling for four years in Perth and are now around 20 per cent below their previous peak. By contrast, in Hobart rents have been rising at the fastest rate for some years. https://www.rba.gov.au/speeches/2019/sp-gov-2019-03-06.html 3/18 3/7/2019 The Housing Market and the Economy | Speeches | RBA Graph 3 As is well understood, shifts in sentiment play an important role in housing markets. When prices are rising, people are attracted to the market in the hope of capital gains. At some point, though, valuations become so stretched that demand tails off and there is a shift in momentum. When prices are falling, it's the reverse. The prospect of capital losses leads buyers to stay away or to delay purchasing. At some point, though, the lower prices draw more buyers into the market. First home owners find it easier to buy a home, investors are attracted back into the market, and trade-up buyers take the opportunity to upgrade to the home they have always wanted. These shifts in sentiment and momentum are seen in most housing cycles, but their precise timing is difficult to predict. Some of these shifts in sentiment are evident in consumer surveys (Graph 4). Over recent times, the number of people reporting that an investment in real estate is the wisest place for their savings has fallen significantly. So, it is not surprising that there are fewer investors in the market. At the same time, the number of people saying it is a good time to buy a home has increased. Lower prices draw more people in and, eventually, this helps stabilise the market. So it is worth closely watching these shifts in sentiment. https://www.rba.gov.au/speeches/2019/sp-gov-2019-03-06.html 4/18 3/7/2019 The Housing Market and the Economy | Speeches | RBA Graph 4 Explaining the Recent Cycle An obvious question to ask is what are the underlying, or structural, drivers of the large run-up in housing prices and the subsequent decline? There isn't a single answer to this question. Rather, it is a combination of factors. Before I discuss these factors, it is worth pointing out that the current adjustment is unusual. Unlike the other four episodes in which housing prices have declined in recent decades, this one was not preceded by rising mortgage rates. Nor has it been associated with a rise in the national unemployment rate. Instead, in New South Wales, where the recent decline in housing prices has been the largest, the unemployment rate has continued to trend down. It is now at levels last seen in the early 1970s. The unemployment rate has also trended lower in Victoria. So, the origins of the current correction in prices do not lie in interest rates and unemployment. Rather, they largely lie in the inflexibility of the supply side of the housing market in response to large shifts in population growth. It is useful to start with the national picture (Graph 5). Australia's population growth picked up noticeably in the mid 2000s and it took the better part of a decade for the rate of home building to respond. It took time to plan, to obtain council approvals, to arrange finance and to build the new homes. Not surprisingly, housing prices went up. Eventually, though, the supply response did take https://www.rba.gov.au/speeches/2019/sp-gov-2019-03-06.html 5/18 3/7/2019 The Housing Market and the Economy | Speeches | RBA place. Over recent times, the number of dwellings in Australia has been increasing at the fastest rate in more than two decades. Again, not surprisingly, prices have responded to this extra supply. Graph 5 The population and supply dynamics are most evident in Western Australia and New South Wales (Graph 6). During the mining investment boom, population growth in Western Australia increased from around 1 per cent to 3½ per cent. This was a big change. The rate of home building was slow to respond. When it did finally respond, it was just at the time that population growth was slowing significantly, as workers moved back east at the end of the boom. This explains much of the cycle. In New South Wales it is a similar story, although it is not quite as stark. The recent rate of home building in New South Wales is the highest in decades. At the same time, population growth is moderating, partly due to people moving to other cities, attracted by their lower housing prices and rents. By contrast, in cities where population patterns and the rate of home building have been more stable, prices, too, have been more stable. https://www.rba.gov.au/speeches/2019/sp-gov-2019-03-06.html 6/18 3/7/2019 The Housing Market and the Economy | Speeches | RBA Graph 6 Another demand-side factor that has influenced prices is the rise and then decline in demand by non-residents. One, albeit imperfect, way of seeing this is the number of approvals by the Foreign Investment Review Board (Graph 7). In the middle years of this decade, there was a surge in foreign investment in residential property, particularly from China. This was apparent not just in Australian cities, but also in ‘international’ cities in other countries. In Australia, the demand was particularly strong in Sydney and Melbourne, given the global profiles of these two cities and their large foreign student populations. More recently, this source of demand has waned, partly as a result of the increased difficulty of moving money out of China as the authorities manage capital flows. https://www.rba.gov.au/speeches/2019/sp-gov-2019-03-06.html 7/18 3/7/2019 The Housing Market and the Economy | Speeches | RBA Graph 7 The timing of these shifts in foreign demand has broadly coincided with – and reinforced – the shifts in domestic demand. However, making a full assessment of their impact on prices is complicated by the fact that international property developers were also adding to supply in Australia at a time of very strong demand. More recently, these developers have scaled back their activity. Domestic investors have also played a significant role in this cycle. This is especially the case in New South Wales, which was the epicentre of strong investor demand (Graph 8). At the peak of the boom, approvals to investors in New South Wales accounted for half of approvals nationwide, compared with an average of just 30 per cent over the five years to 2010. More than 40 per cent of the new dwellings built in New South Wales recently have been apartments, which tend to be more attractive to investors. https://www.rba.gov.au/speeches/2019/sp-gov-2019-03-06.html 8/18 3/7/2019 The Housing Market and the Economy | Speeches | RBA Graph 8 The strong demand from investors had its roots in the population dynamics. Low interest rates and favourable tax treatment added to the attraction of investing in an appreciating asset. The positive side to this was that the strong demand by investors helped underpin the extra construction activity needed to house the growing population. But the rigidities on the supply side, coupled with investors' desire to benefit from a rising market in a low interest rate environment, amplified the price increases. As I discussed earlier, there is an internal dynamic to housing price cycles, and this one is no exception. By 2017, the ratio of the median home price to income had reached very high levels in Sydney and Melbourne (Graph 9). Finding the deposit to purchase a home had become beyond the reach of many people, especially first home buyers if they did not have others to help them. At the same time, the combination of high prices and weak growth in rents meant that rental yields were quite low. So, naturally, momentum shifted. Given the big run-up in prices and the large increase in supply, a correction at some point was not surprising, although the precise timing is nearly impossible to predict. https://www.rba.gov.au/speeches/2019/sp-gov-2019-03-06.html 9/18 3/7/2019 The Housing Market and the Economy | Speeches | RBA Graph 9 No discussion of housing prices is complete without touching on interest rates and the availability of finance. The low interest rates over the past decade did increase people's capacity to borrow and made it more attractive to borrow to buy an asset whose price was appreciating. But the increase in housing prices is not just about low interest rates. The variation across the different housing markets indicates that city-specific factors have played an important role. Recently, much attention has also been paid to the availability of credit. This attention has coincided with a noticeable slowing in housing credit growth, especially to investors (Graph 10). https://www.rba.gov.au/speeches/2019/sp-gov-2019-03-06.html 10/18 3/7/2019 The Housing Market and the Economy | Speeches | RBA Graph 10 It is clear there has been a progressive tightening in lending standards over recent years. The RBA's liaison suggests that, on average, the maximum loan size offered to new borrowers has fallen by around 20 per cent since 2015. This reflects a combination of factors, including more accurate reporting of expenses, larger discounts applied to certain types of income and more comprehensive reporting of other liabilities. Even so, only around 10 per cent of people borrow the maximum they are offered. Sensibly, most people borrow less than what they are offered, so the effect of this reduction in borrowing capacity has not been particularly large. It has also been apparent through our liaison that some lenders became more cautious last year. There was a heightened concern by some loan officers about the consequences to them and their career prospects of making a loan that might not be repaid if the borrower's circumstances changed. So, lenders became more risk averse. This, along with greater verification of expenses and income, led to an increase in average loan approval times, although some lenders have invested in people and technology to address this. Our liaison suggests that application approval rates are largely unchanged. Overall, the evidence is that a tightening in credit supply has contributed to the slowdown in credit growth. The main story, though, is one of reduced demand for credit, rather than reduced supply. When housing prices are falling, investors are less likely to enter the market and to borrow. So too are owner-occupiers for a while. Consistent with this, the number of loan applicants has declined https://www.rba.gov.au/speeches/2019/sp-gov-2019-03-06.html 11/18 3/7/2019 The Housing Market and the Economy | Speeches | RBA over the past year. There is also strong competition for borrowers with low credit risk, which is not something you would expect to see if it were mainly a supply story. This competition is evident in the significant discounts on interest rates on new loans compared with those on outstanding loans. Even though the slowing in credit growth is largely a demand story, we are watching credit availability closely. It is perhaps stating the obvious to say that we want lenders who are both prudent and who are prepared to take risk. As lenders recalibrated their risk controls last year, the balance may have moved too far in some cases. This meant that credit conditions tightened more than was probably required. Now, as lenders continue to seek the right balance, we need to remember that it is important that banks are prepared to take credit risk. And it's important that they have the capacity to manage that risk well. If they can't do this, then the economy will suffer. Impact on the Macroeconomy This brings me to the issue of how developments in the housing market affect the broader economy. Movements in housing prices affect the economy through multiple channels. They influence consumer spending, including through the spending that occurs when people move homes. They also influence the amount of building activity that takes place. Changes in housing prices also have an impact on access to finance by small business by affecting the value of collateral for loans. And finally, they can affect the profitability of our financial institutions. Today, I would like to focus on the effect of housing prices on household consumption. My colleagues at the RBA have examined how changes in measured housing wealth affect household spending. [1] They estimate that a 10 per cent increase in net housing wealth raises the level of consumption by around ¾ per cent in the short run and by 1½ per cent in the longer run. They have also examined how this wealth effect differs by type of spending. They find that it is highest for spending on motor vehicles and household furnishings and that for many other types of spending the effect is not significantly different from zero (Graph 11). Part of the effect on spending on furnishings is likely to come from the fact that periods of rising housing prices are often associated with higher housing turnover, and turnover generates extra spending. https://www.rba.gov.au/speeches/2019/sp-gov-2019-03-06.html 12/18 3/7/2019 The Housing Market and the Economy | Speeches | RBA Graph 11 Over recent years, spending by households has risen at a faster rate than household income; in other words, the saving rate has declined (Graph 12). The results that I just spoke about suggest that rising housing wealth played a role here. If so, falling housing prices, and a decline in measured household wealth, could have the opposite effect. https://www.rba.gov.au/speeches/2019/sp-gov-2019-03-06.html 13/18 3/7/2019 The Housing Market and the Economy | Speeches | RBA Graph 12 The more important influence, though, is what is happening with household income. For many people, the main source of their wealth is their human capital; that is, their future earning capacity. As I have discussed on previous occasions, growth in household income has been quite weak for a while. It is plausible that, for a time, this didn't affect people's expectations of their future income growth; that is the value of their human capital. So they didn't change their spending plans much, despite their current income growth being weak, and the saving rate fell. However, as the period of weak income growth has persisted, it has become harder to ignore it. Expectations of future income growth have been revised down and it is likely that this is affecting spending. My conclusion here is that wealth effects are influencing consumption decisions, but they are working mainly through expectations of future income growth. Swings in housing prices and turnover in the housing market are also having an effect, but they are not the main issue. This assessment is consistent with the data on housing equity injection (Graph 13). Over recent years, households have been injecting substantial equity into housing and have not been using the higher housing prices to borrow to support their other spending. This is in contrast to the period around the turn of the century, when households were withdrawing equity. https://www.rba.gov.au/speeches/2019/sp-gov-2019-03-06.html 14/18 3/7/2019 The Housing Market and the Economy | Speeches | RBA Graph 13 Given this assessment, developments in the labour market are particularly important. A further tightening of the labour market is expected to see a gradual increase in wages growth and faster income growth. This should provide a counterweight to the effect on spending of lower housing prices. Taking these various considerations into account, the adjustment in our housing market is manageable for the overall economy. It is unlikely to derail our economic expansion. It will also have some positive side-effects by making housing more affordable for many people. A related issue that the RBA has paid close attention to is the impact of lower housing prices on financial stability. In 2017, APRA assessed the ability of Australian banks to withstand a severe stress scenario, in which housing prices declined by 35 per cent over three years, GDP declined by 4 per cent and the unemployment rate increased to more than 10 per cent. [2] The estimated impact on bank profitability was substantial, but importantly, bank capital remained above regulatory minimum levels. This provides reassurance that the adjustment in our housing market is not a financial stability issue. We have not experienced the very loose lending practices that were common in the United States before the housing crash there a decade ago. Nor have we seen significant overbuilding around the country. https://www.rba.gov.au/speeches/2019/sp-gov-2019-03-06.html 15/18 3/7/2019 The Housing Market and the Economy | Speeches | RBA Non-performing housing loans in Australia have risen recently, but they remain low at less than 1 per cent (Graph 14). The increase is most evident in Western Australia, where the unemployment rate has risen. Graph 14 The national experience has been that low levels of unemployment and low interest rates allow most people to service their loans, even if weak income growth means that household finances are sometimes strained. Our estimate is that currently, less than 5 per cent of indebted owner-occupier households have negative equity, and the vast bulk of these households continue to meet their mortgage obligations. One factor that has helped here is that the share of new loans with high loanto-valuation ratios (LVRs) has declined substantially (Graph 15). The nature of Australian mortgages – in which there is an incentive to make prepayments – has also helped. https://www.rba.gov.au/speeches/2019/sp-gov-2019-03-06.html 16/18 3/7/2019 The Housing Market and the Economy | Speeches | RBA Graph 15 Monetary Policy I would like to conclude with some words about monetary policy and highlight some of the issues we focused on at yesterday's Reserve Bank Board meeting. As you are aware, the current setting of monetary policy has been in place for some time. A cash rate of 1.5 per cent is very low historically and it is clearly stimulatory. It is supporting the creation of jobs and progress towards achieving the inflation target. Looking forward, a key issue is the labour market. Achieving full employment is an important objective in its own right. But, in addition, a strong labour market is the central ingredient in the expected pick-up in inflation. We are expecting that as the labour market tightens, wages growth will increase further. In turn, this should boost household income and spending and provide a counterweight to the fall in housing prices. The pick-up in spending is, in turn, expected to put upward pressure on inflation. Of course, it is possible that inflation could move higher for other reasons, although the likelihood of this at the moment seems low. This means that a lot depends upon the labour market. The recent data on this front have been encouraging. Employment growth has been strong, the vacancy rate is very high and firms' hiring intentions remain positive. The latest reading of the wage price index also confirmed a welcome, but gradual, pick-up in wage growth, especially in the private sector. https://www.rba.gov.au/speeches/2019/sp-gov-2019-03-06.html 17/18 3/7/2019 The Housing Market and the Economy | Speeches | RBA Other indicators of the economy, though, paint a softer picture. We will receive another reading on GDP growth later this morning, but growth in the second half of 2018 was clearly less than in the first half. This is similar to the picture internationally. In a number of countries, including our own, there is growing tension between strong labour market data and softer GDP data. We are devoting significant resources to understanding this tension. The Board will continue to assess the shifts in the global economy, trends in household spending and how the tension between the labour market and output indicators resolves itself. We have the flexibility to adjust monetary policy in either direction as required. There are plausible scenarios under which the next move in interest rates is up. There are also plausible scenarios under which it is down. At the moment, the probabilities appear reasonably evenly balanced. Given these various cross currents, the Board's judgement remains that the most appropriate course is to maintain the cash rate at its current level. Thank you for listening and I am happy to answer your questions. Endnotes [*] I would like to thank Iris Day, Penny Smith, Andrew Staib and Andrea Brischetto for assistance in the preparation of these remarks. May D, G Nodari and D Rees (forthcoming), ‘Wealth and Consumption’, RBA Bulletin. APRA (2018), ‘Testing resilience: The 2017 Banking Industry Stress Test’, APRA Insight, Issue 3. © Reserve Bank of Australia, 2001–2019. All rights reserved. https://www.rba.gov.au/speeches/2019/sp-gov-2019-03-06.html 18/18 | reserve bank of australia | 2,019 | 3 |
Remarks by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at a Public Forum hosted by the Centre for Policy Development, Sydney, 12 March 2019. | 3/13/2019 Climate Change and the Economy | Speeches | RBA Speech Climate Change and the Economy Guy Debelle [ * ] Deputy Governor Public Forum hosted by the Centre for Policy Development Sydney – 12 March 2019 ‘I love a sunburnt country, a land of sweeping plains, of ragged mountain ranges, of droughts and flooding rains.’ As Dorothea Mackellar eloquently put it in 1908, the weather has always had a significant impact on the Australian economy. One example that I recall vividly from my primary school days in Adelaide is the Goyder Line. Goyder was the Surveyor-General of the colony of South Australia in the second half of the 19th century. In 1865, he rode across the colony to determine what part of the state was arable. He plotted the Goyder line, or the 10-inch rainfall line. Areas to the south of the line were arable, those to the north were not. In the years just after Goyder drew his line, there was a period of high rainfall. Farmers pushed north of the Goyder line, building farmhouses and planting crops. But then, normal rainfall returned and Goyder's line reasserted itself. The legacy of that is still evident today with the ruined farmhouses. Droughts and floods have had a large effect on the Australian economy for many, many years. In the 1990s, the model of the Australian economy at the Reserve Bank developed by David Gruen and Geoff Shuetrim had the Southern Oscillation Index as a significant determinant of GDP in Australia. [1] Today, while agriculture is a much smaller share of the economy than it used to be, the effect of climate on that sector is still evident in aggregate GDP. The current drought has already reduced farm output by around 6 per cent and total GDP by about 0.15 per cent. Even assuming that rainfall returns towards average soon, the drought will continue to weigh on aggregate GDP during 2019. However, the effect of the drought on aggregate output and inflation is finite, though its impact on the people and businesses affected can last much longer. We are used to climate having a temporary effect (though sometimes severe) on output and prices in Australia. https://www.rba.gov.au/speeches/2019/sp-dg-2019-03-12.html 1/10 3/13/2019 Climate Change and the Economy | Speeches | RBA Agriculture is the prism through which we have historically thought about the effect of climate on the economy. Today, climate change presents significant risks and opportunities for a broader part of the economy than agriculture, though the impact on agriculture continues to be significant. I will talk about how climate change affects the objectives of monetary policy and some of the challenges that arise in thinking about climate change. Then I will use two current examples of how climate change is affecting the economy to illustrate these issues. Finally, I will also briefly discuss how climate change affects financial stability. Let me start by highlighting a few of the dimensions that we need to consider: We need to think in terms of trend rather than cycles in the weather. Droughts have generally been regarded (at least economically) as cyclical events that recur every so often. In contrast, climate change is a trend change. The impact of a trend is ongoing, whereas a cycle is temporary. We need to reassess the frequency of climate events. In addition, we need to reassess our assumptions about the severity and longevity of the climatic events. For example, the insurance industry has recognised that the frequency and severity of tropical cyclones (and hurricanes in the Northern Hemisphere) has changed. This has caused the insurance sector to reprice how they insure (and re-insure) against such events. We need to think about how the economy is currently adapting and how it will adapt both to the trend change in climate and the transition required to contain climate change. The time-frame for both the impact of climate change and the adaptation of the economy to it is very pertinent here. The transition path to a less carbon-intensive world is clearly quite different depending on whether it is managed as a gradual process or is abrupt. The trend changes aren't likely to be smooth. There is likely to be volatility around the trend, with the potential for damaging outcomes from spikes above the trend. Both the physical impact of climate change and the transition are likely to have first-order economic effects. The United Nations' Intergovernmental Panel on Climate Change (IPCC) report documents that 1 degree of warming has already occurred from pre-industrial levels as a result of human activities. It provides strong evidence that another half degree of warming will occur in the next 10 to 30 years if warming continues at the current rate. That is the average outcome, with some areas experiencing greater warming. There is also likely to be significant volatility around that outcome, with an increase in the frequency of extreme temperatures. This volatility is highlighted in the first graph in the recent Bureau of Meteorology (BoM) and CSIRO report, . The report states that ‘Australia’s climate has warmed by just over 1 degree C since 1910, ', and expects further warming over the next decade. [3] These extreme events may well have a disproportionately large physical impact. heat events State of the Climate leading to an increase in the frequency of extreme https://www.rba.gov.au/speeches/2019/sp-dg-2019-03-12.html 2/10 3/13/2019 Climate Change and the Economy | Speeches | RBA There is also a greater possibility of compound events, where two (or more) climatic events combine to produce an outcome that is worse than the effect of one of them occurring individually. Combined with the increased volatility, this increases the likelihood of non-linear impacts on the economy. Both the IPCC and the BoM/CSIRO reports highlight the changed environment that the economy will need to adapt to. They also provide evidence on what change is predetermined and what can be affected by actions to strengthen the global response to the threat of climate change. These issues are central to businesses, households and government. The policy environment has a key effect as well as the climatic environment. It is worth noting that the effect on the Australian economy is not just a function of the domestic political environment, but also that of other countries, most notably our trading partners. I will return to this later. Climate Change, Economic Models and Monetary Policy The economics profession has examined the effects of climate change at least since Nobel Prize winner William Nordhaus in 1977. Since then, it has become an area of considerably more active research in the profession. [4] There has been a large body of research around the appropriate design of policies to address climate change (such as the design of carbon pricing mechanisms), but not that much in terms of what it might imply for macroeconomic policies, with one notable exception being the work of Warwick McKibbin and co-authors. How does climate affect monetary policy? Monetary policy's objectives in Australia are full employment/output and inflation. Hence the effect of climate on these variables is an appropriate way to consider the effect of climate change on the economy and the implications for monetary policy. The economy is changing all the time in response to a large number of forces. Monetary policy is always having to analyse and assess these forces and their impact on the economy. But few of these forces have the scale, persistence and systemic risk of climate change. A longstanding way of thinking about monetary policy and economic management is in terms of demand and supply shocks. [6] A positive demand shock increases output and increases prices. The monetary policy response to a positive demand shock is straightforward: tighten policy. Climate events have been good examples of supply shocks. Indeed, droughts are often the textbook example used to illustrate a supply shock. A negative supply shock reduces output but increases prices. That is a more complicated monetary policy challenge because the two parts of the RBA's dual mandate, output and inflation, are moving in opposite directions. Historically, the monetary policy response has been to look through the impact on prices, on the presumption that the impact is temporary. The banana price episode in 2011 after Cyclone Yasi is a good example of this. The spike in banana prices and inflation was temporary, although quite substantial. It boosted inflation by 0.7 percentage points. The Reserve Bank looked through the effect of the banana price rise on inflation. After the banana crop returned to normal, prices settled down and inflation returned to its previous rate. The response to such a shock is relatively straightforward if the climate events are temporary and discrete: droughts are assumed to end; the destruction of the banana crop or the closure of the iron ore port because of a cyclone is temporary; things return to where they were before the climate https://www.rba.gov.au/speeches/2019/sp-dg-2019-03-12.html 3/10 3/13/2019 Climate Change and the Economy | Speeches | RBA event. That said, the output that is lost is generally lost forever. It is not made up again later, but rather output returns to its former level. The recent IPCC report documents that climate change is a trend rather than cyclical, which makes the assessment much more complicated. What if droughts are more frequent, or cyclones happen more often? The supply shock is no longer temporary but close to permanent. That situation is more challenging to assess and respond to. A relevant question for monetary policy is how quickly and easily the economy adjusts to climaterelated shocks, particularly if the shocks are more extreme. Both the impact of the shocks together with the adjustment to those shocks affect the macroeconomic trajectory. The timing and speed of the response by households, businesses and governments is likely to affect the economic outcomes. In economic terms (borrowed from physics), this is described as hysteresis or path dependence. Decisions that are taken now can have significant effects on future climate trends and can limit or eliminate the ability to mitigate the effect of those trends. Hysteresis is complicated for macroeconomic policies such as monetary policy to deal with. Research into hysteresis in the labour market has documented the long-lasting effects of large rises in unemployment and the difficulty in reversing those effects. [7] To me, that research seems a useful framework to think about the effect of climate on the economy. How can we gain insights into the potential impacts of climate change on output and inflation? One avenue is to use scenario analysis. There are some useful studies that look at the impact of climate change on particular sectors of the economy. They are often, by design and necessity, partial equilibrium; that is, taking into consideration only a particular market to analyse the impact. But the effect on the overall economy depends on what else is happening. General equilibrium analysis provides the opportunity to consider how prices adjust and how people respond to price signals in the whole economy. The analytical approach of looking at things in general equilibrium is a critical part of the economics tool kit. It is an important contribution the economics profession can make to the climate change discussion. However, general equilibrium models often provide only a comparative static view. That is, the economy is in one equilibrium now and in the future it will be in another equilibrium. But for monetary policy, we very much care about the dynamics of moving from one equilibrium to another (and also we are generally not dealing with an economy in equilibrium). How long will it take the economy to adjust? Monetary policy has its maximum effect over a horizon of two or so years. Much of the adjustment may be taking place beyond that horizon but we very much need to be alert to when it is having a material influence within that horizon. To do that, we need to have an understanding of what the transition path might look like. Thus for monetary policy we need to assess both the direct physical impact of climate change and also we need to assess the transition (adjustment) path. What will the inflation and output outcomes be along that adjustment path? How should monetary policy respond to these outcomes? We also need to be aware that decisions taken now by businesses and government may have a sizeable https://www.rba.gov.au/speeches/2019/sp-dg-2019-03-12.html 4/10 3/13/2019 Climate Change and the Economy | Speeches | RBA influence on that transition path. Both the physical impact of climate and the transition path can cause both shocks and cause the trend to change. The challenges we have to address are to take the outcomes from climate modelling and map them into our economic modelling. Similarly, the scenario analysis from climate models needs to be translated into the horizons of our economic models, taking account of price changes and how that affects decision-making. General equilibrium analysis also doesn't always take account of adjustment burdens and costs. I see that as one lesson from the debate around trade liberalisation. Trade theory clearly acknowledges that there are winners and losers from trade but that the winners can compensate the losers. But it is clear from the current debate that, in practice, the compensation generally has not occurred. The adjustment costs have fallen on groups that have not received their share of the benefits. A similar situation is present in the case of climate change. The transition path poses challenges, but it also presents opportunities. Particular industries and particular communities that are especially exposed to the costs of changes in the climate will face lower costs if there is an early and orderly transition. Others will bear greater costs from the transition to a lower carbon economy. While others still, such as the renewables sector, may benefit from that transition. But unlike the example of trade, it may not be possible for the winners to compensate the losers in a way that leaves no-one worse off. In economic jargon, it may not be possible to find a Pareto improving outcome, at least in the narrow monetary sense. Current Examples of Climate-related Effects on the Australian Economy I will now turn to two current examples of how climate is affecting the economy that illustrate some of these issues. I will firstly talk about investment in renewable energy sources in the Australian economy. I will then talk about how environmental policy decisions taken in China have had a direct effect on the Australian economy. There has been a marked pick-up in investment spending on renewable energy in recent years. It has been big enough to have a noticeable impact at the macroeconomic level and affect aggregate output and hence the monetary policy calculus. It is a good example where price signals have caused significant behavioural change. [8] There has been a rapid decline in the cost of renewable energy sources, in part because of extensive spending on research and development in renewable energy technology around the world occurring both because of government policies and private actors anticipating the transition to a lower carbon economy. As a result of the price decline, the investment cost-benefit analysis has changed and continues to change quite rapidly. Graph 1 shows the levelised cost of generating electricity and how that has declined in the case of wind and solar to the point where they are now cost-effective sources of generation. However, we also know that the cost of generation is not the whole story. Storage and transmission are also relevant costs. [9] But the cost of storage of electricity through batteries is also declining rapidly, and pumped hydro storage can effectively operate as a very large battery. https://www.rba.gov.au/speeches/2019/sp-dg-2019-03-12.html 5/10 3/13/2019 Climate Change and the Economy | Speeches | RBA Graph 1 Transmission is a more complicated picture. As more households and businesses have installed rooftop solar, they are putting electricity into a grid that was primarily designed to distribute energy from a wholesale-scale source of generation. It was not designed to receive and redistribute power from multiple (small) generators at one part of the day and then go back the other way at night. Moreover, large-scale renewable generators can be located far away from traditional fossil fuel generators, requiring additional investment in transmission infrastructure. This is another example of needing to think in a general equilibrium sense about how people respond to changing price signals. Changes in behaviour in response to these price changes are now occurring within the horizon period where monetary policy cares about. Hence we need to gain a better understanding of what is driving those changes and what is in prospect to affect future changes. The Reserve Bank's business liaison program has been a very useful source of information to help us gain that understanding. The most recent capital expenditure survey from the ABS shows there is more investment in renewables in prospect over the next two years in a way that has a noticeable influence on the aggregate business investment profile. This is also apparent when looking at available information on the probable spending planned or committed and underway now for specific renewable generation and storage projects (Graph 2). https://www.rba.gov.au/speeches/2019/sp-dg-2019-03-12.html 6/10 3/13/2019 Climate Change and the Economy | Speeches | RBA Graph 2 How these price and investment developments evolve over the coming years is something we are playing close attention to, given the importance of the cost of electricity in inflation both directly to households and indirectly as a significant input to businesses. I mentioned earlier that the policy environment is important. An example of that is the effect of China's environmental policies. Environmental concerns have been elevated in the current five-year plan. There has been a policy directive to move to cleaner sources of energy (Graph 3). This trend has provided benefits to Australia, as Australian coal tends to be of higher quality. A long held policy aim has been to gradually reduce overall coal usage. This illustrates that the time frame, the policy incentives and the transition path are important influences on the actual effect on the economy. As China transitions away from coal, natural gas is expected to account for a larger share of its energy mix, and Australia is well placed to help meet this increase in demand. More generally, Australia is also benefitting from the increased demand for battery inputs (especially lithium) and other metals that are used intensively in renewable generation. https://www.rba.gov.au/speeches/2019/sp-dg-2019-03-12.html 7/10 3/13/2019 Climate Change and the Economy | Speeches | RBA Graph 3 Finally, while China is most prominent in thinking about this issue at the moment, India matters too. How energy demand in India is likely to evolve is something the Reserve Bank is spending time thinking about as well. Climate Change and Financial Stability Having talked about the macroeconomic impact of climate change and how that might affect monetary policy, I will briefly discuss climate through the lens of financial stability implications. Financial stability is also a core part of the Reserve Bank's mandate. Challenges for financial stability may arise from both physical and transition risks of climate change. For example, insurers may face large, unanticipated payouts because of climate change-related property damage and business losses. In some cases businesses and households could lose access to insurance. Companies that generate significant pollution might face reputational damage or legal liability from their activities, and changes to regulation could cause previously valuable assets to become uneconomic. All of these consequences could precipitate sharp adjustments in asset prices, which would have consequences for financial stability. The reason that I will cover the implications of climate change for financial stability only briefly today is that they have been very eloquently discussed by Geoff Summerhayes (APRA) and John Price (ASIC) including at this forum over the past two years. [11] I would very much endorse the points that Geoff and John have made. Geoff stresses the need for businesses, including those in the financial sector, to implement the recommendations of the Task Force for Climate-related Financial https://www.rba.gov.au/speeches/2019/sp-dg-2019-03-12.html 8/10 3/13/2019 Climate Change and the Economy | Speeches | RBA Disclosures (TCFD). [12] I strongly endorse this point. We have seen progress on this front in recent years, but there is more to be done. Financial stability will be better served by an orderly transition rather than an abrupt disorderly one. One area that Geoff highlighted in a recent speech is that there is a data gap which needs to be addressed: [13] ‘The challenge governments, regulators and financial institutions face in responding to the wide-ranging impacts of climate change is to make sound decisions in the face of uncertainty about how these risks will play out.’ In that regard, Geoff mentions one challenge that I spoke about earlier in the context of monetary policy. Namely, taking the climate modelling and mapping that into our macroeconomic models. For businesses and financial markets, that challenge is understanding the climate modelling and conducting the scenario analysis to determine the potential impact on their business and investments. Conclusion To help us try to address this data deficit, we are talking with businesses through our business liaison program. We are talking with climate modellers. We share a common understanding with them about looking at these issues in general equilibrium and the importance and challenges in modelling non-linearities. We are working through the challenge of taking this information and translating it to the economic models and frameworks that inform our monetary policy decisionmaking. Last but not least, last year the RBA joined the Network for Greening the Financial System (NGFS), a group of central banks that are examining climate issues. Through all of these channels, we are trying to learn and benefit as much as possible from the expertise of others to understand and contribute to the discussion around the serious challenge of climate change. Endnotes [*] Thank you to David Wakeling in particular and Timoth De Atholia for their input, and to Paul Fisher, Alex Heath and Geoff Summerhayes for helpful comments and discussions. Alexis Tan provided the material on China. Gruen D and G Shuetrim (1994), ‘Internationalisation and the Macroeconomy PDF ’ in P Lowe and J Dwyer (eds) , Proceedings of a Conference, Reserve Bank of Australia, Sydney, pp 309–363. Allen, MR (2018), ‘Framing and Context’, in V Masson-Delmotte ‘Global Warming of 1.5°C’. An Intergovernmental Panel on Climate Change (IPCC) Special Report on the impacts of global warming of 1.5°C above pre-industrial levels and related global greenhouse gas emission pathways, in the context of strengthening the global response to the threat of climate change, sustainable development, and efforts to eradicate poverty. Available at <https://www.ipcc.ch/site/assets/uploads/sites/2/2019/02/SR15_Chapter1_Low_Res.pdf>. The Bureau of Meteorology and CSIRO (2018), ‘State of the Climate 2018’, December (emphasis added). Available at <http://www.bom.gov.au/state-of-the-climate/State-of-the-Climate-2018.pdf>. Stern, N (2007), ‘The Economics of Climate Change: The Stern Review’, Cambridge University Press. Hsiang S and RE Kopp (2018), ‘An Economist’s Guide to Climate Change Science', , 32(4), pp 3– 32. International Integration of the Australian Economy et al https://www.rba.gov.au/speeches/2019/sp-dg-2019-03-12.html et al Journal of Economic Perspectives 9/10 3/13/2019 Climate Change and the Economy | Speeches | RBA See for example, McKibbin W, A Morris, A Panton and P Wilcoxen (2017), ‘Climate Change and Monetary Policy: Dealing with disruption’, available at <https://cama.crawford.anu.edu.au/sites/default/files/publication/cama_crawford_anu_edu_au/201712/77_2017_mckibbin_morris_panton_wilcoxen_0.pdf>, CAMA Working Paper 77/2017. Carney, M (2015), ‘Breaking the tragedy of the horizon – climate change and financial stability’, available at <https://www.bankofengland.co.uk/speech/2015/breaking-the-tragedy-of-the-horizon-climate-change-and-financialstability>, speech given at Lloyd's of London, 29 September; B Couere (2018) ‘Monetary policy and climate change’, available at <https://www.ecb.europa.eu/press/key/date/2018/html/ecb.sp181108.en.html>,’ at a conference on ‘Scaling up Green Finance: The Role of Central Banks’, organised by the Network for Greening the Financial System, the Deutsche Bundesbank and the Council on Economic Policies, Berlin, 8 November; P Fisher (forthcoming), ‘Climate change: the role for central banks’, manuscript. Blanchard, OJ and LH Summers (1986), ‘Hysteresis in Unemployment’, NBER Working Paper No 2035, October. Available at <https://www.nber.org/papers/w2035>. These price signals have also reflected policies promoting investment in renewables. Graham PW, J Hayward, J Foster, O Story and L Havas (2018), , CSIRO Australia. Available at <https://www.csiro.au/~/media/News-releases/2018/Annual-update-finds-renewables-are-cheapest-new-buildpower/GenCost2018.pdf>. A final area that we have been involved in through the G20 process is green finance, which I will not discuss today. For more information, see reference. Price J (2018), ‘Climate Change’, Keynote address at the Centre for Policy Development: Financing a Sustainable Economy, Sydney, 18 June. Available at <https://asic.gov.au/about-asic/news-centre/speeches/climate-change/>. Summerhayes G (2017), ‘Australia's new horizon: Climate change challenges and prudential risk’. Available at <https://www.apra.gov.au/media-centre/speeches/australias-new-horizon-climate-change-challenges-andprudential-risk>. <https://www.fsb-tcfd.org/> Summerhayes G (2019), ‘Financial exposure: the role of disclosure in addressing the climate data deficit’, ClimateWise and University of Cambridge Institute for Sustainable Leadership, London (February). Available at <https://www.cisl.cam.ac.uk/news/news-pdfs-or-prs/financial-exposure-geoff-summerhayes.pdf> See NGFS <https://www.banque-france.fr/en/financial-stability/international-role/network-greening-financialsystem> GenCost 2018 © Reserve Bank of Australia, 2001–2019. All rights reserved. https://www.rba.gov.au/speeches/2019/sp-dg-2019-03-12.html Subscribe: 10/10 | reserve bank of australia | 2,019 | 3 |
Speech by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the KangaNews DCM Summit, Sydney, 19 March 2019. | 3/19/2019 Bonds and Benchmarks | Speeches | RBA Speech Bonds and Benchmarks Christopher Kent [ * ] Assistant Governor (Financial Markets) KangaNews DCM Summit Sydney – 19 March 2019 Introduction It's wonderful to be back at the Debt Capital Markets Summit. The past year in Australia was a bit of a mixed bag in terms of issuance of fixed income securities. Banks' issuance of bonds was high in net terms. Issuance of Residential Mortgage Backed Securities (RMBS) by the non-banks was also high. [1] However, in the second half of 2018 issuance by Australian corporations outside of the financial sector was low. Today I'm going to discuss some of these trends. I'll also discuss trends in yields. When I was at this event last year, I noted that spreads between corporate and government bonds had declined to be around their lowest levels since the global financial crisis (Graph 1). Over 2018, spreads on Australian bonds widened in line with global developments. The sharp rise in spreads around the end of 2018 reflected a greater concern regarding downside risks. [2] While spreads have narrowed a little in early 2019, they remain wider than when I spoke here a year ago. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-19.html 1/19 3/19/2019 Bonds and Benchmarks | Speeches | RBA Graph 1 In the second half of my presentation I want to address the risks relating to interest rate benchmarks. These are directly relevant to many of you here and it's good to see that they will be discussed later today. These benchmarks are right at the heart of the plumbing of the financial system and, if they were to stop suddenly, this could generate significant financial instability. The clock is ticking for institutions with exposures to the London Inter-Bank Offered Rate (LIBOR) benchmarks. However, a path for transition away from LIBOR has been cleared, and we encourage all users to be taking the necessary steps to prepare for this change. And while bank bill swap (BBSW) rate benchmarks remain robust, there are still some issues that users should be addressing, which I will discuss today. If we work collectively, we can significantly reduce these risks. Bonds Let's start though by considering developments in some key Australian bond markets. Bank Bonds Australia's largest corporate fixed income market is that for financial corporation debt, of which bank bonds form a large part. Bank bond spreads widened in line with global developments over the past year or so. Nonetheless, yields remained relatively stable at a low level as benchmark rates edged down (Graph 2). Over 2019, thus far, both spreads and benchmark rates have fallen. So there has been an appreciable decline in the cost of issuing unsecured debt in this form to very low levels by historical standards. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-19.html 2/19 3/19/2019 Bonds and Benchmarks | Speeches | RBA Graph 2 Issuance of bank bonds was quite high in 2018 in net terms. In fact, net issuance was the highest for almost 10 years (Graph 3). That high level of net issuance reflected gross issuance around the average we have seen over the past few years at the same time that maturities in 2018 were at a low level. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-19.html 3/19 3/19/2019 Bonds and Benchmarks | Speeches | RBA Graph 3 In addition to strong net issuance, over the past year the banks have been issuing a larger share of their bonds domestically (Graph 4). The banks have not just issued less paper overseas. They have also issued a higher value of bonds in the domestic market. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-19.html 4/19 3/19/2019 Bonds and Benchmarks | Speeches | RBA Graph 4 Often the perception of the domestic market is that it has limited capacity to absorb sizeable increases in issuance. However, it appears that the banks were able to issue the extra bonds domestically at a price that was at least as, if not a little more, favourable for the banks than the price of bonds issued offshore (after accounting for hedging costs; Graph 5). https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-19.html 5/19 3/19/2019 Bonds and Benchmarks | Speeches | RBA Graph 5 This raises the question of who was buying this domestically issued paper? Comprehensive data (from the Financial Accounts) show that the domestic issuance over the year to September 2018 was widely held across different sectors. But pension funds bought a disproportionate share of the issuance over that period – almost 25 per cent compared with the 5 per cent share that they had typically held. In recent months, another notable feature has been the relatively high value of issuance of covered bonds (Graph 6). This may have been related to the rise in volatility around the turn of the year in domestic and global financial markets. Liaison with banks suggested that the tighter conditions in funding markets at the time did push banks to issue more covered bonds, since these are viewed as a good option for funding at such times. Having said that, there is still plenty of capacity for the banks to tap their covered bond lines if they have the need. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-19.html 6/19 3/19/2019 Bonds and Benchmarks | Speeches | RBA Graph 6 Non-Financial Corporations Over 2018, non-financial corporation spreads followed those of financial corporations, and by extension, spreads in global markets (Graph 7). Issuance in the second half of 2018 was quite low, and the market is off to a slow start in 2019. However, with yields still low, this doesn't appear to be a story about companies finding it difficult to obtain funding in bond markets. Moreover, the growth of business debt more generally – which includes bonds and credit issued by banks – has picked up over the past year or more (Graph 8). This quarter has seen some issuance among resource related corporations. Notwithstanding that, this is likely to remain a relatively quiet corner of the market for some time given that the resources sector in general has been deleveraging following the end of the mining investment boom. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-19.html 7/19 3/19/2019 Bonds and Benchmarks | Speeches | RBA Graph 7 https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-19.html 8/19 3/19/2019 Bonds and Benchmarks | Speeches | RBA Graph 8 Despite 2018 being somewhat quiet, a diverse range of corporations have issued bonds. Last year, I showed some graphs of Herfindahl-Hirschman indices, which is a standard way of measuring concentration. The lower the index, the lower the level of concentration and the more diverse is the set of issuers. [4] In 2017, the index for non-financial corporations hit its lowest – most diverse – levels for some time (Graph 9). There was an uptick in concentration in 2018, but it is still at relatively low levels. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-19.html 9/19 3/19/2019 Bonds and Benchmarks | Speeches | RBA Graph 9 RMBS In 2018, non-banks issued the second largest amount of RMBS since the GFC, only narrowly eclipsed by 2017 issuance (Graph 10). This was associated with strong growth of non-bank housing loans, as they gained some market share from banks. Spreads widened in line with other markets, although spreads for non-conforming deals appear to have widened a little more than for other deals. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-19.html 10/19 3/19/2019 Bonds and Benchmarks | Speeches | RBA Graph 10 The noticeable rise in the share of new mortgages extended by non-banks over recent years reflects, in part, earlier regulatory actions limiting the growth of banks' investor and interest-only mortgages. Banks' tighter lending standards in light of the Royal Commission have also had an effect on their lending activity over the past year. Not only did this change in the banks' behaviour contribute to the strong growth of non-bank lending, it may also have contributed to the shift in the nature of the collateral underlying the nonbank securitisation deals. We can use the Reserve Bank's Securitisation Dataset to see three key changes. [5] First, the share of investor loans in non-bank securitisations has increased over the past few years (Graph 11). Second, their share of interest-only loans has remained relatively high, in contrast to the share of interest-only loans in banks' securitisations. Third, the level of seasoning in non-bank deals has also fallen (Graph 12). In other words, their loans are newer than in the past and newer than for the bank securitisations. The fact that non-banks are bundling up mortgages more quickly into securities suggests that they are writing loans more quickly and, therefore, reaching the limits of their warehouse facilities. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-19.html 11/19 3/19/2019 Bonds and Benchmarks | Speeches | RBA Graph 11 Graph 12 https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-19.html 12/19 3/19/2019 Bonds and Benchmarks | Speeches | RBA In summary, over the past year or so, well-rated corporations – both in and outside of the financial sector – have been able to source funding in bond markets. While spreads on corporate bonds are higher than a year ago, yields remain low. That is a reflection of the effect of the expansionary setting of monetary policy, which is providing support to the economy more generally. Interest Rate Benchmarks I'll change tack now by discussing the reform of interest rate benchmarks. Because these are intertwined with much of the financial system's ‘plumbing’, the issue has been a longstanding focus for the global regulatory community. [6] Increasingly, it needs to also become a key focus of financial market participants, including many of you here today. With that in mind, I'd like to provide a brief update on the work underway to strengthen interest rate benchmarks, both internationally and in Australia. The end of LIBOR The various LIBORs have long been the key interest rate benchmarks for the major currencies. However, given that they are not supported by a sufficient volume of transactions in wholesale shortterm funding markets, it is now widely recognised that these will come to an end. The UK Financial Conduct Authority (FCA), which regulates the LIBOR benchmarks, has made it clear that it will not support LIBOR beyond the end of 2021. [7] This is an important issue for Australian financial institutions, which have substantial exposures to LIBOR through derivatives, bonds and syndicated lending. To replace LIBOR, regulators have worked closely with industry participants to develop alternative risk-free rates, such as the Secured Overnight Financing Rate (SOFR) for the US dollar and the Sterling Overnight Interbank Average Rate (SONIA) for the British pound. [8] The transition to riskfree rates is accelerating internationally across derivatives and bond markets. It is encouraging to see that Australian banks have recently issued sterling floating-rate notes (FRNs) referencing SONIA rather than LIBOR. New products can reference these new benchmarks. But when LIBOR comes to an end, there could be disruptions for many existing products referencing LIBOR unless their contracts contain robust ‘fall-back’ provisions. ISDA (International Swaps and Derivatives Association) has been taking the lead on this work at the request of the Financial Stability Board (FSB). This will involve using the riskfree rates as fall-backs for LIBOR, but with an appropriate adjustment for the historical spread between them. ISDA is expected to finalise these fall-back provisions by the end of the year. We strongly encourage all users of LIBOR in the Australian market to be ready to adopt these new fallback provisions in their contracts. BBSW remains robust The BBSW rates are important interest rate benchmarks for the Australian dollar. A lot of work has already been done to ensure that these remain robust. This market – where banks raise short-term funding by issuing bills to wholesale investors as a liquid asset – is a longstanding one. [10] The bank https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-19.html 13/19 3/19/2019 Bonds and Benchmarks | Speeches | RBA bill market is considerably larger as a share of the Australian major banks' balance sheets than equivalent markets in the US and Europe (Graph 13). As a result, unlike for LIBOR, there are enough transactions in the Australian bank bill market to support a benchmark. Graph 13 Around a year ago, a new methodology was put in place for BBSW. This has made it possible to calculate BBSW rates directly from transactions in the bank bill market between banks and wholesale investors. This required the ASX, market participants and regulators to work together to develop new infrastructure and market practices. The new methodology has performed very well, with much more trading activity now underpinning BBSW during the ‘rate set window’, which is from 8.30am – 10am (Graph 14). https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-19.html 14/19 3/19/2019 Bonds and Benchmarks | Speeches | RBA Graph 14 Strengthening contractual fall-backs for BBSW While BBSW is a robust benchmark, we shouldn't take this for granted. The bank bill market is expected to have a secure future, since the assets of managed funds continue to grow, supported by superannuation contributions. These managed funds need to hold some liquid assets such as bank bills to be able to meet unexpected redemptions. Despite this, bank bills have been slowly declining both as a share of managed funds' assets and the major banks' liabilities (Graph 15). This is partly due to the liquidity standards introduced over recent years, which reduced the value that banks place on short-term wholesale funding. Given these trends, we cannot be certain that the bank bill market will always be large enough to sustain the BBSW rates as viable benchmarks. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-19.html 15/19 3/19/2019 Bonds and Benchmarks | Speeches | RBA Graph 15 If BBSW were ever to cease, the existing fall-back provisions in many contracts would be cumbersome to apply and could generate significant market disruption. The Australian Securities and Investments Commission (ASIC) is the regulator of licensed benchmark administrators. To protect financial stability, ASIC also has the power under the new benchmarks legislation to compel the banks to make submissions so that BBSW can still be calculated. However, if the bank bill market no longer existed, this would clearly not be a long term solution. This is why we have been working with ISDA to strengthen the contractual fall-backs for BBSW at the same time as LIBOR. This will involve using the cash rate – which is the risk-free rate for the Australian dollar – as the fall-back, with an adjustment for the historical spread between BBSW and the cash rate. Once ISDA has finalised the fall-back provisions, we expect all users of BBSW to adopt them where possible. For new securities referencing BBSW, the RBA will make it a requirement that these fall-back provisions be adopted before the securities can be eligible in the RBA's market operations. Currently, this would affect FRNs issued by banks, securitisation trusts and the state governments. Users of 1-month BBSW should consider alternative benchmarks Meanwhile, users of BBSW should also be aware that the market underpinning the 1-month tenor is not as liquid as for the 3-month and 6-month tenors. Unlike for these longer tenors, banks have no incentive to issue 1-month bills. This is because under the liquidity standards, they would be required https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-19.html 16/19 3/19/2019 Bonds and Benchmarks | Speeches | RBA to hold an equivalent amount of high-quality liquid assets. [12] The few transactions that do occur are mainly ones where investors are selling their bills back to the banks. While there are enough transactions to directly measure 3-month and 6-month BBSW on most days, this has only happened about half the time for 1-month BBSW. [13] Since the new calculation methodology was introduced, 1-month BBSW has also been more volatile than 3-month BBSW. This was particularly evident in mid January (Graph 16). So the lack of liquidity in the underlying market for 1-month bills appears to be affecting the benchmark. Graph 16 Given these issues, users of 1-month BBSW should be preparing to use alternative benchmarks. This is particularly relevant to the securitisation and derivatives markets, which frequently reference the 1-month rate. Consistent with this, the Reserve Bank is thinking about this issue given that it is relevant to a number of securities that we hold via our market operations. One option would be for issuers to instead reference 3-month BBSW; another option is to reference the cash rate. It will be important for market participants to evaluate the best options and make progress towards these in a timely manner. The cash rate is the alternative risk-free rate for the Australian dollar The cash rate is best known as the Reserve Bank Board's operational target for monetary policy. But it is also a significant benchmark in Australian financial markets. The cash rate is administered by the https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-19.html 17/19 3/19/2019 Bonds and Benchmarks | Speeches | RBA RBA and calculated directly from transactions in the interbank overnight cash market. With the transition from LIBOR to risk-free rates internationally, we would expect there to be some corresponding migration away from BBSW towards the cash rate. This is particularly the case for financial products where it makes sense to reference a risk-free rate instead of a credit-based benchmark. For instance, FRNs issued by governments and securitisation trusts could instead tie their coupon payments to the cash rate instead of BBSW. The South Australian Financing Authority recently announced its interest in issuing a FRN linked to the cash rate. This would be a first for Australia. term We know that there is also demand from investors for risk-free rates with similar tenors to LIBOR and BBSW. Some benchmark users value having more certainty about their cash flows, since a term rate would be known at the start of the relevant interest period, rather than being calculated at the end of the period by compounding the cash rate. It could be possible to generate a term rate using the overnight indexed swap market or the repo market. We are supportive of efforts by the private sector to develop such term rates. However, there would need to be significant effort to develop the appropriate market infrastructure and practices before these could be considered robust benchmarks. Given this, we encourage market participants to consider using the cash rate rather than waiting for the development of a term rate. In conclusion, there are three main points I would like to leave you with concerning interest rate benchmarks: It is widely recognised that LIBOR will come to an end. Market participants in Australia should continue preparing for this by moving to alternative risk-free rates and adopting more robust fallback provisions in their contracts. While BBSW remains robust, it would be prudent for all users to also adopt more robust fall-back provisions for BBSW in their contracts. Users of 1-month BBSW should be considering alternative benchmarks given the illiquidity in the underlying market. We would suggest that participants consider using other robust benchmarks that are already available rather than waiting for the development of a term risk-free rate. Endnotes [*] I thank Leon Berkelmans, Ellis Connolly and other staff in the Domestic Markets Department for excellent assistance in preparing these remarks. Non-banks refers to financial institutions that are not authorised deposit taking institutions, or non-ADIs. See Kent (2019) ‘Financial Conditions and the Australian Dollar – Recent Developments’, Address to XE Breakfast Briefing, Melbourne 15 February. Graph 4 accounts for hedging costs using cross currency basis swaps and interest rates swaps. The calculations assume that banks swap their issuance into fixed rate Australian debt at the time of issuance, however in reality they can execute the swap at a later date depending on the pricing. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-19.html 18/19 3/19/2019 Bonds and Benchmarks | Speeches | RBA If the market is accounted for by only one industry, this index is 1. If, on the other hand, n industries each have an equal share of the market, the index is 1/n. For more information on the Dataset, see Fernandes K and Jones D (2018), ‘The Reserve Bank's Securitisation Dataset’, RBA , December. See: Debelle G (2018), ‘Interest Rate Benchmark Reform’, Keynote at ISDA Forum, Hong Kong, 15 May; Debelle G (2017), ‘Interest Rate Benchmarks’, Speech at FINSIA Signature Event: The Regulators, Sydney, 8 September; Debelle G (2016), ‘Interest Rate Benchmarks’, Speech at KangaNews Debt Capital Markets Summit 2016, Sydney 22 February; Debelle G (2015). ‘Benchmarks’, Speech at Bloomberg Summit, Sydney, 18 November. Schooling Latter, Edwin (2019), ‘LIBOR transition and contractual fallbacks’, speech delivered at the International Swaps and Derivatives Association (ISDA) Annual Legal Forum, 28 January 2019. Available at: <https://www.fca.org.uk/news/speeches/libor-transition-and-contractual-fallbacks>. SOFR is a broad measure of the cost of borrowing US dollars under repurchase agreements collateralised by US Treasury securities; SOFR is administered by the New York Fed. SONIA is a measure of the cost of borrowing British pounds in the wholesale unsecured overnight market; SONIA is administered by the Bank of England. The Commonwealth Bank issued a FRN referencing SONIA on 3 December 2018 and ANZ issued a covered bond referencing SONIA on 11 January 2019. The instruments traded in the Australian bank bill market are bills of exchange and negotiable certificates of deposit (NCDs). Historically, bills of exchange were the main instrument, although in recent years issuance of NCDs has dominated the market. For more details, see Connolly E and S Alim (2018), ‘Interest Rate Benchmarks for the Australian Dollar’, RBA , September. Under the liquidity coverage ratio (LCR), banks are required to hold sufficient high-quality liquid assets (HQLA) to be able to cover their net cash outflows in a 30-day stress scenario. In this scenario, bank bills maturing within the next 30 days are treated as a cash outflow, so the bank issuing them would be required to hold an equivalent amount in HQLA. To improve the stability of 1-month BBSW, the ASX has announced a change to the methodology that is expected to result in a significant reduction in the proportion of days when 1-month BBSW can be directly calculated using transactions. See ASX (2019), “Consultation on changes to 1 month BBSW VWAP Methodology”, Available at: <https://www.asxonline.com/content/asxonline/public/notices/2019/mar/0160.19.03.html>. The RBA has highlighted this issue in previous speeches: Kent C (2018), ‘Securitisation and the Housing Market’, Address to the Australian Securitisation Forum Conference, 26 November; Debelle G (2018), ‘Interest Rate Benchmark Reform’, Keynote at ISDA Forum, Hong Kong, 15 May Bulletin Bulletin © Reserve Bank of Australia, 2001–2019. 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Speech by Ms Michele Bullock, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Urban Development Institute of Australia (WA), Perth, 20 March 2019. | 3/20/2019 Property, Debt and Financial Stability | Speeches | RBA Speech Property, Debt and Financial Stability Michele Bullock [ * ] Assistant Governor (Financial System) Urban Development Institute of Australia (WA) Perth – 20 March 2019 Thank you for the invitation to speak to you today. It is great to be here and to hear your perspectives. As Assistant Governor (Financial System) I oversee the Bank's work on financial stability. But what is financial stability and what is the Reserve Bank's role in it? The wellbeing of households and businesses in Australia depends on growth in the Australian economy. And a crucial facilitator of sustained growth is credit – flows of funds from people who are saving to people who are investing. Credit provides households and businesses with the ability to borrow on the back of future expected income to finance large outlays, for example, the purchase of a home or equipment to establish or grow a business. A strong and stable financial system is important for this flow of funds. There is no universal definition of financial stability but one way to think about it is to consider what is meant by financial . My colleague Luci Ellis suggested that this is best thought of as a disruption in the financial sector so severe that it materially harms the real economy. [1] This leaves unsaid where the disruption might come from, but we would all recognise the outcomes of financial stability when we see it. For example, while Australia was spared the worst impact of the global financial crisis, internationally it demonstrated the impact that financial instability can have on growth and hence the wellbeing of households and businesses in the economy. instability Most of you will know about the Reserve Bank's role in conducting monetary policy. But another key role of the Reserve Bank that you might be less familiar with is promoting financial stability. In this area, we share responsibility with the Australian Prudential Regulation Authority (APRA). But it is APRA that has responsibility for the stability of individual financial institutions and the tools that go along with that. So how does the Bank contribute to financial stability? https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-20.html 1/14 3/20/2019 Property, Debt and Financial Stability | Speeches | RBA There are a number of things we do. We undertake analysis of the economy and the financial system through the lens of financial stability, looking for financial vulnerabilities that could result in substantial negative impacts on the economy, or economic vulnerabilities that could result in risks to financial stability. We work with other regulators to identify signs of increasing risks in the financial system and measures to address these risks. Where appropriate, we provide advice to government on the potential implications for financial stability of policies. And we talk about the risks we are seeing to help inform other regulators, participants in the financial system, businesses and the general public of the potential risks that might have an impact on the economy. This last action – communicating the risks – is the key purpose of our six-monthly Financial Stability Review (the Review). While any individual financial institution, business or household might think the risks they are taking on are appropriate, they may not be adequately taking into account the risks that are arising at a systemic level from everyone's actions. The Review attempts to bring this system-wide view. Our most recent Review was published in October last year and we are currently in the process of drafting the next one, which will come out in April. So, for the remainder of my talk, I am going to cover some of the key risks that we see at the moment. Given the audience, I am going to focus on risks related to residential and commercial property. First, I will give an update on recent developments in these areas. Then I will talk a little about recent concerns around tighter lending standards. And I will finish up with a few observations on the property market in Western Australia. Household Debt Six months ago in the Review, we noted that global economic and financial conditions were generally positive and that the Australian economy was improving. At the same time, housing prices were declining. In this context, we highlighted a number of vulnerabilities – issues that, were a shock to occur or economic conditions take a turn for the worse, could manifest in a threat to financial stability. At that time, we highlighted two domestic vulnerabilities that are relevant to my talk today – the level of household debt, and the slowdown in housing and credit markets. Six months on, these vulnerabilities remain. If anything, they are a little more heightened. The Bank has highlighted the issue of household debt as a potential threat to financial stability many times over the past few years. Although it does not capture all the important information about household indebtedness, the ratio of household debt to disposable income is one summary indicator. This ratio is historically high (Graph 1). The household debt-to-income ratio rose from around 70 per cent at the beginning of the 1990s to around 160 per cent at the time of the GFC. The ratio steadied for a few years before starting to rise again around 2013 (around the same time that housing price growth began to accelerate) and is now around 190 per cent. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-20.html 2/14 3/20/2019 Property, Debt and Financial Stability | Speeches | RBA Graph 1 I have talked previously about some of the reasons why the debt-to-income ratio has risen so much over the past few decades. [3] In particular, a structural decline in the level of nominal interest rates and deregulation have eased credit constraints and increased loan serviceability. And as households have been able to borrow more, they have been able to pay more for housing. One important driver of high household debt in Australia is, therefore, housing. There is very little debt related to nonhousing loans such as credit cards or car loans. Just as housing costs have been an important driver of household debt, so has the ability to borrow more influenced the price of housing. Over the past decade, housing prices in many parts of Australia have risen but the rise has been particularly sharp in Sydney and Melbourne, which account for around 40 per cent of the housing stock (Graph 2). More recently, housing prices have fallen. Since the peak in mid 2017, housing prices Australia-wide have declined by around 7 per cent. The falls in Sydney and Melbourne have been larger. The question we are asking ourselves is, given the high levels of debt and falling housing prices, are there any significant implications for financial stability? https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-20.html 3/14 3/20/2019 Property, Debt and Financial Stability | Speeches | RBA Graph 2 The answer would be no at this stage – the impacts are not large enough to result in widespread problems in the financial sector. This is not to downplay the financial stress that some households are experiencing. But most of the debt remains well secured against property, even with the decline in housing prices. Total repayments as a share of income remain steady and a large number of indebted households have built up substantial prepayments over the past few years. Broadly, the debt is held by households that can afford to service it. Arrears rates, while increasing a bit over the past few years, remain low. Banks are well capitalised and work over recent years to improve lending standards has made household and bank balance sheets more resilient. Loans at high loan-tovaluation (LVR) ratios and interest-only loans are less common than they were and most households have not been borrowing the maximum amount available. Apartment Development One area that we have focused on in recent years in our analysis of financial stability risks is apartment development. There has been a substantial increase in apartment construction since the start of the decade in the largest Australian capital cities (Graph 3). In Sydney there have been more than 80,000 apartments completed over the past few years adding roughly 5 per cent to housing stock in Sydney. Melbourne and Brisbane have also seen relatively large additions to the supply of apartments and, while the number of apartments being built in Perth has been small by comparison, this has been in the context of a fairly small apartment stock. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-20.html 4/14 3/20/2019 Property, Debt and Financial Stability | Speeches | RBA Graph 3 Our main concern with this from a financial stability perspective is the potential for this large influx of supply to exacerbate declines in housing prices and so adversely impact households' and developers' financial positions. By its nature, high-density development can tend to exacerbate price cycles. Large apartment developments have longer planning and development processes than detached housing. Purchasing the land, designing the development, getting approvals through relevant government bodies and then actual construction of the apartment block all take time. In a climate of rapidly rising prices, developers are willing to pay high prices for land on which to build apartments. Households, including investors, are willing to purchase apartments off the plan, confident that the apartment will be worth more than they paid for it when it is finally completed. This continues as long as prices are rising. This large increase in supply, however, ultimately sows the seeds of a decline in prices which, if large enough, results in development becoming unattractive, new supply falling and the cycle starting again. This presents two risks. The first is to household balance sheets. A decline in apartment prices could negatively impact households that purchased off the plan and are yet to settle. They might find themselves in a situation where the value of the apartment in the current environment is less than they contracted to pay for it. And as market pricing falls, lenders will revise their valuations down https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-20.html 5/14 3/20/2019 Property, Debt and Financial Stability | Speeches | RBA and so will be willing to lend less. Households will therefore have to contribute more funds, either from their own savings or loans from other sources. The second risk is to developers who are delivering completed apartments into the cooling market. If people who had pre-purchased are having difficulty getting finance, or decide it is not worth going ahead with the purchase, there would be increasing settlement failures. Developers would be left holding completed apartments, reducing their cash flow and their ability to service their loans, and impacting banks' balance sheets. Currently, the risks here appear to be elevated but contained. The apartment market is quite soft in Sydney; apartment prices have declined since their peak, rental vacancies have risen and rents are falling (Graph 4). In Melbourne and Brisbane, however, apartment prices have so far held up. Liaison suggests that settlement failures have not increased much and, to the extent that they have, some developers are in a position where they can choose to hold and rent unsold apartments. Further tightening in lending standards might, however, impact both purchasers of new apartments and developers – I will return to this in a minute. Graph 4 Commercial Property A final area worth touching on is non-residential commercial property. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-20.html 6/14 3/20/2019 Property, Debt and Financial Stability | Speeches | RBA Commercial property valuations have, like housing, risen substantially over the past decade, and much more than rents so that yields on commercial property have fallen to very low levels historically (Graph 5). This is particularly the case for office and industrial property. One reason for this is that yields, although they have been historically low in Australia, are high relative to overseas and to returns on other assets. Furthermore, some markets, such as the Sydney and Melbourne office property markets, are experiencing strong tenant demand and vacancy rates are low. But the rapid increase in commercial property prices over the past decade does pose risks. If transaction prices and valuations were to fall sharply, for example, in response to a change in risk preferences, highly leveraged borrowers could be vulnerable to breaching their LVR covenants on bank debt. This could trigger property sales and further price falls, exacerbating the cycle. Graph 5 Lending Standards With that background, I want to turn to an issue that has attracted a fair bit of attention in recent months – the role that tightening lending standards might have played in the downturn in credit and the housing market. We published a special chapter in the October 2018 on this issue and the Deputy Governor discussed it in a speech in November last year so I will only cover it briefly here. Review https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-20.html 7/14 3/20/2019 Property, Debt and Financial Stability | Speeches | RBA Lending standards have been tightening since late 2014, well before housing prices in the eastern states started to turn down. The initial tightening occurred in December 2014 in response to very fast growth in lending to housing investors and an assessment by APRA that banks' lending practices could be improved. APRA required banks to tighten their lending practices in a number of areas, including interest rate buffers, verification of borrower income and expenses, and high LVR lending. The measure that got the most attention at that time, however, was the ‘investor lending benchmark’ in which APRA indicated that supervisors would be paying particular attention to any institutions with annual investor credit growth exceeding 10 per cent. The idea was that it would be temporary while APRA worked with the banks on addressing lending standards. The benchmark and the tightening of standards didn't have an immediate impact on the pace of investor lending. It didn't really start to bite until the middle of 2015 when banks introduced higher interest rates for loans to investors. And at that point, growth in lending to investors slowed sharply (Graph 6). Graph 6 Once things settled down, however, and banks were comfortable that they were well below the benchmark, the growth in lending to investors started to pick up again. Then, in March 2017, APRA introduced restrictions on the share of new interest-only lending as part of its broader suite of measures to strengthen lending practices. As part of this, APRA reinforced its investor benchmark. While the interest-only measure was focused on reducing the volume of higher-risk lending rather https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-20.html 8/14 3/20/2019 Property, Debt and Financial Stability | Speeches | RBA than lending to a particular type of borrower, there was a noticeable impact on the growth in lending to housing investors since interest-only loans tend to be the product of choice for many investors. Both the investor lending benchmark and the interest-only lending benchmark have been removed for banks that have provided assurances on their lending policies and practices to APRA. But the improvements in lending practices implemented by the banks over the past few years have resulted in credit conditions being tighter than they were a few years ago. Application processes have been taking a bit longer as lenders are being more diligent about verifying borrower income and expenses, borrowers are generally being offered smaller maximum loans and some borrowers are finding it more difficult to obtain a loan. Banks are more closely adhering to their lending policies, resulting in fewer exceptions being granted and there are fewer high LVR and interest-only loans being approved. There have been some concerns expressed that these developments have been a key reason for the slowing in credit growth over the past year. Coupled with possibly some increased risk aversion of front-line lending staff in the wake of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, the concern is that this has been impacting housing credit growth and, by extension, housing prices. As concluded in the Banks' February Statement on Monetary Policy, and noted by the Governor in a recent speech, tighter credit conditions do not appear to be the main reason for declining housing credit growth. [5] The evidence points towards declining demand for housing credit as being a more important factor. Nevertheless, it is possible that tighter lending standards could be impacting developers of apartments. This could be direct, reflecting banks' desire to reduce their exposure to the property market, particularly high-density development. But it could also be indirect by banks tightening their lending standards for purchases of new apartments, hence impacting pre-sales for developers and their ability to obtain finance. The Deputy Governor noted this in a speech in November 2018 and concluded that this was of potentially higher risk to the economy than household lending standards. From a financial stability perspective, prudent lending standards are a good thing. They ensure that households and banks are resilient to changes in circumstances. But there needs to be a balance. The regulators are not proposing any further tightening in lending standards. And the appropriate amount of credit risk is not zero – banks need to continue to lend and that will inevitably involve some credit losses. Western Australia Finally, I want to turn my focus to developments in Western Australia. As you will have seen from some of my earlier graphs, the Western Australian circumstances are somewhat different to those of the eastern capital cities. There are two aspects I would like to focus on – household resilience and the commercial property sector. Housing prices in Perth have been declining for some years (Graph 7). The peak in housing prices in Perth was in the middle of 2014. This followed a period of strong housing price growth as the population of Western Australia increased strongly during the mining investment boom and housing https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-20.html 9/14 3/20/2019 Property, Debt and Financial Stability | Speeches | RBA construction took longer to ramp up. When housing construction did respond, however, population growth had slowed markedly and housing prices started to fall. Median housing prices have fallen by around 12 per cent since 2014. Graph 7 This has clearly been a difficult time for many homeowners in Western Australia. There are some households that are having difficulty meeting repayments, as evidenced by a rising arrears rate in Western Australia (Graph 8). At this stage, however, the losses are not large enough to threaten the stability of the financial sector. We nevertheless continue to monitor the situation for any potential systemic impacts. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-20.html 10/14 3/20/2019 Property, Debt and Financial Stability | Speeches | RBA Graph 8 Finally, office property in Western Australia has also been experiencing oversupply. Valuations have fallen over the past decade (Graph 9). Rents have also fallen reflecting a sharp increase in office vacancy rates in Perth's CBD over the past few years (Graph 10). This makes for a challenging environment for owners of these buildings, particularly for owners of older or lower quality office buildings as tenants have taken the opportunity to move into newer buildings as rents have come down. But again, while a difficult time for developers and owners of office buildings, the financial stability implications seem limited. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-20.html 11/14 3/20/2019 Property, Debt and Financial Stability | Speeches | RBA Graph 9 https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-20.html 12/14 3/20/2019 Property, Debt and Financial Stability | Speeches | RBA Graph 10 Conclusion Vulnerabilities from the level of household debt, the apartment development cycle and the level of non-residential commercial property valuations continue to present risks for financial stability. While so far, the financial sector has remained resilient, we continue to monitor developments in household debt and in property markets for signs that these might have more broad ranging effects on the financial system. Endnotes [*] I am grateful to Nicole Adams and Cathie Close for assistance with this speech. https://www.rba.gov.au/speeches/2014/sp-so-fs-040614.html While the Bank's objective for monetary policy is low and stable inflation, in setting monetary policy to achieve this it takes into account its financial stability objective. See for example https://www.rba.gov.au/speeches/2016/sp-gov2016-10-18.html. The September 2016 Statement on the Conduct of Monetary Policy between the Treasurer and the Governor also notes that the Bank takes into account financial stability in conducting monetary policy. https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-10.html https://www.rba.gov.au/publications/fsr/2018/oct/assessing-effects-housing-lending-policy-measures.html https://www.rba.gov.au/speeches/2018/sp-dg-2018-11-15.html https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-20.html 13/14 3/20/2019 Property, Debt and Financial Stability | Speeches | RBA See https://www.rba.gov.au/publications/smp/2019/feb/ and https://www.rba.gov.au/speeches/2019/sp-gov-201903-06.html © Reserve Bank of Australia, 2001–2019. All rights reserved. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-20.html Subscribe: 14/14 | reserve bank of australia | 2,019 | 3 |
Address by Ms Luci Ellis, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Housing Industry Association March Industry Outlook Breakfast, Sydney, 26 March 2019. | 3/26/2019 What's Up (and Down) With Households? | Speeches | RBA Speech What's Up (and Down) With Households? Luci Ellis [ * ] Assistant Governor (Economic) Address to Housing Industry Association March Industry Outlook Breakfast Sydney – 26 March 2019 Thank you to the organisers of this breakfast event for the opportunity to speak with you and share with you some of our thinking about current economic developments. For a little while now, the team at the Bank has been grappling with how one might reconcile apparently weak national accounts figures with the noticeably stronger labour market data. The disconnect can be traced to the household sector. Many other parts of the national accounts measure of output – gross domestic product (GDP) – are actually doing reasonably well. Outside the mining sector, where some large projects are still winding down, business investment is growing at a solid pace. Transport and renewable energy projects have been quite important. Public demand, both consumption and investment, is supporting growth. There are also some areas of weakness outside the household sector, such as the drought-affected rural sector, which is weighing on exports at the moment. Droughts and other recent natural disasters clearly pose difficulties for those directly affected. But the underlying trends in the broader economy are not determined by these events. So in the main, outside the household sector, the economy is not doing too badly. The Labour Market has Unambiguously Improved This makes sense, because employment has been strong and someone must be hiring all those extra workers. Over the past year, total employment has increased by more than 2 per cent. The unemployment rate declined by ½ percentage point over 2018, reaching the level of 5 per cent before our forecasts implied it would (Graph 1). This is a good outcome. Youth unemployment has declined and most measures of underemployment have also come down a bit. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-26.html 1/17 3/26/2019 What's Up (and Down) With Households? | Speeches | RBA Graph 1 Some industries are doing better than others, but overall the strength in employment has been across a diverse range of sectors (Graph 2). We can see this either by looking at the industry that people say they work in, or we can use the ABS's new Labour Account to triangulate this information with what firms say their industry is. Either way, we see jobs being added in a range of industries. Employment in health care and social assistance has been increasing for a while; the rollout of the NDIS is an important driver of this, but not the only one. More recently, we have also seen employment increase in a number of business services industries. Construction employment had also been strong for a while, reaching the highest share of total employment in more than a century of records. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-26.html 2/17 3/26/2019 What's Up (and Down) With Households? | Speeches | RBA Graph 2 One can be reasonably confident in the steer the labour market data are giving us, because it is coming from multiple, independently collected data sets. The employment and unemployment data come from the ABS's survey of households. But a survey of businesses, also from the ABS, tells us that the number of job vacancies has been a very high share of the total jobs available. Separate private-sector surveys of businesses tell us that many firms plan to hire more workers. Many of our own liaison contacts also tell us that they are hiring. And as the labour market gradually tightens, we are beginning to see the effects in wages growth. This has been low for some time, but is gradually trending up now, especially in the private sector (Graph 3). Part of this shift is that fewer workers are subject to wage freezes than was the case a year or so ago. Minimum and award wage rises have also increased. Along with other countries, it's taking longer and a lower unemployment rate to start seeing faster wages growth than historical experience might have suggested. Indeed, we still think Australia is a little way off the levels of the unemployment rate that would induce materially faster wages growth. But as the experience of other countries has also shown, if the labour market tightens enough, wages growth does eventually pick up. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-26.html 3/17 3/26/2019 What's Up (and Down) With Households? | Speeches | RBA Graph 3 Household Consumption Spending is Slowing In contrast to the positive picture implied by the labour market, growth in household income has been slow, and growth in consumption has weakened recently (Graph 4). https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-26.html 4/17 3/26/2019 What's Up (and Down) With Households? | Speeches | RBA Graph 4 If we drill down to see which kinds of spending have slowed the most, we can see that spending on cars and household goods has been particularly affected (Graph 5). Spending on less discretionary items like food has been less affected. There has been a deal of talk about the possibility that ‘wealth effects’ from declining housing prices might be weighing on spending. It's important to remember, though, that people's reaction to a fall in prices is likely to depend partly on how far prices had increased previously. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-26.html 5/17 3/26/2019 What's Up (and Down) With Households? | Speeches | RBA Graph 5 Some recent work by colleagues at the Bank suggests that the link is a bit more subtle than simply that increases in wealth boost spending directly (May, Nodari and Rees 2019). It isn't so much that people wake up one morning, realise their home is worth more, and decide to go out shopping. Rather, if their home is worth more, they can borrow more against it, which matters for some people's decisions to buy a car. And because rising housing prices usually occur in the context of high rates of transactions in the market, spending on home furnishings tends to rise and fall with housing prices. So when housing prices decline, turnover also declines. This means there are fewer people moving house and realising their old couch doesn't fit or they need new furnishings in the extra bedroom. Slow Income Growth is a Drag on Household Spending Beyond this specific link to housing turnover, some slowdown in consumption spending is not entirely unexpected. For several years now, we have been calling out the issue of weak income growth and how it might test the resilience of household consumption spending. This is a particular issue in the context of high household debt and the need to service that debt. One aspect of economic theory that actually works in practice is the observation that people try to smooth their consumption in the face of fluctuating incomes. Income growth is noticeably more volatile than consumption growth. So the usual pattern is that gaps between the two resolve with shifts in income growth, not shifts in consumption growth. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-26.html 6/17 3/26/2019 What's Up (and Down) With Households? | Speeches | RBA But there might be limits to how long households can continue expanding their consumption faster than their income is rising. People are still saving, and they can do so at a slower rate. But at some point they might conclude that this is not temporary and that low income growth will persist. At that point they would be likely to adjust their spending plans. Consumption growth would then slow. So we need to establish how household income growth might indeed return back towards current rates of consumption growth or even higher. To do that, we need to understand why it has been so weak. Labour Income Growth Has Recovered Somewhat For some time, part of the story had been that labour income growth was weak. This has been true across several dimensions. First, the growth of wage rates for particular jobs has been slow (Graph 6). This is the measure of wages growth captured by the ABS's Wage Price Index (WPI). It captures changes in wages paid for a fixed pool of jobs. As I already mentioned, growth in this measure has started increasing, though only gradually. It is still well below what one might expect in the longer run, if inflation is to average between 2 and 3 per cent and if productivity maintains a similar average growth rate to its average over the past decade or so. People's actual incomes include bonuses and other non-wage labour income, and average labour income depends on whether the mix of jobs in the economy is changing. For a number of years, these factors combined to make average earnings per hour, as recorded in the national accounts, increase much more slowly than the mix-adjusted WPI measure. It isn't unusual for growth in this measure of earnings to differ from growth in the WPI. They are compiled on different bases. But in the years following the end of the mining investment boom, this gap was persistently negative, and quite large. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-26.html 7/17 3/26/2019 What's Up (and Down) With Households? | Speeches | RBA Graph 6 Some of the compositional change might have been because people were moving out of higher-paid jobs in mining-related activity, and had gone back to lower-paying work. It's hard to pinpoint how important this effect was, because the weakness in average earnings growth was seen in some industry-level data as well. So at least some people would have had to be switching to lower-paid jobs in the same industry. Another factor that might have been at work was that fewer people were actually switching jobs than in the past. Surveys that track people through time, such as the HILDA survey, show that people who change jobs often see faster income growth in the year they switched, than people who didn't change jobs (Graph 7). https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-26.html 8/17 3/26/2019 What's Up (and Down) With Households? | Speeches | RBA Graph 7 This lower rate of job churn accords with some of the evidence we see in business surveys and the messages coming out of our business liaison program. Many firms report that they find it hard to find suitable labour, at least for some roles, and that this is a constraint on their businesses, though usually not a major one (Graph 8). But when we ask our contacts what they are doing about this problem, paying people more is not the first solution they think of. Even poaching someone from another firm by enticing them with higher pay is not that common. The evidence from our liaison program suggests that it has long been the case that firms first resort to other strategies to deal with labour shortages, and only turn to faster wage increases when the shortages are severe and persistent (Leal 2019). https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-26.html 9/17 3/26/2019 What's Up (and Down) With Households? | Speeches | RBA Graph 8 But whatever the underlying drivers, the gap between the growth rates of the WPI and average earnings has closed more recently. Slow wages growth is still a concern, but in terms of its contribution to income growth, it is less of a puzzle than it was a few years ago. Instead we need to seek the source of the more recent weakness elsewhere. Non-Labour Income Remains Weak If we break household disposable income growth into its components, we can see the drivers of the more recent weakness (Graph 9). Labour income is not especially strong, but it no longer seems at odds with growth in employment and other information about wages growth. Rather, growth in other sources of income has been weak for some time, and this has continued more recently. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-26.html 10/17 3/26/2019 What's Up (and Down) With Households? | Speeches | RBA Graph 9 Within non-labour income, the main components are social assistance, rental income, other investment income, and the earnings of unincorporated businesses. It turns out that a confluence of factors has resulted in growth in most of these categories of income being weak recently. In some cases, this is a trend change that is likely to persist. Some others are driven by shorter-term factors that could reverse in coming years. Social assistance payments have been relatively flat for a number of years (Graph 10). As the labour market has strengthened and unemployment has come down, it is not surprising that some forms of social assistance have not been growing. But there are a few other things going on at the same time. Firstly, the rate of growth of age pension payments has slowed, though it is still positive. There are a number of probable drivers of this, including the increase in the eligibility age, as well as more people above the (higher) eligibility age remaining in the workforce rather than drawing a pension. It is also possible that, as time goes on and the people who are retiring have had longer to accumulate superannuation balances, more people are receiving a part-pension together with an income stream from their superannuation. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-26.html 11/17 3/26/2019 What's Up (and Down) With Households? | Speeches | RBA Graph 10 Secondly, in recent years, growth in social welfare spending by the government has come from new programs (like the NDIS) that are counted as government consumption, not household income, in the national accounts. So while both disability payments and other payments to families with children have been broadly constant in dollar terms for several years, government consumption has been growing strongly over the same period. If we adjusted for this, the growth in the social assistance component of household income would look much closer to its average over the past, rather than well below average. These factors all relate to the design of programs assisting households, and how they are classified in the national accounts. So we would not expect them to reverse all of a sudden. This implies that we should also not expect that measured household income from this source will bounce back strongly any time soon. Rental income has also been a bit weak (Graph 11). This is not surprising considering that rents have been rising only slowly in most cities, and falling for a few years in Perth. But rental income is only earned by 15 per cent of taxpayers, and lower cash rental income for landlords is also lower rent paid by renters, leaving them with more money to pay for other things. [1] So the weakness in rental income is unlikely to be a large driver of any slowdown in consumer spending. Income from other kinds of investments has also been a bit weak, but has recovered a bit lately. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-26.html 12/17 3/26/2019 What's Up (and Down) With Households? | Speeches | RBA Graph 11 Unincorporated business income has also been weak of late. This can be a volatile type of income and sensitive to conditions in particular sectors. The farm sector represents a large share of unincorporated business income, compared with their share of the economy. So one reason this type of income has fallen has been the effect of the drought on farm incomes. A recovery here will depend on how soon normal seasonal conditions return. Much of the rest of unincorporated business income comes from sectors related to the property market, including building tradespeople and real estate agents. They are also seeing lower incomes, as both construction activity and the volume of sales of existing homes decline. Again, it can be envisaged that these sources of income might recover at some point, but not in the very near term. Tax and Other Payments are Dragging on Disposable Income When we think about household income available for consumption and saving, economists usually disposable talk about household income. This is income net of taxes, net interest payments and a few other deductions like insurance premiums. Income payable – the things deducted from gross income to calculate disposable income – increased by nearly 6 per cent in 2018. This was significantly faster than growth in gross household income. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-26.html 13/17 3/26/2019 What's Up (and Down) With Households? | Speeches | RBA Despite the relatively weak picture for household income growth, the tax revenue collected from households has grown solidly in recent years. It's normal for growth in tax revenue to outpace income growth a bit: that is how a progressive tax system works. A useful rule of thumb is that, in the absence of adjustments to tax brackets to allow for bracket creep, for every one percentage point of growth in household income, taxes paid by households will on average increase by about 1.4 percentage points. That's an on-average figure, though. The actual ratio can vary quite a bit. In the past year, taxes paid by households increased by around 8 per cent, more than double the rate of growth in gross household income of 3½ per cent. So the ratio is more like a bit over two-toone at the moment, rather than 1.4 to one. That is at the high end of the range this ratio reaches, but as this graph shows, it is not unprecedented (Graph 12). But this effect has cumulated over time, so that the share of income that is paid in tax has been rising (Graph 12, bottom panel). Graph 12 What is noteworthy is that for all of the past six years, growth in tax paid has exceeded income growth by an above-average margin, at a time when income growth itself has been slow (Graph 13). https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-26.html 14/17 3/26/2019 What's Up (and Down) With Households? | Speeches | RBA Graph 13 There are likely to be several things going on here. Aside from the usual bracket creep, some deductions and offsets have declined, boosting the overall tax take. Interest rates on investment property loans are now higher than for owner-occupiers, but overall the interest rate structure on mortgages is lower than it was a few years ago. So landlords will have lower tax deductions for interest payments on loans on investment properties. At the same time, the significant run-up in housing prices in some cities over the past decade will have increased the capital gains tax liability paid by investors selling a property. Turnover in the housing market has declined. But as best we can tell, the price effect has dominated the effect of declining volumes, and total capital gains tax paid has increased. Compliance efforts and technological progress in tax collection have boosted revenue collected from a given income. The Tax Office reports that its efforts to raise compliance around work-related deductions have boosted revenue noticeably (Jordan 2019). The next wave of this effort, focused on deductions related to rental properties, could result in further boosts to revenue. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-26.html 15/17 3/26/2019 What's Up (and Down) With Households? | Speeches | RBA Some of these drivers boosting tax paid could persist for a while, but they aren't permanent. For example, the earlier period of strong housing price growth will only increase capital gains tax revenue if the asset was owned during that period. It can be expected to become less important, the further into history it passes. Similarly, increased compliance increases the of tax paid on a level given level of income. It is not a change in the trend growth rate in tax paid. That said, the effect could last for a while as efforts shift to different aspects of compliance. Some Recent Policy Changes Might Mitigate the Drag on Consumption The net of all these effects is that household income growth has remained slow even as labour market conditions have been improving. Unlike slow wages growth, though, it is less clear how much weak non-labour income growth will weigh on consumer spending. As I already noted, slow growth in rental income for landlords means that tenants have more money to spend on other things. Some of the weakness in social assistance payments is because new programs are being delivered differently from existing ones, and so they are classified as government consumption. The net benefit to the recipients could be the same or higher. So there might be reasons to think that weak non-labour income growth is less worrisome than weak wages growth. But you would not want to rely on that possibility to underpin your views on the outlook for consumption. So this is an area we need to watch closely. Household consumption spending is a large part of economic activity. A significant retrenchment there would lower growth and feed back into a weaker labour market, as well as into decisions to purchase housing. Parting Thoughts My talk today has deliberately not overlapped with what the Bank has recently said about the housing market. But I think it's clear that conditions in the household sector more broadly are highly consequential for the housing sector and thus this audience. Whatever other forces might be affecting housing market developments, fundamentally demand for housing rests on the household sector's confidence and capacity to take on the financial commitments involved in the purchase or rental of a home. Without enough income, and so without a strong labour market, that confidence and capacity would be in doubt. This is not the only reason we are watching labour market developments closely. But the nexus between labour markets, households and housing are crucial to our assessment of the broader outlook. Thank you for your time. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-26.html 16/17 3/26/2019 What's Up (and Down) With Households? | Speeches | RBA Bibliography Jordan C (2019), ‘Taxing times: positioning the ATO as an instrument of democracy’, Address to The Tax Institute 34th National Convention, Hobart, 14 March. Available at <https://www.ato.gov.au/Mediacentre/Speeches/Commissioner/Commissioner-s-address-to-the-Tax-Institute-National-Convention-2019/>. Leal H (2019), ‘Firm-level Insights into Skills Shortages and Wages Growth’, RBA Bulletin, March. May D, G Nodari and D Rees (2019), ‘Wealth and Consumption’, RBA Reserve Bank of Australia Bulletin, March. This speech uses unit record data from the Household, Income and Labour Dynamics in Australia (HILDA) Survey. For more information, see HILDA Survey Disclaimer Notice. Endnotes [*] Thanks to Tomas Cokis for his invaluable help in putting together the material in this speech. The series in the graph shows total rental income, including both cash rents paid by tenants to landlords, and the rental income imputed to owner-occupiers. Owner-occupiers' imputed rent is imputed using movements in cash rents as a guide, although the (slow-moving) relative quality of the owner-occupied housing stock relative to the rental stock also matters. Over shorter periods, changes in this series reflect developments in the rental housing market. © Reserve Bank of Australia, 2001–2019. All rights reserved. https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-26.html 17/17 | reserve bank of australia | 2,019 | 3 |
Opening panel remarks by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the FX Week Australia, Sydney, 27 March 2019. | Christopher Kent: Opening panel remarks - FX Week Australia Opening panel remarks by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the FX Week Australia, Sydney, 27 March 2019. * * * Thanks to FX Week for the invitation to discuss the FX Global Code. When the FX Global Code was launched in 2017, the aim was that it would promote a robust, fair, liquid and transparent wholesale market. To do that, the Code sets out principles of good practice. As awareness of the Code builds and more market participants commit to adhering to its principles, standards will no doubt improve across the market. The Code has already gained significant traction in the marketplace. A recent survey of market participants by the Global Foreign Exchange Committee (GFXC) confirmed that awareness of the Code within the industry was now very high. Almost all of those surveyed had read part or all of the Code. Furthermore, the vast majority of respondents indicated that they expected or required their counterparties to adhere to the Code. Globally, there are now more than 800 firms that have signed Statements of Commitment to the Code and lodged them on public registers. So what do we need to do from here? Globally, it is clear that the sell-side have embraced the Code. What appears to be missing is comparable take-up from the buy side. This is as apparent in Australia as it is in other jurisdictions. To some extent, this could be just a lag as buy-side participants take longer to complete the process of reviewing the Code and aligning their practices to it. Encouragingly, the GFXC’s survey showed that while current take-up from the buy-side was low, many of the buy-side respondents indicated that they did intend to adhere and some of those had already begun the process. More broadly, though, the GFXC is conscious that greater take-up from the buy-side will be needed and the GFXC is actively looking at ways to achieve that end. For those in the audience from the buy-side the question I would put to you is: can you justify to your stakeholders — whether they are your investors (if you are a fund manager) or shareholders (if you are a business) — why you have not adopted a set of principles which represent industry best practice when you are managing their money? The widespread adoption of the Code will benefit everyone involved in the FX industry, regardless of where you sit in the market. It is worth noting the Code is principles-based rather than rules-based. This is to encourage market participants to think about their practices and how their activities comply with the principles, rather than working narrowly to a set of rules. The Code’s application is also designed to be proportional to the FX business that a participant is involved in. Clearly, there are some principles that aren’t directly relevant to the buy-side. Most obvious are those principles that deal with handling client orders or client mark ups. Ultimately, the Code’s principles are there to give market participants confidence in how the market is operating. There are numerous ways the Code can promote confidence. It can help to improve price competition as liquidity providers’ pricing practices become more transparent to clients. Market participants can also be more confident that good practices around information handling will result in a more level playing field for all. 1/2 BIS central bankers' speeches So I encourage those of you who have yet to familiarise yourselves with the Code to do so. And then consider adopting it. It is a useful tool in many ways, not just to enhance your own practices but, for those on the buy side to gauge what you should expect from your brokers in terms of their execution, the type of market colour they provide and their market practices more generally. Finally, I should mention the work of the Australian Foreign Exchange Committee (AFXC). This committee contributes to maintaining the Code and promoting it within the local market. Our membership comprises a diverse range of market participants, including those from both the sell-side and buy-side, and also those that provide infrastructure to the market, such as the platforms. So if you are interested to know more about the Code, you could contact any one of the members and ask about their own experiences with the Code. 2/2 BIS central bankers' speeches | reserve bank of australia | 2,019 | 3 |
Speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the American Chamber of Commerce in Australia (AmCham) Business Luncheon, Adelaide, 10 April 2019. | null | reserve bank of australia | 2,019 | 4 |
Keynote speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the at the International Swaps and Derivatives Association (ISDA) 34th Annual General Meeting, Hong Kong, 11 April 2019. | 4/12/2019 Progress on Benchmark Reform | Speeches | RBA Speech Progress on Benchmark Reform Guy Debelle [ * ] Deputy Governor Keynote at ISDA's 34th Annual General Meeting Hong Kong – 11 April 2019 Good morning and thanks to ISDA for the opportunity to speak here today. It has been almost two years since Andrew Bailey announced that the FCA (the UK Financial Conduct Authority) would no longer use its powers to sustain LIBOR (the London Inter-Bank Offered Rate) beyond 2021. [1] Since that time, preparing for the end of LIBOR has been a key challenge for the global finance industry. Today I will provide an update on the progress with benchmark reform internationally, and highlight some of the key issues in the Asia-Pacific region. The End of LIBOR There is now widespread recognition that LIBOR will come to an end. The fundamental problem is that there are not enough transactions in the short-term inter-bank market to underpin LIBOR. The banks that make the submissions that are used to calculate these benchmarks are uncomfortable about continuing to do this, as they have to mainly rely on their ‘expert judgement’ rather than actual transactions. To prevent LIBOR from abruptly ceasing to exist, the FCA has received assurances from the current banks on the LIBOR panel that they will continue to submit until the end of 2021. But beyond that point, there is no guarantee that LIBOR will survive. The FCA will not compel banks to provide submissions and the panel banks may choose to stop. Financial regulators around the world expect institutions using LIBOR to be ready to transition to more robust benchmarks. If they haven't already done so, users need to identify their exposures to LIBOR now and be working on transitioning to alternative rates. We know that a sizeable number of financial contracts referencing LIBOR extend beyond 2021, including derivatives, bonds and loans. The transition will involve a substantial amount of work, both to amend contracts and update systems. The Financial Stability Board's (FSB) Official Sector Steering Group (OSSG) has been https://www.rba.gov.au/speeches/2019/sp-dg-2019-04-11.html 1/6 4/12/2019 Progress on Benchmark Reform | Speeches | RBA monitoring progress on the transition and on ensuring that contracts referencing LIBOR include robust fall-back provisions. Progress on Adopting Alternative Risk-free Rates The transition from LIBOR to alternative risk-free rates (RFRs) is accelerating internationally. RFRs have been identified for all the LIBOR currencies by national working groups involving the private sector and regulators. The rates chosen are overnight RFRs, either measured from transactions in inter-bank unsecured lending markets or repo markets. It has now been a year since the Fed started publishing SOFR (the Secured Overnight Financing Rate), and since the Bank of England implemented reforms to SONIA (Sterling Overnight Index Average). Recently, the ECB announced that it will launch €STR (Euro Short-term Rate) at the start of October. These rates are more robust than LIBOR, since they are anchored in active, liquid underlying markets. Usage of RFRs in derivatives markets is increasing. Futures and cleared swaps referencing SOFR have started trading, which is ahead of the schedule set by the ARRC (the Alternative Reference Rates Committee, which is the US working group on LIBOR transition). There has been even more progress for sterling, where trading in cleared OTC derivatives referencing SONIA is now broadly equivalent to that of sterling LIBOR. The RFRs are also being adopted in some cash products. In bond markets in particular, a wide range of institutions have issued floating-rate bonds referencing the RFRs. Since July last year, there have been quite a few deals referencing SOFR. The transition is further advanced for sterling, where SONIA has been used in just over half of the deals this year. This has included two Australian banks issuing sterling floating-rate bonds referencing SONIA. The rapid adoption of SONIA in the bond market demonstrates that RFRs can be used in cash products that previously only referenced LIBOR. Can Robust Term Risk-free Rates Be Developed in Time? Some market participants argue that overnight RFRs may not be the most appropriate benchmarks to use in all cases. In particular, lenders and borrowers in the syndicated loan market have raised concerns about using the overnight RFRs in place of LIBOR. This is not that surprising, since LIBOR was originally set up to cater for the syndicated loan market. Participants in this market want to know the interest payments on loans in advance. This is possible with a forward-looking rate such as LIBOR, which is set at the beginning of the interest period. But it is not possible when compounding an overnight RFR, which can only be calculated at the end of the period. In response to this, some of the national working groups have been considering how to develop ‘term RFRs’. These forward-looking rates could potentially be constructed from derivatives referencing the overnight RFRs. However, for such term RFRs to be considered robust, there would need to be sufficient liquidity and transparency in the underlying derivatives markets. The ARRC is aiming for a term rate based on SOFR derivatives to be developed by end 2021, once there is sufficient liquidity to produce a robust rate. https://www.rba.gov.au/speeches/2019/sp-dg-2019-04-11.html 2/6 4/12/2019 Progress on Benchmark Reform | Speeches | RBA The currency most progressed on developing a term RFR is sterling. But the recent consultation run by the UK working group found that there would need to be a ‘step change’ in activity in derivatives markets for a term SONIA rate to be sufficiently robust. [4] At the other end of the spectrum, the Swiss working group has found that a term RFR is not feasible given the low level of activity in derivatives referencing the Swiss franc RFR. While the development of term RFRs is desirable, it is not yet clear that they will be sufficiently robust. In this context, we encourage market participants preparing for the LIBOR transition to work on using overnight RFRs rather than waiting for the development of term RFRs. Furthermore, the FSB has made it clear that derivatives markets will largely need to transition to the overnight RFRs to ensure financial stability. Derivatives represent the largest exposure to LIBOR, and only transitioning to the overnight RFRs can address the core weakness of LIBOR, which is the absence of deep and liquid markets to underpin these benchmarks. Finalising Work on Contractual Fall-backs Another key focus over the past year has been on developing more robust fall-back provisions in contracts referencing LIBOR. This would reduce the risk of financial instability if these benchmarks were to abruptly cease. It is generally agreed that the existing fall-back provisions would be cumbersome to apply and could generate significant market disruption. To address this risk, the FSB encouraged ISDA to work with market participants to develop a more suitable fall-back methodology, using the RFRs that have been identified. The key challenge has been to agree on a standard methodology for constructing fall-backs for LIBOR using the overnight RFRs. ISDA conducted a consultation on some key technical issues regarding the fall-back methodology in the second half of last year. [7] ISDA found strong support for using as the fall-back, the compounded RFR with an adjustment for the historical spread between the RFR and LIBOR. There are several further steps that need to be completed before the fall-backs will be ready for adoption: ISDA is working on the details of how exactly to calculate the historical spread between the RFR and LIBOR (in particular what historical period to use). The OSSG has asked ISDA to consult on including an additional fall-back ‘trigger’ that would take effect if the FCA found that LIBOR was no longer representative of the underlying market. [8] This would be a ‘pre-cessation’ trigger just for LIBOR. This would be in addition to ISDA's existing triggers, which deal with scenarios where a benchmark has ceased. ISDA will also conduct consultations for additional benchmarks that were not covered in the original consultation, including US dollar LIBOR. Once ISDA has finalised the fall-back provisions, regulators expect users of LIBOR to adopt them. Thanks to ISDA's hard work, this should be relatively straightforward for derivatives markets. It will also be important for users to adopt equivalent fall-backs for cash products wherever possible. To support this, the ARRC has run a series of consultations to establish consistent robust fall-backs for different cash products referencing US dollar LIBOR. https://www.rba.gov.au/speeches/2019/sp-dg-2019-04-11.html 3/6 4/12/2019 Progress on Benchmark Reform | Speeches | RBA Regulatory, Accounting and Tax Issues Affecting Transition LIBOR is deeply embedded in the plumbing of the financial system, so replacing it with overnight RFRs has significant and widespread implications beyond financial markets. For instance, the LIBOR transition raises a number of accounting, tax and regulatory issues. The LIBOR transition has the potential to disrupt the accounting treatment of products referencing LIBOR, particularly when they are used for hedging. This could generate volatility in the reported earnings of companies that is unrelated to their underlying financial performance. It could also have significant tax implications. In response to these concerns, the International Accounting Standards Board is working on amending the global accounting standards to provide relief for existing hedges from the uncertainty generated by the LIBOR transition. The treatment of legacy OTC derivatives referencing LIBOR is also under consideration. These contracts will need to be amended to adopt more robust fall-back provisions, which could affect their status under the G20's OTC derivatives reforms. Regulators are making progress on this. For instance, the Basel Committee and IOSCO recently announced that there would be relief from margin requirements where legacy derivatives are amended to address benchmark reforms. Benchmarks Issues in the Asia-Pacific Region Here in the Asia-Pacific region, considerable work is being undertaken to strengthen local benchmarks and prepare for the LIBOR transition. Australia, Hong Kong, Japan and Singapore are all represented on the FSB's OSSG, and we are also working within regional forums to highlight benchmark reform issues. In Australia, we have taken a ‘multiple rate approach’. The credit-based benchmark BBSW (the Bank Bill Swap Rate) has been strengthened and coexists alongside the cash rate, which is the RFR for the Australian dollar. [12] This has been possible since both BBSW and the cash rate are supported by underlying markets with enough transactions to calculate robust benchmarks. BBSW can continue to exist even after LIBOR ends. For many financial products, it will still make sense to reference a credit-based benchmark. But as markets transition from referencing LIBOR to RFRs, there may be some corresponding migration away from BBSW towards the cash rate. This will depend on how international markets for products such as cross-currency basis swaps end up transitioning away from LIBOR. Good progress is being made on developing new market conventions for trading cross-currency basis swaps, referencing RFRs or combinations of RFRs and IBORs, to give market participants the choice. Regulators in the region are also seeking to strengthen the contractual fall-backs for their benchmarks at the same time as LIBOR. The Australian and Japanese benchmarks (BBSW, JPY LIBOR and TIBOR) were included in ISDA's consultation last year, and the Hong Kong and Singaporean benchmarks (HIBOR and SOR) are expected to be considered in ISDA's next round of consultation. Once ISDA finalises these fall-backs, we strongly encourage all users of benchmarks in the region to adopt them. https://www.rba.gov.au/speeches/2019/sp-dg-2019-04-11.html 4/6 4/12/2019 Progress on Benchmark Reform | Speeches | RBA One issue that has been generating quite a bit of angst in the region is the impact of the European Union's benchmarks regulation (BMR). Under the BMR, EU supervised entities – including banks and CCPs (central counterparties) – can only use benchmarks that are registered in the EU. To achieve this status, benchmarks administered outside the EU would need to be in a jurisdiction with a legal framework judged by the EU to be ‘equivalent’ to the BMR, or would need to substantially comply with the BMR. The EU had set a deadline of 1 January 2020, but has recently announced a two year extension. [13] This is a welcome development, and provides administrators in the region with valuable additional time to comply with the requirements of the BMR. In addition, the EU has recently issued draft decisions recognising the Australian and Singaporean regulatory regimes as equivalent to the BMR. This means that benchmarks such as BBSW and SOR can continue to be used in the EU after 1 January 2022. Conclusion There are three main points I would like to leave you with concerning interest-rate benchmarks. First, the end of LIBOR is approaching. Market participants should continue preparing for this by transitioning to alternative risk-free rates. Second, it is prudent for users of all benchmarks to have robust fall-back provisions in their contracts, not just those referencing LIBOR. ISDA's work on fall-backs is progressing well, and we encourage all users of interest-rate benchmarks to adopt ISDA's fall-backs once they are finalised. Third, most jurisdictions in the Asia-Pacific region have chosen to strengthen their credit-based benchmarks. This includes Australia, where BBSW remains robust. Credit-based benchmarks can coexist alongside risk-free rates when they are supported by liquid underlying markets. Users can then choose the benchmark that is most appropriate for their circumstances. Endnotes [*] I would like to thank Ellis Connolly for all his work in this area. See Bailey A (2017), ‘The Future of LIBOR’, Speech at Bloomberg London, 27 July. Available at: <https://www.fca.org.uk/news/speeches/the-future-of-libor>. I have talked about this issue previously: Debelle G (2018), ‘Interest Rate Benchmark Reform’ Speech at ISDA Forum, Hong Kong, 15 May; Debelle G (2017), ‘Interest Rate Benchmarks’, Speech at FINSIA Signature Event: The Regulators, Sydney, 8 September; Debelle G (2016), ‘Interest Rate Benchmarks’, Speech at KangaNews Debt Capital Markets Summit 2016, Sydney 22 February; Debelle G (2015), ‘Benchmarks’, Speech at Bloomberg Summit, Sydney, 18 November. This is in notional value terms. See Butler M (2019), ‘Ending Reliance on LIBOR: Overview of progress made on transition to overnight risk-free rates and what remains to be done’, Speech at the Investment Association London, 21 February. Available at: <https://www.fca.org.uk/news/speeches/ending-reliance-libor-overview-progress-madetransition-overnight-risk-free-rates-and-what-remains>. See Working Group on Sterling Risk-Free Reference Rates (2018), ‘Term Sonia Reference Rates Consultation – Summary of Responses’, November. Available at: https://www.rba.gov.au/speeches/2019/sp-dg-2019-04-11.html 5/6 4/12/2019 Progress on Benchmark Reform | Speeches | RBA <https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/term-sonia-reference-rates-consultationsummary-of-responses.pdf?la=en&hash=CFD2AB11A3156B31CB15030962ECA9987BEFCED8> See National Working Group on CHF Reference Interest Rates (2018), ‘Minutes from the meeting of the National Working Group on CHF Reference Interest Rates (31 October 2018)’, 14 November. Available at: <https://www.snb.ch/n/mmr/reference/minutes_20181031/source/minutes_20181031.n.pdf> See Financial Stability Board (2018), ‘Interest rate benchmark reform – overnight risk-free rates and term rates’, 12 July. Available at <http://www.fsb.org/wp-content/uploads/P120718.pdf> See ISDA (2018), ‘ISDA Publishes Final Results of Benchmark Fallbacks Consultation’, Press Release, 20 December. Available at: <https://www.isda.org/2018/12/20/isda-publishes-final-results-of-benchmark-fallback-consultation/>. See FSB (2019), ‘FSB Letter to ISDA about derivative contract robustness to risks of interest rate benchmark discontinuation’, 15 March. Available at: <http://www.fsb.org/2019/03/fsb-letter-to-isda-about-derivative-contractrobustness-to-risks-of-interest-rate-benchmark-discontinuation/>. Also see Schooling Latter E, ‘LIBOR transition and contractual fallbacks’, Speech at the ISDA Annual Legal Forum, 28 January. Available at: <https://www.fca.org.uk/news/speeches/libor-transition-and-contractual-fallbacks> See ARRC (2019), ‘Fallback Contract Language’. Available at: <https://www.newyorkfed.org/arrc/fallbacks-contractlanguage> See International Accounting Standards Board (2019), ‘IBOR Reform and its Effects on Financial Reporting’, Available at: <https://www.ifrs.org/projects/work-plan/ibor-reform-and-the-effects-on-financial-reporting/#about> See BCBS and IOSCO (2019), ‘BCBS/IOSCO statement on the final implementation phases of the Margin requirements for non-centrally cleared derivatives’, Press Release, 5 March. Available at <https://www.bis.org/press/p190305a.htm> and <https://www.iosco.org/library/pubdocs/pdf/IOSCOPD624.pdf> For more details on recent benchmark developments in Australia, see Kent C (2019), ‘Bonds and Benchmarks’, Speech at the KangaNews DCM Summit, Sydney, 19 March. See European Commission (2019), ‘Sustainable finance: Commission welcomes agreement on a new generation of low-carbon benchmarks’, Press Release, 25 February, Available at: <http://europa.eu/rapid/press-release_IP-191418_en.htm>. See European Commission (2019), ‘Recognition of financial benchmarks in Australia’, Implementing decision. Available at: <https://ec.europa.eu/info/law/better-regulation/initiatives/ares-2019-1806384_en> and European Commission (2019), ‘Recognition of financial benchmarks in Singapore’, Implementing decision. Available at: <https://ec.europa.eu/info/law/better-regulation/initiatives/ares-2019-1806355_en> © Reserve Bank of Australia, 2001–2019. All rights reserved. https://www.rba.gov.au/speeches/2019/sp-dg-2019-04-11.html 6/6 | reserve bank of australia | 2,019 | 4 |
Keynote speech by Ms Michele Bullock, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the ASIC (Australian Securities and Investments Commission) Annual Forum, Sydney, 16 May 2019. | 5/16/2019 Leaning In: Towards Better Payment and Clearing Systems | Speeches | RBA Speech Leaning In: Towards Better Payment and Clearing Systems Michele Bullock Assistant Governor (Financial System) Keynote at ASIC Annual Forum Sydney – 16 May 2019 It is my pleasure to be speaking here at the ASIC Forum. The Reserve Bank of Australia has a number of roles in the payments system. It operates the real-time gross settlement system for highvalue payments, it provides banking and payment services to government clients, and it oversees and regulates the payments system. It is in the capacity of overseer that I am talking to you today. The Payments System Board of the Reserve Bank has a mandate to promote efficiency and competition in the Australian payments system, as well as stability of the system. The Reserve Bank oversees the system to determine how best to achieve these objectives, including regulating if necessary. So today, I'm going to talk about something that can be very important in achieving these goals – collaboration. Payment systems are networks and as networks they have a couple of important features. The first is that there are externalities associated with networks. As they get larger, the benefits increase disproportionally. We see this in all sorts of payment systems. The more merchants that take cards, for example, the more benefit there is to holding a card. And the more people that hold cards, the more benefit there is to merchants accepting cards. The network effect is both what can make it difficult for new systems to get off the ground and also entrench large networks. The second feature of networks is that they involve people working together. In order to get the positive benefits from networks, there needs to be a commonality of interest among participants that are often competitors. When this is done well, it benefits both participants and end-users, and the wider community. Conversely, when some participants don't collaborate, they can make it difficult for everyone else to realise benefits. https://www.rba.gov.au/speeches/2019/sp-ag-2019-05-16.html 1/8 5/17/2019 Leaning In: Towards Better Payment and Clearing Systems | Speeches | RBA Today I am going to talk about examples where collaboration is necessary to improve our payment systems in Australia – instances where firms that are typically competitors are being asked to ‘lean in’. There are two that I am going to highlight: the New Payments Platform and efforts to reduce fraud. I will finish up with a few remarks on one area of the payments system where we would like to see continued competition. The New Payments Platform A very good example of industry collaboration in recent years has been the development and then the implementation of the New Payments Platform, or the NPP. The NPP is an infrastructure that allows instant payments to be made and received 24/7, with richer information and simpler addressing. Its genesis was the Payments System Board's Strategic Review of Innovation in the payments system (the Strategic Review). When the Strategic Review was announced in 2010, it was noted that the objective was to identify areas of innovation in the Australian payments system that could be improved through more effective cooperation between stakeholders and regulators. The final conclusions released in 2012 set out some high level strategic objectives for the payments system and invited the industry to determine how best to meet those objectives. They included the ability for users to: make real-time payments send more complete remittance information with payments address payments in a relatively simple way make and receive payments outside normal business hours. The industry response was to develop and build the NPP to meet these objectives. The NPP went live in February 2018 and is slowly but steadily building volume. This was a very ambitious project. It was long – it took around 4 years from the industry commitment until ‘go live’. And it still is not complete. It was complicated technically, requiring not only a central build but also substantial work within financial institutions. And, as a large cross industry project it was complicated logistically. But despite this, and the fact that there is still work to do, it has been a successful project. I think there were a few things that contributed to the effective collaboration that delivered the NPP. First, the Reserve Bank and the Payments System Board, with the public interest in mind, gave a very clear message to the industry that building this new infrastructure was important. The conclusions of the Strategic Review set out very clearly what the Reserve Bank was expecting the industry to deliver on. And while it provided the industry with an opportunity to devise a proposal, it was always clear that the Reserve Bank regarded this as a must do if the Australian payments system is to be capable of providing the services expected by users into the future. The Payments System Board followed progress closely and provided continued encouragement both publicly and, where necessary, privately through senior-level contact between the Reserve Bank and other participating financial institutions. https://www.rba.gov.au/speeches/2019/sp-ag-2019-05-16.html 2/8 5/17/2019 Leaning In: Towards Better Payment and Clearing Systems | Speeches | RBA Furthermore, the Reserve Bank demonstrated its own commitment to the project in numerous ways. It was a member of the project steering committee and numerous working groups, committing senior resources to these groups. It also took up a shareholding in NPP Australia Limited (NPPA) and it built the Fast Settlement Service to settle payments individually in real time, 24/7. A second reason why collaboration was successful was that most institutions realised that they were participating in a project that would have significant and broad benefits. There were already a number of fast retail payment services around the world and customers were increasingly expecting payments to keep up with their 24/7 lifestyle. I think that most participants understood this. A third element was the way that the project was organised with a dedicated independent team to manage the project and repeated reminders of the shared vision agreed early in the project's life. One key aspect of this was the social contract that all participants agreed to. This contract emphasised such things as constructive challenge, respect, active listening, positivity and innovative thinking. The result is that we now have a first-rate payments system infrastructure that will be a platform for ongoing innovation. In many respects, Australia's fast payments system is at the cutting edge of such systems. We were not the first to have a fast payments system. But we have been able to learn from experience overseas and improve the model with features such as ISO 20022 message formats, real-time settlement and the addressing service. And the design of the system, which allows for competitive ‘overlay’ services to use the infrastructure, gives the system flexibility to meet the future needs of users of the Australian payments system. Since going live in February 2018, the system has been gradually increasing its volumes (Graph 1). In April, 16 million transactions were processed through the NPP amounting to $13 billion. This is still small relative to the volumes that pass through other retail payment systems. But it is growing steadily and at least as quickly as some comparable overseas fast payment services when they were introduced (Graph 2). One of the positive aspects has been the broad participation of many small financial institutions. Customers of around 50 small banks, credit unions and building societies were able to make and receive fast payments from Day 1 and that number has since grown to nearly 70. https://www.rba.gov.au/speeches/2019/sp-ag-2019-05-16.html 3/8 5/16/2019 Leaning In: Towards Better Payment and Clearing Systems | Speeches | RBA Graph 1 https://www.rba.gov.au/speeches/2019/sp-ag-2019-05-16.html 4/8 5/16/2019 Leaning In: Towards Better Payment and Clearing Systems | Speeches | RBA Graph 2 On a less positive note, we have been somewhat underwhelmed by the progress of some of the major banks. Some of them have been much slower to provide their customers with fast payment services. The majors have all taken different approaches to which functionality they will provide and which customers to bring on first. This is their prerogative. We know they have a lot on their plates and they are in the best position to make decisions on what to prioritise. We also know that they have large and complex IT systems. But with some big banks slow to complete NPP related changes to their internal systems, there remain large numbers of customers that do not have a full range of convenient options for initiating fast payments even if their accounts can be reached by incoming fast payments. There is also more work to be done on increasing the number of accounts that are reachable using the NPP. These gaps have made it very difficult for NPP participants to market the new service to their customers. So the value of the NPP to users is much lower than it could be if payment initiation and account reach were more progressed. That is, the positive network effects have been held back. In order to realise the full benefits of the NPP, most financial institutions, particularly the larger ones, need to be involved in sending and receiving fast payments. There is still more to be done and NPPA is keen to facilitate new applications that use the real-time, data-rich functionality. But industry should be aware that the regulator and the public in general will be expecting the payments industry to deliver on the promise of the NPP. In light of concerns that had been raised by a number of stakeholders, the Reserve Bank, with assistance from the Australian Competition and Consumer Commission (ACCC), has recently undertaken a public consultation on https://www.rba.gov.au/speeches/2019/sp-ag-2019-05-16.html 5/8 5/16/2019 Leaning In: Towards Better Payment and Clearing Systems | Speeches | RBA NPP access and functionality. We are expecting to publish the conclusions and recommendations from this consultation in the coming weeks. Fraud Another area where collaboration is important in payment systems is fraud prevention and mitigation. Individual institutions all have their own ways of dealing with fraud. In card payments, for example, most institutions have algorithms that look for payments that seem to be out of the ordinary. They then seek to verify with the customer as soon as possible whether the payment was genuine. Fraud tends to move to the point of least resistance so there are strong incentives for individual institutions to make sure that their systems for preventing, detecting and mitigating fraud keep pace with their competitors. Otherwise they might find themselves targeted. But there are also good reasons to think about fraud mitigation collectively. First, if there is one participant in a payment system that is very prone to fraud, it could impact the confidence of consumers in using the system. There is therefore a collective incentive to ensure that everyone in the system is meeting certain minimum standards of fraud prevention. Second, and relatedly, payment systems often have protections for users of the system so that if a user finds themselves the victim of fraud through no fault of their own, they are not out of pocket. For example, card systems have protocols for dealing with fraudulent transactions on cards that arise through theft of card details. These protocols need to apply to all participants in the system to meet their aims. PIN@POS was a good example earlier in this decade of a successful collaboration between financial institutions in Australia to improve the security of card transactions at the point of sale. While card transactions through the domestic eftpos system have always required authorisation by Personal Identification Number (PIN) at the terminal, authorisation of transactions through other card systems (American Express, Diners, Mastercard and Visa) was typically via signature. Signature authorisation was much more susceptible to fraud so the industry agreed on a project to move to PIN authorisation for all card transactions. This was a classic collaborative opportunity. If one institution tried to go it alone, it might find resistance from its customers – card holders who don't want to change and merchants who might have to upgrade their terminals. Furthermore, the fraud would probably just move to a merchant that didn't require PINs. Maybe the problem would be solved in the end, but in order to realise the benefits of a move to PIN in a reasonable timeframe, the individual participants had to move together. Another more recent example of industry collaboration to address fraud is in ‘card-not-present’ transactions. Consumers are increasingly making purchases on line and cards are an easy way to do this. But it is more difficult for an online merchant to verify that the card being used belongs to the person using it. As a result, fraud rates on card-not-present transactions are high and rising. This can reduce confidence in the card payment system. And as merchants typically bear the cost of online fraud, it increases their costs of doing business and ultimately prices to consumers. It is bad for society as a whole. https://www.rba.gov.au/speeches/2019/sp-ag-2019-05-16.html 6/8 5/16/2019 Leaning In: Towards Better Payment and Clearing Systems | Speeches | RBA There are ways of authenticating consumers online. But the greatest resistance to adopting these has come from merchants who worry that any anti-fraud measures would introduce friction in the checkout process, causing the purchaser to drop out. Indeed, there is a bit of a ‘prisoner’s dilemma' here. Two merchants would be better off if they both introduce anti-fraud measures. But they each worry that if they adopt such measures, they will lose sales to their competitor who hasn't adopted the additional measures. So neither will adopt. Recognising that this a problem that would benefit from a collaborative solution, Australian financial institutions are currently working together to develop a framework for dealing with card-not-present fraud. Under the auspices of the Australian Payments Network, the industry will be mandating strong customer authentication at merchants that have high fraud rates. This will involve a process that checks two or more independent factors to authenticate the customer. For example, a one-time authentication code might be sent to the consumer's mobile phone, or there may be a fingerprint authentication. The goal is to reduce the cost of fraud as a whole, rather than just shifting it between individual merchants and financial institutions. Other Aspects of Card Payments I want to finish by speaking briefly about competition in the debit card market in Australia. Debit cards are the non-cash payment method of choice for many Australians. Debit cards are connected to a customer's deposit account and draw funds for payment directly from that account. Over the past 10 years, the annual number of debit card transactions per person in Australia has risen from around 80 to around 260. Most debit cards in Australia are dual-network cards. That is, payments made using these cards can be processed across two networks. The network brand on the front, and the most obvious, is typically an international scheme – Mastercard or Visa. On the back is usually the eftpos brand, the Australian domestic debit system. The Payments System Board and the Reserve Bank have been supportive of these cards because they provide convenience and choice to both consumers and merchants. When dipping or swiping their card, consumers could choose the credit button to direct the transaction through the international scheme or the cheque/savings button to direct it through the eftpos system. Merchants could also indicate to customers which network they would prefer to be used. So dual-network cards can play a role in keeping downward pressure on the costs of card acceptance to merchants (and indirectly to consumers). The move to contactless payments (‘tap-and-go’), however, has muted some of the competitive pressures that can come from dual-network cards. Since eftpos moved to tap-and-go later than Mastercard and Visa, a substantial number of payments that were previously processed by the eftpos network are now being processed by the international schemes. While consumers would not have noticed anything different, businesses have seen their costs of card acceptance rise as processing through the international schemes is more expensive than eftpos. https://www.rba.gov.au/speeches/2019/sp-ag-2019-05-16.html 7/8 5/16/2019 Leaning In: Towards Better Payment and Clearing Systems | Speeches | RBA The Bank has attempted to ensure that merchants continue to have choice by obtaining commitments from banks to allow their merchant customers to choose the network through which contactless transactions are processed. Some smaller acquirers – for example Tyro and First Data – have been faster than the major banks to provide their customers with this functionality. But the major banks are now offering or are about to offer merchant choice. This should assist in keeping downward pressure on the fees that merchants pay. But as payments move to different form factors, such as mobile phones or wearables, and new technologies are introduced, there is a risk that some may use it as an opportunity to lock out competitors. The Reserve Bank is of the view that in moving to new technologies, merchants and consumers should continue to have a choice of debit card network. Rules or policies of any scheme that have the effect of removing choice will reduce competition and result in rising costs to merchants. The Bank will be looking closely at developments in the debit card market to ensure that, as far as possible, there is a level playing field for the alternative debit schemes. We will also work with the ACCC as necessary to identify and address any anti-competitive behaviour. In the specific case of least cost routing, we would not want to see the benefits to competition from this innovation thwarted by issuers taking eftpos off dual-network cards. Conclusion Competition is important in payments. It delivers better customer experiences, more convenience and innovative products. But as networks, collaboration is also often required. The development of the NPP and recent work on addressing fraud in card payment systems are good examples of where participants that are normally competitors have cooperated to ultimately deliver better outcomes for Australian consumers and merchants. These collaborative efforts, however, are not without their challenges. As the payments system regulator, the Reserve Bank remains willing to engage with industry and facilitate collaboration where this is in the public interest. © Reserve Bank of Australia, 2001–2019. All rights reserved. https://www.rba.gov.au/speeches/2019/sp-ag-2019-05-16.html 8/8 | reserve bank of australia | 2,019 | 5 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Economic Society of Australia, Brisbane, 21 May 2019. | 5/21/2019 The Economic Outlook and Monetary Policy | Speeches | RBA Speech The Economic Outlook and Monetary Policy Philip Lowe [ * ] Governor Address to the Economic Society of Australia Brisbane – 21 May 2019 Thank you for the invitation to speak to the Economic Society of Australia. It is very good to be back here in Brisbane today. I would like to begin by providing an update on recent developments in the global and Australian economies. I will then discuss how our thinking on the appropriate stance of monetary policy has evolved over recent times. The Global Picture Up until around the middle of last year, the global economy was growing quite briskly (Graph 1). Then, over the second half of the year, growth slowed and this lower pace continued into 2019. https://www.rba.gov.au/speeches/2019/sp-gov-2019-05-21.html 1/16 5/21/2019 The Economic Outlook and Monetary Policy | Speeches | RBA Graph 1 There are a few factors that help explain this slowing in the global economy. The first is a slowdown in the Chinese economy. The Chinese authorities have for some time been seeking to address the build-up of risks in the financial system. As part of their efforts on this front they have sought to rein in shadow banking. The effect of this has been felt across their economy and, given the size of the Chinese economy, the impact has also been felt around the world. A second factor is a marked slowdown in international trade. Over the past year, global trade has not grown at all (Graph 2). This is unusual as, historically, global trade has tended to increase at least as fast as GDP. This recent weakness partly reflects the slowing in the Chinese economy, but the increases in US and Chinese tariffs are also a factor. Not surprisingly, it has flowed through into weaker conditions in the manufacturing sector around the world and there has been a disruption to some supply chains. Business investment, too, has been affected, with firms delaying investment decisions. In the face of increased uncertainty about future trade policy, many businesses have preferred to wait for a clearer picture. A cyclical downturn in the global electronics industry has also weighed on exports and investment, particularly in some east Asian economies. https://www.rba.gov.au/speeches/2019/sp-gov-2019-05-21.html 2/16 5/21/2019 The Economic Outlook and Monetary Policy | Speeches | RBA Graph 2 A third factor contributing to the slowdown in global growth has been a series of country-specific factors, including natural disasters in Japan, a new vehicle emissions testing regime in Germany and some extreme weather events. So, these are some of the key factors that have been at work. Looking forward, the global picture looks a little brighter and it is reasonable to expect that growth will strengthen a little later in the year. The Chinese authorities have responded to the slowing in their economy with measures to support economic activity. Globally, financial conditions are very accommodative and major central banks have signalled an easier monetary policy stance than was earlier expected. It is also reasonable to expect that the drag on growth from some of the country-specific factors that I mentioned will pass in time. Consumption growth in many economies also remains robust, supported by strong employment growth and rising wages. And notably, the weakness in the manufacturing sector has not spilled over in a material way to the services sector. All this means that the global economy appears quite resilient at the moment. The big uncertainty remains trade policy. A resolution of the current disputes would help boost trade flows and reduce some of the uncertainties facing businesses. In that case, we could expect a pickup in investment too. On the other hand, a failure to resolve the disputes represents a major downside risk to the global economy. So there is a lot riding on this issue. https://www.rba.gov.au/speeches/2019/sp-gov-2019-05-21.html 3/16 5/21/2019 The Economic Outlook and Monetary Policy | Speeches | RBA One other feature of the global economy that I would like to draw your attention to is the coexistence of low unemployment and low inflation. Unemployment rates in many of the major economies are the lowest they have been in many decades. At the same time, inflation remains low. While wages growth has picked up, inflation rates are mostly below 2 per cent and below the central banks' targets (Graph 3). Graph 3 This experience is the opposite to that of the 1970s and early 1980s. During that period, many countries experienced what became known as stagflation: the coexistence of high unemployment and high inflation. Today, the picture is very different: we have low unemployment and low inflation. This is obviously a much better configuration. Understanding why this has happened is a priority for us, as we too in Australia are experiencing something similar. We are still searching for the full answers, but the fact that the experience is common across so many countries suggests that there are some global factors at work. In my view, these are partly linked to changes in technology and to globalisation. Both of these affect perceptions of competition and they both are a source of uncertainty about the future. In turn, they are affecting pricing decisions across the world. https://www.rba.gov.au/speeches/2019/sp-gov-2019-05-21.html 4/16 5/21/2019 The Economic Outlook and Monetary Policy | Speeches | RBA We can't be sure how long these effects will last and whether the coexistence of low inflation and low unemployment is temporary, or whether it is a new normal. Whether or not it is permanent, the coexistence of low inflation and low unemployment does appear to be highly persistent. This persistence has led to a reassessment in a number of countries of the unemployment rate that is sustainable without inflation becoming a concern. This is an important issue and one I will return to in the context of Australian monetary policy. The Australian Economy I would first like to provide an update on the Australian economy. Just as the global economy slowed over the second half of 2018, so too did the Australian economy – we went from growing at an above-average pace in the first half of 2018 to a below-average pace in the second half (Graph 4). Graph 4 As has been the case globally, we had our own country-specific factors that have temporarily weighed on economic growth, including the drought and some disruptions to resource production and exports. More fundamentally, though, the main reason for the shift in momentum in the Australian economy is a slowdown in household consumption growth. Over the second half of 2018, household consumption increased by just ¾ per cent, which is an unusually soft outcome. https://www.rba.gov.au/speeches/2019/sp-gov-2019-05-21.html 5/16 5/21/2019 The Economic Outlook and Monetary Policy | Speeches | RBA The decline in housing prices is a factor here, but the more important factor is the long period of weak growth in household income (Graph 5). Over the past three years, household disposable income has increased at an average rate of just 2¾ per cent. This compares with an average of 6 per cent over the preceding decade. As this period of weak income growth has persisted, it has become harder for households to dismiss it as just a temporary development – as something that will pass quickly. The lower rate of income growth has also made it harder for households to pay down debt. The end result has been that many people have decided to adjust their spending plans. There was further evidence of this adjustment in the retail trade data for the March quarter. Graph 5 We are not expecting a quick turnaround in growth in consumer spending, but we are expecting a gradual improvement. This is largely on the basis of an expected pick-up in growth in household income, and a stabilisation of the housing market over the period ahead. We are expecting household disposable income to grow at an average rate of 4 per cent over the next couple of years, which is noticeably higher than the average of recent times. Stronger growth in income will help, but the more important factor is some tax relief. Over the past year, tax paid by households increased at a much faster rate than did income; almost 10 per cent, compared with 3¼ per cent – that is a big difference and it is unusual. We are not expecting it to continue for a couple of reasons. First, the tax offsets for low- and middle-income earners announced in the recent budget will boost disposable income. And second, it is likely that we will return to a more normal relationship between growth in incomes and tax paid. https://www.rba.gov.au/speeches/2019/sp-gov-2019-05-21.html 6/16 5/21/2019 The Economic Outlook and Monetary Policy | Speeches | RBA Our expectation is that the stronger growth in disposable income will flow through into household spending, although this will take some time. Looking beyond household spending, the outlook for the Australian economy is being supported by a number of other developments. The first is the ongoing investment in infrastructure. This investment is important. It is not only supporting demand in the economy at a time when this is needed, but it is also adding to the supply capacity of the economy and directly improving people's lives, including through a reduction in transport congestion. There is also strong growth in demand for a range of services, partly as a result of ongoing strong population growth. Another factor supporting growth is the recent lift in the terms of trade, which have continued to surprise on the upside, boosting our national income. The outlook for investment in the resources sector has also improved, due to both higher levels of sustaining capital investment and the commencement of some new projects. After five years of declining mining investment as LNG projects were completed, we are expecting an increase over the coming year (Graph 6). Non-mining business investment is also on an upward trend as firms invest in additional capacity. By contrast, investment in residential construction is likely to be a drag on the economy for the next few years. After six years of strong growth, residential construction is now declining and this is likely to continue for a while yet. https://www.rba.gov.au/speeches/2019/sp-gov-2019-05-21.html 7/16 5/21/2019 The Economic Outlook and Monetary Policy | Speeches | RBA Graph 6 In comparison with the GDP data, the labour market data over the past year have painted a stronger picture of the economy and have mostly surprised on the upside. More people have joined the labour market and job creation has been strong, with employment increasing by 2½ per cent over the year, compared with growth in the working-age population of 1¾ per cent. The unemployment rate has also declined over the past year (Graph 7). https://www.rba.gov.au/speeches/2019/sp-gov-2019-05-21.html 8/16 5/21/2019 The Economic Outlook and Monetary Policy | Speeches | RBA Graph 7 Recently, though, some labour market indicators have softened a little: the unemployment rate ticked up to 5.2 per cent in April; the underemployment rate has also moved a little higher as there are more part-time workers who are seeking additional hours; job advertisements have declined; and hiring intentions have come off their earlier highs. At the same time, the vacancy rate remains high, monthly employment growth remains firm and hiring intentions remain above average. Taking these various indicators together, the labour market continues to be resilient, although our expectation is that employment growth will slow to be broadly in line with growth in the working-age population. The other element of the labour market that I would like to comment on is wages. As the labour market has strengthened over the past year, wages growth in the private sector has picked up. By contrast, wages growth in the public sector has been steady at around 2½ per cent (Graph 8). Overall, though, wages growth remains lower than the rate that would appear consistent with inflation being comfortably within the target range. Even in New South Wales and Victoria – where the unemployment rates have averaged around 4½ per cent over recent times – wages growth has been running at just 2½ per cent. It would appear that some of the global factors that I mentioned earlier are working here as well. https://www.rba.gov.au/speeches/2019/sp-gov-2019-05-21.html 9/16 5/21/2019 The Economic Outlook and Monetary Policy | Speeches | RBA Graph 8 Putting these various elements together, our central scenario – as outlined in our recent Statement on Monetary Policy – is for the Australian economy to grow by 2¾ per cent over both 2019 and 2020 (Graph 9). As always, though, there is a range of uncertainty around this forecast. But the central outlook is for growth at around our estimate of potential growth in the Australian economy. Given this, over these two years the unemployment rate is forecast to be around 5 per cent. In 2021, the central forecast is for slightly better outcomes, partly due to a pick-up in the resources sector. https://www.rba.gov.au/speeches/2019/sp-gov-2019-05-21.html 10/16 5/21/2019 The Economic Outlook and Monetary Policy | Speeches | RBA Graph 9 It is worth pointing out that when preparing these forecasts, we used our normal technical assumption that interest rates would move broadly in line with market pricing. At the time the forecasts were prepared, market pricing implied that the cash rate was expected to decline to 1 per cent over the next year. If, instead, we had used an assumption of unchanged interest rates, the growth forecast would have been lower and the forecast for unemployment would have been higher. Turning now to inflation, the outcome for the March quarter was noticeably lower than we had expected. In year-ended terms, headline inflation was 1.3 per cent and in underlying terms it was around 1½ per cent (Graph 10). Looking through the details of the CPI, there appear to be only limited inflation pressures across much of the economy. The low rates of wages growth are contributing to relatively low rates of inflation in the services sector. Rent inflation is also the lowest it has been in decades. And various government initiatives to ease cost-of-living pressures are contributing to lower increases in many administered prices. Together, these factors have led to a low rate of inflation for non-traded goods and services (Graph 11). https://www.rba.gov.au/speeches/2019/sp-gov-2019-05-21.html 11/16 5/21/2019 The Economic Outlook and Monetary Policy | Speeches | RBA Graph 10 https://www.rba.gov.au/speeches/2019/sp-gov-2019-05-21.html 12/16 5/21/2019 The Economic Outlook and Monetary Policy | Speeches | RBA Graph 11 The picture for traded goods and services inflation is a little different. Recently, there have been increases in some food prices as a result of the drought and floods. The earlier small depreciation of the exchange rate has also been passed through into the prices for some consumer durables. These developments mean that tradables prices as a group are no longer declining. Even so, inflation remains low for most traded goods and services. Looking forward, the central forecast is for underlying inflation of around 1¾ per cent this year, 2 per cent next year and a little higher the following year. In headline terms, inflation is expected to be noticeably higher in the June quarter, due to the recent increase in petrol prices. For 2019 as a whole, headline CPI inflation is expected to be around 2 per cent and the same the following year. This means that inflation is expected to remain around the bottom of the medium-term target range over the forecast period. Monetary Policy I would like to turn now to monetary policy and how our thinking and communication have evolved over recent times. You might recall that through 2018 we had three main messages: (1) we were making progress towards our inflation and unemployment goals; (2) given that this progress was expected to continue, it was more likely that the next move in interest rates would be up, rather than down; and https://www.rba.gov.au/speeches/2019/sp-gov-2019-05-21.html 13/16 5/21/2019 The Economic Outlook and Monetary Policy | Speeches | RBA (3) given the progress towards our goals was expected to be only gradual, any move in interest rates was some time off. Earlier this year, our assessment of the balance of probabilities around the likely direction of the next move in interest rates shifted a little. At the Reserve Bank Board meeting in February, we assessed that the probabilities of an interest rate increase and a decrease had become more evenly balanced than they were through 2018. This shift reflected two developments. The first was the slowing in the Australian economy over the second half of 2018 that I just spoke about. And the second was the lower-than-expected inflation outcome for the December quarter. The main countervailing consideration was the labour market, which painted a stronger picture of the economy than the other indicators. In the face of these conflicting signals, we judged that the best approach was to hold interest rates steady while we obtained a clearer picture of the direction of the economy. It was relatively clear, though, that if the GDP data were giving the better signal – and the labour market eventually softened – lower interest rates would likely be appropriate. This was especially so in light of the ongoing low rate of inflation. This assessment was reflected in the minutes of the Board's April meeting, where we discussed a scenario in which there was a lack of progress on inflation and the unemployment rate trended higher. Following our April meeting, we received another reading on inflation, which confirmed that price pressures were subdued across the economy. Over the past year – and particularly in the past two quarters – inflation has come in lower than we expected and our inflation forecasts have been revised down. This is evident in Graph 12, which shows the forecasts a year ago, the actual outcomes and our current forecasts. In contrast to the subdued inflation outcomes, employment growth has been stronger than we expected a year ago. This can be seen in the right-hand panel. In most cases, when employment growth is stronger than expected, we expect to see an upside, not a downside, surprise on inflation. So, from this perspective, the recent experience is a little unusual. https://www.rba.gov.au/speeches/2019/sp-gov-2019-05-21.html 14/16 5/21/2019 The Economic Outlook and Monetary Policy | Speeches | RBA Graph 12 As the Board has sought to understand this experience and studied similar experiences overseas, we have been asking ourselves: what rate of unemployment is achievable in Australia without generating inflation concerns? Over recent years, the answer to this question was thought to be around 5 per cent – in other words, it was thought that an unemployment rate below 5 per cent was likely to put pressure on the supply capacity of the economy and, in turn, raise possible inflation concerns. But from today's perspective, I think we can do better than this. My judgement of the accumulating evidence is that the Australian economy can support an unemployment rate of below 5 per cent without raising inflation concerns. This would be consistent with the experience overseas, with many other advanced economies sustaining lower rates of unemployment than previously thought possible without leading to a noticeable uplift in inflation. If this judgement is correct, the question is: how does our society achieve and sustain a lower rate of unemployment? It is possible that the current policy settings are sufficient to deliver lower unemployment. The labour market has surprised on the upside over recent times, and it could do so again. While we can't rule out this possibility, the recent flow of data makes it seem less likely. In the event that the unemployment rate does not move lower with current policy settings, there are a number of options. These include: further monetary easing; additional fiscal support, including through spending on infrastructure; and structural policies that support firms expanding, investing https://www.rba.gov.au/speeches/2019/sp-gov-2019-05-21.html 15/16 5/21/2019 The Economic Outlook and Monetary Policy | Speeches | RBA and employing people. Relying on just one type of policy has limitations, so each of these is worth thinking about. The Reserve Bank Board recognises that monetary policy has a role to play here. Earlier today, we released the minutes of the Board's meeting two weeks ago. At that meeting, we discussed a scenario in which there was no further improvement in the labour market and the unemployment rate remained around the 5 per cent mark. In this scenario, we judged that inflation was likely to remain low relative to the target and that a decrease in the cash rate would likely be appropriate. A lower cash rate would support employment growth and bring forward the time when inflation is consistent with the target. Given this assessment, at our meeting in two weeks' time, we will consider the case for lower interest rates. Thank you for listening. I look forward to answering your questions. Endnote [*] I would like to thank Andrea Brischetto for assistance in the preparation of this talk. © Reserve Bank of Australia, 2001–2019. All rights reserved. https://www.rba.gov.au/speeches/2019/sp-gov-2019-05-21.html 16/16 | reserve bank of australia | 2,019 | 5 |
Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Reserve Bank Board Dinner, Sydney, 4 June 2019. | Philip Lowe: Today's reduction in the cash rate Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Reserve Bank Board Dinner, Sydney, 4 June 2019. * * * On behalf of the Reserve Bank Board, I would like to warmly welcome you to this community dinner. Thank you for joining us this evening. We value this opportunity to hear firsthand from you about the challenges and opportunities you face. I would also like to take advantage of the timing of this dinner to explain today’s decision on interest rates. As you would have heard already, earlier today the Reserve Bank Board decided to lower the cash rate by a quarter of a percentage point to 1¼ per cent. This decision comes after more than 2½ years in which we have held the cash rate steady. The last change was back in August 2016. At its core, today’s decision was taken to support employment growth and to provide greater confidence that inflation will be consistent with the medium-term target. I want to emphasise that the decision is not in response to a deterioration in our economic outlook since the previous update was published in early May. The economic outlook remains reasonable, with the main downside risk being the international trade disputes, which have intensified recently. The Australian economy is still expected to strengthen later this year, supported by the low level of interest rates, a pick-up in growth in household disposable income, ongoing investment in infrastructure and a brighter outlook for the resources sector. So today’s decision does not reflect a weaker outlook. Rather it reflects the fact that, even with the expected pick-up in growth, the Australian economy is likely to have spare capacity for a while yet. Today’s easing of monetary policy will help us make further inroads into that spare capacity. It will assist with faster progress on reducing unemployment and will help achieve more assured progress towards the inflation target. So that is our rationale. I know that many of you are likely to have questions about today’s decision. I would like to take this opportunity to provide answers to some of your probable questions. I am also happy to answer your other questions after my prepared remarks. The four questions that I thought it would be useful to answer are the following: 1. Why did the Board act today, after having held the cash rate steady for more than 2½ years? 2. Are there more interest rate reductions to come? 3. Should today’s reduction be fully passed through to mortgage rates? and 4. What about the savers – has the Board forgotten about them? First, why move now, after holding steady for so long? The answer is the accumulation of evidence. As you would expect, the Board is constantly sifting through masses of data and seeking to understand what are often conflicting signals about the economy. As we have gone about this task over recent times, there has been a progressive accumulation of evidence in support of two conclusions. The first is that inflation pressures are subdued and they are likely to remain so. And the second and related conclusion is that there is still significant spare capacity in the Australian labour market. The most recent batch of data has provided further evidence in support of both conclusions. The 1/4 BIS central bankers' speeches March quarter CPI was low and it was below expectations, as was the previous reading on inflation. In addition, the wage data for the March quarter confirmed that wages growth remains subdued, although it has picked up from a year ago. And the recent labour market report also confirmed that strong employment growth is not making material inroads into spare capacity in the labour market. The Board judged that the accumulation of this further evidence meant that it was now appropriate to adjust monetary policy. Given the importance of these two conclusions, I would like to elaborate a little on them and explore their implications. The subdued inflation pressures reflect a number of factors. These include slow growth in wages, increased competition in retailing, the adjustment in the housing market – with rents increasing at the slowest pace in decades – and various government initiatives to reduce the cost of living pressures on households. These factors are all putting downward pressure on prices and they are likely to remain with us for some time yet. Collectively, these factors have contributed to delayed progress in returning inflation to the 2– 3 per cent target range. In underlying terms, inflation has now been below 2 per cent for three years and the latest reading was 1½ per cent. Looking forward, inflation is still expected to increase, but it is unlikely to be comfortably within the 2–3 per cent range for some time yet. So the progress on returning inflation to target is more gradual than we had hoped. It is important to remember, though, that our inflation target is intentionally flexible and that the Australian economy has benefited from this flexibility over the past 25 years. The Board is aiming to ensure that Australia has an average inflation rate of between 2 and 3 per cent over time. The focus is on the average and the medium term. We have never sought to have inflation always between 2 and 3 per cent. The RBA adopted flexible inflation targeting before other central banks, and this flexibility has served us well. It has allowed the Board to set monetary policy so as best to achieve its broad objectives, with the ultimate aim of contributing to the economic prosperity and welfare of the people of Australia. It has also allowed the Board to look through temporary factors affecting inflation. This flexibility, however, is not boundless. The point of our inflation target is to provide a strong medium-term anchor that helps deliver low and stable inflation, which, in turn, is an important precondition to sustainable growth in employment and incomes. If inflation stays too low for too long, it is possible that inflation expectations move lower – that Australians come to expect sub2 per cent inflation on an ongoing basis. If this were to happen, it would be harder to achieve the medium-term inflation goal. So we need to guard against this possibility. Moving on to our conclusion about spare capacity in the labour market. For some years, most estimates of full employment, including our own, equated to an unemployment rate of around 5 per cent – it was thought that if unemployment went below that for too long, inflation would rise and become a problem. But, given the combination of the labour market and inflation outcomes we have seen of late, our judgement now is that we can do better than this – that we can sustain an unemployment rate of 4 point something. It is also worth noting that the supply side of the labour market is turning out to be more flexible than we had earlier expected. The recent evidence is that when jobs are there, more people join the labour force and other Australians stay in work longer. Reflecting this, the participation rate is currently at a record high, despite demographic shifts that we anticipated would reduce participation. It is also the case that people are prepared to work extra hours when there is strong demand for their labour. Together, these observations support the conclusion that there is still spare capacity in the labour market and this is likely to remain the case for a while yet. The recent data have given us more confidence in this assessment and we have responded to this. 2/4 BIS central bankers' speeches Over the past few years, one concern has been that lower interest rates could add to the medium-term risks facing the Australian economy as a result of high household debt. We need to keep a close eye on this issue, but this concern has receded recently. Lending practices have been tightened considerably and many lenders have become quite risk averse. The demand for credit has also slowed due to the changed dynamics of the housing market and slower income growth. So the risks on this front look to be less than they were previously. This brings me to the second question: are interest rates going to be reduced further? The answer here is that the Board has not yet made a decision, but it is not unreasonable to expect a lower cash rate. Our latest set of forecasts were prepared on the assumption that the cash rate would follow the path implied by market pricing, which was for the cash rate to be around 1 per cent by the end of the year. There are, of course, a range of other possible scenarios and much will depend on how the evidence evolves, especially on the labour market. If you accept the argument that a sustainably lower rate of unemployment in Australia is achievable, the question that we should all be thinking about is: how do we get there? It is possible that the current policy settings will be enough – that we just need to be patient. But it is also possible that the current policy settings will leave us short. Given this, the possibility of lower interest rates remains on the table. Monetary policy does have an important role to play and we have the capacity to play that role if needed. In saying that, I also want to recognise that monetary policy is not the only option. There are certain downsides from relying just on monetary policy and there are limitations on what, realistically, can be achieved. So, as a country, we should also be looking at other options to reduce unemployment. One option is for fiscal support, including through spending on infrastructure. This spending not only adds to demand in the economy, but it also adds to the economy’s productive capacity. So it works on both the demand and supply side. Another option is structural policies that support firms expanding, investing, innovating and employing people. All three options are worth thinking about. From my perspective, the best option is the third one – structural policies that support firms expanding, investing, innovating and employing people. A strong dynamic business sector is the best way of creating jobs. Structural policies not only help with job creation, but they can also help drive the productivity growth that is the main source of improvement in our living standards. So, as a country, it is important that we keep focused on this. I will now change tack and move to the third question: should today’s reduction in the cash rate be fully passed through to mortgage rates? My usual practice in answering this question has been to explain that there are a range of other factors that influence mortgage pricing, and then say ‘it all depends’. There are often reasonable explanations for why the standard variable mortgage rate does not move in lock-step with the cash rate. Today, though, I would like to break with my usual practice and provide a clearer answer. And that is: Yes, this reduction in the cash rate should be fully passed through to variable mortgage rates. This answer is based on recent reductions in bank funding costs. Not only have these costs declined as a result of the change in monetary policy, but they have also declined because of 3/4 BIS central bankers' speeches movements in market-based spreads. Last year, these spreads increased and most lenders responded by increasing their standard variable rates by around 15 basis points. Over recent months, these spreads have reversed all the increase that occurred last year and returned to their 2017 levels. The result is that there has been a substantial reduction – at both the short end and the long end – in the cost of banks raising funds in wholesale markets. Average rates on retail deposits have also come down. This means that the lower cash rate should be fully passed through into standard variable mortgage rates. Full pass-through would also mean that the economy receives the full benefit of today’s policy decision. That brings me to the final question: what about the savers, have we forgotten about them? I know this question is on the minds of a lot of Australians, especially older Australians. I am reminded of this daily as people write to me telling me how the already low deposit rates are affecting their income. I am expecting to receive more such letters and emails after today’s decision. The Board had a thorough discussion of this issue at our meeting today. We recognise that many Australians have saved hard and rely on interest from term deposits to support their income and spending. Today’s decision will reduce their income from this source and we understand why they would be disappointed with the outcome of today’s meeting. At the same time as paying close attention to this issue, the Board considered what was best for the overall economy. Our judgement is that lower interest rates will help the economy as a whole. At the moment, this benefit is likely to come mainly through two channels. The first is a lower value of the exchange rate than otherwise would have been the case. The second is a boost to the disposable income of the household sector. In aggregate, the household sector pays around two dollars in interest for every dollar it receives in interest income. So, in aggregate, lower interest rates reduce the net interest payments of the household sector and so boost overall disposable income. In time, we would expect the lower exchange rate and the boost to disposable income to lead to more jobs, lower unemployment and a stronger economy. This should benefit us all, although I recognise that in the short run the effects are felt unevenly across the community. It is partly because of this unevenness that I want to repeat a point I made in answering the second question. And that is: the best approach to delivering lower unemployment and a stronger economy is through structural policies that support firms expanding, investing, innovating and employing people. These policies can have distributional effects too, but the benefits are more broadly based. So, as I said, as we ease monetary policy, it is in the country’s interest that other policy options are considered too. That brings me to the end of my four questions and answers. I hope that this has helped you understand the Board’s thinking and why we took the decision today. I am happy to answer other questions that you might have. Thank you for listening and for joining us this evening. 4/4 BIS central bankers' speeches | reserve bank of australia | 2,019 | 6 |
Text of the 2019 Freebairn Lecture in Public Policy by Ms Luci Ellis, Assistant Governor (Economic) of the Reserve Bank of Australia, at the University of Melbourne, 12 June 2019. | Speech Watching the Invisibles Luci Ellis [ * ] Assistant Governor (Economic) The 2019 Freebairn Lecture in Public Policy University of Melbourne – 12 June 2019 It's great to be back at one of my alma maters to deliver the Freebairn Lecture in Public Policy. John Freebairn's extensive publication record and long history of contributions to public debate speak to his abiding interest in public policy across a broad range of areas. It is indeed an honour to be invited to speak as part of a lecture series named for him. My lecture tonight is motivated from the point of view of someone tasked with advising on the setting of monetary policy. In doing so, we should occasionally step back and consider how we think about what we are trying to achieve. It has long been known that the effects of monetary policy occur with a lag. Less appreciated is that some of the crucial concepts in our analysis are in some sense invisible and therefore not directly observable. So it can be a question of how we can even know if monetary policy is achieving its goals. So that is the focus of my talk tonight. Reserve Bank Act 1959 The objectives of monetary policy are given in the and further elaborated in the Statement on the Conduct of Monetary Policy. We have an inflation target. The Board is seeking to set monetary policy so that inflation averages between 2 and 3 per cent over the medium term. We are also charged with pursuing ‘full employment’, and contributing to the economic prosperity and welfare of the people of Australia. Taking the inflation target first, to know what to do we need to know what drives inflation and how monetary policy can influence those drivers. This is an issue of causal relations. There are many factors influencing the pricing decisions of firms and other participants in the economy. A core influence, however, is surely the balance of supply and demand or, in other words, the amount of spare capacity. When demand is strong and begins to outstrip supply, firms raise their prices. Taking this micro-level behavioural response up to the macro, economy-wide level, economists have often represented this dynamic as a relationship between inflation and unemployment (Graph 1). Graph 1 At first this graph looks like a random scatter of points with no real structure. Things become clearer when we connect the dots through time. There are a few short periods where inflation increases temporarily, even though I have used an inflation series that excludes ‘volatile items’, namely petrol, fruit and vegetables. Abstracting from those brief periods, we see two distinct down-sloping relationships – one with high inflation in the late 1980s, and one with much lower inflation that continues to the present day. Those two distinct phases are connected by a period where both unemployment and inflation declined. Observations of this shifting relationship, both here and abroad, spurred the economics profession to recast how they thought about it. The seminal intervention on this was Milton Friedman's presidential address to the American Economics Association in 1968 (Friedman 1968). Friedman argued that it was not a relationship between unemployment and inflation themselves. Rather, the connection concerned the gap between actual unemployment and a notion of full employment on the one side, and low or high inflation on the other. Inflation was high in the 1980s and lower more recently – even with lower unemployment – because that's what people expected. And if you wanted to lower unemployment, there was a limit to how far you could go without creating ‘surprise’ inflation. To keep unemployment below that limit, you would end up creating ever-higher inflation as people were no longer ‘surprised’ by its new higher rate. The rate of unemployment consistent with ‘full employment’ was the ‘non-accelerating inflation’ rate of unemployment, or ‘NAIRU’. unexpectedly According to this reasoning, the relationship between unemployment and inflation was therefore an ‘expectations-augmented Phillips Curve’, and it looked something like this: (actual inf lation − expected inf lation) = f (unemployment − N AI RU ) There was just one problem. There were things on both sides of this equation that you can't directly observe. Neither expected inflation nor the NAIRU can be directly measured. If this is really how we think the world works, it means making monetary policy on the basis of things that are invisible. Four Kinds of Invisible In grappling with this issue, I've found it helpful to categorise economic concepts and quantities according to how ‘visible’ they are: whether they can be directly observed, indirectly inferred, or neither. The easiest quantities to deal with are those that are directly observable. The price of the coffee many of you bought this morning was observable. So was its volume, if you had been inclined to measure that. There are many such quantities in economic life, including the current exchange rate between the Australian and US dollars, the most recent transacted price on an asset such as a particular house, the legal minimum wage, the interest rate charged on a particular loan, or my bank balance. A somewhat less straightforward set of concepts are those that aren't quite directly observable, but are measurable, perhaps with some effort. Often these are collective measures of related individual quantities that are not completely homogeneous. They include things like the unemployment rate or inflation. Individual employment statuses and individual prices can in principle be directly observed. But you have to make choices about how to combine those individual states into an economy-wide statistic. Harder still are the things that are unobservable but are inferable, because they can be detected indirectly. This might be because of the effect they have on something that is more easily observed. A good example here is the NAIRU – the rate of unemployment below which wages growth starts to pick up. You can't observe it directly, but you can guess that you are below it if wages growth is accelerating. Another kind of inferable is the subjective view someone has about an observable or measurable quantity. Expectations and forecasts fall into this category. You can't directly observe the expectation inside somebody's head, but you can ask about it. And because it's a belief about something more concrete, people should be able to elicit those beliefs. So the two unobservable things in our Phillips Curve are, at least in principle, inferable. But they aren't directly measurable and it is reasonable to expect that they might be estimated with considerable error. Finally, though, there are important economic concepts for which measurement can only be regarded as impossible. Sometimes this is because they are complete abstractions, where measurement depends entirely on an assertion that some observable thing is ‘really’ the abstract thing. Think of things like ‘social capital’, ‘ease of doing business’, or ‘animal spirits’. What are they, and how would you know if they are changing? Other impossible concepts include qualities of people's preferences or beliefs that they can't reasonably be expected to elucidate. These include time preference, risk preference, and elasticities of substitution. If a pollster called you tonight and asked you about your rate of time preference or the curvature of your utility function, could you tell them? Now, maybe you could elicit somebody's time preference or risk appetite indirectly by watching people's behaviour as circumstances changed. This is what we mean by ‘revealed preference’. But it's not something you can learn from them by asking. This feature distinguishes these concepts from the ‘inferable’ ones that I already mentioned. Invisibility and Public Policy If something is not fully observable, this has many implications for its role in public policymaking. This is true for any policy realm, whether it be health, education, defence, macroeconomic management or anything else. I suspect that many of these implications are underappreciated. The less visible something is, the harder it is to use as an objective of policy Most people would be familiar with the adage, originally a quote from Peter Drucker, ‘what gets measured gets managed’. Others frame the idea as ‘you become what you measure’. A whole industry of KPI design and dashboard creation has grown up to serve industry and government's needs to define objectives and hold people accountable for achieving them. But some things are hard to measure. And, indeed, the negative version of the statement – that ‘you can't manage what you can't measure’ is almost as popular as the positive framing. It is easy to measure a firm's leadership on meeting quantitative objectives such as sales, profits or staff turnover. It is much harder to measure many qualities that might matter more, like those leaders' judgement, ability to manage a crisis or inspire and engage staff. So it is with public policy. Concrete, measurable metrics are easier than abstractions. This is also true for the people charged with achieving the objectives as well as those holding them accountable. It is far easier to know if you are succeeding at a goal of reducing maternal mortality than a goal to foster social harmony, or indeed to preserve financial stability. That doesn't mean you shouldn't try to achieve these more abstract goals, but it does make it harder to know if you are on the right track. You might need to be a bit humbler about what is achievable. If objectives must be measured, not directly observed, some judgement is needed If an objective is measurable, but not directly observable, things are easier than if the objective must be inferred, let alone if it is a complete abstraction like ‘social harmony’ or ‘confidence’. But the way these ‘observables’ are measured is still a matter for judgement. Take the case of inflation as an example, where this is defined as the rate of change in prices of goods and services that households buy. To measure this, many different prices must be collected and combined into an index. A number of decisions need to be made. These include what prices to put in the index, how these prices should be collected, how they should be combined, and over what time period their rate of increase should be calculated. There are principles of good statistical practice that apply here, such as whether a particular approach yields an index that is representative, robust and verifiable. Other decisions will be shaped by what is feasible with current technology and resources. As more goods and services are sold online and not in stores, it becomes less costly to collect those prices. Supermarket scanners capture both price and quantity of goods sold at a highly granular level. This makes it easier for statistical agencies to combine prices according to current spending patterns rather than older patterns that might no longer be representative. Indeed, it is one of the developments that has helped reduce substitution bias in the CPI, giving the Bank and other stakeholders a more accurate view of current inflation pressures. This has complemented the improvement in this area coming from the Australian Bureau of Statistics' recent shift to updating the weights in the CPI more frequently than in the past. Sometimes, though, there is more than one right answer. For example, when measuring consumer price inflation, statistical agencies exclude asset prices, such as existing homes, because purchases of these are generally transfers between households. But there is a genuine choice to be made about whether to measure housing costs by imputing a rental payment to all households, as is done for the US measure of the CPI, or to do so using an ‘acquisition method’ to capture the cost of newly built homes, as in Australia's CPI. Measurement of objectives involves social licence Because of the need for judgement in measurement, use of a ‘measurable’ objective becomes a social process. The credibility of that objective is a form of social licence. This kind of social licence affects both the compiler of that measurement and those held accountable for achieving it. Often we hear claims that the cost of living is rising much faster than the actual inflation figures would imply. Part of this is a salience issue. There is longstanding literature showing that people are more likely to notice inflation in the prices of things they buy frequently, like groceries, than in things they purchase rarely, like cars, appliances or newly built homes. [1] And they notice certain prices, like petrol, more than the multiple prices of other things that add up to the same share of their budget, like pet food. People also tend to notice the big increases in a few prices more than they notice smaller increases, or even declines, in many prices. It's also the case that the price that people pay isn't necessarily the way the price is recorded in official statistics. This can also lead to misperceptions of the current inflation rate. In particular, if a firm starts selling a higher-quality good at the same price, this is recorded as a fall in prices. The faster computer, the car with more features, the project home with better appliances – these are all examples of this issue. But people won't necessarily perceive these as a fall in prices. The price they actually pay is the same. They're just getting more for it. These issues are all challenges for inflation measurement, but they're also challenges of communication for central banks. To meet this challenge, the best response is transparency. The inflation measure that the Bank is mandated to target is not, strictly speaking, a measure of the cost of living, but it is close to it. In practice, measures of increases in the cost of living are similar to CPI inflation (Graph 2). That similarity is important for social licence: if we are going to be mandated to target something, that target should be relevant to the welfare of the Australian people. Graph 2 Thus it is important for inflation-targeting central banks to be transparent about the nature of the target, how it relates to the prices people see in their daily lives, and how we interpret the various forces affecting inflation and the cost of living over time. Furthermore, it is important to be able to communicate those messages in a range of forums. Inferring the value of an invisible quantity amounts to assuming a particular theory is true When we move from the observables, like CPI inflation, to the inferables, like the NAIRU, even more issues arise. One is that inferring some invisible quantity from the behaviour of some more visible one amounts to an assertion that these things are related in a particular way. You are in essence asserting that a particular theory, a particular model of how the world works, is true. In the case of the NAIRU, at least, that assertion is based on reasonably solid grounds. The exact relationship might change over time, and the uncertainty of measurement might complicate things, but across many countries and many decades, there is a level of unemployment below which wages growth starts to pick up meaningfully. You can see when an economy has reached that point. That is all that the NAIRU is – the label we give to that point. The strength here is that the definition of the NAIRU is framed in terms of things that are more visible and measurable – actual unemployment and wages growth (and inflation). For other concepts, such as risk appetite or uncertainty, the connection to measurable quantities is far more nebulous. That is partly because the theory in these areas is less settled. Many inferable quantities are emergent properties of the system Taking the example of the NAIRU again, we should note that its precise value is not a number handed down from the heavens. It is an outcome. It is the result of individual decisions of a large number of workers and firms. Those decisions do not depend on people knowing the current level of the NAIRU, or even that such a thing exists. Rather, people make decisions about the level and rate of change in wages to offer; those decisions are presumed to relate in some systematic way to the state of the labour market. It really helps to think about the economics here, and specifically about the human behaviour aspect. Think about what is happening when a firm decides to offer a larger wage increase than before – or when workers successfully demand one. A firm might decide to offer higher wages if they can't find a suitable candidate at the current wage. It's easy to see why that decision might depend on the overall level of unemployment, because the unemployed represent an important part – though not the entirety – of the pool of potential candidates. That said, it's also easy to see why it might depend on other things as well. For example, it could depend on how well the skills of the candidate pool match the requirements of the jobs on offer, and on how easy it is to find those candidates. What this means is that the level of the NAIRU is an emergent property of the system. It is not baked in. It can change. In a number of advanced economies, it has indeed changed. The unemployment rate has reached multi-decade lows in several economies. Wages growth has been picking up for a while, suggesting that the unemployment rates in these countries are now below whatever their NAIRU is. But they also reached much lower levels of unemployment before this happened than they would have expected based on historical estimates of the NAIRU. Accordingly, official estimates of these countries' NAIRUs have declined (Graph 3). Graph 3 Invisible quantities relating to subjective beliefs or preferences are inherently harder to rely on than emergent system properties We can't directly observe the NAIRU – we don't know exactly where it is – but we can infer how far above or below it we are from the behaviour of wages growth and inflation. We can't even be sure if it is a sharp line or a more gradual and amorphous transition to a different state of the labour market. But at least we know when we have crossed that threshold. It is much harder to rely on our estimates of a subjective belief or preference, such as inflation expectations. How do we know if these have risen or fallen? How do we know where they sit relative to the target for inflation that the Bank has been charged with achieving? Well, we can keep asking people about their expectations, but this presupposes that the measures we have are capturing the views of the people whose decisions matter for economic outcomes. It also presupposes that the people we ask are telling the truth about their beliefs. And the fact that we are asking at all presupposes that people's expectations about this outcome even matter for the decisions they make. So it's no wonder that in economics, we make much of the usefulness of ‘revealed preferences’ – observing people's actions rather than asking their opinions. You can tell me how much you think a thing is worth, but you reveal your preference when you actually pay money for that thing. And in the case of financial market pricing, you reveal your beliefs about future inflation when you are prepared to stake money on the outcome. But your beliefs could still be biased, and they might not affect actual outcomes much, so some caution is warranted here. Trends are also invisible Much of economic forecasting and analysis is all about extracting signal from noise. It's about abstracting from the temporary bumps and one-offs that pervade economic data, and getting at the trend. The team at the Bank spends a lot of time trying to identify these one-offs – whether it's the effect of a cyclone on iron ore exports or the effect of petrol prices or policy changes on particular components of the CPI. For inflation, at least, there are established techniques for abstracting from outliers. Assessment of where the trend lies is especially important for forecasting. Our assessment of trend growth in productive capacity will affect our view of how quickly spare capacity might be absorbed. Our assessments of trend growth in the population and in productivity both affect our view of trend growth in productive capacity. And so on. You can bring data to bear on these questions. In the end, though, you also have to make a call about how fast trends can change. Again, that is complicated because the trend is invisible and has to be inferred. Given that much of my talk has used the NAIRU as an illustration of the issues surrounding invisibles, it's worth noting that another important, yet invisible, trend is the trend in inflation expectations, the other invisible in the Phillips Curve. There are many different measures of expectations, capturing different horizons of the future and the views of different groups in society. There will inevitably be both measurement noise and a variety of biases in these individual measures. It is important to cut through that noise and estimate a sensible measure of the trend. Again, both data and a judgement about the smoothness of that trend must be brought to bear on that assessment. When Invisibles are Consequential No matter what kind of invisible something is, there are clearly times when invisible things can be consequential. The NAIRU is the perfect example of this. The Bank's estimate of the level of the NAIRU is important for our assessment of the state of the economy and the appropriate stance of monetary policy. The unemployment rate is currently around the lowest it has been in recent decades. Only in the mid 2000s, in the midst of the mining boom, was unemployment lower than the 5 per cent rate that it reached late last year. In that previous episode, wages growth and inflation were picking up strongly and some parts of the economy showed signs of overheating. In contrast, wage and price pressures are low at present, even though unemployment is only a bit higher than during the mining boom. We infer from this that there is still spare capacity in the labour market. One might want to conclude that the reason wages growth has remained low is that some special factor is preventing it from increasing. There are all sorts of factors one might point to, including government wages caps, changes in competitive pressures or bargaining power, or increased feelings of job insecurity. And maybe they do matter separately from the level of the NAIRU. But a more comprehensive explanation – and in my view a more plausible one – is that the NAIRU is lower than it used to be, possibly because of some of these factors. So even though unemployment is low, the unemployment gap is still positive. This seems like a plausible explanation because we've already seen it happen elsewhere. As I already mentioned, official estimates of the NAIRU for other advanced economies have come down over the past decade. It seems reasonable to think that this could happen in Australia, too. The most basic way to infer the NAIRU is simply to observe actual unemployment, wages growth and inflation. For example, if wages growth is low and not picking up materially at the current unemployment rate, we infer that this rate is above the NAIRU; the NAIRU must be lower than wherever we are now. We can also use statistical models to make this assessment, but in essence these are just more sophisticated approaches for making the same comparison. The statistical model used by the Bank to estimate the NAIRU assumes that the unemployment gap affects inflation and wages growth in a consistent manner over time, but the NAIRU itself is allowed to vary over time. Similar models are used at other advanced economy central banks. There are judgements to be made about, for example, how smoothly and slowly you expect the NAIRU to change. There are technical decisions about exactly how you calculate a trend. But the model we use to estimate the NAIRU is broadly in line with those used elsewhere. We last published our standard statistical model for estimating the NAIRU in 2017 (Cusbert 2017). We have made some technical changes to the model since then. In particular, we have allowed for the possibility that the data have become less volatile since the 1980s. This is a known feature of the macroeconomic data, and allowing for this structural change means that we can be a bit more confident in our estimate for the more recent period. We have also refined our estimate of the trend in inflation expectations to better account for the biases in some of the survey measures that are inputs to it. The technical changes have not driven the recent change in our assessment, though: the data have. As new data on unemployment, wages and inflation is received, the Bank's estimates of the NAIRU can be updated. For example, if wages growth and inflation are lower than expected, a possible explanation is that the NAIRU was lower than previously thought and the unemployment gap was larger. Given the uncertainty of such an assessment, the NAIRU estimate would typically only move gradually in response to lower-than-expected wages or inflation. This very gradual adjustment of the NAIRU means that changes in the actual unemployment rate are generally a pretty good gauge of short-term movements in the unemployment gap. Larger revisions to NAIRU estimates can occur over a number of years. Over the past five years wages growth has been slower than would have been expected based on past behaviour. We have therefore gradually revised down the estimate of the prevailing NAIRU from 5¼ per cent a few years ago to 4½ per cent now. There is substantial uncertainty around our estimate of the NAIRU. First, there is uncertainty around the estimate of the NAIRU even when assuming this model of the relationship between wages, inflation and the unemployment gap is the best model. This is because even with the best choice of statistical approach, it is difficult to be precise about that relationship. The model estimates that there is a two-thirds chance that the current NAIRU is between 4 and 5 per cent, and a 95 per cent chance it is between 3½ and 5½ per cent (Graph 4). But given what we are seeing in the data, right now we feel comfortable about being a bit more specific than that. Graph 4 A second source of uncertainty around our current estimate is uncertainty about whether the model has been specified correctly. The main choice here is the economic variables to be explained by the unemployment gap and the ways the unemployment gap affects those variables. For instance, the model assumes that the unemployment gap affects unit labour costs growth and inflation in a nonlinear manner. That is, the inflationary effects of an unemployment rate below the NAIRU are larger than the disinflationary effects when the unemployment rate is above the NAIRU. A third source of uncertainty, as I've already mentioned, is that one of the inputs into this exercise – inflation expectations – are also unobservable. The more uncertain our assessment of inflation expectations, the less confident we can be in our assessment of the NAIRU. The more sensitive we think inflation expectations are to recent inflation outcomes, the less the NAIRU would move. Put another way, if we thought the recent period of low inflation had resulted in expectations becoming de-anchored, we would conclude that the NAIRU was higher than we currently think. A fourth source of uncertainty is that we are necessarily estimating the NAIRU on the presumption that it moves fairly slowly. As a consequence, as new data come in, it doesn't just change our estimate of the latest value of the NAIRU. It can also affect the recent past. This ‘end-point’ problem means that our prior estimates will be revised. A year or so ago, we were saying that we thought the NAIRU was around 5 per cent. The point estimate at the time was rounding to 5 per cent. Given the uncertainties in estimation, it is probably best to talk in round numbers. So that is what we did. With the benefit of the incoming data, not only has the estimate for the current value of the NAIRU changed, but so has that for the recent past (Graph 5). This sensitivity of the past to subsequent data is called the ‘end-point’ problem. It is a generic problem with many kinds of trend extraction procedures, and it is a reason to be cautious about over-interpreting the latest estimate. Graph 5 Interpreting the Invisible The NAIRU is estimated to have declined over the past 40 years. Simple observation of the data also supports this conclusion. But our usual methods for estimating the NAIRU don't tell us why that happened. They are statistical methods, so they are simply not designed to explain changes in the NAIRU, only to identify those movements. We must instead seek to understand the causes by using other information about the labour market, such as the composition of unemployment. One way to think about this question is to think of the NAIRU as capturing the types of unemployment that would remain, even when there is no spare capacity in the labour market and inflation is sustainably at target. For example, there would still be some frictional unemployment; the people who are ‘between jobs’ for a short time. The short-term unemployment rate – the share of the labour force who have been unemployed for four weeks or less – should be a good proxy for this. Short-term unemployment has declined slowly since the mid 1990s (Graph 6). This suggests that frictional unemployment may have declined and the labour market has become more efficient at matching workers and jobs. It isn't hard to imagine that the shift to online job advertising has had something to do with this. So there's one reason why the NAIRU might be lower nowadays. Graph 6 The textbooks also talk about ‘structural unemployment’ as being part of the NAIRU. These are the people who for a variety of reasons cannot find any kind of job at prevailing wage rates. This might be because they lack the appropriate skills, or they have caring responsibilities, disabilities, or other circumstances that make it hard to find a suitable position. The long-term unemployment rate is a good proxy for this concept. People who have been unemployed for more than a year are much less likely to find a job (and to keep it) than people whose unemployment spell is much shorter. Here, too, we see evidence supporting the idea that the NAIRU has fallen. Long-term unemployment has also declined substantially since the early 1990s. It increased a bit around the end of the mining investment boom. More recently, though, it has fallen for those who have been unemployed for more than one year but less than two. However, the share of the labour force who have been unemployed for two years or more has not declined in the same way. Finding explanations for the decline in one-to-two-year unemployment is a bit less straightforward than for the short-term variety. It might be that increasing flexibility in job design makes it easier for some people to combine work with caring responsibilities, or for firms to accommodate workers with disabilities. But perhaps more importantly, it might well be that when labour markets are tight, firms start seeing more people as employable. The labour market literature is full of discussion of the problem of ‘hysteresis’, or path-dependence, where the scarring experience of unemployment damages people's future employment prospects. In this way, higher unemployment begets a higher NAIRU. In my observation, this process can also go the other way: when labour markets tighten progressively, previously long-term unemployed people are given a go. This helps them build up skills and experience that improves their future employment prospects. Policies to reduce barriers to employment might help here. But probably the single most effective policy would be to run the labour market a bit tighter so that there are more jobs to be filled. Could we look back in a few years and realise that the NAIRU is even lower than we thought today? There's no way to know for sure until we get there, but I can't rule it out. And if that turns out to be the case, that would be an excellent outcome. It would mean that more people were in jobs. It would probably mean that the long-term unemployment rate has fallen further. Both of these factors would mean that fewer people were facing the kinds of disadvantage and economic exclusion that long-term unemployment can involve. The Implications of the Invisible I'd like to conclude by drawing two main lessons from this journey amongst the invisibles. First, many things that society takes to be important are in some sense invisible. They might be valued in their own right, like financial stability or social harmony. Or, like the NAIRU, they might be something important to our understanding of how the world works and how we can achieve our goals. Their invisibility makes it harder to conduct policy, and to know if we are on the right track, but it doesn't make it impossible, so we should still try. Second, and more specific to our monetary policy mandate, as the data have unfolded, it has become apparent that the unemployment rate that Australia can feasibly sustain is lower than it has been in at least the past 40 years. This is great news. Along with low and stable inflation, one of the Bank's mandates is full employment. If it turns out that full employment is even ‘fuller’ than we thought, getting there would be a real contribution to our third mandate, the economic prosperity and welfare of the Australian people. The level of unemployment consistent with full employment might be an invisible, but it is crucial. If Australia truly can have lower unemployment – sustainably – policy should be used to try to get there. As the Governor explained last week, that was one important consideration motivating the Board's recent decision to lower the cash rate. Thank you for your time. Endnotes [*] This talk has benefited from the work and helpful assistance of Natasha Cassidy, Blair Chapman, Ewan Rankin, Mike Read and Dan Rees. See, for example, Trehan (2011), Georganas, Healy and Li (2014), and, closer to home, Ballantyne This might not surprise John, who has published research showing that equilibrium unemployment (not quite the same concept as the NAIRU) can change, and relates those changes back to the more micro-level behaviour of the flows into and out of unemployment. (Dixon, Freebairn and Lim 2007). et al (2016). Bibliography Ballantyne A, C Gillitzer, D Jacobs and E Rankin (2016), ‘Disagreement about Inflation Expectations’, RBA Research Discussion Paper No 2016-02. Cusbert T (2017), ‘Estimating the NAIRU and the Unemployment Gap’, RBA Bulletin, June, pp 13–22. Dixon R, JW Freebairn and G Lim (2007), ‘Time-Varying Equilibrium Rates of Unemployment: An Analysis with Australian Data’, , 10(4). Australian Journal of Labour Economics Friedman M (1968), ‘The Role of Monetary Policy’, American Economic Review, 58(1), pp 1–17. Georganas S, PJ Healy and N Li (2014), ‘Frequency bias in consumers' perceptions of inflation: An experimental study’, , 67(1), pp 144–158. European Economic Review Trehan B (2011), ‘Household Inflation Expectations and the Price of Oil: It's Déjà Vu All Over Again’, , 2011(16). of San Francisco Economic Letter Federal Reserve Bank © Reserve Bank of Australia, 2001–2019. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. | reserve bank of australia | 2,019 | 6 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to a Committee for Economic Development of Australia (CEDA) Event, Adelaide, 20 June 2019. | Speech The Labour Market and Spare Capacity Philip Lowe [ * ] Governor Address to a Committee for Economic Development of Australia (CEDA) Event Adelaide – 20 June 2019 I would like to thank CEDA for the invitation to address this lunch. It is a great pleasure to be back in Adelaide and to participate in another CEDA event. Those of you who follow the RBA closely would have noticed frequent references to the labour market in our recent communication. Today, I would like to explain why this is so and also discuss how we assess the amount of spare capacity in the labour market. I will then finish with some comments on monetary policy. The Broad Policy Framework Reserve Bank Act Students of central bank history would be aware that the was passed by the Australian Parliament in 1959 – 60 years ago. In terms of monetary policy, the Parliament set three broad objectives for the Reserve Bank Board. It required the Board to set monetary policy so as to best contribute to: i. The stability of the currency ii. The maintenance of full employment iii. The economic prosperity and welfare of the people of Australia These objectives have remained unchanged since 1959. Here, in Australia, we did not follow the fashion in some other parts of the world over recent decades of setting just a single goal for the central bank – that is, inflation control. In my view it was very sensible not to follow this fashion. Our legislated objectives – having three elements – are broader than those of many other central banks. The third of our three objectives serves as a constant reminder that the ultimate objective of our policies is the collective welfare of the Australian people. From an operational perspective, though, the flexible inflation target is the centre piece of our monetary policy framework. The target – which has been agreed to with successive governments – is to deliver an average rate of inflation over time of 2–3 per cent. Our focus is on the average and on the medium term. Inflation averaging 2 point something constitutes a reasonable definition of price stability. Achieving this stability helps us with our other objectives. Low and stable inflation is a precondition to the attainment of full employment and it promotes our collective welfare. As I have said on other occasions, we are not targeting inflation because we are inflation nutters. Rather, we are doing so because delivering low and stable inflation is the most effective way for Australia's central bank to promote our collective welfare. So where does the labour market fit into all this? The answer is that it is central to all three objectives. The connection with the second objective – full employment – is obvious. The RBA is seeking to achieve the lowest rate of unemployment that can be sustained without inflation becoming an issue. In doing this, one of the questions we face is what constitutes full employment in a modern economy where work arrangements are much more flexible than they were in the past. I will return to this issue in a moment. The labour market is, of course, also central to the third objective in our mandate – our collective welfare. It is stating the obvious to say that for many Australians, having a good job at a decent rate of pay is central to their economic prosperity. Trends in the labour market also have a major bearing on inflation outcomes, so they are important for the first element of our mandate as well. Over time, there is a close link between wages growth and inflation. And a critical influence on wage outcomes is the balance between supply and demand in the labour market; or in other words how much spare capacity is there in the labour market? This question is closely linked to the one about what constitutes full employment. So, it is natural that we focus on the labour market as the Board makes its monthly decisions about interest rates. Spare Capacity With that background I would now like to discuss how we assess the degree of spare capacity in the Australian labour market. I will do this from four perspectives: 1. The rates of unemployment and underemployment 2. The flexibility of labour supply 3. The effectiveness with which people are matched with job vacancies 4. Trends in wages growth. Unemployment and underemployment The conventional measure of spare capacity in the labour market is the gap between the actual unemployment rate and the unemployment rate associated with full employment. Even at full employment, some level of unemployment is to be expected as workers leave jobs and search for new ones. As my colleague Luci Ellis discussed last week, we don't directly observe the unemployment rate associated with full employment – we need to estimate it. [1] Over recent times there has been a gradual accumulation of evidence which has led to lower estimates. While it is not possible to pin the number down exactly, the evidence is consistent with an estimate below 5 per cent, perhaps around 4½ per cent. Given that the current unemployment rate is 5.2 per cent, this suggests that there is still spare capacity in our labour market. The fact that the conventional estimate of spare capacity is based on the unemployment rate reflects an implicit assumption that if you have a job you are pretty much fully employed. In decades past, this might have been a reasonable assumption. But it is not a realistic assumption in today's modern flexible labour market. As more people work part time, it has become increasingly common to be both employed and to work fewer hours than you want to work. In the 1960s, less than one in ten workers worked part time (Graph 1). Today, one in three of us works part time. Almost one in two women work part time and more than one in two younger workers work part time. Graph 1 A few more facts are perhaps helpful here. According to the ABS, around 3 million people work part time because they want to, not because they can't find a full-time job. Most people who are working part time do so because they are studying or have caring responsibilities, or for other personal reasons. So we should not think of part-time jobs as being jobs, and full-time jobs as being bad good jobs. Rather, one of the success stories of the Australian labour market is that we have been able to accommodate this desire for part-time work and flexibility. Having said that, around one-quarter of people working part time are not satisfied with the hours they are offered and would like to work more hours: we can think of these people as underemployed (Graph 2). The share of part-time workers who are underemployed moves up and down from year to year, and the current share is above its average level over the past two decades. Graph 2 As part of the ABS's monthly survey of 50,000 people, it asks underemployed workers how many extra hours they would like to work. On average, they answer that they would like to work an extra 14 hours per week. It is interesting that this figure has trended down over the past two decades; it used to be more than 16 hours. Over the same period, the average hours worked by part-time workers has increased by around 2 hours to 17 hours per week. Taken together, these data suggest that businesses are doing a better job of providing the hours that part-time workers are seeking. This shift to part-time work means that in assessing spare capacity we need to consider measures of underemployment as well as measures of unemployment. The RBA has been doing this for some time. As part of our efforts here, we have constructed a measure of underutilisation that takes account of the part-time workers who want to work more hours. This measure adds the extra hours sought by these workers to the hours sought by those who are unemployed (Graph 3). [2] These extra hours are equivalent to around 3.3 per cent of the labour force, which, taking account of conventional unemployment, means that the underutilisation rate is 8.1 per cent. This hours-based measure is preferable to heads-based measures of underutilisation that treats an unemployed person in the same way as a part-time worker seeking a few more hours. Graph 3 Unlike the unemployment rate, which has trended down over the past 20 years, the underemployment rate has been relatively stable. These different patterns in unemployment and underemployment suggest that fewer inroads have been made into spare capacity in the labour market than suggested by looking at the unemployment rate alone. This is something we take into account in thinking about monetary policy. There is, though, one other perspective on the measure of underemployment that I would like to share with you. In the past, when part-time work was not as readily available, many people – mostly women – faced the choice of taking full-time paid employment or no paid employment at all. Many chose to, or had to stay outside the labour force because working was not a realistic option. From the perspective of society as a whole, this was a serious form of underutilisation – it just wasn't measured as such by the ABS. Given the trend towards part-time and more flexible jobs, people have more options than they had before and many have chosen to join, or have deferred leaving, the labour force. [3] From the perspective of adding to the productive capacity of the nation, this is a good outcome and if there was a measure of underutilisation that took account of exclusion from the workforce, it would surely have declined. I don't want to downplay the issue of underemployment, but it is worth recognising this broader perspective, and remembering where we have come from. Flexibility of the supply side This naturally brings me to my second window into spare capacity in the labour market – the flexibility of labour supply. Over the past 2½ years, the working-age population has increased at an annual rate of around 1¾ per cent. Over that same time period, employment has increased at an average rate of 2¾ per cent. The fact that employment has been increasing considerably faster than the workingage population has led to a reduction in the unemployment rate, but the reduction is not as large as might have been expected. The reason for this is that the supply of labour has increased in response to the stronger demand for workers. This flexibility in labour supply is evident in the substantial rise in labour force participation. The participation rate currently stands at 66 per cent, which is the highest on record (Graph 4). Reflecting this, the share of the working-age population in Australia with a job is currently around the record high it reached at the peak of the resources boom. As I discussed a few moments ago, the availability of part-time and flexible working arrangements is one reason for this. Graph 4 There are two groups for which the rise in participation has been particularly pronounced: women and older Australians (Graph 5). The female participation rate now stands at 61 per cent, up from 43 per cent in 1979. Australia's female participation rate is now above the OECD average, although it remains below that of a number of countries, including Canada and the Netherlands. The participation rate of older workers has also increased over recent decades as health outcomes have improved and changes have been made to retirement policies. The eligibility age for the pension was progressively raised from 60 to 65 for females and is now being gradually increased to 67 for everybody by 2023. The preservation age at which individuals can access their superannuation is also being gradually increased. These changes are contributing to higher participation by older Australians. Graph 5 Another source of potential labour supply is net overseas migration. Migration, including temporary skilled workers, increased sharply during the resources boom when demand for skilled labour was very strong, and has subsequently declined (Graph 6). While migrants add to both demand and supply in the economy, they can be a particularly important source of capacity for resolving pinchpoints where skill shortages exist. Graph 6 A related source of flexibility stems from our unique relationship with New Zealand. When labour demand is relatively strong in Australia, there tends to be an increase in the net inflow of workers from New Zealand to Australia. When conditions are relatively subdued here, the reverse occurs. During the resources boom, the inflow from across the Tasman was as large as the inflow of temporary skilled workers. The overall picture here is one of a flexible supply side of the labour market. When the demand for labour is strong, more people enter the jobs market or delay leaving. This rise in participation is a positive development. But it is one of the factors that has meant that strong demand for labour has not put much upward pressure on wages. The matching of people with jobs A third perspective on spare capacity in the labour market can be gained from examining how well people looking for jobs are matched with the jobs that are available. Looking at the labour market from this perspective, things look a little tighter than suggested by the other two perspectives that I have discussed. Currently, almost 60 per cent of firms report that the availability of labour is either a minor or a major constraint on their business (Graph 7). This share is not as high as it was during the resources boom, but it is still quite high. Reports from the RBA's liaison program suggest that there are currently shortages of certain types of engineers, workers with specialised IT skills and some tradespeople associated with public infrastructure work. Businesses in regional areas are also more likely to report a greater degree of difficulty finding suitable labour. Graph 7 One contributing factor here is an underinvestment in staff training. In the shadow of the global financial crisis many firms cut back training to reduce costs. We are now seeing some evidence of the adverse longer-term implications of this. As the labour market tightens further, I would hope that more firms are prepared to hire workers and provide the necessary training. Another lens on job matching is the ratio of the number of unemployed people to the number of job vacancies (Graph 8). At present, there are fewer than three unemployed people for each vacancy. This compares with over 20 people for every vacancy in the early 1990s recession and five people for every vacancy in 2014. From this perspective the labour market looks reasonably tight. There is also some tentative evidence that, on average, unemployed workers are not as well matched to job vacancies as was the case in 2007, when the ratio of the two was at a similar level. Graph 8 One such piece of evidence is that as the unemployment rate has come down over recent years, there has been little progress on reducing very long-term unemployment, defined as those who are unemployed for more than two years (Graph 9). Addressing the causes of this chronic unemployment remains an important challenge for our community. More positively, the share of the labour force that has been unemployed between one and two years has trended down over recent times. Graph 9 Another lens on job matching and the overall tightness of the labour market is the rate of job mobility; that is, how often people change their jobs. Here, the evidence is interesting. Despite the frequent reports of a lack of job security and regular job switching by millennials, the average time that workers are staying with an employer is increasing. Reflecting this, the share of employed people who switch employers in a given year is the lowest it has been in a long time (Graph 10). Looking at the data by occupation, the rate of job mobility is lowest for managers and business professionals and highest for tradespeople and workers in the hospitality industry. Graph 10 In a tight labour market, we would expect to see either strong wages growth or frequent job changing as businesses seek out workers. But we are seeing neither at present. One possible explanation for this is the uncertainty that many people feel about the future. This uncertainty means that if you have a job you want to keep it rather than take a risk with a new employer. This might be especially so if you also have a large mortgage. So it is possible that the high level of household debt is also affecting labour market dynamics. Wages I will now turn to the fourth perspective on labour market tightness – that is wages growth. Over the past year, wages growth has picked up as the labour market tightened. This is not surprising given the strength of demand for labour. But the pick-up has been fairly modest and is only evident in the private sector (Graph 11). Over the past year, the private-sector Wage Price Index increased by 2.4 per cent, up from 1.9 per cent in the previous year. The past two quarters have, however, seen lower wage increases than in the previous two quarters. In contrast to trends in the private sector, wages growth in the public sector has been steady at around 2½ per cent, largely reflecting the wage caps across much of the public sector. It is also worth pointing out that overall wages growth in New South Wales and Victoria has been running at just 2½ per cent despite the unemployment rate being 4½ per cent or lower over the past year. Graph 11 Another perspective on wages growth is from the national accounts, which reports average earnings per hour worked (Graph 12). This measure is volatile, but the latest data painted a fairly weak picture, with average hourly earnings up by just 1 per cent over the past year. Graph 12 In summary, the overall picture from these various windows into the labour market is that despite the strong employment growth over recent times, there is still considerable spare capacity in the labour market. We remain short of the unemployment rate associated with full employment, there is significant underemployment and there is further potential for labour force participation to increase when the jobs are there. Consistent with all of this, wages growth remains modest and is below the rate that would ensure that inflation is comfortably within the 2 to 3 per cent range. The one caveat to this assessment is the difficulty that some firms are having finding workers with the necessary skills. This underlines the importance of workplace training. Monetary Policy I would like to finish with a few words on monetary policy. As you are aware, the Reserve Bank Board reduced the cash rate to 1¼ per cent at its meeting earlier this month. This was the first adjustment in nearly three years. This decision was not in response to a deterioration in the economic outlook since the previous update was published in early May. Rather, it reflected a judgement that we could do better than the path we looked to be on. The analysis that I have shared with you today supports the conclusion that the Australian economy can sustain a higher rate of employment growth and a lower unemployment rate than previously thought likely. Most indicators suggest that there is still a fair degree of spare capacity in the economy. It is both possible and desirable to reduce that spare capacity. Doing so will see more people in jobs, reduce underemployment and boost household incomes. It will also provide greater confidence that inflation will increase to be comfortably within the medium-term target range. Monetary policy is one way of helping get us onto to a better path. The decision earlier this month will assist here. It will support the economy through its effect on the exchange rate, lowering the cost of finance and boosting disposable incomes. In turn, this will support employment growth and inflation consistent with the target. It would, however, be unrealistic to expect that lowering interest rates by ¼ of a percentage point will materially shift the path we look to be on. The most recent data – including the GDP and labour market data – do not suggest we are making any inroads into the economy's spare capacity. Given this, the possibility of lower interest rates remains on the table. It is not unrealistic to expect a further reduction in the cash rate as the Board seeks to wind back spare capacity in the economy and deliver inflation outcomes in line with the medium-term target. It is important though to recognise that monetary policy is not the only option, and there are limitations to what can be achieved. As a country we should also be looking at other ways to get closer to full employment. One option is fiscal policy, including through spending on infrastructure. Another is structural policies that support firms expanding, investing, innovating and employing people. Both of these options need to be kept in mind as the various arms of public policy seek to maximise the economic prosperity of the people of Australia. Thank you for listening. I would be happy to answer your questions. Endnotes [*] I would like to thank Natasha Cassidy, Blair Chapman and Ewan Rankin for assistance in the preparation of this talk. Ellis L (2019), ‘Watching the Invisibles’, The 2019 Freebairn Lecture in Public Policy, University of Melbourne, 12 June. The ABS also produces a similar ‘volume’ measure of underutilisation with a much shorter history. For more on trends in workplace flexibility and the rise in part-time work see Heath A (2018), ‘The Evolving Australian Labour Market’, Speech at the Business Educators Australasia 2018 Biennial Conference, Canberra, 5 October. © Reserve Bank of Australia, 2001–2019. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. | reserve bank of australia | 2,019 | 6 |
Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Darwin Community Dinner, Darwin, 2 July 2019. | Philip Lowe: Remarks at Darwin Community Dinner Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Darwin Community Dinner, Darwin, 2 July 2019. * * * Good evening. A very warm welcome to this community dinner with the Reserve Bank Board and senior staff. This morning the Board held its monthly meeting here in Darwin. We were very kindly hosted at the Northern Territory Parliament building. The last time the Board met in Darwin was more than 50 years ago. I am sure that we all agree that this was too long ago. I can promise that you will be seeing more of us over the years ahead. This evening I would first like to talk a little about our history in the Northern Territory and how things have changed and then talk about today’s interest rate decision. The previous Board meeting in Darwin was held on 5 June 1968. The Board met here to celebrate the opening of the RBA’s new branch on Bennett Street. We operated out of this building for around 30 years, distributing banknotes and providing banking services to the Northern Territory Government. But beyond this, as many of you will know, the building on Bennett Street has played an important role in the history of Darwin. It was one of the few buildings that was virtually unscathed by the fury of Cyclone Tracy in 1974. This meant that in the aftermath of Tracy, we were able to make our banking chamber available to the police to use as their emergency coordination and communications centre. In some ways this experience symbolises the RBA itself. We build on strong foundations, we place great weight on stability and resilience, and we seek to serve the public interest. Our presence here in Darwin did all this. I am very pleased to see that the building is still serving the public interest as the location of Tourism Top End. In preparation for our meeting today, I looked back at our archives for details of the meeting in 1968, including the Minutes of that meeting, which I am glad to be releasing today. That meeting was the second last for Governor Nugget Coombs before he retired. Reading this archival material reminded me of how much the world has changed. One obvious change is in the way that monetary policy works. The main decision made by the Board at that meeting back in 1968 was that Dr Coombs recommend to the Treasurer that he adjust the interest rates on trading bank fixed deposits and saving bank deposits by a quarter of a per cent. From today’s perspective, this is remarkable on two levels. First, the RBA was just making a recommendation to the government – this was obviously before the days of central bank independence. Second, monetary policy was exercised partly through direct controls on bank deposit rates. So, it was a very different world. Today, the Board makes its decisions independently of government and we don’t directly control bank interest rates for households and businesses. Another difference that struck me was the way the Board worked and its approach to risk management. In 1968, the Board was made up of nine men; no women at all. This is very different from our Board today. In 1968, the Board also took advantage of the trip to Darwin to make a one-week tour of northern Australia, visiting Gladstone, Weipa, Gove, Kununurra, the Ord River, Dampier, Mt Tom Price and Alice Springs. Almost the entire Board travelled together on a private chartered plane. Today, our risk management guidelines wouldn’t allow this. They don’t allow us to travel all together and we certainly don’t take private planes. And unfortunately, the demands of today’s globalised world make such an extensive trip very difficult in 2019. 1/4 BIS central bankers' speeches One other area where there has been much change since the Board last met here is in the relationship between the Original people of this land and the wider Australian community. In his last months as Governor of the Reserve Bank, Nugget Coombs began work as Chair of the Council for Aboriginal Affairs. The Council was established by Prime Minister Harold Holt after the 1967 referendum. Coombs worked tirelessly for almost three decades advocating for Indigenous rights and social justice. He was a strong advocate of land rights and encouraging pride in the identity of Indigenous Australians. He cared passionately about their welfare and the preservation of cultural values and traditions. Over the years, Nugget Coombs developed a particularly strong relationship with the people of Arnhem Land, especially with the Yolngu around Yirrkala. You might recall that they were responsible for the Yirrkala bark petitions submitted to the Australian Parliament in 1963. The Yolngu wanted to be consulted as the traditional custodians of the land before the government granted mining rights. These petitions were an important step towards the native title rights that exist today. Coombs travelled to Yirrkala many times, the first time being shortly before the Board met here in 1968. He wanted the interests of the community to be recognised and was looking for ways that its members could benefit from the new bauxite mine at Gove. Tomorrow, I will have the great honour of being able to travel to East Arnhem Land and Yirrkala just as Nugget Coombs did. I am incredibly pleased to be accompanied on this trip by Susan Moylan-Coombs. Susan was born in Darwin and is part of the group known today as the Stolen Generations and was adopted by Nugget’s oldest son, John, and John’s wife, Jan. Susan is continuing her Grandfather’s work as a tireless advocate for the welfare and prosperity of Indigenous Australians. We will be accompanied by two members of the Reserve Bank Board: Phil Gaetjens, who is also Secretary of the Australian Treasury, and Catherine Tanna, who is also Chief Executive of Energy Australia. We are all greatly looking forward to the visit. We want to pay our respects to the traditional owners of the land and to learn from their wisdom. We will also unveil a plaque to Nugget Coombs, whose ashes are buried both at Yirrkala and the Australian National University in Canberra, which he helped found in 1946. I am hopeful that our visit will help keep alive the long relationship between the RBA and the people of East Arnhem Land. Turning back to today’s Board meeting, we had a thorough discussion of the Northern Territory economy. We discussed the difficulties that you have faced as investment has fallen following the completion of the LNG plant. The effects of this decline in investment are evident right across the economy: in the housing market; in retail spending; in the labour market; and in public sector finances. As we reviewed these indicators, though, we were struck by the fluidity of the labour market and the population here in the Northern Territory. Despite employment falling significantly over the past year, the unemployment rate remains below the national rate. At our Board meeting we also discussed the future opportunities facing the Northern Territory economy, including in the areas of defence infrastructure, tourism, the cattle industry, and in minerals and gas. In addition, we considered the progress that has been made in addressing the sources of disadvantage for Indigenous Australians. There are many areas where Nugget Coombs would have been pleased to see the progress that has been made. But, regrettably, there are too many areas where not enough progress has been made and where the progress has been too slow. I would now like to turn to today’s interest rate decision. As I am sure you are aware, this morning the Board decided to reduce the cash rate by a quarter of a percentage point to 1 per cent. This follows a similar adjustment last month. This easing of monetary policy will support jobs growth across the country and provide greater confidence that inflation will be consistent with the medium-term target of 2 to 3 per cent. Our assessment is that despite the Australian economy having performed reasonably well over 2/4 BIS central bankers' speeches recent years, there is still a fair degree of spare capacity in the economy. It is both possible and desirable to reduce that spare capacity. We should be able to achieve a lower rate of unemployment than we currently have and we should also be able to reduce underemployment. If, as a country, we can do this, we could expect a further lift in wages growth and stronger growth in household incomes. These would be good outcomes. As I hope you are aware, the Reserve Bank’s monetary policy framework is centred on the inflation target, but the ultimate objective of our policies is to promote the collective economic prosperity of the people of Australia. In the Board’s judgement, the easing of monetary policy last month and this month will help promote our collective welfare. At the same time, though, we recognise that the benefits are not evenly distributed across the community and that there are some downsides to monetary easing. Partly for these reasons, over recent times I have been drawing attention to the fact that, as a nation, there are options other than monetary easing for putting us on a better path. One option is fiscal support, including through spending on infrastructure. This spending adds to demand in the economy and – provided the right projects are selected – it also adds to the country’s productive capacity. It is appropriate to be thinking about further investments in this area, especially with interest rates at a record low, the economy having spare capacity and some of our existing infrastructure struggling to cope with ongoing population growth. Another option is structural policies that support firms expanding, investing, innovating and employing people. A strong, dynamic, competitive business sector generates jobs. It can help deliver the productivity growth that is the main source of sustainable increases in our wages and incomes. So, as a country, we need to keep focused on this. To repeat the point, it is important that we think about the task ahead holistically. Monetary policy does have a significant role to play and our decisions are helping support the Australian economy. But, we should not rely on monetary policy alone. We will achieve better outcomes for society as a whole if the various arms of public policy are all pointing in the same direction. The two cuts in interest rates the Board has delivered recently will make an important contribution to putting us on a better path and winding back spare capacity. It is also worth drawing your attention to a few other developments. First, borrowing costs for almost all borrowers are now the lowest they have ever been. As an illustration, the Australian Government can borrow for 10 years at around 1.3 per cent, the lowest rate it has faced since Federation in 1901. It is also able to borrow for 30 years at an interest rate of less than 2 per cent. Private businesses and households also face low borrowing rates. This is not only because official interest rates are low, but because credit spreads are low too. Second, Australia’s terms of trade have risen again, largely due to higher iron ore prices. Investment in the resources sector is also expected to increase over the next few years, after having declined steadily for almost seven years. To be clear, we are not expecting another major mining boom, but we are expecting a solid upswing in the resources sector, which will help the overall economy. I hope that, in time, the effects of this upswing will be felt here in the Northern Territory too. Third, the exchange rate has depreciated over the past couple of years and, on a trade-weighted basis, is at the bottom end of its range of recent times. This is helping support important parts of the economy. And fourth, we are expecting stronger growth in household disposable income over the next couple of years, partly due to the expected implementation of the low and middle income tax offset. Stronger growth in incomes should support household spending. 3/4 BIS central bankers' speeches Together, these various developments will help the Australian economy. At the same time, though, we need to watch global developments very closely. Over recent times, the uncertainty generated by the trade and technology disputes between the United States and China has made businesses in many countries nervous about investing. Many are preferring to sit on their hands, rather than commit to capital spending that is difficult and costly to reverse. The result is less international trade and a weakening trend in investment globally. If this continues for too much longer, the effects on economic growth are likely to be significant. For this reason, the risks to the global economy remain tilted to the downside. The combination of these persistent downside risks and continuing low rates of inflation has led investors around the world to expect interest rate reductions by all the world’s major central banks. In Europe and Japan, official interest rates are already negative but investors are expecting the central banks to go further into negative territory. And in the United States, investors are expecting a substantial reduction in interest rates over the period ahead. This is quite a different world from the one we were facing earlier in the year. What all this means for us here in Australia is yet to be determined. We need to remember that the central scenario for both the global and Australian economies is still for reasonable growth, low unemployment and low and stable inflation. As I discussed a few moments ago, there are a number of developments that are providing support to the Australian economy. So we will be closely monitoring how things evolve over coming months. Given the circumstances, the Board is prepared to adjust interest rates again if needed to get us closer to full employment and achieve the inflation target in a way that supports the collective welfare of all Australians, including those who call the Northern Territory home. Thank you once again for joining us this evening and for listening. Related Information Minutes of the June 1968 Reserve Bank Board meeting Historical photographs of the Reserve Bank’s presence in Darwin 4/4 BIS central bankers' speeches | reserve bank of australia | 2,019 | 7 |
Keynote address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at FX Week USA, New York City, 11 July 2019. | Guy Debelle: FX Global Code Keynote address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at FX Week USA, New York City, 11 July 2019. * * * Thanks to Matt Boge for all his assistance. Today I will talk about the FX Global Code. 1 I will talk about where we’ve come from and where we are going. The Code was first published a little over two years ago in May 2017. It is important to remember why the Code was needed and why it was produced. Why was the Code necessary? The foreign exchange (FX) industry was suffering from a lack of trust and dysfunction. The public lost trust in the market through the front-page coverage of the scandals that hit the market and the billion dollar fines. This lack of trust was there between participants in the market which was impairing market functioning. The market had to move toward a better place and allow market participants, and the public, to have much greater confidence that the FX market is functioning appropriately. It is also important to remember what the alternative was in the aftermath of the scandals. There was a decent chance that authorities could conclude that a regulatory response was necessary to generate the desired improvement in market structure and conduct. But the Code provided the opportunity for a joint public/private sector approach to address the lack of trust and market dysfunction. The Code is not regulation. The Code sets out global principles of good practice in the FX market to provide a common set of guidance to the market. Its aim is to promote the effective functioning of the wholesale FX market. How have we gone on that? In my view the FX market is in a better place than it was a few years ago. That is confirmed by surveys of market participants too. But there is further progress to be made. The process for creating the Code was global, coordinated between central banks and the private sector. I was the Chair of the group that produced the Code, with the great assistance of David Puth who led the market participants. At the time the Code was launched, a Global Foreign Exchange Committee (GFXC) was created to maintain the Code. I have just been appointed as GFXC Chair, taking over from Simon Potter who did a great job of leading the GFXC and over a number of years has been a major driver of change for the better in the global FX market. The GFXC is a genuinely global committee and the breadth of its reach has continued to expand. Seventeen national or regional FX committees are now full members of the GFXC, including the newly formed committees of Scandinavia, Switzerland and Russia. Smaller currency areas are also encouraged to participate through associate membership of the GFXC. Each of these local FXCs are committed to promoting the Global Code in their market. Over recent years, we’ve also seen the local committees expand the breadth of their membership to include more buy-side participants, non-bank liquidity providers, etc. So what has the GFXC been doing since its formation? An initial areas of focus was to provide greater guidance around the practice of ‘last look’. In 1/4 BIS central bankers' speeches reaching its conclusions in this area, it was appropriate for the GFXC to gather input from the full range of interested parties in a consultative, transparent manner. In that instance, the Committee used a public Request for Feedback, with the submissions we received made available on the GFXC’s website. The outcome of that process was Principle 17 of the Code. The use of ‘last look’ will likely always remain controversial and continue to be debated within the industry. Beyond the text of the Code, the GFXC also has a role to play in promoting wider knowledge of different aspects of the foreign exchange market. Earlier this year, the GFXC published two reports that had been drafted by working groups put together to focus on certain areas of the market. The membership of these working groups was drawn from around the globe, and involved a very wide range of market participants with expertise in the subject matter. The first report focussed on the trading practices of market participants who seek to avoid market risk when managing trade requests from their clients.2 This so-called ‘cover and deal’ arrangement is widely used in certain segments of the market and it’s important for clients to know when it is being used by the banks they’re dealing with and to understand what that means for them. The GFXC’s report should help foster that understanding. The other report published by the GFXC earlier this year focussed on disclosures.3 The Code emphasises the role that disclosures can play in promoting integrity and transparency within the market. However, the GFXC’s Report identified a number of challenges that limit the ability of disclosures to play that role, ranging from the accessibility of disclosures, their clarity, and the relevance of a lot of the information contained in them. In each of these areas, the report provided guidance to market participants on what characteristics they should be looking for when using disclosures and when they are writing them. Some of the disclosures in the market clearly conform to the principles articulated in the Code, but some very much push the boundaries. Personally, I am concerned about the disclosures which take the form of ‘as long as I warn you, then I can do whatever I want when I want when I am dealing with you’ – what might be termed full caveat emptor disclosures. In my view, these type of disclosures are not in the spirit of the Code in helping move the market to a better place. The challenges around ensuring sufficient transparency on trading capacities and behaviours are particularly acute on anonymous trading platforms. The GFXC is doing further work to bring about greater understanding of how information flows across these platforms, and what roles the different participants play, be they liquidity providers, prime brokers or the platforms themselves. In describing particular areas of the market and the different trading arrangements that may exist, the GFXC has highlighted how the principles of the Code are relevant to these practices. The reports produced by the working groups have been written with that purpose in mind. Another way of highlighting the applicability of the Code’s principles to different settings is through short illustrative examples. The Annex to the Code includes around 50 such examples covering a wide range of scenarios. The GFXC will continue to add to the initial suite of examples where it believes it is useful to do so. While these examples and the reports published by the GFXC do not form part of the Code, they are intended to assist market participants when thinking about how the Code applies to their activities. Over the period ahead, we will be looking at adding more material like these reports that help to flesh out the principles. As many of you would be aware, the GFXC encourages market participants to sign a Statement of Commitment to the Global Code as a public demonstration of their intention to adhere to the Code’s principles. There are numerous public registers on which market participants can post their Statements. On the GFXC website, an index now allows you to search across all of these registers.4 I would 2/4 BIS central bankers' speeches encourage everyone in the market to have a look at that index. As it now has more than 900 entries, if you are not able to find your counterparties or your other service providers in the foreign exchange market, you should be asking them why they haven’t committed to the Code. Getting greater adoption from the buy-side remains a focus for the GFXC and we have various initiatives in train on that front. A range of materials has been developed with the aim of making it easier for firms to engage with and commit to the Code. These materials are now available on the GFXC’s website and will be added to over time.5 If you are a buy-side firm with an active FX operation, then the Code very much applies to you. If you have a less direct or frequent interaction with the market, the Code is still relevant but I would emphasise that the Code is designed to be applied in a proportionate manner. The steps any firm needs to take should align with the nature and extent of their engagement with the market. While the Code is voluntary in nature, the benefits of the Code and the relevance of its principles have been recognised by many regulators and supervisory authorities around the globe. Most recently, the United Kingdom’s Financial Conduct Authority confirmed its recognition of the Code,6 meaning that individuals there will be able to point to their compliance with the Code’s principles as part of demonstrating that they are meeting the ‘proper standards of market conduct’ required under the UK’s Senior Managers regime. The FX Global Code has been in place for a few years now and remains fit for purpose. From the outset, and to ensure that the Code remains fit for purpose, the GFXC committed to undertaking a review of the Code at least once every three years. It is appropriate to review it periodically to reflect the continuously evolving market structure and dynamics. The first review of the Code will take place during 2020. The intention is that this will be a targeted review, and not a root and branch overhaul of the Code. Throughout the second half of this year, we will be identifying specific areas that need to be addressed. One such area is likely to be anonymous trading. As mentioned, the GFXC’s Working Group on disclosures and transparency is doing more work on this topic, and that will include thinking about whether it’s sufficiently clear how the Code’s principles are to be applied in this area. In identifying other areas of focus for the three-year review, the GFXC will gather feedback as widely as possible. Each of the local FXCs around the globe will be seeking input from their members and other market participants and industry groups in their jurisdiction in the coming months. So that is one avenue for you to provide feedback. At the same time, the GFXC will soon be launching its annual survey of market participants. This year, we will be giving respondents an opportunity to point to areas where they think greater guidance from the Code might be necessary. More broadly, the survey will also be gauged to general awareness of the Code and opinions on its effectiveness. The survey will be distributed through the local FXCs but also available on the GFXC website, so I would encourage as many as possible to participate. In short, in conducting this review of the Code, we’ll be looking to employ the same consultative approach that was used in initially drafting the Code a couple of years ago. We will work closely with each of the local FXCs and other industry organisations to ensure that the Code reflects what is considered good practice. In this, I will be assisted by the two vice chairs from the market: Akira Hoshino head of FX at Citi in Tokyo and Neill Penney co-head of trading at Refinitiv. If you have feedback on the Code, you can also get in touch with me directly in addition to the other channels I have mentioned. We really want to hear from you to ensure the Code remains fit for purpose in contributing to an appropriately and effectively functioning foreign exchange market. 3/4 BIS central bankers' speeches 1 www.globalfxc.org/fx_global_code.htm 2 www.globalfxc.org/reports.htm?m=72%7C427 3 www.globalfxc.org/reports.htm?m=72%7C427 4 www.globalfxc.org/global_index.htm 5 See www.globalfxc.org/education.htm?m=71%7C433. 6 www.fca.org.uk/news/statements/fca-confirms-recognition-fx-global-uk-money-markets-codes 4/4 BIS central bankers' speeches | reserve bank of australia | 2,019 | 7 |
Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to Bloomberg, Sydney, 23 July 2019. | Speech The Committed Liquidity Facility Christopher Kent [ * ] Assistant Governor (Financial Markets) Address to Bloomberg Sydney – 23 July 2019 I'd like to thank Bloomberg for the opportunity to speak to you about the committed liquidity facility (CLF). The CLF has been in place now for almost five years. As we announced in June, after a careful review, the RBA will be adjusting the settings of the CLF starting from next year. [1] Today, I thought it would be helpful to discuss the developments that have led us to make these adjustments. We have also published a detailed article on this on the RBA's website. [2] But first, let's review why we needed the CLF in the first place. Why Do We Need a CLF? The global financial crisis highlighted how important it is for banks to manage their liquidity risk. During the crisis, many banks overseas faced significant liquidity problems having not paid enough attention to their liquidity management in the lead up to the crisis. Following this experience, the Basel Committee on Banking Supervision proposed tougher liquidity requirements as part of its broader package of reforms, known as the Basel III regulations. These changes have made the banking system more resilient to periods of financial market stress. One of the key planks of the requirement to increase liquidity of the banks was the introduction of the liquidity coverage ratio (LCR). The LCR requires banks to have enough high-quality liquid assets (HQLA) to cover their estimated net cash outflows during a scenario that entails a 30-day period of stress. The idea is that a bank experiencing stress will have enough liquid assets that they can use to meet their short-term liquidity needs. In this way, each bank holds a sufficient amount of HQLA as self-insurance against liquidity risk. Like all insurance, this comes at a cost. In this case, the cost to each bank is incurred because the HQLA earn a lower yield than alternative, less liquid assets that the bank could otherwise hold, such as mortgages or business loans. For HQLA securities to be of sufficient quality and liquidity, they should be both low risk and actively traded in markets. In Australia's case, Australian Government Securities (AGS) and securities issued by the state and territory borrowing authorities (semis) meet this test. In contrast, there is relatively little trading in other Australian dollar securities, such as those issued by foreign agencies (supras), banks and securitisation trusts (Graph 1). Graph 1 However, there is less government debt in Australia relative to the size of the banking system, and the economy more generally, than is the case in many other countries (Graph 2). This means that there are fewer HQLA in Australia. Indeed, back in 2015, if there had been no other way for Australian banks to meet their LCR, collectively they would have had to have held around two-thirds of the total stock of AGS and semis. And if the banks had held such a high share of those government securities, the liquidity of those markets would have been substantially impaired, thereby defeating the purpose of them being counted on as HQLA. Graph 2 In recognition of this issue, the Basel liquidity standards allow jurisdictions with limited HQLA to use alternative approaches. One of those approaches is for the central bank to offer a facility to provide banks with a guaranteed source of liquidity. [3] And so the CLF was born. This entails the central bank committing to stand ready to provide a bank with liquidity against high-quality collateral that would otherwise be illiquid in the market. This commitment can be counted by banks towards meeting their LCR. In return for the CLF, banks are charged a fee on the entire committed amount, whether or not it is actually drawn upon. This fee is akin to the insurance premium that banks would implicitly pay if instead of the CLF, they had to hold additional HQLA. Starting from 2015, the RBA has provided the CLF as part of Australia's implementation of the Basel III liquidity reforms. The First Five Years of the CLF Under the CLF, the RBA commits to provide liquidity under repo against securities eligible in its operations. To access the CLF, a bank must meet several conditions: it must have paid its CLF fee; the bank's CEO has to have attested that the bank has positive net worth; and the RBA has to have judged that this is indeed the case. In the five years since the CLF was introduced, 15 banks have applied to APRA for access to the CLF. None of these banks have needed to draw on the facility in response to a period of financial stress. Each year, APRA determines the total size of the CLF. It's the difference between the banking system's liquidity needs and the amount of AGS and semis that the RBA assesses that the banks can hold without impairing the functioning of the market. The size of the CLF was set at $274 billion in 2015. As an input to this, the RBA assessed that the banks could reasonably hold 25 per cent of the stock of AGS and semis. This was a sizeable step up from their holdings earlier in the decade (Graph 3). Graph 3 However, since then, the stock of AGS and semis has increased by almost a third. In comparison, the LCR requirements of the banks have been little changed. So the banks can hold more HQLA securities compared to their liquidity needs. As a result, the size of the CLF has declined to just below $250 billion. The increase in AGS and semis also means that the shortage of HQLA securities is not as large as it once was, although there is still a shortage. Reassessing the Banks' Reasonable Holdings of HQLA Securities To assess the amount of HQLA securities that the banks can reasonably hold, the RBA takes into account the behaviour of other holders of these securities, along with conditions in bond and repo markets. In 2015, a large share of Australian government debt was held by what can be described as ‘buy and hold’ investors. That is, these investors were not particularly sensitive to the prices of these securities, and typically they did not contribute to liquidity in the market. Many of these investors were non-residents, which were holding nearly 60 per cent of the total stock of HQLA securities earlier in the decade (Graph 4). Graph 4 However, over recent years more HQLA securities have become available for use as collateral. In particular, the Australian repo market has grown substantially, driven by more HQLA securities being sold under repo. Of note, non-residents have been lending more of their holdings of AGS and semis back into the domestic market (Graph 5). Graph 5 Also, our analysis of transactions in bond and repo markets demonstrates that most HQLA securities were being actively traded. Turnover ratios for individual AGS bond lines were well above zero and much higher than for other Australian dollar securities. Although semis were traded less frequently than AGS, only a small share of the bond lines of semis had low turnover ratios (Graph 6). Given this, it appears unlikely that a moderate increase in banks' holdings of AGS and semis would present a problem for liquidity in these markets. Graph 6 Another issue we considered in 2015 was the ‘scarcity premium’ that was present for AGS. Australia's relatively strong economic performance and AAA credit rating have been very appealing for investors globally. The scarcity premium was prominent in the years leading up to 2015, when the yield on AGS was well below the expected cash rate over the period to maturity (Graph 7). Since then, however, the scarcity premium has gradually dissipated. This has occurred alongside an increase in the stock of AGS. It is also consistent with these securities being less tightly held. The combination of these changes suggests that the banks can now hold a higher share of the AGS on issue without impairing the functioning of the market. Graph 7 This brings us to the first of two changes that we have made to the settings of the CLF. We have assessed that banks can increase their holdings of HQLA securities from 25 to 30 per cent of the outstanding stock. This will result in the CLF being smaller than it otherwise would have been. To minimise the effect of this change on the market, the increase will occur at the gradual pace of 1 percentage point each year, beginning with an increase to 26 per cent in 2020. Setting the CLF Fee The second change we are implementing relates to the CLF fee. The CLF fee should be set at a level at which banks will face similar financial incentives to meet their LCR through the CLF or by holding HQLA (if there were enough available). However, determining this level of the fee is easier to do in theory than in practice. The starting point for determining the fee is to make use of the spread between the yields on HQLA securities and the collateral that the banks hold for the CLF. This collateral is all eligible for the RBA's market operations, and is mainly the banks' self-securitised residential mortgage backed securities. We have estimated that this spread was around 90 basis points earlier this year. But the higher yield on CLF collateral reflects compensation for a variety of risks. In particular, a sizeable share of the spread owes to the higher credit risk on these securities. However, the CLF fee should only reflect the liquidity risk component of the spread, and that is very difficult to identify separately. When the Reserve Bank set the CLF fee earlier this decade, it looked at repo rates on some CLFeligible securities to gauge how much a one-month liquidity premium might be worth. The answer was not very much in normal circumstances. Based on data from the RBA's open market operations, it was estimated to be around 10 basis points. However, given that part of the point of the liquidity reforms was to recognise that the market had underpriced liquidity in the past, it was judged to have been appropriate to set the fee at 15 basis points. Now that we have several years of experience with the CLF, we can look back and see how the banks have responded to the existing framework. Since the CLF was introduced, the banks, in total, have consistently overestimated their ‘net cash outflow’ projections in their CLF applications for the following year. [7] These projections were used by APRA to determine the size of the CLF. As a result, the banks have been granted a larger CLF than would have been the case had the net cash outflow projections been more accurate ex ante (Graph 8). In recent years, the banks have also been holding fewer HQLA securities than the RBA judged that they could reasonably hold. Taken together, these observations suggest that the CLF fee should be set at a higher rate in the future. Graph 8 A higher CLF fee will help to make the banks indifferent between holding more HQLA securities and asking for a larger CLF. However, if the fee is too high, this could trigger a disruptive shift away from using the CLF facility and create distortions in the markets that use HQLA. Accordingly, we have concluded that the fee should be increased moderately and occur in two steps. The fee will rise from 15 to 17 basis points in January 2020 and to 20 basis points in January 2021. When taken together, these two changes to the settings for the CLF will result in a small increase in the cost of the CLF for the banks. To show this, we can fully apply the new settings to the current CLF amounts, assuming everything else is held constant. If the banks were holding the higher level of AGS and semis that the RBA has assessed would be reasonable, this would reduce the size of the CLF from just below $250 billion to around $200 billion. If we then apply the 5 basis points total increase in the CLF fee, collectively the banks would pay around $30 million more than they do currently for the liquidity commitment they receive from the RBA. Conclusion In conclusion, the CLF is important for Australia's implementation of the Basel III liquidity reforms. The facility has been working well, but after five years it is time to make some modest and gradual adjustments to the settings, in a way that reduces the need of the banks to make use of the CLF while also increasing their cost of doing so a little. In combination, these changes will help to ensure that the banks continue to have strong incentives to manage their liquidity risk appropriately. Endnotes [*] I thank Michelle Bergmann, Ellis Connolly, Joseph Muscatello and Dmitry Titkov for invaluable assistance in preparing these remarks. See RBA (Reserve Bank of Australia) (2019), ‘Reserve Bank Adjusts the Committed Liquidity Facility’, Media Release No 2019-16, 7 June. Bergmann M, E Connolly and J Muscatello (2019), ‘The Committed Liquidity Facility’, RBA viewed 23 July 2019. The other approaches include the regulator allowing banks to hold foreign currency HQLA to cover domestic currency liquidity needs, or allowing banks to hold lower quality assets as HQLA (known as Level 2 assets), with haircuts applied. For more information about the introduction of the CLF, see Debelle G (2011), ‘The Committed Liquidity Facility’, Speech to the APRA Basel III Implementation Workshop 2011, Sydney, 23 November. Banks (more formally, domestically incorporated authorised deposit-taking institutions (ADIs) subject to the LCR) must apply to APRA to obtain approval to establish a CLF. The legal documentation for the CLF is published on the RBA's website at <https://www.rba.gov.au/mkt-operations/resources/tech-notes/pdf/clf-terms-and-conditions.pdf> and <https://www.rba.gov.au/mkt-operations/resources/tech-notes/clf-operational-notes.html>. Were a bank to draw on the CLF by selling securities to the RBA under repo, the RBA would only be exposed to credit risk from the securities if the bank defaulted on its obligation to repurchase the securities. To minimise this risk, the RBA imposes haircuts on the securities that it purchases under repo. This is relative to the banks' final estimates of net cash outflows under the LCR stress scenario using data on their balance sheet position as at the end of the relevant year. This compares to the CLF banks' annual operating income of around $100 billion. Bulletin, September, © Reserve Bank of Australia, 2001–2019. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. | reserve bank of australia | 2,019 | 7 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Anika Foundation Luncheon supported by NAB and the ABE, Sydney, 25 July 2019. | 7/25/2019 Inflation Targeting and Economic Welfare | Speeches | RBA Speech Inflation Targeting and Economic Welfare Philip Lowe [ * ] Governor Address to Anika Foundation Luncheon Supported by NAB and the ABE Sydney – 25 July 2019 It is a great pleasure to address the Anika Foundation lunch for the third time. I would like to start by winding the clock back, not by three years, but instead by 40 years. It was 40 years ago that I started studying economics in high school in Wagga Wagga. I sat the 3 unit economics exam for the Higher School Certificate (HSC) in 1979. At that time, the standard exam question was in two parts: why did Australia have both high inflation and high unemployment and what should policy do about it? I recall writing numerous essays on this troubling topic. I also recall learning about the Misery Index. For those of you whose memories don't go back that far, this index is the sum of the unemployment rate and the inflation rate. Few people talk about this index these days, but I thought it would be useful to show it to you as background (Graph 1). As you can see, things were pretty miserable in the 1970s and 1980s. Today, though, at least according to this metric, they are not too bad. The Misery Index is now as low as it has been since the late 1960s. Today, we are living in a world of low and stable inflation and low unemployment. It is useful to remind ourselves of this sometimes. https://www.rba.gov.au/speeches/2019/sp-gov-2019-07-25.html 1/14 7/25/2019 Inflation Targeting and Economic Welfare | Speeches | RBA Graph 1 So this means that today's HSC students are likely to be writing about why inflation is so low at the same time that unemployment is also low. I hope that they are also being asked to write about how public policy should respond to low inflation and its close cousins of slow growth in nominal wages and household incomes. These are important issues to be thinking about. Given this, I would like to use this opportunity to address two related questions that I am asked frequently. The first of these is why is inflation so low globally and in Australia? And the second is, is inflation targeting still appropriate in this low inflation world? I will then draw on my answers to make some remarks about monetary policy here in Australia. 1. Why is Inflation so Low? It is useful to start off with a couple of graphs. The first is the average rate of inflation globally (Graph 2). The picture is pretty clear. Global inflation declined over the three decades to the early 2000s and has been low and stable for some time. https://www.rba.gov.au/speeches/2019/sp-gov-2019-07-25.html 2/14 7/25/2019 Inflation Targeting and Economic Welfare | Speeches | RBA Graph 2 Low inflation has become the norm in most economies. This is evident in this next graph, which shows the share of advanced economies with a core inflation rate below 2 per cent and below 1 per cent (Graph 3). Currently, three-quarters of advanced economies have an inflation rate below 2 per cent, and one-third have an inflation rate below 1 per cent. https://www.rba.gov.au/speeches/2019/sp-gov-2019-07-25.html 3/14 7/25/2019 Inflation Targeting and Economic Welfare | Speeches | RBA Graph 3 The obvious question is why this has happened? There is no single answer. But there are three factors that, together, help explain what has happened. These are: the credibility of the current monetary frameworks; the continuing existence of spare capacity in parts of the global economy; and structural factors related to technology and globalisation. I will say a few words about each of these. First, the credibility of the monetary frameworks. One of the responses to the high inflation rates of the 1970s and 1980s was to put in place monetary frameworks with a strong focus on inflation control. In some countries, this took the form of rewriting the law to require the central bank to focus on just one thing: inflation. Many countries also adopted an inflation target, with monetary policy decisions being explained primarily in terms of inflation. This increased focus on inflation has helped cement low inflation norms in our economies. Many people understand that if inflation were to pick up too much, the central bank would respond to make sure the pick-up was only temporary. This means that workers and firms can make their decisions on the basis that the rate of overall inflation will not be too different from the target rate. This has made the system less inflation prone than it once was. https://www.rba.gov.au/speeches/2019/sp-gov-2019-07-25.html 4/14 7/25/2019 Inflation Targeting and Economic Welfare | Speeches | RBA The second explanation for low inflation is the continuing existence of spare capacity in parts of the global economy. The existence of spare capacity was an important factor explaining low inflation in the aftermath of the global financial crisis. And today, it remains a factor in some countries, including here in Australia. But, on the surface, it is a less convincing explanation for low inflation in countries where unemployment rates are now at multi-decade lows. Based on conventional measures of capacity utilisation, these economies are operating close to their sustainable limits. One explanation for continuing low inflation in this environment is that the current rate of aggregate demand growth is simply not fast enough to put meaningful pressure on capacity. If so, stronger demand growth would be expected to see inflation pick up. Another possibility is that the unemployment rate, by itself, no longer provides a good guide to spare capacity, partly due to the flexibility of labour supply. I will come back to this idea in the discussion of inflation outcomes in Australia. The third explanation is that globalisation and advances in technology have changed pricing dynamics. There are two main channels through which this appears to be happening. The first is by lowering the cost of production of many goods. And the second is by making markets more contestable and increasing competition. The main effect of these changes should be on the level of prices, rather than on the ongoing rate of inflation. But this level effect is playing out over many years, so it appears as persistently low inflation. It is widely accepted that the entry into the global trading system of hundreds of millions of people with access to modern technology put downward pressure on the prices of manufactured goods. Reflecting this, goods prices in the advanced economies have barely increased over the past couple of decades (Graph 4). But the effects of globalisation and technology extend beyond this and into almost every corner of the economy, including the services sector. https://www.rba.gov.au/speeches/2019/sp-gov-2019-07-25.html 5/14 7/25/2019 Inflation Targeting and Economic Welfare | Speeches | RBA Graph 4 In today's globalised world, there are fewer and fewer services that can be thought of as truly non-traded. Many services can now be delivered by somebody in another country. Examples include: the preparation of architectural drawings, document design and publishing, customer service roles and these days many people in professional services work with team members located in other countries. In addition, many tasks, such as accounting and payroll, are being automated. All this has been made possible by technology and by globalisation. The new global technology platforms have also revolutionised services such as retail, media and entertainment, and transformed how we communicate and search for information and compare prices. These changes are having a material effect on pricing, with services price inflation lower than it once was. Many firms know that if they don't keep their prices down, another firm somewhere in the world might undercut them. And many workers are concerned that if the cost of employing them is too high, relative to their productivity, their employer might look overseas or consider automation. And, more broadly, better price discovery keeps the competitive pressure on firms. The end result is a pervasive feeling of more competition. And more competition normally means lower prices. https://www.rba.gov.au/speeches/2019/sp-gov-2019-07-25.html 6/14 7/25/2019 Inflation Targeting and Economic Welfare | Speeches | RBA So these are the three important factors that are contributing to low inflation. None of them by themselves is sufficient to explain what is happening, but together they are having a powerful effect. The current high inflation rates in Argentina and Turkey remind us that globalisation and technology, by themselves, do not drive low inflation. The monetary framework clearly matters too. Weaknesses in that framework still result in high inflation. 2. Is Inflation Targeting Still Appropriate? This brings me to my second question: is inflation targeting still the appropriate monetary framework for most countries? It is understandable that people are asking this question. Given the factors that I have just discussed, some commentators have argued that central banks will find it increasingly difficult to achieve their inflation targets. Some then go on to argue that central banks should just accept this, not fight it; perhaps they should shift the goal posts, or even adopt another monetary framework. A related argument is that the very low interest rates that have accompanied the pursuit of inflation targets are pushing up asset prices in an unsustainable way and sowing the seeds for damaging problems in the future. You might, or might not, agree with these perspectives. Either way, it is reasonable to ask if we are on the right track: is inflation targeting still appropriate? Before I address this question, I would like to push back against the idea that central banks simply can't achieve their inflation targets. As we all know, some central banks have struggled to achieve their targets over a long period of time; Japan and the euro area are the obvious examples. But this is not a universal experience. Over recent times, inflation has been around target in Canada, Norway, Sweden and the United Kingdom. So the experience is mixed (Graph 5). https://www.rba.gov.au/speeches/2019/sp-gov-2019-07-25.html 7/14 7/25/2019 Inflation Targeting and Economic Welfare | Speeches | RBA Graph 5 There is no single factor that explains this mixed experience. But countries that are operating nearer to full capacity are more likely to have inflation close to target. It also appears that if you have an extended period of very low inflation – as did Japan and the euro area – it is harder to get back to target as a deflationary mindset takes hold. It is also possible that demographics may be playing a role, although the evidence here is mixed. Overall, these varying experiences do not support the idea that it has become impossible for central banks to achieve their targets. Here in Australia, some have argued that a lower inflation target would be a good idea given the ongoing low rates of inflation; that we should adjust our formulation of 2–3 per cent, on average, over time. Lowering the target might have the short-run advantage of allowing us to say we have achieved our goal, but shifting the goalposts hardly seems a good way to build long-term credibility. Shifting the goal posts could also entrench a low inflation mindset. More broadly, over recent years the international debate has gone in the other direction: that is, to argue for a higher, not lower, inflation target. The argument is that a higher rate of inflation – and thus a higher average level of interest rates – would promote economic welfare by providing more room to lower interest rates, without running up against the lower bound. This greater flexibility for monetary policy could stabilise the economy when it was hit with a negative shock. https://www.rba.gov.au/speeches/2019/sp-gov-2019-07-25.html 8/14 7/25/2019 Inflation Targeting and Economic Welfare | Speeches | RBA To be clear, I am not arguing for a higher inflation target, but rather acknowledging there are arguments in both directions. This brings me back to the question: is inflation targeting still appropriate? The short answer is yes, but it is important to be clear what this means in practice. Inflation targeting can mean different things to different people. It comes in different shapes and sizes. Some versions require a central bank to focus on inflation alone and set monetary policy so that the forecast rate of inflation is equal to the target. But inflation targeting does not need to be rigid like this. In my view, an inflation targeting regime should consist of the following four elements. 1. The inflation target should establish a clear and credible medium-term nominal anchor for the economy. A high degree of uncertainty about future inflation hurts both investment and jobs. The economy works best if there is a degree of predictability. Most people can cope with some variation in the inflation rate from year to year. But dealing with uncertainty about what inflation is likely to average over the medium term is more difficult. Inflation targeting plays an important role in reducing that uncertainty by providing a strong nominal anchor. 2. The inflation target should be nested within the broader objective of welfare maximisation. It is worth remembering that inflation control is not the ultimate objective. Rather, it is a means to an end. And that end is the welfare of the society that we serve. I sometimes feel that as some central banks sought to establish their credentials as inflation fighters they overemphasised the importance of short-run inflation outcomes. And this has been difficult to walk back from. Some central banks have been concerned that if they gave weight to other considerations, the community might doubt their commitment to inflation control. So, it became all about inflation. But central banks have a broader task than just controlling inflation in a narrow range. They play an important role in preserving macroeconomic stability and thus the steady creation of jobs. Also, their decisions affect borrowing and asset prices and thus financial stability too. Central banks have to determine how to balance these considerations when making monetary policy decisions. This means it makes sense for inflation targeting to be embedded within the broader objective of maximising the welfare of society. 3. The inflation target should have a degree of flexibility. This is not to say that the target itself should be flexible; this would diminish its usefulness in providing a medium-term anchor. Rather, some variation in inflation from year to year is acceptable and indeed unavoidable. How much variation is too much is difficult to know, but https://www.rba.gov.au/speeches/2019/sp-gov-2019-07-25.html 9/14 7/25/2019 Inflation Targeting and Economic Welfare | Speeches | RBA the variation should not be so large that it generates doubt about the commitment of the central bank to achieving the target over time. 4. The inflation target needs to be accompanied by a high level of accountability and transparency. If the inflation target is operated flexibly and is nested within the broader objective of welfare maximisation, the central bank has a degree of discretion. It is important that when exercising this discretion, the central bank is transparent. Problems can arise if the community doesn't understand the central bank's actions, or if they see it as acting unpredictably or inconsistently with its mandate. This means you should expect us to explain what we are doing, why we are doing it and how we are balancing the various trade-offs. So these are the four elements that I see as important to an effective inflation-targeting regime. We have all four elements in Australia. Our commitment to deliver an average inflation rate over time of 2 point something provides a strong nominal anchor. We have always viewed the inflation target in the wider context, reflecting the broad mandate for the RBA set out in the Reserve Bank Act 1959. That Act was passed 60 years ago and has stood the test of time. The RBA was also one of the earliest advocates of flexible inflation targeting – this is evident in our use of the words, ‘on average, over time’ when describing our target. We also place a heavy emphasis on explaining our decisions and their rationale to the community. Our overall assessment is that Australia's monetary policy framework has served the country well over the past three decades. The flexibility that has always been part of our regime has helped underpin a strong and stable economy and has helped Australia deal with some very large economic shocks. We are not inflation nutters. Rather, we are seeking to deliver low and stable inflation in a way that maximises the welfare of our society. Over the nearly 30 years we have had the inflation target, inflation has averaged 2.4 per cent, very close to the midpoint. It has, however, been below this average over recent years and I will talk about this in a few moments. Before I do so, it is important to note that we periodically review the formulation of the current target and examine alternative monetary frameworks, including at our annual conference last year. [2] We are also monitoring closely the discussions that are taking place in the academic community and in other central banks. In my view, the evidence does not support the idea that a change to our inflation target would deliver better economic outcomes than achieved by our current flexible inflation target. Some alternative frameworks would also be more difficult to implement and/or be harder to explain to the community. But it is important that we regularly examine the arguments. Australian Monetary Policy I would now like to discuss recent inflation outcomes and monetary policy in Australia. https://www.rba.gov.au/speeches/2019/sp-gov-2019-07-25.html 10/14 7/25/2019 Inflation Targeting and Economic Welfare | Speeches | RBA Like other countries, Australia has had low inflation over recent years. Over the past four years, headline inflation has mostly been below 2 per cent, although it has been slightly above that mark on a couple of occasions (Graph 6). In underlying terms, inflation has been below the band for three years. Graph 6 Given this history, it is reasonable to ask why this happened and how the Reserve Bank Board has thought about it. I will first focus on the period from late 2016 to late 2018. Through most of this period, gradual progress was being made in returning inflation to target and the unemployment rate was moving lower. Inflation was on a gentle upswing and the unemployment rate was coming down more quickly that we had expected. Reflecting this, in August 2017 the two-year ahead inflation forecast was 2½ per cent. Since then it has been lower than this, at 2–2¼ per cent. Throughout this period, the Board discussed the case for seeking a faster and more assured return of inflation to around the midpoint of the target range. It was natural to be discussing this because having inflation around the midpoint of the target range allows more scope for surprises in either direction. https://www.rba.gov.au/speeches/2019/sp-gov-2019-07-25.html 11/14 7/25/2019 Inflation Targeting and Economic Welfare | Speeches | RBA As you know, in the end the Board did not adjust interest rates through this period. It judged that seeking to achieve a faster return of inflation to the midpoint of the target range would have been accompanied by more rapid growth in debt, at a time when household balance sheets were already very extended. Our judgement was that, given the progress that was being made towards our goals, it was appropriate to use the flexibility in our inflation target to pursue a course that was more likely to be in the country's long-term interest. We could have generated a bit more inflation, but we would have had faster growth in household debt as well. I acknowledge that others might see this trade-off differently. But given the unemployment rate was coming down and inflation had lifted from its trough, we did not see a strong case for monetary easing. Towards the end of last year, that assessment began to shift. Inflation was turning out to be lower than we had earlier expected and our forecasts for inflation were being marked down. There are a few reasons for this, but the one I want to highlight today is the flexibility of labour supply, as this links back to my earlier discussion of the reasons for low inflation globally. When we prepared our forecasts in mid 2017, we did so on the basis that the share of the adult population participating in the labour market (the participation rate) would remain steady over the next couple of years (Graph 7). At the time, this was considered a reasonable forecast: while we expected some increase in participation from an encouraged worker effect because of solid employment growth, we thought this would be offset by the ageing of the population. Graph 7 https://www.rba.gov.au/speeches/2019/sp-gov-2019-07-25.html 12/14 7/25/2019 Inflation Targeting and Economic Welfare | Speeches | RBA Since then, things have turned out quite differently. Employment growth has been much stronger than expected and the participation rate has risen by 1½ percentage points, which is a large change over a fairly short period. Put simply, the strong demand for labour has been met by more labour supply. It is useful to consider the following thought experiment. Suppose the participation rate had still risen materially, but by ¾ per cent, rather than 1½ per cent. All else constant, this would have meant the unemployment rate today would have been well below 5 per cent. This flexibility of labour supply is a positive development and has meant that strong employment growth has not tested the economy's supply capacity. More demand for workers has been met with more labour supply. This has contributed to the subdued wage outcomes over recent times, which in turn has contributed to the low inflation outcomes. The more flexible supply side means that employment growth can be stronger without fears of overheating. At the same time, the unemployment rate that would put upward pressure on inflation is also lower than it once was. As the evidence accumulated in support of these propositions, the outlook for monetary policy changed and the Board lowered the cash rate in June and July. In making these decisions the Board also recognised that the earlier concerns about the trajectory of household debt had lessened. The Board has also paid attention to the shift in the outlook for monetary policy globally. These two recent reductions in the cash rate will support demand in the Australian economy. So too will recent tax cuts, higher commodity prices, some stabilisation in the housing market, ongoing investment in infrastructure and a lift in resource sector investment. We also need to remember that the underlying foundations of the Australian economy remain strong. It remains to be seen if future growth in demand will be sufficient to put pressure on the economy's supply capacity and lift inflation in a reasonable timeframe. It is certainly possible that this is the outcome. But if demand growth is not sufficient, the Board is prepared to provide additional support by easing monetary policy further. However, as I have discussed on other occasions, other arms of public policy could also play a role in this scenario. Whether or not further monetary easing is needed, it is reasonable to expect an extended period of low interest rates. On current projections, it will be some time before inflation is comfortably back within the target range. The Board is strongly committed to making sure we get there and continuing to deliver an average rate of inflation of between 2 and 3 per cent. It is highly unlikely that we will be contemplating higher interest rates until we are confident that inflation will return to around the midpoint of the target range. Thank you for listening. I look forward to answering your questions. https://www.rba.gov.au/speeches/2019/sp-gov-2019-07-25.html 13/14 7/25/2019 Inflation Targeting and Economic Welfare | Speeches | RBA Endnotes [*] I would like to thank Ellis Connolly for assistance in preparing these remarks. Conceptually, it is possible to think of these structural factors as adding to global supply, so this third explanation could be seen as elaboration of the second explanation. These structural factors are also likely to be pushing down the equilibrium real rate of interest. Simon J and M Sutton (eds) (2018), Conference, Reserve Bank of Australia, Sydney. Available at <https://www.rba.gov.au/publications/confs/2018/>. Central Bank Frameworks: Evolution or Revolution? Proceedings of a © Reserve Bank of Australia, 2001–2019. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2019/sp-gov-2019-07-25.html 14/14 | reserve bank of australia | 2,019 | 7 |
Address by Ms Michele Bullock, Assistant Governor (Financial System) of the Reserve Bank of Australia, to the Toowoomba Chamber of Commerce, Toowoomba, 8 August 2019. | Financial Stability Through the Lens of Business | Speeches | RBA 08/08/2019 Speech Financial Stability Through the Lens of Business Michele Bullock [ * ] Assistant Governor (Financial System) Address to the Toowoomba Chamber of Commerce Toowoomba – 8 August 2019 Thank you to the Toowoomba Chamber of Commerce for inviting me to speak with you today. It is a pleasure to be here. I have spoken about financial stability from a number of perspectives in the past – resilience of the banking sector, developments in the property sector and developments in the household sector. Today I want to talk about financial stability from the perspective of the business sector. In our regular , we always discuss the corporate sector balance sheet and its resilience. Today I want to draw out some of the issues we have been focusing on in recent months. Financial Stability Review But, first of all, what is financial stability and why is it important? As I have said in the past, there is no universal definition. But basically, it is when the financial sector is doing its job of facilitating a smooth flow of funds in the economy to support economic growth. The opposite, financial instability, is probably easier to picture though. This is where the financial sector is experiencing disruptions so that it harms the economy. The global financial crisis, or GFC, was a very vivid demonstration of what can happen when the financial system is unstable – credit supply dries up, investment and consumption fall and unemployment rises. So there is a very human cost to financial instability. While we at the Reserve Bank do not have responsibility for the supervision of financial institutions, we do have an important role in monitoring the financial system as a whole and the economy for financial imbalances that could lead to instability. We typically look at such things as developments in financial markets, and, in particular, evidence of excessive risk-taking behaviour, the balance sheets of financial institutions and their resilience to changes in economic circumstances, and household and business balance sheets. Part of our role is to draw attention to potential risks that might be building and have an impact on the stability of the financial system. Why are developments in the business sector relevant for financial stability? One obvious link is that if businesses are struggling to meet their obligations, they impact on the real economy and this could https://www.rba.gov.au/speeches/2019/sp-ag-2019-08-08.html 1/13 08/08/2019 Financial Stability Through the Lens of Business | Speeches | RBA have flow-on effects to bank balance sheets through increasing non-performing loans and defaults. But poorly performing businesses in one sector could also feed through to employment and businesses in other sectors, amplifying the effect. For example, poorly performing retail businesses might impact workers as well as owners and developers of shopping centres. Farm businesses that are affected by the drought will reduce their expenditure on capital and labour as well as their expenditure on discretionary consumption, impacting a range of businesses in their communities. And these impacts in turn will be reflected in banks' asset quality if households and businesses find it more difficult to service their loans. Furthermore, while specific shocks to a particular business sector may not have immediate financial stability implications, they can mean that businesses in that sector are, for some time, more vulnerable to broader macroeconomic shocks. So it is important for us to understand and assess the impact of idiosyncratic shocks on balance sheet health. In addition, some developments can be quite specific to business conditions in particular regions, and to those financial institutions that have extended credit to businesses and households in those regions. The end of the mining investment boom, for example, had significant implications for the economy and businesses in mining intensive regions, such as Western Australia and parts of Queensland. This in turn has seen large falls in housing prices and increases in arrears in these regions. However, banks appear to be managing this, and the increase in arrears does not currently pose a risk to financial stability. Nonetheless, it does illustrate that in assessing the financial stability implications of business conditions, it is important to give some consideration to sectors, regions, and even the size of the firms. In the rest of my speech, I will discuss some aspects of business conditions that are relevant to thinking about financial stability. I will start with some information on businesses in aggregate. I will then talk a little about some individual sectors and I will finish up with a focus on the small business sector. Conditions in the business sector There are a number of metrics we use to look at the financial health of firms. Profitability or return on equity give an indication of the general health of the business. Firms with low profitability are more likely to cease operations due to poor performance and, in the process, potentially default on their debts. Gearing looks at how much debt relative to equity there is in the business. Firms with high gearing are more vulnerable to asset price falls and losses from their operations as they have a relatively small equity buffer. This makes them more likely to go bankrupt and default. So, if gearing is high, the firm is likely to be viewed as riskier. Debt-servicing ratios measure the ratio of interest expenses on any debt to the profits of the business. This gives an indication of firms' capacity to repay their loans. The higher this is, the more at risk firms are if interest rates rise or profits fall. Liquidity measures the ratio of cash to a firm's current liabilities. This measures the firm's ability to repay its current liabilities as they become due. If this is very low, firms are at risk of being unable https://www.rba.gov.au/speeches/2019/sp-ag-2019-08-08.html 2/13 08/08/2019 Financial Stability Through the Lens of Business | Speeches | RBA to meet their short-term financial obligations. The most current data we have on the financial position of businesses is from listed corporations. Companies listed on the stock exchange tend to be large, and have to report regular information to the market. This provides a useful source of timely information on companies' financial health. In contrast, small businesses are unlisted and so information about their financial health is less readily available and comes with a longer lag. Because they account for the majority of borrowing, large businesses pose a greater risk to financial stability. That's not to say small businesses aren't important, and I will come back to discuss them later. On the basis of listed companies reporting, conditions in the business sector in 2018 were positive overall, supported by continued economic growth and low interest rates. In aggregate, profits of listed non-financial corporations have looked healthy over recent years. The aggregate return on equity (before interest, tax and depreciation) of these firms was around 25 per cent in 2018, a little higher than it has been on average since the GFC (Graph 1). Gearing and debt-servicing ratios have trended lower in recent years and liquidity has increased further. This means that, in aggregate, firms have a larger equity buffer in their business, are less vulnerable to unexpected decreases in cash flows and are better placed to repay their short-term financial obligations. This is good from the perspective of financial stability as firms seem to be less vulnerable to negative economic shocks. https://www.rba.gov.au/speeches/2019/sp-ag-2019-08-08.html 3/13 08/08/2019 Financial Stability Through the Lens of Business | Speeches | RBA Graph 1 But the aggregates can disguise substantial differences across firms. It is therefore important to look at the distribution of the various financial metrics. For this purpose we typically look at the median and the risky ‘tails’ of the distribution. The median is the value of the metric which is in the middle of the group – half the group have values above the median and half have values below. There are a number of ways to define the risky tail of the distribution. Today, I am defining it as either the top or bottom 25 per cent depending on the relationship between the financial metric and firm riskiness. For example, higher gearing and debt-servicing ratios make a firm more vulnerable to negative shocks. So we examine more carefully those firms for whom gearing and debt-servicing burden fall in the top 25 per cent of the group. On the other hand, low profitability and liquidity tend to make firms more vulnerable. Consequently, we look at developments in the group of firms with ratios in the bottom 25 per cent of the distribution. Looking at the distributions of the financial metrics, the financial position of the most vulnerable firms generally improved over the past few years (Graph 2). While the least profitable 25 per cent of companies are making losses, returns on equity for this group have risen slightly over the past few years. These companies, however, tend to have very little debt overall so there is little potential for flow-on effects to the financial sector. Gearing ratios for firms in the top 25 per cent of the group are quite a bit lower than they were a decade ago. In line with low gearing and the low interest rate https://www.rba.gov.au/speeches/2019/sp-ag-2019-08-08.html 4/13 08/08/2019 Financial Stability Through the Lens of Business | Speeches | RBA environment, the debt-servicing ratios for companies in the top 25 per cent of the distribution are also at low levels, having fallen sharply over the past decade. Lastly, the liquidity position of companies in the bottom 25 per cent has been reasonably stable over the past few years at higher levels than seen in the years leading up to the financial crisis. In general, it would seem that the financial stability risks from these vulnerable firms are not increasing. Graph 2 Sectoral differences Another perspective on financial stability risks comes from looking at sectors facing changes in their environment that could make them more vulnerable. The two I am going to focus on here are domestic retailing and mining because they provide some interesting contrasts. Domestic retailing, particularly bricks-and-mortar retailing for discretionary goods, has been experiencing challenging conditions in recent years. Competition from both large international and online retailers has been intense; consumer spending is growing slowly and consumer preferences are changing. Some colleagues of mine undertook some work on the potential financial stability risks associated with the retailing sector in the second half of last year. [1] Broadly, they concluded that, although https://www.rba.gov.au/speeches/2019/sp-ag-2019-08-08.html 5/13 08/08/2019 Financial Stability Through the Lens of Business | Speeches | RBA retailers and investors face a number of risks, there is currently no strong evidence of widespread vulnerability, or that risks to banks are high. They found that while listed discretionary goods retailers appear to be in good financial health overall, there were some signs of financial difficulties in some unlisted and smaller retailers. The next two graphs, drawn from their work, show some key financial ratios for listed and unlisted retailers respectively. There is a lot of information here so I want to draw your attention to just a few points. Starting with the listed sector, the financial position of discretionary retailers generally appear sound (Graph 3). Profitability as measured by return on equity has remained broadly stable at reasonably high levels across the distribution. Similarly, liquidity ratios are also at reasonably high levels so companies appear well positioned to meet their short-term liabilities. Turning to the bottom panels of the graph, gearing has been broadly unchanged at low levels across the distribution. In line with this, and also reflecting declining interest rates, debt-servicing ratios have trended downwards to be fairly low. Graph 3 Unlisted retailers, on the other hand, are not so well positioned in terms of gearing and liquidity (Graph 4). Over one quarter of unlisted retailers are highly indebted, with gearing ratios above 100 per cent. This implies that their debt is larger than their equity and, as a result, they are more https://www.rba.gov.au/speeches/2019/sp-ag-2019-08-08.html 6/13 08/08/2019 Financial Stability Through the Lens of Business | Speeches | RBA vulnerable to asset devaluations or losses. In addition, liquidity ratios declined in recent years and remain at low levels. This in turn has increased the risk that they will not be able to meet their shortterm liabilities without selling assets. Another negative development in this sector is that the share of loss-making retailers has increased over the past few years. However, these retailers are, on average, smaller, accounting for around 10 per cent of total retail sector debt. Similarly, they found that, looking across listed and unlisted companies, small retailers are more likely to be identified as vulnerable than large retailers. [2] This classification is based on whether at least two out of the four financial ratios fall in the most vulnerable 25 per cent of their distributions. Basing this classification on at least two ratios is important because looking at one financial metric alone may not give us a true sense of the firm's financial health. For example, a firm may have a relatively high gearing ratio but may be able to safely sustain this due to strong profitability. Taken together, smaller retailers appear to be facing more difficult conditions in both the listed and unlisted sector. Having said that, there is no current evidence of widespread vulnerability and difficulties in the sector appear unlikely to pose a significant risk to the banking sector. Graph 4 https://www.rba.gov.au/speeches/2019/sp-ag-2019-08-08.html 7/13 08/08/2019 Financial Stability Through the Lens of Business | Speeches | RBA However, the challenges faced by brick-and-mortar retailers have spilled over into the demand for retail floor space. Conditions are weakest in mid-sized shopping centres, where vacancy rates have increased to around 5 per cent, up from around 3 per cent a few years ago (Graph 5). Vacancy rates have also drifted a little higher in large shopping centres. Rents have been flat over the past few years, and landlords have attempted to avoid vacancies by increasing incentives and changing tenancy mixes. And retail valuations have been rising much slower than other commercial property valuations. At the same time, there has been a considerable increase in retail development activity in recent years, both in terms of refurbishments and the building of new centres. It is possible that some of this might just be keeping pace with population growth. But there is also a risk that new and improved shopping centres simply cannibalise business from some other centres, eventually resulting in excess supply, particularly in light of weak household spending of late. This would weigh on rents and valuations. And, to the extent that owners of these centres hold debt, difficulties in servicing repayments could result in further sales and price declines. Graph 5 Ultimately, the implication for financial stability of these vulnerabilities depends on the exposures of the financial institutions to retail businesses and developers. So the third issue addressed by my colleagues was banks' exposures to retail commercial property development. Given the increase in retail property development over the past decade, it is perhaps not surprising to see that banks' exposures have also risen (Graph 6). Indeed, in terms of commercial property, banks are most exposed to office and retail, and exposures to both these sectors have increased sharply over the https://www.rba.gov.au/speeches/2019/sp-ag-2019-08-08.html 8/13 08/08/2019 Financial Stability Through the Lens of Business | Speeches | RBA past decade. Nevertheless, at less than $60 billion, the exposure represents less than 3 per cent of major banks' assets. And despite the difficult conditions in this sector, this has not translated into a deterioration in loan performance with non-performing loans to the retail sector remaining unchanged at low levels. So, while there may be vulnerabilities in the retail sector, these do not currently seem to pose a significant risk to the financial sector. Graph 6 The second sector I want to focus on is the mining sector. In contrast to the retail sector, mining firms in aggregate have experienced improved conditions recently, driven by increased commodity prices. Accordingly, profitability has increased to be at its highest level in the past ten years (Graph 7). Liquidity is also at a very high level. At the same time, debt and gearing ratios are at the lower end of the ranges seen over the past couple of decades. In fact, they are also relatively low when compared to firms outside of the resources sector. As a result, mining firms' balance sheets appear well placed to absorb shocks, perhaps more than has been the case for some time. So, while risks related to market conditions have abated somewhat, this has occurred alongside ongoing improvements in mining firms' balance sheet positions. Specifically, firms in the sector have reported a strong focus on reducing costs, realising efficiencies and paying down debt, particularly amid earlier expectations of commodity price declines (as global supply increased and demand was seen to be moderating). And while banks' direct exposures to the mining sector tend to be very low at around one per cent, the mining sector accounts for around 20 per cent of Australia's business https://www.rba.gov.au/speeches/2019/sp-ag-2019-08-08.html 9/13 08/08/2019 Financial Stability Through the Lens of Business | Speeches | RBA investment. As such, there are important spillover channels to the rest of the economy, which mean that the improved position of mining firms reduces risks to firms in other parts of the economy. Graph 7 Small business The final issue I want to briefly cover is conditions for small business more generally and risks that could arise from this source. Small businesses are a substantial part of the Australian economy. They account for 70 per cent of employment and 40 per cent of production in the private nonfinancial sector. Difficult conditions in small business could therefore have flow-on effects to the economy through decreasing employment and lower income for unincorporated enterprises, and hence to the health of households' balance sheets more broadly. And these effects are often particularly felt in regional areas where small businesses are part of the lifeblood of the community. Furthermore, there could be impacts on banks' asset quality if non-performing loans rise. Small businesses have been facing tighter credit conditions over the past year or so from a level that was already tight. Over the past couple of years, lending to small businesses (which includes businesses with annual turnover of less than $50 million) has hardly grown at all, unlike lending to large businesses, which has grown by around five per cent per year on average (Graph 8). https://www.rba.gov.au/speeches/2019/sp-ag-2019-08-08.html 10/13 08/08/2019 Financial Stability Through the Lens of Business | Speeches | RBA Graph 8 There are a number of reasons why small businesses are facing tighter credit conditions. [4] First, there is a more of a blurring in the line between lending to small business and personal credit. The obligations placed on financial institutions for lending to consumers (under responsible lending obligations) are stricter than the requirements for lending to small business, and these have tightened over the past couple of years. But lenders are increasingly treating small businesses as household borrowers, imposing the stricter conditions on small business lending. Furthermore, property is a common form of security for small business lending – around 50 per cent of loans to small business are secured by residential property. The decline in housing prices over the past couple of years has therefore likely to have reduced the amount of money that small businesses can borrow. Having said that, some colleagues of mine have done some work looking at the characteristics of firms that are likely to receive credit. [5] They showed that, while the size of the business is an important consideration in the lender's decision to extend credit, other factors are also important once you control for size and other characteristics. These other factors include profitability, debtservicing ratios and credit history. For example, more profitable firms are more likely to receive credit after controlling for the influence of other characteristics. https://www.rba.gov.au/speeches/2019/sp-ag-2019-08-08.html 11/13 08/08/2019 Financial Stability Through the Lens of Business | Speeches | RBA Nonetheless, tighter credit conditions make it more difficult for small businesses to fund themselves or to refinance existing debt. It is likely to be particularly challenging in regional areas impacted by the drought, where many businesses are already experiencing difficulties. It is possible that these tighter credit conditions might push small businesses into failure and default on their loans. But any impact from this channel on the financial system at this stage is still quite small. Non-performing loans in the private unincorporated business sector have risen a bit over the past year or so but they remain at relatively low levels (Graph 9). And lending to this sector accounts for a small share of banks' assets. Graph 9 Conclusion Today I have outlined a view of the stability of the Australian financial system through the lens of the business sector. In general, the financial health of businesses looks sound. And while some individual sectors and regions do face challenges, these do not currently pose a threat to financial stability. Financial institutions are resilient and their exposures to these areas remain low. It is nevertheless important to keep an eye on developments in the business sector and remain alert to possible risks to financial stability from this source. https://www.rba.gov.au/speeches/2019/sp-ag-2019-08-08.html 12/13 08/08/2019 Financial Stability Through the Lens of Business | Speeches | RBA Endnotes [*] I am grateful to Gabriela Araujo and Cathie Close for assistance with this speech. Araujo G and T De Atholia (2018), ‘Financial Stability Risks and Retailing’, RBA They define small businesses as those with less than $10 million in assets, medium-sized businesses as those with more than $10 million but less than $100 million in assets, and large businesses as those with $100 million or more in assets. There are a variety of definitions of small business. The definition here is businesses with annual turnover less than $50 million. Connolly E and J Bank (2018), ‘Access to Small Business Finance’, RBA Araujo G and J Hambur (2018), ‘Which Firms Get Credit? Evidence from Firm-level Data’, RBA Bulletin, September. Bulletin, September. Bulletin, December. © Reserve Bank of Australia, 2001–2019. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2019/sp-ag-2019-08-08.html 13/13 | reserve bank of australia | 2,019 | 8 |
Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 9 August 2019. | Philip Lowe: Opening statement to the House of Representatives Standing Committee on Economics Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 9 August 2019. * * * Chair Members of the Committee Thank you for this opportunity to share our views on the Australian economy and the RBA’s important public policy responsibilities. My colleagues and I strive for a high level of transparency and these hearings are an important part of the accountability process. Later this morning, we will be releasing our quarterly Statement on Monetary Policy, which will include our latest forecasts. I would like to begin today by highlighting the main points regarding the forecasts for output growth, the labour market and inflation. I will then turn to monetary policy. Our central forecast is for the Australian economy to expand by 2½ per cent this year and 2¾ per cent over 2020. The growth forecast for this year has been revised down since we met six months ago, but the forecast for next year is unchanged. The downward revision this year mainly reflects weak consumption growth. It has become increasingly clear that the extended period of unusually slow growth in household incomes has been weighing on household spending, as has the adjustment in the housing market. Given this experience, the outlook for consumption continues to be the main domestic source of forecast uncertainty. Even so, looking ahead, there are signs the economy may have reached a gentle turning point. Consistent with this, we are expecting the quarterly GDP growth outcomes to strengthen gradually after a run of disappointing numbers. This outlook is supported by a number of developments including: lower interest rates, the recent tax cuts, a depreciation of the Australian dollar, a brighter outlook for investment in the resources sector, some stabilisation of the housing market and ongoing high levels of investment in infrastructure. It is reasonable to expect that, together, these factors will see growth in the Australian economy return to around its trend rate next year. The major uncertainty continues to be the trade and technology disputes between the United States and China. These disputes pose a significant risk to the global economy. Not only are they disrupting trade flows, but they are also generating considerable uncertainty for many businesses around the world. Worryingly, this uncertainty is leading to investment plans being postponed or reconsidered. It is also now generating volatility in financial markets and has increased the prospects of monetary easing in many countries. This means that we have a lot riding on these disputes being resolved. Turning now to the Australian labour market, the unemployment rate, at 5.2 per cent, is a little higher than when we met six months ago. This is despite employment growth having been stronger than we had expected. What has happened is that increased demand for labour has been met with more labour supply, especially by women and older Australians. Reflecting this, a higher share of the Australian adult population is participating in the labour market than ever before. This is good news. But one side-effect of this flexibility of labour supply is that it is harder to generate a tight labour market and so, in turn, it is harder to generate a material lift in aggregate wages growth. Looking forward, while some slowing in employment growth is expected, the central scenario is for the unemployment rate to move lower to reach 5 per cent again in 2021. If things evolve in line 1/4 BIS central bankers' speeches with this central scenario, it is probable that we will still have spare capacity in the labour market for a while yet, especially taking into account underemployment. This means that the upward pressure on wages growth over the next couple of years is likely to be only quite modest, and less than we were earlier expecting. Caps on wages growth in public sectors right across the country are another factor contributing to the subdued wage outcomes. At the aggregate level, my view is that a further pick-up in wages growth is both affordable and desirable. Turning now to inflation, the June quarter outcome was broadly in line with expectations, after a run of lower-than-expected numbers in earlier quarters. Over the year to June, inflation was 1.6 per cent, in both headline and underlying terms, extending the period over which inflation has been below the 2–3 per cent medium-term target range. The Reserve Bank Board remains committed to having inflation return to this range, but it is taking longer than earlier expected. There are a few factors that I would highlight as contributing to the low inflation outcome over the past year. These are: the slow growth in wages; the ongoing spare capacity in the economy; various government initiatives to address cost-of-living pressures on households; and the adjustment in the housing market, which has contributed to unusually low increases in rents and declines in the price of building a new home in some cities. Working in the other direction, the drought and the depreciation of the exchange rate have been pushing some prices up. Looking ahead, inflation is still expected to pick up, but the date at which it is expected to be back at 2 per cent has been pushed out again. Over 2020, inflation is forecast to be a little under 2 per cent and over 2021 it is expected to be a little above 2 per cent. At this point, I would like to turn to monetary policy. When we met with the Committee in February, I indicated that I thought the probabilities of a cash rate increase and a cash rate decrease were broadly balanced. Following that hearing, the situation continued to evolve and the Board reduced the cash rate twice – at its June and July meetings – to a new low of 1 per cent. A reasonable question to ask is: what changed? The answer is the accumulation of evidence that the economy could be on a better path than the one we looked to be on. The incoming data on wages, prices, GDP and unemployment all suggested that the Australian economy was some distance from running up against capacity constraints. It also suggested that the day at which inflation was comfortably back within the 2– 3 per cent medium-term target range was not getting any closer. Faced with this evidence, the Board decided that it was appropriate to lower the cash rate, after having kept it unchanged for more than 2½ years. It judged that a lower cash rate would boost jobs and help make more assured progress towards the inflation target. In the current environment, easier monetary policy mainly works through two channels. The first is that it affects the exchange rate, which is now at the lowest level it has been for some time. The second is that it boosts aggregate household disposable income. I acknowledge that lower interest rates hurt the finances of the many Australians who rely on interest payments and the Board has paid close attention to this issue. At the aggregate level though, for every dollar the household sector receives in interest income, it pays well over two dollars in interest to the banks and other lenders. This means that lower interest rates put more money into the hands of the household sector and, at some point, this extra money gets spent and this helps the overall economy. At its meeting earlier this week, the Board decided to leave the cash rate unchanged at 1 per cent. 2/4 BIS central bankers' speeches It judged that after having moved twice in quick succession it was appropriate to wait and assess developments both internationally and domestically. As I mentioned earlier, there have been a number of developments that could be expected to support the Australian economy over the next couple of years. Determining with precision the combined effect of these developments is difficult. It is certainly possible that their combined effect will be greater than the sum of the individual parts. If so, growth would surprise on the upside. Of course, it is also possible that the concerning international developments and the ongoing weak growth in household incomes could see the economy underperform our central scenario. The labour market will continue to provide an important guide as to which path we are on. It is, nevertheless, reasonable to expect an extended period of low interest rates in Australia. This reflects what is happening both overseas and here at home. While we might wish it were otherwise, it is difficult to escape the fact that if global interest rates are low, they are going to be low here in Australia too. When the global appetite to save is elevated relative to the appetite to invest – as it is now – interest rates in all countries are affected. Our floating exchange rate gives us the ability to set our own interest rates from a cyclical perspective, but it does not insulate us from long-lasting shifts in global interest rates driven by saving/investment decisions around the world. In the central scenario that I have sketched today, inflation will be below the target band for some time to come and the unemployment rate will remain above the level we estimate to be consistent with full employment. While this remains the case, the possibility of lower interest rates will remain on the table. The Board is prepared to ease monetary policy further if there is additional accumulation of evidence that this is needed to achieve our goals of full employment and inflation consistent with the target. Time will tell. As I have discussed on other occasions, if further stimulus to demand growth is required to get us to full employment and closer to the economy’s capacity, monetary policy is not the country’s only option. Monetary policy certainly can help, and it is helping, but there are certain downsides from relying too much on monetary policy. One option is for fiscal support, including through spending on infrastructure. Spending on infrastructure not only adds to demand in the economy but, done properly, it can boost the economy’s productivity. It can also directly improve the quality of people’s lives through reducing congestion and improving services. At the moment, there are some capacity constraints in parts of the infrastructure sector, but these should not prevent us from looking for further opportunities to boost the economy’s productive capacity and support domestic demand. There is no shortage of finance to do this, with interest rates the lowest they have ever been. This week, all governments in Australia can borrow for 10 years at less than 2 per cent. Another option is structural policies that support firms expanding, investing, innovating and employing people. A strong, dynamic business sector is the best way of creating jobs and growing the overall economy. We will all do better if Australia is viewed as a great place to expand, invest, innovate and employ people. A program of structural reform would help move us in this direction. It would also help boost productivity growth, which over recent times has slowed noticeably. If this slowing is maintained, it will become a serious issue and as a society we will have to make some difficult adjustments. So it is important that we think about the possibilities here, not just from a short-term perspective but from a long-term perspective as well. I would like to mention a couple of other areas of the Reserve Bank’s activities. As you would know, the Reserve Bank is the banker for the Australian Government. As the Government’s banker, our systems process the government’s payments and receive its 3/4 BIS central bankers' speeches revenue. Over recent years, we have undertaken major investments in these systems. Two weekends ago, we finally turned off the mainframe computer on which we had been running these important banking services for many, many years. Our new technology will allow us to continue to provide a very high level of service to the government and its agencies and we are working with them on some innovative payment solutions. The Department of Human Services is already using fast payments to get money to those in immediate need. The Reserve Bank is also continuing to invest heavily in the resilience of the systems we operate that are at the core of Australia’s interbank and fast payment system. In other payments related work, the Bank is continuing to look for ways to encourage faster development of the New Payments Platform, which allows Australians to move money between bank accounts in real time 24/7. We have not been satisfied with the progress to date by the major banks and want to see a faster pace of innovation that benefits individuals and small businesses. The Bank’s Payments System Board, in conjunction with the Council of Financial Regulators, is also reviewing the regulatory framework for money held in stored-value facilities and digital wallets. With so much innovation occurring in the world of digital payments, including by nonbank players, it is important that the regulatory regime in Australia is fit for purpose and appropriately balances competition and the protection of consumers. We are currently reviewing the regulatory regime in this area and as we complete this work, this issue may come before the Parliament. Another issue that we are working on that may come before the Parliament is the strengthening of the regulatory arrangements that apply to the financial infrastructures that underpin Australia’s financial markets. Finally, we will be releasing the new $20 banknote on 9 October. There are currently around 170 million $20 notes in circulation, so this is a big logistical exercise. I am confident that Australians will enjoy spending these new high-tech highly secure banknotes. I brought along a sheet today hot from the printing press for you to have a look at. Thank you. My colleagues and I appreciate this opportunity to answer your questions. 4/4 BIS central bankers' speeches | reserve bank of australia | 2,019 | 8 |
Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Finance & Treasury Association, Sydney, 13 August 2019. | Speech The Usual Transmission – Monetary Policy and Financial Conditions Christopher Kent [ * ] Assistant Governor (Financial Markets) Address to Finance & Treasury Association Sydney – 13 August 2019 Introduction I'd like to start by thanking the Finance and Treasury Association for the opportunity to speak to you today about the transmission of monetary policy. In my current position at the Reserve Bank I oversee the Financial Markets Group. Among other things, we spend our time analysing financial market developments, around the globe and in Australia. A key task is to consider the ways in which monetary policies are affecting economic developments. The first stage of that transmission is the effect of policies on financial conditions. The second stage of transmission – which I won't address today – is how those financial conditions then influence business and household decisions regarding investment and consumption, and the size and nature of their balance sheets. The first two years or so in my current position were characterised by a degree of stability in financial markets. [1] Taking just one example, 10-year government bond yields, which had increased through 2016 were moving in a relatively narrow range over most of 2017 and 2018 (Graph 1). Yields were drifting a little higher in the United States, to just above 3 per cent, they were stable within the range of 2.5 to 3 per cent in Australia, much lower than that but still positive and stable in Germany, and little changed around zero in Japan. Graph 1 Meanwhile, stimulatory monetary policies were gaining traction. Spare productive capacity in economies was being absorbed, with unemployment rates declining to relatively low levels and wages growth gradually picking up in a wide range of advanced economies. In a number of advanced economies – with inflation at, or close to targets – central banks were removing some stimulus. Most notable was the US Federal Reserve, but it was not alone in raising its policy rate (Graph 2). Moreover, market pricing suggested that monetary policies in a broader range of advanced economies – including in Australia – were more likely to be tightened rather than eased, even if that prospect was still some way off. Graph 2 Through 2018, higher US interest rates were placing some external financing pressure on a number of emerging market economies (EMEs), particularly those that had unhedged exposures to US dollar debts. Partly in response, a large share of EME central banks had raised their policy rates over the second half of that year. That global picture of steady improvement in economic conditions and gradual removal of monetary stimulus has changed significantly since late last year. Just a couple of weeks ago, the US Federal Open Market Committee (FOMC) reduced the federal funds rate. The Reserve Bank of Australia has also reduced the overnight cash rate in recent months, as has the Reserve Bank of New Zealand. Moreover, market pricing implies that a number of central banks in advanced economies are expected to reduce policy rates in the coming months. Central banks in a large share of EMEs have also reduced their policy rates. In the rest of my presentation, I will outline some reasons for this change in the stance of monetary policies. I'll then turn to the response of financial markets to those changes, with a focus on some of the key aspects of the transmission to financial conditions in Australia. The Changing Stance of Monetary Policies The market's view of the likely course of monetary policies in the major advanced economies has changed noticeably in just the past few months (Graph 3). Two weeks ago, the US FOMC reduced the fed funds rate by 25 basis points. At the same time, the Chair of the FOMC emphasised that the US economy remains strong, and that the policy easing should be viewed as a ‘mid-cycle adjustment’. In other words, more of a course correction than a reversal of course. The FOMC emphasised that it was responding to subdued inflation and the downside risks to the outlook for US economic activity. The FOMC also noted the easing in global growth, reflected most recently in a softening in business investment. Given all of this, and the recent ratchetting up of the US–China dispute, [2] market pricing currently suggests that the Fed is expected to lower its policy rate by a further 100 basis points by around this time next year. Graph 3 While US economic growth has held up reasonably well, growth in the euro area has slowed more noticeably. At its recent meeting, the European Central Bank (ECB) emphasised that it will provide additional stimulus in the absence of a further improvement in the outlook for inflation, which has averaged under 1 per cent for the past few years, compared with the ECB's medium-term target of close to, but below, 2 per cent. Should further stimulus be necessary, the ECB noted that it could lower its policy rate, strengthen its guidance on the future path of policy, and resume the expansion of its balance sheet (by purchasing additional government and private sector securities). Market analysts expect a package of such measures to be announced in September. And market pricing now implies that the ECB is expected to reduce its policy rate further into negative territory, from −40 basis points currently to −60 basis points by the end of this year. Meanwhile, the Bank of Japan (BoJ) recently emphasised that it will consider additional easing measures ‘… if momentum towards achieving …’ its inflation target were to be lost. Accordingly, market participants expect that the BoJ will lower its policy rate by 10 basis points to −20 basis points before the end of the year. Given increasing concerns about downside risks to growth around the world, and generally subdued inflation pressures, market pricing implies that policy rates are expected to be lowered in a number of other advanced economies. In Australia, with growth having slowed to a below-trend pace and inflation pressures subdued, the Board of the Reserve Bank reduced the cash rate at its June and July meetings. The Board noted that, although employment growth remained strong, there had been little inroad made into spare capacity in the labour market recently, with the unemployment rate having risen slightly. Financial market prices currently imply that the cash rate is expected to be reduced by a further 25 basis points later this year and then again in the first half of next year. The Response of Financial Markets Globally Towards the end of 2018, trade disputes were weighing on manufacturing, trade and business confidence around the globe. A broader easing in the pace of economic growth in some economies was also emerging, including in Europe and China. Financial markets responded to those developments, and rising concerns about the downside risks to the global outlook in an environment of subdued inflation. Of particular note, longer-term interest rates turned down. Those declines were extended more recently as the market reassessed the outlook for monetary policies as well as the outlook for growth in light of ongoing downside risks. With expectations that policies are likely to be more stimulatory than earlier anticipated, and with inflationary pressures remaining subdued, interest rates right along the yield curve have declined noticeably over the past year (Graph 4). Yields at 10 years are back below 2 per cent in the United States, and are at historic lows elsewhere, including in Germany, where 10-year yields are trading at close to −60 basis points. Rates in Japan have moved by less, which appears to reflect the market expectation that the BoJ is not likely to provide significant additional stimulus. Most notably though for this audience, the Australian yield curve has shifted down more so than in these other economies over the past year. Graph 4 As well as helping to reduce risk-free rates, the effect of the easier stance of monetary policies is evident in other financial markets. Corporate bond yields have declined this year (Graph 5). This reflects both lower government bond yields and lower corporate bond spreads. One possible interpretation of the low level of corporate bond spreads is that investors' concerns about corporate defaults are about as low as they have been for quite a few years. That is somewhat at odds though with significant concerns about downside risks to global growth. So it's possible that market participants are placing considerable faith in the willingness and ability of central banks to respond to adverse shocks. Alternatively, record low risk-free rates may be encouraging investors to search for yield, and so they may be underappreciating and underpricing the risks to corporate earnings. Graph 5 Also, for much of this year, equity prices have been supported by the effect of the changing stance of monetary policies on sovereign bond yields (Graph 6). In part, this reflects the rise in the discounted value of future corporate earnings arising from lower risk-free rates. At the same time, market analysts still expect good growth in earnings next year, despite some slowing in earnings growth this year and notwithstanding rising downside risks to global growth. Again, this suggests that participants judge that adverse shocks to growth are either likely to have only a modest effect on corporate earnings, and/or that policy accommodation will help to mitigate the effects of any adverse shocks to growth. However, as seen during the recent ratchetting up in the US–China dispute, asset prices could fall quickly if market participants become more concerned about its potential to weigh on growth of the global economy and corporate earnings. Graph 6 The combination of all of these changes has underpinned a general easing in global financial conditions through the course of this year. Changes in Australian Financial Conditions The transmission to Australian financial conditions of easier monetary policy both here and globally can be traced through the effects on funding costs, and on the Australian dollar. Funding costs – banks, businesses and households The recent reductions in the overnight cash rate in Australia – and the decline in interest rates right along the yield curve – have reduced the costs of funding to historical lows for banks, businesses and households. Banks' funding costs have declined across the board (Graph 7). The cost of funding in short-term money markets has declined noticeably this year. Much of the fall follows from the decline in the cash rate and the anticipation of a further decline over the coming months – as captured by the rate for the overnight indexed swaps, or OIS for short. Graph 7 But in addition to the change in the stance of monetary policy, the spread of the 3-month bank bill swap (BBSW) rate to OIS has declined this year, more than unwinding the increase seen in 2018 (Graph 8). Indeed this spread has declined to its lowest level in many years. Graph 8 Yields on the major banks' bonds have declined in response to both lower risk-free yields and a decline in the spreads of bank bonds to these reference rates. Also, banks have passed through most of the cash-rate reductions to interest rates on retail deposits, which account for about a third of their debt funding. As is typical, the interest rates on transaction accounts (which are at or close to zero) have not been changed following the reductions in the cash rate. However, these account for only a small share of the total value of the banks' retail deposits. [4] Other at-call deposit rates are estimated to have been lowered by 40−45 basis points, while interest rates on term deposits have fallen significantly over recent months. The banks have passed on these lower costs of funds to borrowers. Interest rates on loans to large businesses – the bulk of which are closely tied to BBSW rates – have declined over recent months to very low levels (Graph 8). Lending rates on outstanding loans to small businesses decreased by around 20 basis points following the reduction in the cash rate in June (the latest data available). Small business lending rates remain noticeably higher than interest rates for large businesses. This partly reflects the higher default rates associated with small business loans. Graph 9 Lenders have passed through most of the cash rate reductions to housing interest rates. Following the 50 basis point reduction in the cash rate from June to July, lenders lowered their standard variable rates (SVRs) on housing loans by an average of 44 basis points (Graph 10). The extent of pass-through was broadly consistent with the experience of the past decade. Graph 10 The average interest rate actually paid on outstanding variable-rate housing loans in the Reserve Bank's Securitisation Dataset decreased by 23 basis points in June, the same as the average announced reduction in SVRs. Similar reductions in outstanding rates are expected to be recorded for July data. So the declines in SVRs are being pushed through to all existing borrowers, which make up the so called ‘back book’. Rates on new loans have also been lowered. Indeed, new borrowers, and those refinancing existing loans, continue to be offered interest rates that are on average well below those applying to existing loans. So customers who are actively looking around at what's on offer, are able to take advantage of the strong competition among lenders that is focused squarely on the ‘front book’. Meanwhile, interest rates on fixed-rate housing loans have also declined significantly over recent months. Although housing credit growth declined further in June, approvals for new loans increased. This increase in approvals was broadly based, across owner-occupiers and investors, across states and across different types of lenders. It was also consistent with the improved conditions in housing markets evident in a range of indicators, such as auction clearance rates and housing price growth, particularly in New South Wales and Victoria. [5] If housing conditions continue to improve in the coming months, we would expect to see a further rise in loan approvals. The Exchange Rate Finally, I'll say a few words about the exchange rate, given that it is an important part of the transmission of monetary policy. In trade-weighted terms, the Australian dollar has declined by about 7 per cent over the past year or so and is now lower than it has been for many years (Graph 11). Graph 11 While commodity prices have declined more recently, they had trended higher over much of the past year when the exchange rate had been depreciating. But that earlier rise in commodity prices may have been less supportive for the exchange rate than in the past for a number of reasons. [6] First, at least some of increase in commodity prices over the past year had been expected to be short lived, given that was driven by supply disruptions. Second, the rise in commodity prices over the past year or so was likely to have been seen as less expansionary than in the past. Certainly, it is unlikely to have supported a boom in mining investment of the like seen a few years ago. [7] Third, the positive effect of the upward trend in commodity prices on the exchange rate might have been partly offset given downside risks to the outlook for the Chinese economy that could weigh on demand for Australian goods and services outside of resources (such as education and tourism, for example). Despite these possibilities, the upward trend in commodity prices was still likely to have provided some support to the value of the Australian dollar over much of the past year or more. Despite that support, the Australian dollar had depreciated over that period when commodity prices had been rising. That implies that the effect of monetary policy on the exchange rate has been broadly working as usual. As I mentioned before, there has been a noticeable decline in Australian interest rates relative to those of major advanced economies. At a two-year horizon, this interest rate differential has declined by about 100 basis points over the past year. This lower return on Australian assets would no doubt have contributed to a decline in the value of the Australian dollar. Conclusion Bringing all of this together, I draw the conclusion that the transmission of monetary policy in Australia to financial conditions is working in the usual way. In particular, the change in the stance of policy has underpinned the decline in risk-free rates along the yield curve. It has also contributed to a decline in the cost of funding in corporate bond markets, supported equity prices, and lowered the cost of funding for banks, including through lower rates on bank deposits. Much of the reduction in banks' funding costs has been passed through to business and household borrowers. And notwithstanding an easier stance of monetary policy globally, the decline in interest rates in Australia has contributed to the depreciation of the Australian dollar. That broad-based easing in financial conditions in Australia will provide some additional support to demand in the period ahead. Endnotes [*] I thank Max Wakefield for valuable assistance in preparing this material. See Debelle G (2018), ‘Risk and Return in a Low Rate Environment’ Speech at Financial Risk Day, Sydney, 16 March. For a more detailed discussion of the implications of this and other trade disputes for the economic outlook see Debelle G (2019), ‘Risk to the Outlook’, speech at the 14th Annual Risk Australia Conference, Sydney, (upcoming). While global developments influence Australian financial conditions, changes in monetary policy settings elsewhere need not, and do not, mechanically feed through to the funding costs of Australian banks. For a further discussion of this point, see Kent C (2018), ‘US Monetary Policy and Australian Financial Conditions’, The Bloomberg Address, Sydney, 10 December. As of June, retail deposits paying no interest accounted for a little under 10 per cent of the value of the major banks' retail deposits. The share of deposits that paid some interest, but less than 50 basis points, was also a little under 10 per cent in June (up from around 5 per cent of deposits in February). See RBA (Reserve Bank of Australia) (2019), , August, viewed 9 August 2019. Available at https://www.rba.gov.au/publications/smp/2019/aug/>. Statement on Monetary Policy Statement on Monetary Policy RBA (2019), , August, viewed 9 August 2019. Available at https://www.rba.gov.au/publications/smp/2019/aug/. Chapman B, J Jaaskela and E Smith (2018), ‘A Forward-looking Model of the Australian Dollar’, RBA , December, viewed 9 August 2019. Available at <https://www.rba.gov.au/publications/bulletin/2018/dec/a-forwardlooking-model-of-the-australian-dollar.html>. Bulletin RBA (2019), ‘Box B: The Recent Increase in Iron Ore Prices and Implications for the Australian Economy’, , August, pp 37–40. on Monetary Policy Statement © Reserve Bank of Australia, 2001–2019. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. | reserve bank of australia | 2,019 | 8 |
Keynote address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the 14th Annual Risk Australia Conference, Sydney, 15 August 2019. | 8/15/2019 Risks to the Outlook | Speeches | RBA Speech Risks to the Outlook Guy Debelle [ * ] Deputy Governor Keynote Address at the 14th Annual Risk Australia Conference Sydney – 15 August 2019 Today I am going to talk about some of the key risks around the outlook for the Australian economy. Statement on Monetary Policy I will draw on the material published last week in the August . On the global side, I will discuss some of the implications of the trade and technology disputes between the US and China. On the domestic side, the key risk for some time has been the outlook for consumption. I will highlight some of the main uncertainties that are likely to affect that outlook. Beyond the near-term risks for the economy, climate poses a material risk for the economy and financial markets over a longer horizon. Finally, given the audience, I will remind you of an actuality, not a risk, that you need to be prepared for; namely the cessation of LIBOR, the key interest rate benchmark in financial markets. Trade and Technology Dispute The trade dispute between the US and China has been with us in its current form for almost two years now. The direct effect of the tariffs that have been imposed to date on global growth has not been all that large, though the impact on particular businesses has been significant. Rather, the larger impact has been the uncertainty generated by the dispute. That uncertainty takes two forms: uncertainty about the size and incidence of the tariffs and uncertainty about how, and even if, the technology dispute will be resolved. On the tariff side, the prospect of a 25 per cent tariff is a firstorder consideration in determining whether to invest in a new factory or new machinery and where to locate that investment. It is plausible that the effect of the technology dispute will be larger than that of the tariffs. The technology dispute raises the possibility that any business involved in the technology production chain will have to choose between East and West rather than selling into a global market. https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-15.html 1/10 8/15/2019 Risks to the Outlook | Speeches | RBA The uncertainty as to how the dispute will play out on both the trade and technology fronts means businesses are waiting to see how the uncertainty resolves rather than invest. It is too risky to commit to a multi-year project or buy a large piece of plant if the economics of the decision can get completely undermined by a policy decision. The effect of that decision to wait rather than invest is clear in surveys of manufacturing businesses right round the world, which have fallen to low levels over the course of the past twelve months as the dispute has intensified (Graph 1). It is particularly apparent in east Asia, most obviously South Korea, as well as places like Germany. Both of these countries are heavily integrated in the global supply chain, and produce a large amount of investment goods. However, the impact is not universally negative. Some economies have actually recorded increases in investment. Vietnam, in particular, is close to full capacity as businesses relocate operations there to try to avoid the direct effect of the tariffs. Graph 1 Investment in manufacturing sectors around the world is weak and is dragging on growth. At the same time, the domestic side of a number of economies, which is insulated from the trade dispute, has been resilient to date. Reflecting this, employment growth has been strong and unemployment rates are at multi-decade lows in the US, Japan, Germany and the UK. Notwithstanding the increased uncertainties around the outlook, businesses have been continuing to employ workers at a solid pace. In part, this is because it is generally easier and less costly for businesses to adjust the size of https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-15.html 2/10 8/15/2019 Risks to the Outlook | Speeches | RBA their workforce than it is to adjust their capital stock. In turn, both are much less expensive and easier to adjust than the decision to build a whole new factory. But this short-term adjustment can only go on for so long. In the end, the decision to build or not build that new factory needs to be taken. The longer businesses hold off, the weaker demand will be, which will further confirm the decision to wait. That runs the risk of a self-fulfilling downturn. If, on the other hand, domestic demand remains resilient, there could be enough demand that businesses decide an investment will be profitable regardless of the trade uncertainty. Another material outcome of the current dispute, which would have a large and long-lasting impact, is the threat it poses to the system of rules-based trade that has prevailed for many years. Despite some flaws, that system has provided a high degree of certainty around the operating environment. The China–US dispute casts serious doubt on that. We can also see that manifest in the US–Europe trade issues, as well as those between South Korea and Japan. Trade is being used as the bargaining tool of choice, including for issues that don't have much to do with trade. How is the trade dispute affecting the Australian economy? Australia is not very involved in the global supply chain, particularly for technology. We consume the end product but we don't provide much of the inputs along the way. We export resources not microchips. While the Australian economy is often regarded as a proxy for China, the primary exposure of the Australian economy is to the Chinese domestic economy, not the Chinese external sector. The external sector has been the part of the Chinese economy most affected by the trade dispute. As the external sector in China has come under pressure from the trade dispute and the Chinese economy has slowed, the Chinese policymakers have responded with stimulus to the domestic economy. So far, they have been relying more on fiscal policy than monetary policy. Our assessment is that the degree of overall fiscal stimulus in China is probably about on par with that in 2015, but still noticeably less than the very large stimulus implemented in 2009 in the aftermath of the Global Financial Crisis. The stimulus has been directed to the parts of the Chinese economy that are steel intensive, most notably infrastructure. This has boosted demand for coal and iron ore. In turn, the price of iron ore, in particular, rose by much more than expected, receiving a further significant boost from reduced supply in Brazil in the aftermath of the tailings dam collapse and weather-related supply disruptions in Australia. As a result, the terms of trade in Australia are at their highest level since 2013, and more than 10 per cent higher than we (and others) thought would be the case (Graph 2). https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-15.html 3/10 8/15/2019 Risks to the Outlook | Speeches | RBA Graph 2 How does that rise in the terms of trade feed through the economy? It is a significant boost to national income, particularly given it has occurred alongside a depreciation of the Australian dollar. However, it is often difficult to pin down the channels through which a rise in the terms of trade propagates through the economy. What is clear is that we are not going to get a repeat of the resources boom that occurred when iron ore prices were last at these levels. There is some increased investment in train to maintain the current levels of production but not to materially increase them. So we have seen the effect of the increased demand in China reflected in the price not in higher export volumes. While a significant share (around three-quarters) of these profits from the high iron ore prices accrue to foreign shareholders, some flows to domestic households through direct and indirect share ownership. Public sector revenue will also receive a boost, mainly through higher tax receipts and mining royalties. It is unclear what the governments will do with this unexpected revenue. Hence, the domestic stimulus in China to offset the trade dispute has contributed to a short-term boost to the Australian economy and significantly mitigated the impact of the trade disputes on us. How long this lasts will depend on the effectiveness and longevity of Chinese domestic stimulus. The iron ore price has fallen from its peaks and we expect the iron price to decline further from here, and with it the terms of trade. But over the past year, we, along with the market, have been significantly surprised on the upside (Graph 3). https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-15.html 4/10 8/15/2019 Risks to the Outlook | Speeches | RBA Graph 3 Australia also has significant exports to China in both tourism and education. To date, these have been broadly unaffected by the slowdown in the Chinese economy. But a further significant slowing in the Chinese economy and household incomes would clearly pose a risk. To date, the Australian economy has been largely shielded from the effect of the trade disputes. But Australia has been a major beneficiary from the rules-based global trading system over many decades. The current threats to that are clearly a major risk for the Australian outlook over a longer horizon. Consumption Turning to the domestic economy, the primary risk for some time has been the outlook for consumption. The risks to consumption are always going to be important, because consumption is such a large share of the economy (around three-fifths). Over the past few years, it has been challenging to assess both the current pace and outlook for consumption. In the first half of 2018, consumption had been recorded as growing at a solid pace, around 3 per cent. But the September quarter national accounts recorded both a notably slower pace of consumption growth in that quarter, and a downward revision to the recent history, so that growth was measured to be around half a percentage point slower than previously thought. This changed our assessment of the consumption outlook. The momentum was not as strong as https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-15.html 5/10 8/15/2019 Risks to the Outlook | Speeches | RBA previously thought, which was further confirmed with slow growth in consumption in the December and March quarters (Graph 4). Graph 4 What has been weighing on consumption? A primary cause has been the slow pace of growth in household disposable income, that is, income after tax. Household income growth has been low for a number of years now. This is despite strong employment growth and clearly reflects the slow wages growth. As households have come to expect that this slow wages growth will persist, they have constrained their spending plans. On top of that, despite the low income growth, household tax payments grew at a very fast pace: 10 per cent over 2018 (Graph 5). [1] This seems to have reflected increased compliance and lower tax deductions, as well as bracket creep. As a result, income left after tax was considerably less than we and, I suspect, households had expected. This contributed to a further slowdown in consumption spending. https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-15.html 6/10 8/15/2019 Risks to the Outlook | Speeches | RBA Graph 5 Overlaid on the slow growth in household income has been the effect of the decline in housing prices. Some part of that effect comes through a wealth effect: as housing prices fall, homeowners' wealth declines, which reduces their spending. Some part of the effect comes through the lower housing turnover that has accompanied the decline in housing prices. Housing turnover is around its lowest level in more than 20 years. When people move house, they spend more on things like household furniture. [2] The decline in housing prices has also been accompanied by a particularly large reduction in spending on cars. Looking forward, there are a number of factors moving in different directions that affect the outlook for consumption. Income growth is picking up a little. We do not expect much of an increase in wages growth although employment growth is expected to be reasonable, though slower than recent history. But household disposable income growth is likely to be higher because of the direct effect of the tax offset payments to low and middle income households, and also because we don't expect that tax payments will continue to significantly outpace income growth. Low and middle income households are getting their tax refunds around about now. It is uncertain how much of that they will spend or save, or use to pay down their mortgage. Based on past experience, we are assuming they will spend around half of it. We will see how this plays out through our liaison and in the data in the coming months. Households are also benefiting, in aggregate, from the effect of lower interest rates. While the income of households with deposits is lower, the household sector as a whole has around twice as much debt as deposits. Hence the cash flow boost from lower mortgage payments outweighs that of https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-15.html 7/10 8/15/2019 Risks to the Outlook | Speeches | RBA lower deposit rates. Again, there is uncertainty about how much of that cash flow boost will be spent or saved, including in the form of paying down mortgages faster. If households use the additional cash flow to pay down their mortgages, it does bring closer the date that they will be more comfortable with their balance sheets and return to more regular spending habits. A final factor affecting the consumption outlook is the dynamics in housing markets. There is evidence that the decline in housing prices has reached its end. If this is the case, the drag from declining wealth and turnover will dissipate. Housing market conditions may even start to support consumption growth again in the period ahead. In conclusion, there are some near-term downside risks to the consumption outlook, including from a softer labour market. But further out, the risks to the outlook are more evenly balanced. Looking at the domestic outlook more broadly, we are expecting the GDP growth outcomes to strengthen after a run of disappointing numbers. This outlook is supported by a number of developments including: lower interest rates, the recent tax cuts, a depreciation of the Australian dollar, a brighter outlook for investment in the resources sector, some stabilisation of the housing market and ongoing high levels of investment in infrastructure. Determining with precision the combined effect of these developments is difficult, but the overall risks appear to be more balanced. Climate Risk Having talked about two major near-term risk for the economic outlook, I would also remind you to take appropriate account of one risk that plays out over a longer horizon, namely climate risk. I talked about this in detail earlier in the year. [3] Given your roles as risk managers, it is important that you have a useful framework to assess this risk to your business. Climate is a challenging risk to assess but an increasingly necessary one. Businesses need to take account of both the physical risks and the transition risks. Physical risk is about the direct impact of climate on your business and the assets that it holds. What will be the effect of climate change on the price of an asset my company owns, particularly if it is a long-lived asset such as, for example, a mortgage? Transition risk is about the potential effects to businesses as the country and the economy adjusts to the changes in the climate. This includes the adjustment to policy responses required to meet the Paris objectives. As risk managers, you can bring your skills at calculating the expected future value of financial assets across a number of potential scenarios. In that sense, climate risk is not that different from other risks, though the challenge of translating uncertain future paths for the climate into paths for the economy and the prices of financial assets is harder than some of the other risks that you generally deal with. But it a challenge that needs to be confronted. is I would emphasise the importance of disclosure, echoing the comments by Geoff Summerhayes of APRA and John Price of ASIC, as well as the information that ASIC released earlier this week. [4] You should all be aware of the recommendations of the recent report of the Task Force on Climaterelated Financial Disclosures (TCFD) chaired by Michael Bloomberg. It is important not just to have disclosure for disclosures sake, but to have consistent and informative disclosure. Investors need to https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-15.html 8/10 8/15/2019 Risks to the Outlook | Speeches | RBA be able to take account of that information in making their decisions, and be able to compare that across companies and across financial assets. Risk management under uncertainty is always challenging, but the challenge can be reduced with better and consistent information both in terms of the data inputs and the consistency of the scenarios considered. Interest Rate Benchmark Reform The final issue I would like to talk about is quite different from the risks I've discussed so far. The end of LIBOR is not a risk. It's a certainty that the finance industry needs to be ready for. It has now been just over two years since Andrew Bailey announced that the FCA (the Financial Conduct Authority) would no longer use its powers to sustain LIBOR beyond 2021. Financial regulators around the world expect institutions using LIBOR to be ready to transition to more robust benchmarks. With strong support from the RBA and APRA, ASIC recently wrote to the CEOs of major Australian financial institutions to seek assurance that they are taking appropriate action. The transition from LIBOR to alternative risk-free rates (RFRs) is accelerating internationally. Usage of RFRs in derivatives markets is increasing, and they are being adopted in some cash products. There has also been good progress on developing more robust fall-back provisions in contracts referencing LIBOR. ISDA has completed consultations on the fall-back methodology for almost all of the LIBOR currencies (and some other IBORs including BBSW). [7] ISDA found strong support for using as the fall-back: the compounded RFR with an adjustment for the historical spread between the RFR and LIBOR. Once ISDA has finalised the fall-back provisions, regulators expect users of benchmarks to adopt them. In Australia, we have taken a different path. The credit-based benchmark BBSW (the Bank Bill Swap Rate) has been strengthened and coexists alongside the cash rate, which is the risk-free rate for the Australian dollar. This has been possible since both BBSW and the cash rate are supported by underlying markets with enough transactions to calculate robust benchmarks. We have been encouraging users of Australian dollar benchmarks to be choosing the benchmark that is most appropriate for their circumstances. Sometimes it makes sense to use a credit-based benchmark, such as BBSW, particularly when banks are issuing funding instruments. However, it often makes more sense to use a risk-free benchmark, such as when governments raise funding. There has been progress on this in recent months, with the South Australian Government Financing Authority issuing the first FRN referencing the cash rate. Nevertheless, the lesson from LIBOR is that no benchmarks should be taken for granted. So while BBSW remains robust, it is prudent to have robust fallbacks in your contracts in case it were ever to cease. This is why we have been working with ISDA to strengthen the contractual fallbacks for BBSW too. Once ISDA has finalised the fall-back provisions, we expect all users of BBSW to adopt them where possible. The RBA will be managing our own risks in this area by requiring new securities referencing BBSW to have robust fall-back provisions in order to be eligible in the RBA's market operations. https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-15.html 9/10 8/15/2019 Risks to the Outlook | Speeches | RBA Conclusion To conclude, I have highlighted two near-term risks to the economic outlook, one global, one domestic. I have also raised the longer-term risk of climate. None of these risks are easy to assess, but nor can they be ignored. I have also highlighted the issue of benchmark reform that is not a risk but an actuality, which absolutely needs attention right now. Endnotes [*] Thanks to Mark Chambers, Ellis Connolly and Tom Rosewall for helpful input. Ellis L (2019), ‘What's Up (and Down) With Households?’ Address to Housing Industry Association March Industry Outlook Breakfast, Sydney, 26 March. See May D, G Nodari, and D Rees (2019), ‘Wealth and Consumption’, RBA March. Available at <https://www.rba.gov.au/publications/bulletin/2019/mar/wealth-and-consumption.html>. Debelle G (2019), ‘Climate Change and the Economy’, Address at the Centre for Policy Development, Public Forum, Sydney, 12 March. Price J (2018), ‘Climate Change’, Keynote address at the Centre for Policy Development: Financing a Sustainable Economy, Sydney, 18 June. Available at <https://asic.gov.au/about-asic/news-centre/speeches/climate-change/>. Summerhayes G (2017), ‘Australia's new horizon: Climate change challenges and prudential risk’. Available at <https://www.apra.gov.au/media-centre/speeches/australias-new-horizon-climate-change-challenges-andprudential-risk>. See also <https://asic.gov.au/about-asic/news-centre/find-a-media-release/2019-releases/19208mr-asic-updates-guidance-on-climate-change-related-disclosure/> I have talked about this issue previously: Debelle G (2019), ‘Progress on Benchmark Reform’, Keynote at ISDA's 34th Annual General Meeting, Hong Kong, 11 April; Debelle G (2018), ‘Interest Rate Benchmark Reform’ Speech at ISDA Forum, Hong Kong, 15 May; Debelle G (2017), ‘Interest Rate Benchmarks’, Speech at FINSIA Signature Event: The Regulators, Sydney, 8 September; Debelle G (2016), ‘Interest Rate Benchmarks’, Speech at KangaNews Debt Capital Markets Summit 2016, Sydney 22 February; Debelle G (2015), ‘Benchmarks’, Speech at Bloomberg Summit, Sydney, 18 November. See RBA, APRA, ASIC (2019), ‘Regulators Urge Financial Institutions to Plan for LIBOR Transition, Joint Media Release, 9 May. Available at <https://www.rba.gov.au/media-releases/2019/mr-19-12.html>. See ISDA (2018), ‘ISDA Publishes Final Results of Benchmark Fallbacks Consultation’, Press Release, 20 December. Available at <https://www.isda.org/2018/12/20/isda-publishes-final-results-of-benchmark-fallback-consultation/> and ISDA (2019), ‘ISDA Publishes Preliminary Results of Supplemental Benchmark Fallbacks Consultation’, Press Release, 30 July. Available at <https://www.isda.org/2019/07/30/isda-publishes-preliminary-results-ofsupplemental-benchmark-fallbacks-consultation/>. Bulletin, © Reserve Bank of Australia, 2001–2019. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-15.html 10/10 | reserve bank of australia | 2,019 | 8 |
Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at "Challenges for Monetary Policy", a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 25 August 2019. | Philip Lowe: Remarks at Jackson Hole Symposium Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at "Challenges for Monetary Policy", a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 25 August 2019. * * * I would like to thank the Kansas City Fed for the invitation to participate in this panel. It is a great honour to be able to contribute to the discussion. Given the theme of the symposium, I would like to focus on three broad challenges facing monetary policy globally. It is quite possible that you will find my perspective idiosyncratic, but it is shaped by coming from a country that has: had a long period of uninterrupted growth not needed to engage in quantitative easing prospered as a small open economy with a floating exchange rate and an open capital account bipartisan political support for the monetary policy framework a central bank with a triple mandate (not a dual mandate), namely price stability, full employment and the economic prosperity of the people of Australia. My perspective is also shaped by coming from a central bank that is feeling the full weight of some powerful global forces that are shaping monetary policy everywhere. So, with those qualifiers, the three global challenges that I would like to talk about are: 1. the difficulty of navigating when the ‘stars’ are shifting 2. dealing with elevated expectations that monetary policy can deliver economic prosperity 3. the challenge of communicating effectively with the broader public, not just financial markets. Navigating When the ‘Stars’ are Shifting Over recent times there have been very large shifts in estimates of full employment (U star) and the equilibrium real interest rate (r star). These shifts have occurred not just in one or two countries, but they have occurred almost everywhere. The fact that the experience is so common across countries strongly suggests there are some global factors at work. It is worth noting that these shifts in the stars were not predicted – they have come as a surprise. However, once it became clear that the stars were shifting, the economics profession has become very good at developing explanations for why this has happened. Even so, the reality is that our understanding is still far from complete about what constitutes full employment in our economies and how the equilibrium interest rate is going to move in the future. I would, though, like to highlight two of the likely explanations for why the stars have moved. The first is major changes around the world in the appetite to save and to invest (at any given interest rate). These changes are linked to: demographics; the rise of Asia; the legacy of too much borrowing in 1/6 BIS central bankers' speeches the past; slower productivity growth; and, importantly, increased uncertainty and a lack of confidence about the future. Together, these factors have fundamentally altered savings and investment decisions. The second major change is an increased perception of competition as a result of globalisation and advances in technology. The earlier waves of globalisation mainly affected firms and workers in the manufacturing industries in the advanced economies. But today’s wave is affecting a much broader range of industries, including the service industries. Many more people now understand that somebody, somewhere else in the world, can do their job, perhaps at a lower rate of pay. This is a result of both advances in technology and the globalisation of business. I see this shift very clearly in Australia, with jobs once done in Sydney and Melbourne now able to be done in Bangalore, Chengdu and Manila. As a result, the number of truly non-traded jobs is shrinking. One example of this that illustrates the point is that the executive assistants to some senior executives in Sydney are now located in the Philippines, with the Sydney-based executive clicking on an app on their computer to communicate via video link. This has been made possible by technology and globalisation. The implication of this is that the same competitive forces that were earlier felt in the manufacturing sector are now being felt in many service industries. More competition means less pricing power, for both firms and workers. There are exceptions to the general idea that globalisation and technology have increased competition – the global technology platforms being the most obvious – but most businesses and workers feel that the world has become more competitive. Together, the shifts in saving and investment decisions and increased perceptions of competition are having major effects. They are leading to: lower interest rates an economic system that is less prone to inflation, at least for an extended period lower estimates of the unemployment rate associated with full employment the old signposts being less reliable than they once were. If you accept this diagnosis, the obvious question is how do we respond? I would like to make two points here. The first is that the paper by Alan Taylor and Oscar Jorda at this symposium points us in the right direction. Any individual country’s interest rates are partly determined by global factors that are difficult to resist and often difficult to predict. This means that we need to pay close attention to these global factors in our decision-making. At the Reserve Bank of Australia we are very conscious of these global forces. We still feel that, thanks to our floating exchange rate, we have a high degree of monetary autonomy from a cyclical perspective. So from that viewpoint, the textbook still applies. At the same time, though, we feel that we have no autonomy when it comes to shifts in the global equilibrium real interest rate. If we were to maintain our interest rate in the face of a decline in the global rate, our exchange rate would appreciate, likely moving us away from our goals for inflation and unemployment. So we have to move too and this has been a consideration in our recent thinking on interest rates. The second response to the uncertainty about the shifting stars is to accept a degree of flexibility in inflation outcomes. Given the global forces at work, short-term inflation control looks harder than it once was and 2/6 BIS central bankers' speeches there is more uncertainty about what is required to deliver this control. When inflation targeting was first introduced, a great deal of emphasis was placed on central banks achieving their targets as precisely as they could. They wanted to do this to demonstrate their commitment to inflation control and to build their credibility as inflation fighters. But times have now moved on and this opens up the possibility of a refined approach. In my view, the uncertainty about the stars increases the already strong case for a flexible inflation target. And in some cases, there is nothing wrong in using that flexibility. From a welfare perspective, what is important is that we deliver low and stable inflation. While people in financial markets pay very close attention to whether inflation is 1.6 per cent or 2.0 per cent or 2.2 per cent, most people in the communities that we serve don’t see much difference in these numbers. And most of the time, nor should they; they all constitute low inflation. In fact, many people in our communities are incredulous that we would be too worried over whether inflation was 1.6 per cent, 2.0 per cent or 2.2 per cent. They ask, ‘haven’t you got something more important to worry about?' In Australia, we have long had a flexible inflation target. Our target is to achieve an average rate of inflation, over time, of between 2 and 3 per cent. We also see the inflation objective as nested within the broader objective of welfare maximisation. So the question the Reserve Bank Board often asks itself in making its interest rate decision is how our decision can best contribute to the welfare of the Australian people. Keeping inflation close to target is part of the answer, but it is not the full answer. Given the uncertainties we face, it is appropriate that we have a degree of flexibility, but when we use this flexibility we need to explain why we are doing so and how our decisions are consistent with our mandate. I recognise that there are limits to how much flexibility in inflation outcomes central banks can tolerate. One risk is that if inflation outcomes are away from the target for too long, inflation expectations could also drift away from the target too. We need to guard against this, but keeping an eye on the ultimate goal of low and stable inflation mitigates that risk. Elevated Expectations That Monetary Policy Can Deliver Economic Prosperity The second challenge I want to discuss is dealing with the elevated expectations that monetary policy can deliver economic prosperity. As we have discussed at the symposium, growth in aggregate output and incomes in many countries is weaker than we would like and there are clear downside risks. Reflecting this, in some political systems and in some parts of the community there is a strongly held view that the central banks should fix this. At the same time, they should address income and wealth inequality and deliver economic prosperity for the whole community. As most people at the symposium would appreciate, the reality is more complicated than this, not least because weak growth in output and incomes is largely reflecting structural factors. Another element of the reality we face is that monetary policy is just one of the levers that are potentially available for managing the economy. And, arguably, given the challenges we face at the moment, it is not the best lever. Another part of the reality we face is that a number of the other possible levers are hard to move, or are stuck. This means that more is being asked of monetary policy and, arguably, this is suboptimal from a welfare perspective. One way of looking at the world economy at the moment is that we are experiencing a series of significant political shocks – the serious issues between the United States and China, Brexit, the problems in Hong Kong, the tensions between Japan and South Korea, and the stresses in Italy. 3/6 BIS central bankers' speeches As we heard yesterday, these shocks are generating considerable uncertainty. Faced with this uncertainty, businesses are reconsidering their investment plans. Many are preferring to wait and see how things evolve before committing to difficult-to-reverse decisions about technology and capital spending. Not surprisingly, the result is weaker global growth. Central banks are seeking to offset the effects of these shocks with lower interest rates and/or more monetary stimulus. This is entirely understandable, although it remains to be seen how effective it will be. When easing monetary policy, all centrals bank know that part of the transmission mechanism is a depreciation of the exchange rate. But if all central banks ease similarly at around the same time, there is no exchange rate channel: we trade with one another, not with Mars. There are, of course other transmission mechanisms, but once we cancel out the exchange rate channel, the overall effect for any one economy is reduced. If firms don’t want to invest because of elevated uncertainty, we can’t be confident that changes in monetary conditions will have the normal effect. What we can have more confidence in, though, is that the easier monetary conditions will push up asset prices, which brings its own set of risks. So what are the other policy levers? Broadly speaking, there are three. The first is to reduce the political shocks. I will leave it to others to speculate as to how likely this is to occur. If it did occur, the global economy could look forward to better times, as firms make up for delayed investment in an environment where monetary conditions remain highly accommodative. A second lever is fiscal policy, including through extra spending on quality infrastructure. If this lever could be used, it could boost aggregate demand and support future productivity. It is worth recalling that very low interest rates increase the value of projects with very long-lived payoffs. Some well-chosen infrastructure projects would fall into this category. In many countries, the fiscal/infrastructure lever is hard to move or is stuck because of either a high level of existing public debt or difficulties in generating the political consensus about what should be done. A third potential lever is structural reforms that encourage firms to expand, invest, innovate and hire people. Given the productivity challenges that we face, this is probably the best lever. But it, too, is hard to move or is stuck in many countries. Structural reforms are often highly politically contested and our political systems are having trouble building the necessary consensus about what to do, and how to do it. To the extent that other policy levers are hard to move, or are stuck, monetary policy is carrying a lot of the weight. A reasonable question to ask is: is this a problem? Is it just that central banks don’t like the weight and would rather shift responsibility? Or are there more serious issues at stake? I would suggest it is the latter. First, monetary policy can’t drive long-term growth, but the other policy levers can. Second, relying on monetary policy risks further increases in asset prices in a slowing economy, which is an uncomfortable combination. And third, a failure to meet community expectations could lead to a political response that undercuts the credibility of central banks and undermines their effectiveness. It is hard to predict exactly how this might work out, but the answer is not well. This all means that there is a lot riding on these other levers becoming easier to move. Communicating Effectively in This Challenging and Changing World 4/6 BIS central bankers' speeches The third broad challenge that I would like to discuss is how best to communicate with the broader public. I agree very much with Athanasios Orphanides about the importance of: transparency; of having a clearly understood framework; and the use of simple language by the central bank. Despite my agreement with these high-level principles, I did not find his specific prescriptions that helpful in dealing with the communications challenges that I face. His prescriptions include: 1. being explicit about the exact weights applying to each of the elements in the central bank’s objective function 2. establishing a presumption that policy will be adjusted according to a rule, with an annual review of the rule 3. communicating uncertainty by publishing, for each member of the monetary policy committee, the full probability distribution of their expectations for key variables. These prescriptions strike me as overly technical. I don’t see it as particularly helpful to base communications on coefficients in objective functions, full probability distributions and rules. I understand that some people in financial markets and some academic economists find this approach appealing and, in some situations, there is a case for it. But the vast bulk of people in our societies do not think in these terms. There is therefore a risk that following this approach could cost the central bank the support and confidence of the broader community. This risk is increased by the other two challenges that I have discussed – navigating when the stars are shifting and the potential for over-reliance on monetary policy. I am much more attracted to the notion of constrained discretion and giving a committee the responsibility for exercising that discretion and dealing with all the complexities, trade-offs, data problems and uncertainties that we face in the real world. In communicating to a broader audience it is important to talk in stories that people can connect with, rather than to talk in just numbers, coefficients and rules. It is useful to tell stories about the forces shaping the economy and its future and how those forces are changing. It is also useful to tell stories about the trade-offs we face and how we are managing those trade-offs. And it is also useful to tell stories about how our policies are contributing to economic welfare and to things that people really care about – jobs, income security, a decent return on their savings and the stability of the economy. A challenge facing almost all central banks is to find the balance between the need to provide a strong narrative to the broader community and at the same time talk to the financial markets. This is an area that warrants further thought. Finally, I would like to endorse a central conclusion of the paper by Silvana Tenreyro: that is, a commodity-exporting country that faces large commodity price shocks can fare quite well with a flexible exchange rate and an inflation target. Australia provides a very good example supporting this conclusion. Indeed, in our case, the exchange rate has become the great stabiliser of the Australian economy, arguably playing a more important role than monetary policy in dealing with the major shocks that we have experienced over recent times. There are a number of features of our economy and financial markets that have led to this position. These include: The Australian dollar tends to move in line with commodity prices (or our terms of trade), cushioning the economy from the effects of these prices changes. Our manufacturing industry is not closely integrated into global supply chains. 5/6 BIS central bankers' speeches Our financial markets, including those for managing risk, are reasonably well developed. Australian entities are able to issue debt in our own currency and when they choose to issue in foreign currency, they are able to remove the exchange rate risk by using the foreign currency swap markets. Exchange rate pass-through is fairly muted and inflation expectations are well anchored. To pick up a point in Sebnem Kalemli-Ozcan’s paper, the institutional structure in Australia is strong. So, to end on a positive note, Australia’s experience is a useful reminder that even when there are large shifts occurring in the global economy, it is possible to prosper as a small open economy with a floating exchange rate and flexible inflation target. Thank you. 6/6 BIS central bankers' speeches | reserve bank of australia | 2,019 | 8 |
Address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, to the Economic Society of Australia, Canberra, 27 August 2019. | 8/28/2019 A Balance of Payments | Speeches | RBA Speech A Balance of Payments Guy Debelle [ * ] Deputy Governor Address to the Economic Society of Australia Canberra – 27 August 2019 When I started my working life here in Canberra at the Treasury just over 30 years ago, one of the most prominent macroeconomic issues was the current account deficit. Heated discussions took place about twin deficits, banana republics, consenting adults and whether or not the current account should be an objective for monetary policy. [1] Early on in my Treasury career, in between my radio shows on 2XX, I worked in the Balance of Payments section. There was a whole unit devoted to analysing and forecasting the current account deficit, given its prominence in the economic and political debate. Today, three decades on and back in Canberra, I am going to again focus on the current account balance and Australia's external position. But the rationale for doing so today is quite different to that in the 1980s. Today, the current account deficit is the smallest it has been as a share of the economy since the 1970s and the trade surplus is about the largest it has been since the 1950s. The payments are the closest to being in balance in decades! As a result, Australia's net foreign liabilities, that is, how much we owe foreigners less how much foreigners owe us, have been declining for the past decade to be at their lowest as a share of GDP since the early 2000s. [2] And the composition of those liabilities has changed quite significantly. It is markedly different from that in the 1980s. In the 80s, foreign liabilities were often regarded as a significant vulnerability for the Australian economy. I think this risk was overstated. The liabilities were predominantly in Australian dollars, which meant the exchange rate still could work very effectively as a shock absorber. I will explain why later. It is worth examining how and why Australia's external position has changed over recent decades. The nature and extent of the change is generally underappreciated, and is worth highlighting as the trade surplus and the current account deficit reach multi-decade milestones. https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-27.html 1/12 8/28/2019 A Balance of Payments | Speeches | RBA The Current Account I will start with the current account deficit. For pretty much all of its modern history, Australia has been a net importer of capital. Because there are a lot of profitable investment opportunities in Australia relative to the size of the Australian savings pool, we have sourced capital from the rest of the world either in the form of debt or equity. This is not because savings in Australia is particularly low; it is about on par with many other advanced economies. Rather, it is because the share of investment in the Australian economy is higher than that in many other advanced economies, and foreigners were attracted by the investment returns on offer. The counterpart to Australia being a net importer of capital is that the country runs a current account deficit (CAD). Through the 1980s, 1990s and 2000s, the CAD averaged around 4 per cent of GDP. But since 2015, the CAD has narrowed to be currently around 1 per cent of GDP. In the March quarter this year, the deficit was 0.6 per cent of GDP, and it may well be smaller still in the June quarter just past. This is the narrowest the current account has been since the December quarter 1979. The current account is comprised of two components: the trade balance and the net income balance (Graph 1). The narrowing of the CAD reflects a substantial shift in Australia's trade balance. For three decades, the trade balance was generally in deficit, averaging around 1¼ per cent of GDP from 1980 until 2015. Since then, the trade balance has shifted into surplus. In the March quarter, the surplus amounted to 3 per cent of GDP, the largest surplus since 1973. https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-27.html 2/12 8/28/2019 A Balance of Payments | Speeches | RBA Graph 1 The large surplus reflects a number of dynamics. Two of the primary drivers come from the resources sector. The first is the high revenue from resource exports, both because of the large increase in the volume of resource exports (i.e. how many tonnes Australia exports) as well as the high prices we have recently been receiving for those exports, in particular iron ore. The second is that as the resource investment boom has reached its end, the import of investment goods to boost the capacity in the resources sector (in particularly the LNG sector) has declined considerably. The extra revenue has bolstered national saving and resource investment has declined considerably over the past five years. This is a major reason why the gap between investment and saving has declined to its lowest in a long time, which, if you remember your national accounting identities, is directly equivalent to the current account being at multi-decade lows. But the trade balance story is not just a resources story. There has been strong growth in exports of education and tourism. The share of services in Australia's exports has increased from 17 per cent in the 1980s to 21 per cent now. The other noteworthy development of late has been the strong growth in manufactured exports. These include pharmaceutical goods and medical devices, and have grown by 15 per cent over the past two years. The other part of the current account is the net income balance. The net income balance is the difference between how much it costs to service the country's foreign liabilities (for example, interest payments on foreign debt) and the earnings on Australia's foreign assets (for example, dividend payments to residents from foreign share holdings). The income balance has widened a little in https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-27.html 3/12 8/28/2019 A Balance of Payments | Speeches | RBA recent years, but is around the middle of the range it has been in since the late 1980s at 3.4 per cent of GDP. I will come back to this later. Net Foreign Liabilities Each quarter that Australia funds its current account deficit with net borrowing from the rest of the world, we gradually add to the stock of net foreign liabilities (NFL) we owe to the rest of the world. As Australia ran current account deficits through the 1970s, 80s, 90s and 2000s, that stock of NFL grew, peaking at 60 per cent of GDP in 2009. But since then, reflecting the lower levels of the CAD and correspondingly lower net capital inflows, the stock of Australia's NFL (as a share of GDP) has declined over the past decade to be 50 per cent of GDP currently (Graph 2). The decline in NFL as a share of GDP masks some significant changes in the composition of both the gross foreign liabilities and gross foreign assets. Graph 2 It is important to stress the need to look at the gross flows and stocks, not just the net numbers. There are large capital inflows and outflows all the time, even when the net capital flow (or the current account deficit) is low. As a result, the gross stocks can change quite significantly even with low net flows. Debt https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-27.html 4/12 8/28/2019 A Balance of Payments | Speeches | RBA On the liability side, there has been a large shift from short-term debt to long-term debt. In net terms, long-term debt liabilities are currently 52 per cent of GDP. They are slightly larger than Australia's total net foreign liabilities. They have risen from around 25 per cent of GDP in the early 2000s. Over the same period, the share of short-term debt has declined from 20 per cent to be just under 5 per cent of GDP now. As Graph 3 shows, the movement in the net position masks, as it often does, different dynamics in the gross positions. The decline in net short-term debt is mostly due to the growth in short-term debt assets that we hold. But short-term debt liabilities have also declined from their peak. Graph 3 What has been the driver of the increase in foreigners' holdings of Australian long-term debt over the past decade or so? The main explanation has been the large accumulation of Australian public sector debt by foreigners, including by central banks and other public sector asset managers. Central banks increased their allocation to Australia in their foreign reserves portfolios in the aftermath of the global financial crisis. Foreign ownership of Australian Government bonds increased from around 40 per cent in the early 2000s, peaking at nearly 80 per cent in 2012 (Graph 4). [3] At the same time, the size of the Australian Government bond market grew significantly. https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-27.html 5/12 8/28/2019 A Balance of Payments | Speeches | RBA Graph 4 As a result, foreign holdings of public sector [4] debt increased from 7.5 per cent of GDP in 2009 to around 20 per cent by 2015 and has been relatively stable since then. Correspondingly the public sector's share of gross debt liabilities increased from around 10 per cent in the late 2000s to around 20 per cent in 2012, where it has remained since (Graph 5). At the same time, the share of private financial debt (mainly banks) has fallen since the crisis. https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-27.html 6/12 8/28/2019 A Balance of Payments | Speeches | RBA Graph 5 In 2007, the banking sector accounted for the bulk of Australia's net foreign liabilities. Their annual borrowing amounted to around about the same size as the current account deficit. This led to the misplaced claim that the banks funded the current account deficit, which ignored the other large capital outflows and inflows that were occurring. [5] The banking sector's net flows and stocks were the same order of magnitude as the aggregate net flows and stocks. But this wasn't causal. There were large capital flows occurring in both directions in other parts of the economy at the same time. And on the stocks side, there were other large stocks of debt and equity, both assets and liabilities, which all also contributed to the aggregate net foreign liability position in addition to those of the banking system. Equity At least as dramatic has been the shift in the net equity position. For most of its modern history, foreigners owned more equity in Australian companies than Australians owned in foreign companies. But since 2013, that has not been true. Since 2013, Australians have owned more foreign equity than foreigners have owned Australian equity (Graph 6). This largely reflects the significant allocation to foreign equity by the Australian superannuation industry together with the fact that the superannuation sector is relatively large as a share of the Australian economy. Currently, Australian equity investment abroad exceeds foreign equity investment in Australia by 7% of GDP. That is, the country has a net foreign equity position. This compares to an average net equity position of 10 per cent of GDP between 1990 and 2010. liability https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-27.html asset 7/12 8/28/2019 A Balance of Payments | Speeches | RBA Graph 6 The shift to a net foreign equity asset position reflects: the ongoing accumulation of foreign equities by Australia's large superannuation sector (these flows have partially, but not completely, offset continued equity inflows to Australia from foreign investors) asset valuation effects, as foreign equities have outperformed Australian equities over the past several years the depreciation of the Australian dollar over this period. Because foreign equity assets are denominated in foreign currency, the value of foreign equity assets in Australian dollar terms increases when the Australian dollar depreciates. But the value of equity liabilities, which are obviously denominated in Australian dollars, does not change. So, when the Australian dollar depreciates, the net equity position increases. This is a major shift in Australia's external position. Net Income Deficit Despite the reduction in Australia's stock of net foreign liabilities over the past couple of years, the net income deficit has widened a little, because the average yield that Australia pays on its net foreign liabilities has increased by more than the yield it receives on net foreign assets. https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-27.html 8/12 8/28/2019 A Balance of Payments | Speeches | RBA Graph 7 Graph 7 shows the breakdown in the yields we pay and earn between debt and equity and between liabilities and assets. The graph shows that the main development has been a sharp increase in the payments on foreign equity liabilities. Much of that increase has been due to significantly higher payments recently to foreign owners of direct equity in Australia's mining sector because of the increased profitability of the mining sector. The foreign ownership of the large mining companies is around three-quarters. Earlier I highlighted how the trade surplus had risen to historically high levels because of higher resource exports. These higher payments to the foreign shareholders limit the narrowing of the current account that occurs from the boost to the trade surplus from this source. These payments result in ‘notional’ capital outflows because most of the mining companies' profits are earned in US dollars and the distribution of those earnings to foreign owners are also predominantly in US dollars. So these amounts never come onshore into Australia, or are converted into Australian dollars, even though the balance of payments records them as capital flows. While net equity payments have increased, the servicing cost on the debt liabilities has been little changed in recent years, despite the maturity extension of Australia's net debt liabilities. This is because government debt has lower servicing costs than bank debt and it now comprises a much larger share of the stock of liabilities. Indeed, the cost of servicing overall debt has declined to be its https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-27.html 9/12 8/28/2019 A Balance of Payments | Speeches | RBA lowest on record. With Australian Government bond yields now materially below those on US yields, the debt component of the net income deficit may decline further still. Vulnerability? Foreign debt liabilities are often regarded as a vulnerability. Should we be concerned about this? In my view, we shouldn't be. Firstly, the vast bulk of Australia's foreign debt is denominated in Australian dollars, not foreign currency. All of the public sector debt is issued in Australian dollars. The debt that is denominated in foreign currency, which is issued by the banks and corporates, is hedged back into Australian dollars (and generally the hedge is maturity-matched). Where it is not, there is often a natural hedge available in the form of foreign currency income. As a result, the vast bulk of Australia's foreign debt liabilities are in Australian dollars, especially once you take into account the hedging. Moreover, all of the equity liabilities are in Australian dollars too. To put some numbers on this, 68 per cent of foreign liabilities are denominated in Australian dollars, this increases to 85 per cent after hedging. Historically, a high level of foreign liabilities has been seen as a cause for concern. A number of countries have got into serious trouble because of high foreign liabilities, particularly debt. But in almost every case, the root cause has been the currency exposure. The countries that have got into trouble have had high level of foreign debt denominated in foreign currency. The latter has been the crucial source of vulnerability. It means that the exchange rate can no longer play the important role of shock absorber. If a country with a high level of debt in foreign currency experiences a depreciation, the debt rises in domestic currency terms. The country's ability to service and repay the debt worsens. This can lead to sudden stops, that is, an immediate cessation of capital flows, as investors try to withdraw. These are the archetypal currency crises of Latin America and the Asian crisis. This isn't an issue for Australia because of the currency composition. The exchange rate depreciation can play the important role of shock absorber, as the experience in the Asian crisis and again in 2008 and 2009 demonstrated. But it took some time to convince external observers of this. To demonstrate that the currency composition of the foreign liabilities wasn't a vulnerability, the RBA commissioned a survey from the ABS to measure this. The first of these surveys was in 2001, and we have continued to get the ABS to repeat the survey every three years. These have shown a consistent picture of minimal foreign currency exposure, including in the most recent survey in 2017. A large share of Australia's foreign assets are denominated in foreign currency (86 per cent, which declines to 63 per cent, taking account of Australian investors hedging their foreign currency assets). So, if you look at the balance sheet of the country as a whole, Australia has a net foreign currency position. This is true on an unhedged and hedged basis (Graph 8). Hence when the exchange rate depreciates, the value of net foreign liabilities actually declines rather than increase. asset https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-27.html 10/12 8/28/2019 A Balance of Payments | Speeches | RBA Graph 8 To reiterate, this allows the exchange rate to play the important role of shock absorber to external shocks. The exchange rate's ability to do so is not compromised by Australia's net foreign liability position. The fact that the liabilities are effectively denominated in Australian dollars while the assets are in foreign currency does not impede the exchange rate adjustment. If anything, it actually helps the adjustment. This wouldn't be true if the debt were denominated in foreign currency. Conclusion To conclude, Australia's balance of payments and external accounts have undergone a significant transformation since the days of Paul Keating's banana republic comment. The transformation has been quite dramatic and often overlooked. I have highlighted some of the most noteworthy developments. The trade surplus is around its largest, and the current account its narrowest, as a share of GDP in many decades. On the capital account, the mirror image of the current account, there has been a significant change in both the composition of the capital flows and, as a result, the stock of foreign liabilities and assets. Government debt now comprises a much larger share of debt liabilities and bank debt a smaller share. The maturity profile of that debt is much longer. On the asset side, the large increase in Australian offshore equity investment, mostly through the superannuation sector, means the country as a whole has a net asset position in equities. The structure of Australia's external accounts now resembles that of the United States. While Australia doesn't have the exorbitant privilege of the US, https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-27.html 11/12 8/28/2019 A Balance of Payments | Speeches | RBA the external accounts do not constitute a source of vulnerability and have become increasingly resilient over the past 30 years. All of these developments have taken place under the rules-based global trading system that has been in place for a number of decades now. Despite some flaws, that system has delivered sizeable benefits for global growth and welfare. Australia has clearly been a major beneficiary of that system. The current threats to the system are a significant risk to both Australia and the world. Endnotes [*] Thanks to Dana Lawson, Emma Smith, Isabel Hartstein and Jarkko Jaaskela for their assistance. John Pitchford was one of the main contributors to the debate at the time. See Pitchford J (1989), ‘A Sceptical View of Australia's Current Account and Debt Problem’, , 86, pp 5–14. The current account isn't the only determinant of whether net foreign liabilities rise or fall as a share of GDP. That also depends on the growth of nominal GDP and the servicing cost on those liabilities. The foreign ownership share has declined in recent years. Foreigners have continued to buy public debt, just not in the same share as it has been issued. This share is adjusted for holdings under repo. This adjustment currently affects the ownership share by around 4 percentage points. I think it is better to add back the holdings under repo as it gives a better sense of actual foreign ownership. See Becker C and P Rickards (2017), ‘Secured Money Market Transactions: Trends in the Australian Repo Rate’, Paper presented at the 22nd Melbourne Money and Finance Conference ‘Evolutionary Trends in the Australian Financial Sector’, Hosted by the Australian Centre for Financial Studies, Melbourne, 10–11 July. This includes the Commonwealth and state governments, central borrowing authorities and public non-financial corporations, but excludes the RBA. Debelle G (2014), ‘Capital Flows and the Australian Dollar’, Address to the Financial Services Institute of Australia, Adelaide, 20 May. See R Dornbusch, I Goldfajn and R Valdés (1995), ‘Currency Crises and Collapses’, Brookings Papers on Economic Activity. See L Berger Thompson and B Chapman (2017), ‘Foreign Currency Exposure and Hedging in Australia’, RBA , December, pp 67–75. Gourinchas, P-O, and H Rey. ‘International Financial Adjustment’. Journal of Political Economy, 115:4, pp 665–703, August 2007. Gourinchas, P-O, and H Rey. ‘From World Banker to World Venture Capitalist: US External Adjustment and the Exorbitant Privilege’, NBER Working Paper 11563. Australian Economic Review Bulletin © Reserve Bank of Australia, 2001–2019. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2019/sp-dg-2019-08-27.html 12/12 | reserve bank of australia | 2,019 | 8 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Armidale Business Chamber, Armidale, 24 September 2019. | Speech An Economic Update Philip Lowe [ * ] Governor Address to the Armidale Business Chamber Armidale – 24 September 2019 I would like to thank the Armidale Business Chamber for the invitation to speak this evening. I grew up in regional New South Wales – in Cootamundra and Wagga Wagga – so it is a treat for me to have been invited to speak in another great regional city. Thank you. Tonight, I would like to provide you with an economic update. I will focus first on the global situation and then talk about the Australian economy. And finally, I will make some remarks about monetary policy. The main message on the global economy is that while it is still growing reasonably well, the risks are increasingly tilted to the downside. The main source of these downside risks are geopolitical developments in many parts of the world. These developments are creating considerable uncertainty and this uncertainty is causing businesses to reconsider their spending plans. This is making the international environment more challenging for us. On the Australian economy, there are two main messages. The first is that after having been through a soft patch, a gentle turning point has been reached. While we are not expecting a return to strong economic growth in the near term, we are expecting growth to pick up. Against this backdrop, the main source of domestic uncertainty continues to be the strength of household spending. The second message is a longer-term one. And that is the fundamental factors underpinning the longer-term outlook for the Australian economy remain strong. One of the ongoing challenges we face as a country is to capitalise on those strong fundamentals. The Global Economy This first graph shows global economic growth and the International Monetary Fund's (IMF) forecasts for the next few years (Graph 1). Looking at this graph, one might ask why the concern: global growth has been stable and reasonable over recent times and the IMF is forecasting this to continue over the next couple of years. If this forecast were to come to pass, that would make for 12 years of solid growth. Graph 1 Looking at labour markets, one might also ask why the concern. Unemployment rates in most advanced economies are the lowest they have been in many decades, and businesses are finding it more difficult to fill jobs (Graph 2). These tighter labour markets are finally translating into stronger wages growth, with wages now increasing at close to the rates seen before the financial crisis in some countries. With inflation remaining low, this pick-up in wage growth is translating into real wage increases and strong growth in household spending. Graph 2 So why the concern? The answer is the increased downside risks generated by various geopolitical developments. The most prominent of these are the trade and technology disputes between the United States and China. Others include: the Brexit issue, developments in the Middle East, the problems in Hong Kong and the tensions between Japan and South Korea. The US–China disputes, in particular, are having a disruptive effect on international trade flows. Over the past year there has been no growth at all in international trade, despite the global economy growing at a reasonable rate (Graph 3). This weakness on the trade front is flowing through to factory output, with growth in industrial production slowing considerably. Graph 3 More broadly, though, the geopolitical concerns are creating considerable uncertainty about the future. This can be seen in measures of economic policy uncertainty constructed from news stories in leading media around the world (Graph 4). Graph 4 In the face of this uncertainty, it is not surprising that many businesses are preferring to wait before committing to significant investments; they are inclined to sit on their hands for a while and see how things play out. This is evident in the surveys of business investment intentions, which have fallen considerably (Graph 5). The effect is also evident in June quarter GDP figures, with GDP declining in Germany, the United Kingdom and Singapore. Graph 5 A particular concern is that if this uncertainty continues, businesses might decide not only to defer investment, but to also defer hiring. Of course, it is also possible that some of these uncertainties will be resolved. If this were to happen, the global economy could grow quite strongly as firms caught up on their capital spending in an environment of easy financial conditions. Notwithstanding this possibility, as the downside risks have come more clearly into focus, there has been a marked shift in the outlook for monetary policy globally. Almost all major central banks are expected to ease monetary policy over the year ahead, with the United States Federal Reserve and the European Central Bank having already moved in this direction (Graph 6). Given that inflation is low – and forecast to remain low – investors are also expecting central banks to maintain very accommodative settings of monetary policy for years to come. Graph 6 This expectation has had a major effect on long-term bond yields around the world. In Europe and Japan, investors are paying governments to hold their money for them (Graph 7). The Swiss Government, for example, can borrow for 30 years at a negative interest rate of 0.5 per cent. For the world as a whole, around a quarter of the total stock of government bonds on issue has negative yields. And where yields are in positive territory, they are at very low levels and in many cases at the lowest on record. Graph 7 All this is making for a challenging international environment. The Australian Economy I would now like to move to the Australian economy. Over recent times, our economy has been going through a soft patch. Over the year to June, GDP grew by just 1.4 per cent, which is the slowest year-ended growth for some years (Graph 8). We did not expect this slowdown, so it has come as a bit of a surprise. Graph 8 It is important, though, that we keep things in perspective. The economic expansion in Australia has now been running for 28 years. That is quite an achievement. Over such a long expansion, there are going to be ebbs and flows in growth. There are also going to be periods where growth is stronger than expected – as it was in the first half of 2018 – and other periods, like now, where growth is weaker than expected. With the benefit of hindsight, there are a few factors that help explain the slowing in the Australian economy over the past year. One is the international developments that I spoke about earlier. While Australia has been less directly affected by the US–China trade disputes than have many other countries, there is an indirect effect through slower global growth and increased global uncertainty. A second and more important factor is weak consumption growth. Over the past year, there has been no growth at all in consumption per person, which is an unusual outcome at a time when employment is growing strongly (Graph 9). An important part of the explanation here is that household disposable income has been increasing only slowly for an extended period, reflecting both subdued wage increases and strong growth in taxes paid. Graph 9 The persistence of slow growth in household income has led many people to reassess how fast their incomes will increase in the future. As they have done this, they have also reassessed their spending, particularly on discretionary items, which has been quite weak over recent times (Graph 10). Not surprisingly, spending on household essentials has been much less affected. Graph 10 Another part of the explanation for weak growth in household spending is the adjustment in the housing market. As housing prices have fallen, there has been a marked decline in housing turnover, with the turnover rate having declined to the lowest level in more than 20 years (Graph 11). With fewer of us moving homes, spending on new furniture and household appliances has been quite soft. So too has expenditure on moving costs and real estate fees. More broadly, the correction in the housing market has also affected the economy through its impact on residential construction activity. Graph 11 A third factor contributing to the slower growth has been the drought. Across the Murray-Darling Basin, including here in the Northern Tablelands, farmers have faced extremely dry conditions. Indeed, as indicated in this graph, in some areas conditions have been the driest on record (Graph 12). Reflecting this, farm output in Australia has fallen for the past two years and there has been a sharp drop in farm income as farmers have had to cope with the increased costs for obtaining feed and water. These difficult conditions have contributed to the weakness in overall household incomes and consumption, and the effects are particularly felt in regional communities. The drought has also put upward pressure on food prices over the past year, particularly for bread, milk and meat. We are all hoping that the drought breaks soon. Graph 12 © Commonwealth of Australia 2019, Australian Bureau of Meteorology; available at <http://www.bom.gov.au/climate/drought/> under Creative Commons Attribution 3.0 Australia Licence. Full terms at <http://creativecommons.org/licenses/by/3.0/au/>. Even after accounting for these three factors – the slowdown overseas, weak growth in household disposable incomes and the drought – part of the slowing in the Australian economy remains unexplained. This is especially so taking into account the labour market data, which continue to paint a stronger picture of the economy than the GDP data. Over recent times, employment growth has been stronger than was expected. Over the past year, the number of people with a job increased by 2½ per cent (Graph 13). Reconciling this with GDP growth of just 1½ per cent remains a challenge, because, normally, output growth exceeds employment growth, rather than falls short. We are seeking to understand what is going on here. It is possible that it is just measurement noise, but we can't yet rule out something more structural. Graph 13 The other striking feature of the labour market over recent times has been a large increase in labour supply. In particular, there has been a material lift in the labour force participation by women and by older Australians (Graph 14). As a result, the increase in labour supply has more than outstripped the increase in labour demand. Reflecting this and despite the strong employment growth, the unemployment rate has moved higher since the start of the year to 5¼ per cent. Graph 14 This increase in labour supply is a positive development, but it does mean that it is proving quite difficult to generate a tight labour market with the flow-on consequence that wage increases remain subdued. Over the past year, the Wage Price Index increased by just 2.3 per cent (Graph 15). This is a pick-up from the rates of recent years, but the lift in wages growth looks to have stalled recently. Another relevant factor here is the ongoing caps on wage increases in the public sector. Graph 15 Low wages growth is one of the factors contributing to low inflation outcomes. Over the year to June, inflation was 1.6 per cent, in both headline and underlying terms (Graph 16). Another contributing factor is the adjustment in the housing market, with rents increasing at the slowest rate in decades and declines being recorded in the price of building a new home in some cities (Graph 17). Another factor is various government initiatives to address cost-of-living pressures, with these initiatives pushing down inflation in administered prices. The price rises for utilities are also much lower than over recent years. Working in the other direction, the drought and the depreciation of the exchange rate have been pushing up retail prices over the past year. Graph 16 Graph 17 Looking forward, there are some signs that, after a soft patch, the economy has reached a gentle turning point. This is evident in the fact that GDP growth over the first half of this year was stronger than it was over the second half of last year (Graph 8). We are expecting a further modest pick-up in the quarters ahead. This outlook is supported by a number of developments, including lower interest rates, the recent tax cuts, the depreciation of the Australian dollar, ongoing spending on infrastructure, the stabilisation of the housing markets in some cities and a brighter outlook for the resources sector. It is reasonable to expect that, together, these factors will see growth in the Australian economy return to around its trend rate next year, although there are some obvious risks to this outlook. One factor that should help is an expected pick-up in household disposable income. Many households are currently receiving larger tax refunds due to the low and middle income tax offset. These payments will boost aggregate household income by 0.6 per cent this year. Past experience suggests that around half of these tax refunds will be spent over coming quarters. Household disposable income is also being boosted by lower interest rates, although the effect is uneven across the community, with lower rates reducing the income of those households who rely on interest income. Household spending should also be supported by an increase in housing turnover. Working in the other direction, though, is a further contraction in residential construction activity. Another positive element is likely to come from the resources sector. Mining investment is expected to increase over the next year, after having declined for six years as the LNG investment boom wound down (Graph 18). Mining companies are increasing their investment not only to sustain their current production levels but, in some cases, to expand capacity as well. There has also been a pickup in exploration activity. To be clear, we are not predicting a return to boom-time conditions in the resources sector. But we are predicting better times for the sector ahead. Graph 18 Business investment elsewhere in the economy is also expected to move higher. Earlier I discussed how uncertainty globally is affecting the outlook for investment in many countries. Fortunately, we don't see the same spike in the measure of policy uncertainty in Australia that I showed in the earlier graph for the world economy. There has, however, been some softening in measures of business conditions – from well above average to around average. The investment outlook is being supported by a solid pipeline of infrastructure projects. This ongoing investment in infrastructure is not only supporting demand in the economy at a time when this is needed, but it is also adding to the supply capacity of the economy and directly improving people's lives, including through providing better services and reducing transport congestion. Together, it is reasonable to expect that these various factors will see annual growth pick up from here. Apart from the international uncertainties, the main source of uncertainty around this outlook continues to be the strength of household spending. It remains the case that a sustained pick-up in household spending will require faster growth in household incomes than we have seen over recent times. As we grapple with these issues, it is important that we do not lose sight of the fact that the Australian economy has strong fundamentals. Australia is fortunate in having enviable endowments of natural resources, both in terms of minerals and agricultural land. We have a reputation as a highly reliable supplier and a producer of highquality clean food. We also have close links with the rapidly growing countries of Asia. Three of the four most populous countries in the world – China, India and Indonesia – are in our neighbourhood. And our ties with these countries are strengthened by the many people from there who live, work and study in Australia. Our demographics are also reasonably favourable. Our population is aging less quickly than that of many other advanced economies. The population is also growing relatively rapidly for an advanced economy – 1.7 per cent a year, compared with 0.6 per cent in the United States and declining populations in some countries in north Asia and Europe. Immigration has been a strong contributor to this: almost half of us were born overseas or have at least one parent who was born overseas. While we have struggled to meet the infrastructure needs that come with this growing population, it does bring a dynamism that is not easily matched in countries with declining populations. We also have a highly talented, flexible and adaptive workforce. We have strong public institutions, a well-established macroeconomic framework, and the rule of law is respected. There is also a demonstrated record of responsible fiscal policy and low public debt. And, finally we benefit from having both a flexible exchange rate and a flexible labour market. So, our fundamentals are strong. The challenge we face is to fully capitalise on these fundamentals. If we can do this then I am confident that we can, once again, experience strong growth in real incomes in Australia. Monetary Policy I would like to finish with some remarks about monetary policy. As you would be aware, the Reserve Bank Board lowered the cash rate in June and July to a new low of 1 per cent. Financial markets are pricing in further reductions in the cash rate over the next year. Our decisions – and the expectations of investors about the future – reflect both international and domestic factors. On the international front, as I discussed earlier, interest rates around the world are low and they are moving lower. There are many reasons for this, but the central reason is that the global appetite to save is elevated relative to the global appetite to use those savings to invest in new productive capital. When lots of people want to save and there is not much demand for those savings, savers earn low returns. We live in an interconnected world, which means that we cannot completely insulate ourselves from long-lasting shifts in global interest rates. Our floating exchange rate gives us a degree of monetary independence, but we can't ignore structural shifts in global interest rates. If we did seek to ignore these shifts, our exchange rate would appreciate, which, in the current environment, would be unhelpful in terms of achieving both the inflation target and full employment. As I have spoken about on other occasions, the key to more normal interest rates globally is addressing the factors that are leading to a depressed appetite to invest relative to the appetite to save. Whether or not this will happen, time will tell. But as a small open economy, we have to take the world and global interest rates as we find them. On the domestic front, there has been an accumulation of evidence over recent times that the economy can sustain lower rates of unemployment and underemployment than previously thought likely. The flexibility of labour supply also means that strong rates of employment growth can be sustained without inflation becoming a problem. These are both positive developments. Inflation has been below the 2–3 per cent medium-term target range for some time now for the reasons that I spoke about earlier. Looking ahead, inflation is expected to pick up, but to remain below the midpoint of the target range for some time to come. The decisions to ease monetary policy in June and July were taken to help make more assured progress towards full employment and the inflation target. Further monetary easing may well be required. While we are at a gentle turning point and expect growth to pick up, the strength and durability of this pick-up remains to be seen. Regardless of the short-term outlook for monetary policy, the point about the solution to low global rates is relevant here in Australia too. We will all be better off if businesses have the confidence to expand, invest, innovate and hire people. Given Australia's strong fundamentals, this is not out of our reach, but it does require constant effort. At our Board meeting next week, we will again take stock of the evidence. It is nevertheless likely that an extended period of low interest rates will be required in Australia to make progress in reducing unemployment and achieving more assured progress towards the inflation target. The Board is prepared to ease monetary policy further if needed to support sustainable growth in the economy, make further progress towards full employment, and achieve the inflation target over time. Thank you for listening. I look forward to answering your questions. Endnotes [*] I would like to thank Ellis Connolly for assistance in the preparation of this talk. © Reserve Bank of Australia, 2001–2019. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. | reserve bank of australia | 2,019 | 9 |
Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Reserve Bank Board Dinner, Melbourne, 1 October 2019. | Philip Lowe: Remarks at Reserve Bank Board Dinner Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Reserve Bank Board Dinner, Melbourne, 1 October 2019. * * * Good evening. On behalf of the Reserve Bank Board I would like to thank you for joining us at this community dinner. The Board held its monthly meeting here in Melbourne today. This was the first meeting that we have held in our new offices on Collins Street after last year selling our building on the corner of Collins and Exhibition Streets. So even if we are in a different location, it is really good to be back in Melbourne. As you are probably aware, at our meeting today, the Board decided to cut the cash rate by a quarter of one per cent to 0.75 per cent. This decision followed a detailed assessment of both global and domestic developments. Globally, the main issue at the moment is the uncertainty generated by a series of geopolitical events, particularly the US–China disputes over trade and technology. Understandably, this uncertainty is causing many firms around the world to sit and wait before proceeding with costly investment decisions. At the same time, many businesses are having to deal with disruptions to their supply chains. The result of all this is that after a period of reasonable growth in the global economy, the risks are clearly to the downside. Central banks are responding to these downside risks by lowering interest rates. With inflation low – and expected to remain low – they are seeking to take out some insurance against the possibility of a noticeable slowdown in economic growth. From a longer-term perspective though, central banks have for some time been responding to fundamental shifts in the global appetite to save and invest. The underlying explanation for low interest rates globally is that the global appetite to save is high relative to the global appetite to invest. Like many things in economics it comes down to supply and demand. When the global supply of savings is high relative to the global demand for funding to invest in new capital, the price of savings – or the global interest rate – is going to be low. There are certainly other factors at play as well, but savings and investment decisions are at the heart of the issue. This means that the key to a return to more normal interest rates globally is addressing the factors that are leading to the low appetite to invest, relative to the appetite to save. This is mainly a task for governments and businesses, not for central banks. Whether or not this will happen, only time will tell. But as a central bank in a small open economy we have to take the world as we find it. While we might wish it were otherwise, we can’t ignore these global trends and their impact on our economy. So, the Board is watching these global developments. Domestically, the Board today discussed how the Australian economy appears to have reached a gentle turning point. The economy has been through a soft patch recently, but we are expecting a return to around trend growth over the next year. There are a number of factors that are supporting this outlook. These include the low level of interest rates, the recent tax cuts, ongoing spending on infrastructure, signs of stabilisation in some established housing markets, and a brighter outlook for the resources sector. Together, these factors provide a reasonable basis for expecting that the economy will remain on an improving trend from here. The Board has also been paying close attention to the labour market. Over recent years, employment growth has consistently surprised on the upside, which is good news. At the same 1/4 BIS central bankers' speeches time, the strong demand for workers has been met with strong growth in the supply of available workers, with the participation rate now at a record high. Partly as a result of this flexibility on the supply side, unemployment is a little higher than it was at the beginning of the year, and there has not been much upward pressure on wages. In turn, this has contributed to the extended run of inflation outcomes below the medium-term target range. In considering these developments today, the Board decided that it was appropriate to ease monetary policy further. We are seeking to make more assured progress towards both full employment and the inflation target. We still expect to make progress on both fronts, but that progress is slower than we would like. Today’s decision will help. In reaching that decision, the Board recognises that the impact of monetary policy on the economy has changed over time, and that there can be some undesirable side effects from low interest rates. The many people who write to me saying how low interest rates are hurting their finances serve as a constant reminder of this. But, importantly, the Board also recognises that monetary policy still works. It works to support employment, jobs and income growth across the economy. Today’s decision, together with our decisions in June and July, will assist on each of these fronts. In doing so, these decisions will promote the collective economic welfare of the Australian people, which we need to remember is the ultimate goal of monetary policy. Even so, my earlier point about the solution to low interest rates globally is relevant here in Australia too. We will all be better off if businesses have the confidence to expand, invest, innovate and hire people. Given Australia’s strong longer-term fundamentals this should not be out of our reach, but it does require constant effort. One part of this effort could be a renewed focus on structural measures to lift the nation’s productivity performance. At our meeting today, as well as considering monetary policy, the Board had its six-monthly deep dive into financial stability issues. On Friday, the Bank will be releasing the results of this in our Financial Stability Review. Ahead of that, I would highlight three issues we discussed. The first is that internationally, there seems to be a disconnect between the uncertainty that investors feel about the economic situation and the compensation that they require for holding risk. Normally when people feel uncertain about the future, they want to be compensated for taking on risk. At the moment though, despite the uncertainty, credit spreads are low and asset prices are generally high. At our meeting today we talked about the possibility that a shock somewhere in the global system could cause a recalibration, leading to a disruptive repricing of risk. The second issue is that the resilience of Australia’s financial system has steadily improved over recent times. The core capital ratios of our banks are now well within the top quartile of banks around the world. Our banks are well placed to withstand a wide range of shocks and their position will be further strengthened as they meet requirements to increase their loss absorbing capacity further over the next few years. Lending standards have also been strengthened, although in some areas the pendulum may have swung a bit too far. It is important that our financial institutions support small businesses in particular. Lenders should not be so scared of making a loan that goes bad that they don’t provide the credit that the economy needs. One other risk area that we are paying close attention to is cyber and technology risks. Banks’ systems have become more complex and digital platforms are now key to banking. We need to make sure that these systems are safe and resilient. The third issue is that while the Australian household sector has a high level of debt, it has also 2/4 BIS central bankers' speeches built up substantial buffers. All up, the balances in mortgage offset accounts and redraw facilities amount to 16 per cent of outstanding housing debt. This is equivalent to around 2½ years of required mortgage payments at current interest rates. It is important to recognise though that this figure masks a lot of variation across households. We estimate that around a quarter of households with a mortgage have either no buffer or a very small one. Loan arrears remain low, although they have risen over recent years. Also, we estimate that for almost 4 per cent of borrowers their current loan balance exceeds the value of their property. Over half of these borrowers are in Western Australia where there has been a large and persistent decline in housing prices. So this is an area that bears watching. On a completely different matter, I would like to draw your attention to the fact that we will be releasing the new $20 note next week, on 9 October. This note is printed here in Melbourne, at our printing works in Craigieburn. I have brought along a few notes tonight hot off the presses for you to have a look at. I sometimes get asked why the Reserve Bank is replacing the existing series of banknotes, especially when more of us are moving to electronic payments. People also wonder with contactless payments now so ubiquitous, do we still need banknotes? Given these questions, it might surprise you then to know that the demand for banknotes in Australia is still strong. The stock of banknotes on issue, relative to the size of the economy, is close to the highest it has been in 50 years. It is possible that low interest rates are part of the story here. All up, there are 14 $100 notes on issue for every Australian, 30 $50s, and 7 $20s. That makes for around $3000 worth of banknotes on issue for every Australian. I, for one, don’t have anywhere near that amount. At the RBA, we have recently undertaken some work to understand the whereabouts of all these banknotes. It is hard to know exactly, but we estimate that around a quarter are used to make legitimate day-to-day transactions within Australia.1 It also appears that between half and threequarters are held as a store of value in safes, under beds and at the back of cupboards, both here in Australia and elsewhere around the world. We estimate that a further 4 to 8 per cent are used in the shadow economy, either to hide transactions from the tax office or to undertake illegal transactions. Finally, it appears that between 5 and 10 per cent of banknotes are either simply lost, maybe at the beach, or destroyed, perhaps in a natural disaster. So, as best we can tell, that is where all the banknotes are. One indicator of the decline in the use of banknotes for day-to-day transactions is the fact that the value of cash withdrawals through ATMs has fallen by a quarter over the past decade. Australians have clearly embraced the convenience of contactless payments. We are also increasingly embracing payments through Australia’s fast 24/7 payment system, the New Payments Platform. If you have not already got your PayID to use the simple addressing feature of this new system, I encourage you to get one. If your bank is not offering this new fast payment service to you, I encourage you to ask them why. And if you are not happy with the answer, give some thought to switching banks. Before finishing I would like to return to the question of why we have been issuing a new series of banknotes. The main answer is to keep ahead of the counterfeiters. We have long had one of the safest and most secure currencies in the world. The level of counterfeiting in Australia is low and declining, with around 15 counterfeits detected per million banknotes in circulation in recent times. This compares with rates above 50 for some other major currencies. But the counterfeiters don’t stand still and we need to stay ahead. So we have added new high-tech security features to the new banknotes so that they remain safe, secure and reliable. For those of you who still use banknotes for your spending, it would be good to see a bit more use and spending out there. 3/4 BIS central bankers' speeches Finally, I would like to thank you again for joining us this evening. We are looking forward to hearing directly from you about how things are going here in Victoria. 1 For more information, see Finlay R, A Staib and M Wakefield (2018), ‘ Where’s the Money An Investigation into the Whereabouts and Uses of Australian Banknotes’, RBA Research Discussion Paper No 2018–12. 4/4 BIS central bankers' speeches | reserve bank of australia | 2,019 | 10 |
Address by Ms Luci Ellis, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Ai Group, Geelong, 4 October 2019. | 10/4/2019 Lumps, Bumps and Waves | Speeches | RBA Speech Lumps, Bumps and Waves Luci Ellis [ * ] Assistant Governor (Economic) Address to the Ai Group Geelong – 4 October 2019 Thank you to the Ai Group for the invitation to speak to you today. It's great to be in Geelong. It's been a big week for the Bank in Victoria, with the Board meeting in Melbourne on Tuesday and the Governor's speech that evening. I don't plan to repeat what he said or speak in detail about the Board's decision. Rather, I'd like to take a step back and talk about some aspects of how the Bank's economics team understand and interpret economic developments, so we can do the analysis that is an important input into the Board's decisions. Most of our job is interpreting recent data and using that to forecast the future. We lean heavily on our intellectual frameworks in economics for thinking about how economies work. But we also need to account for an array of special factors and big-picture trends that don't sit neatly in top-down, whole-economy models, such as standard economic forecasting models. So today I'd like to talk about how we handle special factors in our understanding of the economy. I'll also give some examples of the kinds of factors that have been relevant of late. How do we know if there is a special factor at play? One source of information is our liaison teams across the country. They meet with all sorts of organisations and groups to better understand these special factors and trends. [1] In many cases, the story behind the numbers is as important as the numbers. The Ai Group and many of its members have been generous partners in our liaison program for many years. We truly appreciate your insights into those stories. If you are facing some special factor, how do you make sense of it? You can get the story behind the numbers from the players on the ground. But how do you incorporate those insights into your view of the overall economic outlook? I'd argue that it helps to look at the basic shape of that special factor, so you can form a view about how it will play out. Informally put, you need to work out if what you're looking at is a lump, a bump, or a wave. https://www.rba.gov.au/speeches/2019/sp-so-2019-10-04.html 1/13 10/4/2019 Lumps, Bumps and Waves | Speeches | RBA ‘Lumps’ occur when single firms, industries or products have a discernible, outsized effect on overall outcomes. Examples include the recent effect of the Victorian nurses' pay equity agreement on overall public sector wages growth, or of individual large projects on mining investment. ‘Bumps’ are the factors we can't or don't typically model that push economic outcomes around temporarily. Examples include the effect of the drought on rural exports and food prices, and the effect of Cyclone Veronica on iron ore exports. ‘Waves’ are the large, long-lasting and often ‘structural’ forces that take the economy to a new state. Examples here include technological change, climate change and demographic change. Just these simple, non-technical descriptions can show why it's useful to know something about the underlying shape of a particular special factor. If something is a lump or a bump, it doesn't mark the beginning of a change in trend. Its effect may not last. In developing our forecasts or setting monetary policy, we might want to look through those lumps and bumps, and focus instead on the longer-term trends. On the other hand, if it's a wave, it might represent a change in trend. Often the economy needs to transition to that new trend or new normal. It might not be obvious exactly where that new endpoint is or how long that transition will take. This is very different from a lump or bump, where things can be expected to revert to previous norms quite quickly. Lumps, bumps and waves also differ in how well they can be anticipated and quantified. Lumps come from single industries, firms, products or policies having an outsized effect on the total. Often these effects can be anticipated. In particular, if they come from a policy change, they are often preannounced. For the same reason, they can usually also be quantified, at least approximately. Bumps can be a bit trickier. By their nature they are often impossible to anticipate. After all, who could have predicted the dam collapse at an iron ore mine in Brazil, or the more recent drone attacks on Saudi oil processing facilities? Certainly not central bank economists. And although some aspects of their effects can often be quantified – the production loss, for example – the effect on prices or the subsequent effects on behaviour can be harder to assess. The waves are in many ways the hardest. By definition, they persist for some time, so you know you need to take them into account in your view of the outlook, even if you didn't anticipate their beginnings. But because they have such pervasive effects, it is often unclear exactly to take them into account. how The Signal in the Noise Lumps and bumps are in some sense both noise. In principle, noise should wash out of the total figures. But in real-world economies, it doesn't. Like pop songs or movies, where a few blockbuster hits far overshadow the long tail of minor releases, industries and economies also often follow something like a ‘power law’, with a large number of small entities and a small number of very large ones. This kind of structure is probably more prominent in a country like Australia than a larger, more diverse economy like the United States. What's important, though, is that idiosyncratic shocks to a large entity can be enough to affect the total, on its own or by propagating to other entities. https://www.rba.gov.au/speeches/2019/sp-so-2019-10-04.html 2/13 10/4/2019 Lumps, Bumps and Waves | Speeches | RBA When thinking about how these lumps and bumps affect the economy, and our forecasts, it's important to consider what the bounce-back looks like. We need to ask: is this a shock to the level, or to the growth rate? Consider the case where a natural disaster or some other event disrupts production at a particular facility. When things return to normal, is there a period of catch-up, where production is temporarily higher than normal? Or does production just revert to the previous normal level, in which case the production that would otherwise have occurred in the disrupted period is simply lost? Or is the effect on production levels more permanent, so that the growth rate returns to normal, but the level of production now follows a persistently lower trend track? These lumps and bumps can affect how you interpret the data, and they're not always about natural disasters. A recent example can be seen in public sector wages growth. The Bank has for some time been noting that government wages policies are restraining wages growth in the public sector. In some cases, these policies also apply to workers in the private sector doing work on behalf of governments, such as on construction projects or in parts of the health sector. So it might have been thought a little surprising that public sector wages growth actually picked up noticeably in the June quarter of this year. But it wasn't a surprise – it was a fully anticipated lump. A longstanding agreement to bring wages of Victorian nurses and midwives in line with those in New South Wales accounted for essentially all of this pick-up in the growth rate (Graph 1). And because it is an adjustment to the wage in subsequent quarters. level, we expect the rate of wages growth to fall back to its recent averages Graph 1 https://www.rba.gov.au/speeches/2019/sp-so-2019-10-04.html 3/13 10/4/2019 Lumps, Bumps and Waves | Speeches | RBA A ‘lump’ like this is relatively easy to anticipate and incorporate into your analysis, as long as you know it is happening. That isn't always feasible: sometimes lumps, such as large investment projects or certain wage deals, are not public information, or at least not until after they've happened. By contrast, natural disasters are the canonical example of bumps that you can't fully predict, but you can anticipate as a possibility. And it's obvious when they've happened. The effect of the drought on rural production and food prices is a good example of this. So were the two recent disasters affecting the iron ore market. The early months of the year are cyclone season in the Pilbara, so some disruptions to production can be reasonably anticipated, but Cyclone Veronica was far more disruptive than most. Together with the Brazilian mine disaster, this greatly reduced supply into the seaborne market for iron ore (Graph 2), and boosted iron ore prices. Because iron ore is such an important export for Australia, export revenue, the terms of trade and fiscal revenue all increased noticeably. And yes, this means some things didn't turn out as we had forecast. Graph 2 Weather-related and other disasters aren't the only cause of bumps. Sometimes people's actions are the root cause. These can be as prosaic as maintenance schedules that affect shipments of exports, or as alarming as the recent attacks on Saudi oil facilities. The impact of these events depends on how sustained the effect on production and prices will be. Higher oil prices flow through fairly directly to petrol prices, and thus generate short-term fluctuations in CPI inflation, both here and abroad. The broader implications depend on how strong global demand might be, how quickly production is restored, and on how easily replacement sources https://www.rba.gov.au/speeches/2019/sp-so-2019-10-04.html 4/13 10/4/2019 Lumps, Bumps and Waves | Speeches | RBA of supply can ramp up. In the case of the recent attacks, it seems that Saudi supply has been mostly restored already. So the effect on prices has been small and transient. But it is easy to see how these kinds of events can have more pervasive effects. Surfing the Waves … Now we come to the big waves, the secular trends or transitions to new states of the world. These might be easy to identify and name, but they are often hard to anticipate, and their effects can be pervasive and hard to disentangle. It's also easy to be struck by just how many ‘waves’ there are, and how diverse their causes can be. Non-economic waves Many of these waves come from causes that are in some sense outside the economic system. Demographic forces are perhaps the best-known of these. Because these forces play out over long periods, they are usually thought of as being outside the system, though of course policy can affect demography to some extent. The rise of China and its wave of urbanisation is a good example where policy and underlying demography have both mattered. With that urbanisation has come a lot of housing and infrastructure construction. This in turn has increased demand for steel and related commodity prices, with profound effects on the world economy, especially Australia. Perhaps the best example here, though, is the demographic shift that is the ageing of the population. This is something the Bank has talked about publicly in recent years, and it has been a priority of the Japanese Presidency this year in the G20. Today I'd like to highlight the implications of population ageing for labour force participation. It is often assumed that population ageing will reduce participation, because more people will be elderly and retired. But in Australia the opposite has occurred. This is also true for other advanced economies, with the United States being the exception. Although there are more older people, and older people do tend to participate less in the labour force than people in their middle years, participation rates in each age group have increased enough to more than offset this. Older people have increased their participation, and so have women across many age groups. Part of this effect could be cyclical. Women in their middle years and older workers of both sexes are two of the groups who increase their labour supply noticeably when demand for labour is strong (Evans, Moore and Rees 2018). But there is also a structural element to these increases. In fact we should have expected it. That is because these two groups are also the groups whose participation you'd expect would increase as part of population ageing. Population ageing comes from two drivers – lower fertility, and increasing longevity. If women are having fewer children on average, then fewer women are out of the labour force caring for children at any one time. This arithmetic applies even if there is no change in the cultural presumption that women, not men, should be the ones staying home to care for their children. This trend comes on top of the more general shift of women entering the workforce as social, educational and legal barriers to female participation were removed over past decades. Thus female participation has increased almost everywhere and, most recently, especially in Japan (Graph 3). https://www.rba.gov.au/speeches/2019/sp-so-2019-10-04.html 5/13 10/4/2019 Lumps, Bumps and Waves | Speeches | RBA Graph 3 And if people are living longer, healthier lives, fewer people will be retiring early due to ill health. So more people in older age groups will be able to continue working (and will need to in order to fund longer retirements). We shouldn't be surprised, then, that this group will also see a trend increase in their participation (Graph 4). https://www.rba.gov.au/speeches/2019/sp-so-2019-10-04.html 6/13 10/4/2019 Lumps, Bumps and Waves | Speeches | RBA Graph 4 It is hard to disentangle the cyclical from the trend. Still, many observers focused on the idea that, with a higher proportion of the workforce in older age groups that have lower average participation, total participation would fall. But (except in the United States) the opposite happened, because the underlying drivers of the wave – lower fertility and longer healthy lifespans – necessarily also created the conditions for higher participation in some groups in the population. Waves from ideas Some waves of change are initially spurred by something outside the economic system but their effects are heavily mediated by subsequent business decisions. The best example here is probably the adoption of technology. Invention of a new technology could easily be seen as outside the economic system: while research funding, property rights and other incentives no doubt influence the rate of invention, in the end, somebody has to have an idea, and that probably can't be forced. Once the idea is out there, though, adoption depends on many factors. It matters whether a technology is generally applicable, how much it costs, and whether people need new or rare skills to make best use of it. Over recent decades, computer software has become an increasingly important set of tools supporting many different kinds of work. You can see the computer and internet revolutions in firms' spending on software investment, culminating in a peak around the dot-com boom and Y2K rectification work, which can be seen as bumps on top of the wave (Graph 5). More recently, this type of investment has again been increasing faster than the economy as a whole, as firms adopt mobile, cloud and other new technologies. https://www.rba.gov.au/speeches/2019/sp-so-2019-10-04.html 7/13 10/4/2019 Lumps, Bumps and Waves | Speeches | RBA Graph 5 Sometimes technological change is less about the invention of a new technology and more about policy incentives, as well as the subsequent iterative development that makes the technology cheaper. As the Deputy Governor pointed out a few months ago, the cost of generating renewable energy has declined significantly over the past decade (Debelle 2019). It is now cost-competitive with traditional generation methods. Partly in response to this price signal, as well as policy incentives, we are seeing a wave of private sector investment in renewable energy in Australia and elsewhere. This investment is clearly visible in the aggregate investment data, and we take this shift into account in our forecasts. The result of that investment wave is also increasingly visible in the shift to renewables in total electricity generation (Graph 6). So far much of the increase has been in wind and small-scale rooftop solar generation. As renewable generation technologies continue to develop (including energy storage), this shift can be expected to continue. https://www.rba.gov.au/speeches/2019/sp-so-2019-10-04.html 8/13 10/4/2019 Lumps, Bumps and Waves | Speeches | RBA Graph 6 Waves from decisions Other waves can come from ‘inside’ the system, from the business decisions people make and the business models people adopt. A change in business structure can change how the economy operates and how economic variables relate to each other. A good example of this in Australia has been the increasing degree of competition in retailing, partly resulting from the entry of large global retailers to the Australian market. It wasn't so long ago that Australia's retail landscape looked very different, with few of the global retailers that populated the shopping centres of large cities overseas. That has changed over the past decade, especially in groceries and clothing retail (Graph 7). https://www.rba.gov.au/speeches/2019/sp-so-2019-10-04.html 9/13 10/4/2019 Lumps, Bumps and Waves | Speeches | RBA Graph 7 The effect on pricing models has been profound. After a long period where retail prices tended to rise at roughly the same rate as inflation generally, for the past decade or so, these prices have been flat to falling. This is a big change in pricing behaviour for some important parts of the Consumer Price Index. The question of how long this shift will last has been a key issue for us as we compile our inflation forecasts. Markets can open up to new players right across the economy. As we mentioned in our most recent in August, some parts of Australia's manufacturing sector are performing strongly and seeing their exports increase. This upswing is most evident in scientific instruments and in medicinal and pharmaceutical products (Graph 8). In some cases this is driven by a small number of Australian firms, so you could argue that these are lumps not waves. But once markets open up to one player, they generally stay open. This is another development that we have factored into our forecasts, and again we have to grapple with the question of how long it will go on. Statement on Monetary Policy https://www.rba.gov.au/speeches/2019/sp-so-2019-10-04.html 10/13 10/4/2019 Lumps, Bumps and Waves | Speeches | RBA Graph 8 Decisions by firms and other economic actors can also have wave effects at the regional level. Even if they wash out at the national level, they can still have a big effect on some people's lives. Certainly Geelong has seen the effects of these decisions, with a number of government agencies locating here in recent years, and the opening up of some transport infrastructure better connecting the whole region to Melbourne and beyond. Both of these factors have been at work in attracting people to the Geelong and Surf Coast regions (Graph 9). https://www.rba.gov.au/speeches/2019/sp-so-2019-10-04.html 11/13 10/4/2019 Lumps, Bumps and Waves | Speeches | RBA Graph 9 … Without Being Dumped There are many lessons to draw from the existence of lumps, bumps and waves. First, lumps and bumps aren't always forecastable, except policy changes that are announced before they are implemented. So we can forecast the effect of the low and middle-income tax offset on household disposable income, or the childcare subsidy changes on inflation, but we can't predict dam collapses and cyclones in advance. Second, tracking the lumps, bumps and other temporary special factors doesn't always feel a whole lot like the economics we learned at university. But if we don't do it, we will end up missing important developments and could seriously misinterpret the aggregate data. Third, there are established techniques for looking through the noise in data. This is important for avoiding ‘excuse-making’ – stripping out the inconvenient movements while leaving in the ones that line up with the story you want to tell. We do need to look through the lumps and bumps and noise to discern the underlying trend. But if we just excluded certain movements in an ad hoc way, we could be accused of bias, or we could miss something important. So even though our policy target is specified as a medium-term average of overall CPI inflation, we use the trimmed mean measure in our forecasting because it strips out extremes on both the high and low sides, and it doesn't presume where the noise comes from. There are other techniques for getting at the underlying trend in a series like inflation, and we look at those measures too. https://www.rba.gov.au/speeches/2019/sp-so-2019-10-04.html 12/13 10/4/2019 Lumps, Bumps and Waves | Speeches | RBA Finally and most importantly, the real art, and the value-add, is in identifying and quantifying the waves. This is more like the economics that we were trained to do. But it is still hard because a lot of standard economic theory necessarily starts from a presumption that the environment is stable. Waves, by definition, are a period of transition between two different states of the world. This doesn't mean that our economic understanding is all superfluous. The standard models need not be thrown out completely. And we have to be careful to avoid seeing paradigm shifts in every wiggle in the data. But structural change permeates the economy, and always will. I hope these examples have given a flavour of some of the issues and trends we grapple with as we try to understand economic developments. Our engagement with the business sector and with community groups is very important to our understanding. So as well as thanking you for your time today, I'd like to thank all of the firms and community groups we meet with. Among the lumps, bumps and waves, there are many important stories that we need to hear. Without you, it would be much harder to do so. Endnotes [*] Thanks to Sharon Lai for her assistance in preparing this talk. See RBA (2014). See Gabaix (2016) for a discussion of how and where power laws can arise in economies, and Gabaix (2011) for an analysis of how power law distributions can lead to firm-level shocks having economy-wide effects. In the economic jargon, these are called ‘exogenous’. References Debelle G (2019), ‘Climate Change and the Economy’, Public Forum hosted by the Centre for Policy Development, Sydney, 12 March. Bulletin Evans R, A Moore and D Rees (2018), ‘The Cyclical Behaviour of Labour Force Participation’, RBA , September, viewed 2 October. Available at < https://www.rba.gov.au/publications/bulletin/2018/sep/the-cyclical-behaviour-of-labourforce-participation.html>. Econometrica, 79(3), pp 733–772. Gabaix X (2016), ‘Power Laws in Economics: An Introduction’, Journal of Economic Perspectives, 30(1), pp 185–206. RBA (2014), ‘The RBA's Business Liaison Program PDF ’, RBA Bulletin, September, pp 1–6. Gabaix X (2011), ‘The Granular Origins of Aggregate Fluctuations’, © Reserve Bank of Australia, 2001–2019. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2019/sp-so-2019-10-04.html 13/13 | reserve bank of australia | 2,019 | 10 |
Article by Philip Lowe, Chair of the CGFS and Governor of the Reserve Bank of Australia, and Jacqueline Loh, Chair of the Markets Committee and Deputy Managing Director of the Monetary Authority of Singapore, in the Financial Times, published on 7 October 2019. | null | reserve bank of australia | 2,019 | 10 |
Address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the CFA Societies Australia Investment Conference, Sydney, 17 October 2019. | Speech Housing and the Economy Guy Debelle [ * ] Deputy Governor Address at the CFA Societies Australia Investment Conference Sydney – 17 October 2019 The housing market has a pervasive impact on the Australian economy. It is the popular topic of any number of conversations around barbeques and dinner tables. It generates reams of newspaper stories and reality TV shows. You could be forgiven for thinking that the housing market the is Australian economy. [1] That clearly is not the case. But at the same time, developments in the housing market, both the established market and housing construction, have a broader impact than the simple numbers would suggest. This has been known for a long time, but often housing cycles have occurred simultaneously with other events. For example, the housing downturn in the early 1990s occurred at the same time as the 90s recession. As a result, it can be difficult to fully isolate the direct effect of the housing market itself from the other forces at work. We have models which go some way towards doing this, but they also tend to suffer from the problem of disentangling the various factors. Over the past few years, the housing cycles have moved in different directions, and varied quite considerably around the country. The construction and price cycles are clearly highly interconnected. Both reflect the standard economic forces of supply and demand. Both cycles often move in sync, but this time they aren't. So this current cycle presents the possibility to more clearly understand the differing effects of the housing construction cycle and the housing price cycle. The large variation in both cycles across cities round the country also means that we can separate out the effect of some macroeconomic factors which are common across the country and hence shouldn't be a driver of the differences across states. In particular, interest rates have been the same across the country. Today I am going to discuss the evolution of the housing market and its effect on the economy. Some of the channels of transmission have occurred as expected, some have been more unexpected. 1/17 10/17/2019 Housing and the Economy | Speeches | RBA I will first talk about the construction cycle, then the price cycle. Following that I will examine how each of these two cycles has spilled over to activity and inflation in the broader economy. Finally, I will focus on developments on the lending side. Construction Cycle The housing construction cycle in Australia clearly turned down at the end of last year. That brought to an end a long upswing at the national level that started in 2012. This downturn in the housing sector was not preceded by rising interest rates. This makes it a particularly unusual cycle because nearly every housing cycle in the past was preceded by rising interest rates. This time around, the dynamics of supply and demand have been paramount. The cycle started following a pick-up in population growth in the mid 2000s that was, by and large, unexpected. It took a while for construction (the supply side) to respond to this increase in demand. It started to do so around 2012, when there was a solid upswing for the next four years. One factor contributing to the slow response of supply was the historically high share of high and medium density housing. Graph 1 shows that currently there is almost as much investment spending on higher-density dwellings as detached houses. But this equal spending translates into 2½ higherdensity apartments being built for every detached house at the moment. Graph 1 https://www.rba.gov.au/speeches/2019/sp-dg-2019-10-17.html 2/17 10/17/2019 Housing and the Economy | Speeches | RBA The lead time for high-density construction is long. A higher-density development also requires more certainty around demand before going ahead given the developer is trying to sell more dwellings at the same time. That is relevant for the pre-sale financing too. And then, once construction is actually underway, it takes about two years to build higher-density housing compared with around nine months for a detached house. The greater share of higher-density means the construction response to changes in demand is probably slower on the way up and on the way down, as higher-density is harder to stop once it's underway. Detached housing construction is generally more flexible than higher-density construction, though in Sydney and Melbourne, the higher-density and detached housing construction are in very different parts of the cities. The construction cycle has been mostly an east coast story, particularly (greater) Melbourne and Sydney. Western Australia has also had its own construction cycle, which was very much driven by the resources boom. The WA cycle shows the importance of incomes and population dynamics in driving the construction and price cycles. The resource investment boom saw a marked change in the population dynamics in WA. Population growth picked up from 1.1 per cent in 2002 to 3½ per cent at its peak in 2008. Incomes also grew very strongly with the resources boom. The construction response again followed with a lag. But the strong inward migration turned to outward migration once the resources cycle turned and incomes declined too. Housing construction continued past the turn in the cycle, contributing to the price dynamics that I will come to shortly. One reason for highlighting the differences in construction cycles between the east and the west coast is to illustrate the point that these differences occurred across the country despite the same interest rate prevailing. This means that it is not just interest rates that matter for housing. Other fundamentals such as population growth, incomes and lags on the supply side were important drivers of the construction and price cycles. That said, interest rates cost of finance is an important consideration. do play an important role; the Residential construction grew from 2012 to be 6 per cent of GDP at the beginning of 2016 and stayed around there for the next three years. This was its highest share of the economy since 2006. While the supply response to the increase in population growth in the mid 2000s took some time, in the end it did come. The increase in supply has worked to address the increased demand. Hence it is not surprising to the see construction activity decline, particularly when it is combined with a decline in demand from foreigners, as well as from domestic investors in a market where prices were falling and facing tighter credit conditions. Since September 2018, residential construction activity has declined by 9 per cent. The decline has been broad-based across detached and higher-density housing, as well as spending on renovations (alterations and additions in national accounts terminology). Nevertheless, the pipeline of work to be done remains at a high level, particularly for higher-density projects in New South Wales and Victoria, though it has declined in most states (Graph 2). https://www.rba.gov.au/speeches/2019/sp-dg-2019-10-17.html 3/17 10/17/2019 Housing and the Economy | Speeches | RBA Graph 2 Given the large size of the pipeline, we had expected construction activity to remain at a pretty high level for most of this year, but it turned down sooner and by more than we had expected. The fall has been larger in higher-density than in detached, but still sizeable in each. Even so, much of the downturn in construction activity is still ahead. Building approvals are around 40 per cent lower than their peak in late 2017 (Graph 3). https://www.rba.gov.au/speeches/2019/sp-dg-2019-10-17.html 4/17 10/17/2019 Housing and the Economy | Speeches | RBA Graph 3 We are forecasting a further 7 per cent decline in dwelling investment over the next year, and there is some risk the decline could be even larger. This will directly subtract around 1 percentage point from GDP growth from peak to trough, given that dwelling investment accounts for around 6 per cent of GDP. The effect of the downturn in housing construction on the broader economy, though, is likely to be somewhat larger than 1 percentage point given the linkages the sector has with other parts of the economy. For example, the residential construction sector has linkages to the business services sector through architects, draftspeople and construction engineers, and to the manufacturing sector through steel, bricks, etc. The residential construction sector itself accounts for around 2 per cent of total employment. But when we look more broadly, just under 6 per cent of employment is closely related to the residential construction sector (Table 1). https://www.rba.gov.au/speeches/2019/sp-dg-2019-10-17.html 5/17 10/17/2019 Housing and the Economy | Speeches | RBA Table 1: Employment Related to Residential Construction Share of Total Employment; 2016/17 (per cent) Residential construction 2.0 Construction services 1.0 Manufacturing 0.8 Distribution 0.6 Business services 0.6 Household services 0.3 Other 0.3 Total 5.8 Sources: ABS; RBA As the residential construction sector downturn continues over the next year, the impact will be felt in these sectors too. However, before this comes across as too gloomy, there are a number of mitigants. Firstly, depending on the skills they have, a number of these workers can shift to the nonresidential construction sector where activity is at a high level and is likely to remain so in the period ahead. This includes the high level of infrastructure spending, but is not limited to that. Secondly, while there is a significant downturn in prospect over the next year or so, some of our liaison contacts in the construction sector have said that they can see through the trough in activity to the other side. While the increase in supply has finally met the earlier increase in demand, demand will continue to grow given population growth but supply is going to decline. So there is quite likely to be a shortfall again in the foreseeable future. Hence some large developers tell us that they are prepared to retain their employees through the coming trough in activity. That said, the outlook for smaller contractors, which are quite prevalent in the housing sector, is not so great in the period ahead. Price Cycle I will now turn to the housing price cycle, which is mostly about the established market. Around 70 per cent of housing sales are from the existing housing stock. Even in the peak of the construction cycle last year and at a time when the number of sales in the established market was declining, at most 50 per cent of turnover came from newly built housing. Clearly, the established and the newly built market are closely related. They are linked by the unavoidable fact that everyone has to live somewhere. [5] That is a fundamental force in the housing market that always needs to be kept in mind. How many people live in each dwelling can change, but that is generally slow moving. It is affected by social forces that influence average household size as well as economic forces like prices, rents and income. https://www.rba.gov.au/speeches/2019/sp-dg-2019-10-17.html 6/17 10/17/2019 Housing and the Economy | Speeches | RBA The housing price cycle has also turned, but in the opposite way to the construction cycle (Graph 4). Again the picture is very different across the states. It also differs across cities within states, and even across suburbs within cities. A large part of these differences reflect different population dynamics, particularly migration flows. In turn, that also reflects differences in employment and income as well as differences in the cost of housing. Graph 4 The price cycles in Sydney and Melbourne reflected similar dynamics to the construction cycle I talked about earlier. There was a large increase in demand, which outpaced the increase in supply. Some part of the increase in demand was a result of lower interest rates, but there were clearly other factors such as population growth and foreign demand. Those factors played out differently across the different cities, contributing to the difference in price dynamics. But again, it is worth remembering that the same interest rate applied across all of the cities across the country throughout their considerably different price cycles. This has particularly been the case over the past decade. This is in contrast to the cycle from the mid 1990s to the mid 2000s, which was more uniform and more clearly related to the shift down in the nominal interest rate structure. The cycles in Melbourne and Sydney have been particularly stark. Prices in those cities increased by 58 and 75 per cent, respectively, from 2012 to 2017. Prices turned down in 2017. Again, this was not a result of rising interest rates. To a large degree, the cycle was likely to turn given the large run-up in prices, although the exact timing of this was hard to predict. The increase in the supply of new housing also contributed, as did the decline in foreign demand. The tightening in lending standards https://www.rba.gov.au/speeches/2019/sp-dg-2019-10-17.html 7/17 10/17/2019 Housing and the Economy | Speeches | RBA that occurred from around 2014 also played a role. [6] Once prices started to turn down, investors pulled back, not being willing to buy into a falling market. This further contributed to the downward pressure on prices. Prices declined by 11 and 15 per cent in Melbourne and Sydney, respectively. Over the past few months, the cycle has turned again in Melbourne and Sydney. This has coincided with the lower cash rate and mortgage rates, as well as APRA's recent changes to the interest rate threshold. In addition, it is possible that prices had fallen far enough to rekindle some demand. At the same time, housing prices in Perth and Darwin have continued to decline. Lower interest rates have not been enough to outweigh the impact of other drivers of housing prices in those two regions including sharply lower population growth. Conditions in other cities have been more subdued, both on the way up and on the way down. Turnover in the housing market declined to historically low levels earlier in the year, and has only just begun to rise off those lows despite the turnaround in the price cycle. Turnover fell to the lowest it has been as a share of the housing stock in more than three decades (Graph 5). This low turnover has had a number of macroeconomic impacts, which I will come to shortly. Graph 5 Financial Before that, I will briefly discuss negative equity (this is covered in more detail in the recent ). Falling housing prices heighten concerns about negative equity. Negative equity is Stability Review https://www.rba.gov.au/speeches/2019/sp-dg-2019-10-17.html 8/17 10/17/2019 Housing and the Economy | Speeches | RBA not necessarily a problem in and of itself, although households would have preferred not to have bought at the peak of the market. Rather, negative equity increases the vulnerability of those households should they encounter problems in managing their mortgage, particularly if they were to lose their job. We estimate that around 3¾ per cent of mortgage balances (by value) are in negative equity. This is up from around 2 per cent a year ago. Over half of these mortgages are in WA and NT, where a little under one-fifth of balances are in negative equity. While this is clearly of concern for those households in negative equity, loans in these areas account for less than 2½ per cent of mortgage balances in Australia. Other Spillovers to the Economy Earlier I talked about the direct effect of the downturn in residential construction on the economy and some of the spillovers to other parts of the economy including through employment. Part of this has been reflected in the decline in income for small business, which is evident in the national accounts. Gross mixed income, which is primarily small business income, declined by 3.8 per cent over the past year. Some part of this is lower incomes in the farm sector from the impact of the drought, but a sizeable part is low income growth from contractors in the residential construction sector. This has contributed to the overall historically low growth in household incomes and thereby to the lower growth in consumption. Growth in disposable income slowed from 4 per cent at the end of 2017 to 2 per cent by the end of 2018. We estimate that this explains around half of the recent slowing in consumption. The decline in housing prices has also led to a fall in household wealth. Our standard estimate of the wealth effect is that a 10 per cent fall in housing prices leads to a 1½ per cent fall in household consumption over time. [7] Given the decline in housing prices that has occurred, we estimate this accounted for the other half of the recent slowdown in consumption growth. As Graph 5 shows, the fall in housing prices has been accompanied by very low housing turnover. So some part of the ‘wealth effect’ is likely to be related to the (unsurprising) fact that when people move house they tend to buy a lot of household goods like furniture at the same time. In the past, housing prices and turnover have moved in lock step so it has been difficult to determine the impact of each channel. But with prices starting to grow again now, but turnover so far only picking up a little from its lows, we may get a better sense of which has been the bigger drag on consumption – wealth or turnover – and hence what the outlook for consumption might be now the housing price cycle has turned. The fall in housing prices and turnover has also reduced stamp duty revenue for state governments. [8] But by and large this hasn't resulted in state governments changing their expenditure plans materially, so this hasn't had a procyclical impact. A related effect on measured GDP growth has been the effect of the decline in turnover on an item in the national accounts called ‘ownership transfer costs’. This little-known part of the accounts measures costs involved with transferring properties such as stamp duties and fees paid to real https://www.rba.gov.au/speeches/2019/sp-dg-2019-10-17.html 9/17 10/17/2019 Housing and the Economy | Speeches | RBA estate agents and lawyers. Spending on these costs declined by more than 20 per cent over the year to the March quarter and reduced aggregate GDP growth by around 0.4 percentage points. We had not fully taken account of this in our forecasts of GDP and it is part of the explanation of why GDP growth has turned out to be slower than we had expected. Inflation Impact One other area where the spillover from housing to the rest of the economy has been larger than we had expected is its impact on inflation (Graph 6). The two largest housing-related components of the CPI basket are rents and new dwelling purchases by owner-occupiers, which together account for around one-sixth of the CPI basket. (Note that established housing prices are not directly in the CPI.) Inflation in these components is around historical lows, reflecting the conditions in the housing market. Graph 6 Since 2017, the new dwelling purchase component of the CPI has reflected the cost of building higher-density housing as well as the price of newly built detached housing (prior to that it excluded the cost of higher-density housing) (Graph 7). Surprisingly, despite activity in the housing sector being around historical highs in 2017 and 2018, there was not much pressure on building costs. So inflation from this source was contained. More recently, as the construction cycle has turned down https://www.rba.gov.au/speeches/2019/sp-dg-2019-10-17.html 10/17 10/17/2019 Housing and the Economy | Speeches | RBA and as demand for new housing has declined significantly, developers have been offering discounts. These haven't been so much in the form of price discounts but rather in the form of add-ons such as a new kitchen, a better fitout etc. Developers do this to limit the spillover of lower prices to other potential sales. The ABS treats these in-kind discounts as quality improvements, which translate into a material reduction in the cost of detached housing in the CPI. Graph 7 On the rental side, the large additions to the stock of housing, and particularly higher-density housing, have had an impact on rents, particularly in Sydney, where the rental vacancy rate rose sharply to be at its highest in 16 years in June (Graph 8). Consequently, advertised rents are declining, and the rental inflation component in the CPI, which captures existing rents, is close to zero for Sydney (Graph 9). The vacancy rate in Melbourne has remained low as the substantial increase in new housing supply has been largely absorbed by strong population growth. Hence rental inflation in Melbourne has remained around 2 per cent. In contrast, Perth rents have fallen by 22 per cent since 2014, although the pace of decline has eased gradually, as newly advertised rents have increased and the vacancy rate has begun to decline. https://www.rba.gov.au/speeches/2019/sp-dg-2019-10-17.html 11/17 10/17/2019 Housing and the Economy | Speeches | RBA Graph 8 https://www.rba.gov.au/speeches/2019/sp-dg-2019-10-17.html 12/17 10/17/2019 Housing and the Economy | Speeches | RBA Graph 9 Lending Conditions Finally, it is important to look at lending conditions and credit growth and how that has interacted with the construction and housing price cycles. My main argument is that the slowdown in housing credit growth to households has primarily reflected the housing cycle rather than driven it. That is, the slowdown in credit growth is primarily a demand story rather than a supply story. I talked about this last November. At the time I said I didn't see much sign of a credit crunch. And with the benefit of hindsight I would stand by much of that assessment. Yes, there was a tightening in lending standards from 2014 onwards. But through the first part of this, housing lending continued to grow at a fast pace. There was some further tightening over 2018 following the Royal Commission, mostly through stronger enforcement of existing policies. But the bulk of the tightening had preceded that. Credit growth started to slow materially in mid 2017 (Graph 10). Investor demand has slowed to such an extent that the stock of outstanding credit to investors has actually fallen in recent months. In my view this is primarily a decrease in investor demand given falling housing prices, more than the impact of tighter lending conditions. https://www.rba.gov.au/speeches/2019/sp-dg-2019-10-17.html 13/17 10/17/2019 Housing and the Economy | Speeches | RBA Graph 10 Throughout, competition for high-quality borrowers with standard loan applications has remained strong. In the end, it is difficult to separate the effect of demand and supply, but this strong competition suggests there is more of a demand than a supply story. We are seeing a number of borrowers taking advantage of this competition by refinancing to lower rates. This, along with continued switching from interest only to principal and interest loans, amounts to a reduction in variable mortgage rates paid of around a basis point per month. There is still plenty of scope for more of this to occur, given that the interest rate on a new loan is some 30 basis points below the average outstanding rate for owner-occupiers. This brings me to the question of what will happen now that mortgage rates have declined. Following the recent 75 basis point reduction in the cash rate, on average, variable mortgage rates have declined by around 60 basis points. Interest rates are historically low. Will we see a material increase in borrowing as a result? While turnover in the housing market remains low, credit growth is likely to remain low, even as prices pick up. Households may be more conservative in their willingness to borrow given low income growth. Lenders are applying tighter standards than in the past. Both of these may well combine to result in a more muted pick-up in lending than in the past. https://www.rba.gov.au/speeches/2019/sp-dg-2019-10-17.html 14/17 10/17/2019 Housing and the Economy | Speeches | RBA Loan approvals have begun to rise but we have yet to see this flow through to a pick-up in housing credit growth (Graph 11), which has remained at historically low rates for both owner-occupiers and particularly investors. One issue that we are closely monitoring is the extent to which households choose to take advantage of lower interest rates to pay down their mortgages faster. This would be evident in an increase in loan approvals that is not accompanied by an increase in credit growth. Graph 11 While I believe that the slowdown in housing credit is more a result of weaker demand than tighter supply, I said last November ‘the effect of a tightening in lending to developers seems to me to be a higher risk to the economic outlook than the direct effect of the tighter lending standards on households, which has ameliorated risk. Relatedly, there may also be a bigger impact on lending to small business given the extensive use of property as collateral for small business loans.’ This still is very much the case nearly twelve months on. Conclusion Let me now bring this together. There is a sizeable downturn in construction underway. Contacts in the Bank's liaison program indicate that demand for new houses and apartments has remained around the low levels of late 2018. The typical lags between the sale and construction of new dwellings imply that the decline in dwelling investment will continue for some time, despite the recent signs of stabilisation in the established housing market. I have highlighted that the effect on https://www.rba.gov.au/speeches/2019/sp-dg-2019-10-17.html 15/17 10/17/2019 Housing and the Economy | Speeches | RBA the economy is greater than the direct effect of the decline in construction, with significant spillovers to other parts of the economy and also inflation. 2020 looks like being the low year for the residential construction sector. But we can see through the trough to the other side. Demand is still continuing to increase given population growth. While there are pockets of oversupply, particularly in parts of Sydney where the vacancy rate is high, they are not widespread. Prices have turned in Melbourne and Sydney (though not Perth or Darwin), which probably brings the investor back into the market. The long lead times on higher-density construction mean the supply response is likely to be slow. The tight conditions on lending to developers may mean it is even more protracted. The growth in demand without a meaningful supply response will lead to a larger price response. From a financial stability perspective that is not so much an issue if it is not accompanied by a material expansion in borrowing. Housing price increases clearly have a distributional impact, but monetary policy is not well placed to address that. Monetary policy is concerned about aggregate outcomes for inflation and unemployment. In that regard, unemployment is a little higher than it was at the beginning of the year, and there has not been much upward pressure on wages. In turn, this has contributed to the extended run of inflation outcomes below the medium-term target range. As a result, the Board has decided to ease monetary policy in recent months. These actions take account of the expected evolution of the housing cycle that I have talked about today. With these actions, we are seeking to make more assured progress towards both full employment and the inflation target. Endnotes [*] Thanks to Kate McLoughlin and Penny Smith for their input. This is not purely an Australian story. See Leamer E (2007), ‘Housing IS the Business Cycle’, National Bureau of Economic Research Working Paper 13428. For a full exposition, see Lowe P (2019), ‘The Housing Market and the Economy’, Address to the AFR Business Summit, Sydney, 6 March. At the same time, in my home town of Adelaide, there hasn't been much of a cycle at all right through this period. Saunders T and P Tulip (2019), ‘A Model of the Australian Housing Market’, RBA Research Discussion Paper 201901. That said, more than 110,000 people were estimated to be homeless on Census night in 2016. RBA (2018), ‘Assessing the Effects of Housing Lending Policy Measures PDF ’, pp 75–88. May D, G Nodari and D Rees (2019), ‘Wealth and Consumption PDF ’, RBA , March, viewed [14 October 2019]. Available at <https://www.rba.gov.au/publications/bulletin/2019/mar/wealth-and-consumption.html>. There are also effects on capital gains tax revenues. Financial Stability Review, October, Bulletin https://www.rba.gov.au/speeches/2019/sp-dg-2019-10-17.html 16/17 10/17/2019 Housing and the Economy | Speeches | RBA Debelle G (2018), ‘Assessing the Effects of Housing Lending Policy Measures’, Remarks at FINSIA Signature Event: The Regulators, Melbourne, 15 November. Some of this difference reflects differing borrower characteristics. But for a significant number of borrowers there is the opportunity to refinance at a lower rate or put pressure on your existing lender to lower your mortgage rate. © Reserve Bank of Australia, 2001–2019. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2019/sp-dg-2019-10-17.html 17/17 | reserve bank of australia | 2,019 | 10 |
Text of the Sir Leslie Melville Lecture by Mr Philip Lowe, Governor of the Reserve Bank of Australia, Canberra, 29 October 2019. | 10/30/2019 Some Echoes of Melville | Speeches | RBA Speech Some Echoes of Melville Philip Lowe [ * ] Governor Sir Leslie Melville Lecture Canberra – 29 October 2019 Thank you for the invitation to deliver this year's Sir Leslie Melville lecture. When Ian Macfarlane delivered the inaugural lecture in this series in 2002, he said: ‘any objective assessment of achievements would place Sir Leslie among the most distinguished Australians of the past century’. [1] It is a great privilege for me to be able to honour those achievements today. Leslie Galfreid Melville had a long and close association with the Reserve Bank of Australia. He was a member of the Reserve Bank Board for most of the time between 1960 and 1975. And before joining the Board, he played a critical role in the debates that shaped the mandate given to the Reserve Bank in 1959. It is six decades now since that mandate was passed by Parliament. It has more than stood the test of time. From this perspective alone, we have a lot to thank Leslie Melville for. In today's lecture I would like to discuss two issues that Melville had strong opinions on. The first is the appropriate objectives of the central bank. And the second is his view regarding the impossibility of zero interest rates. Both of these issues have echoes in today's discussions of monetary policy. Central Bank Objectives Over recent decades there has been much discussion in the academic and policy communities as to whether a central bank should have a single mandate – price stability – or a dual mandate – price stability and full employment. In practice, we see examples of both around the world. https://www.rba.gov.au/speeches/2019/sp-gov-2019-10-29.html 1/18 10/30/2019 Some Echoes of Melville | Speeches | RBA Here in Australia though, the Reserve Bank of Australia has neither a single nor a dual mandate – we have a triple mandate. Under the legislation passed in 1959, it is the duty of the Reserve Bank Board to ensure that its policies are directed to the greatest advantage of the people of Australia so as to best contribute to: 1. the stability of the currency of Australia; 2. the maintenance of full employment in Australia; and 3. the economic prosperity and welfare of the people of Australia. This triple mandate was taken from earlier legislation, passed in 1945, that set the objectives for the central banking division of the Commonwealth Bank. It had its origins in a post-World War II Australia, when ensuring economic stability and high levels of employment were very much top of mind. Establishing such a broad mandate for the central bank ran against the conventional wisdom of the time, which was that central banking was about just currency and banking. Indeed, in his book on the history of the Reserve Bank, Boris Schedvin was moved to write: ‘This bold declaration of responsibility was a landmark in the history of central banking.’ It was a landmark in the sense that the Australian Parliament recognised that central banking was not only about money and finance, but it was also about jobs and the welfare of our society. As the current governor of the Reserve Bank of Australia, I very much share this perspective. Ultimately, central banking is not only about finance and money; rather, it is about enhancing the economic welfare of the people we serve, primarily through achieving price and financial stability and maximum sustainable employment. Melville had an important hand in setting this direction. His contribution goes back to at least 1936, when he made a lengthy submission to the Royal Commission on the Monetary and Banking Systems in Australia. The first sentence of that submission reads: ‘The ultimate purpose of monetary policy is to enable the economic system to achieve the optimum use of available resources as far as this is possible’. [4] It was then 23 years later that this idea – in different words – found expression in the Reserve Bank Act 1959. It is worth recalling that Melville had less success in his quest for full employment to be incorporated into the charters of global economic institutions that were set up after World War II, including the International Monetary Fund. This was not for want of trying – at all the major international economic conferences at the end of the war, he was a strong advocate for what became known as the ‘Full Employment Approach’. But back to the world of central banking. Since the early 1990s, the conventional wisdom has been that the best contribution a central bank can make to full employment and economic welfare is to maintain low and stable inflation. This is because by keeping inflation under control and within a narrow range, the central bank can https://www.rba.gov.au/speeches/2019/sp-gov-2019-10-29.html 2/18 10/30/2019 Some Echoes of Melville | Speeches | RBA reduce uncertainty and economic distortions and, in so doing, provide a stable foundation for people to make decisions about savings and investment. In turn, this provides the basis for reaching the maximum level of employment that is achievable given the choices that society makes about things such as the social safety net, the nature of employment arrangements, and training and education. After the high inflation 1970s and 1980s, many central banks adopted an inflation target as the means to deliver the sought-after low and stable inflation. Central banking in many parts of the world became all about inflation control, and adopting an inflation target became the way of delivering that control. As part of this shift, central banks also changed their communication to focus very much on inflation outcomes. Accountability mechanisms were also developed to make sure that the central bank kept its focus squarely on inflation. This approach made a lot of sense and it worked. Inflation rates have been lower and more stable. Central banks have established strong anti-inflation credentials and expectations of high inflation have been wrung out of the system. Core inflation in the advanced economies has been consistently around 1–2 per cent for the past 20 years (Graph 1). And measures of inflation expectations suggest that inflation is expected to remain low for many years to come. Graph 1 https://www.rba.gov.au/speeches/2019/sp-gov-2019-10-29.html 3/18 10/30/2019 Some Echoes of Melville | Speeches | RBA Despite this success, things have not exactly worked out as hoped, and recent experience is causing some rethinking of aspects of the conventional wisdom. I would draw your attention to two aspects of that experience. The first is that low and stable inflation is not a sufficient condition for financial stability and thus ultimately full employment. Indeed, it is possible that, in some circumstances, a low and stable inflation environment provides fertile ground for the emergence of some financial stability risks. As we have seen too often, the crystallisation of these risks can have very large welfare consequences, with people losing their jobs, their incomes and their savings. So just achieving low and stable inflation is not enough to maximise economic welfare. The second aspect that I would like to draw your attention to is that there is more uncertainty than there was previously about what is required to deliver short-run inflation control. This partly reflects some powerful worldwide forces – including technology and increased competition from globalisation – that are affecting inflation dynamics almost everywhere. So it is more difficult to manage inflation tightly than it once was. In my view, the Australian approach to inflation targeting together with our broad mandate are better suited to this changing world than are more rigid arrangements. In Australia, since the early 1990s we have had a flexible inflation target. Our target is to achieve an average rate of inflation, over time, of between 2 and 3 per cent. This means that there is an acceptable degree of variation in inflation from year to year, and we have been prepared to use this flexibility. Our focus is very much on the medium term – hence ‘on average’ and ‘over time’. The Board is seeking to provide a strong nominal anchor that people can rely on when making their decisions. Most people in our society can cope with small variations in inflation from year to year, but medium-term uncertainty is much harder to deal with. Importantly, we have always seen the inflation target as nested within the broader objective of welfare maximisation. This means that the question the Reserve Bank Board asks itself when making interest rate decisions is how those decisions can best contribute to the welfare of the Australian people. In particular, we are seeking to achieve the maximum sustainable rate of employment consistent with inflation being at target. And we are seeking to do this in a way that limits the build-up of financial imbalances that can be the source of instability down the track. In doing this, we can make a material contribution to the welfare of the society we serve. I acknowledge there is an element of judgement and discretion in this approach. Certainly, there is more judgement involved than in an approach to monetary policy that mechanically sets interest rates so that forecast inflation is at the target in two years' time. My view is that our more flexible system has served Australia well and can more easily accommodate the changes taking place in the economic system than can other approaches. More generally, I also see longer-term benefits in terms of the standing of central banks in the community if they explain their decisions in terms of jobs and incomes, not just short-run https://www.rba.gov.au/speeches/2019/sp-gov-2019-10-29.html 4/18 10/30/2019 Some Echoes of Melville | Speeches | RBA variations in inflation rates. That's not to say inflation control is unimportant – because it clearly is important. Rather, we need to remember that it is a means to an end, and that end is welfare maximisation. I suspect that this is a sentiment that Melville would have agreed with. I want to emphasise that the discretion we have and our broad mandate to promote the economic welfare of the Australian people do not constitute a licence for the Reserve Bank Board to pursue or advocate economic policies outside our area. Our focus is on inflation control, the labour market, the payments system and financial stability. Dealing with these matters is our contribution to our collective welfare. I also want to emphasise that the flexibility of our inflation target and our broad mandate – and the discretion it allows – requires a high level of transparency and accountability from us. When we make decisions, there is always an element of judgement and we have to wrestle with difficult trade-offs, where reasonable people can come to different judgements. This means you should expect us to explain our decisions clearly. You should also expect us to explain the various tradeoffs we face and how we are balancing them. And as these trade-offs become more complicated in today's world of very low interest rates, you should expect us to be as clear as we can be about how we are viewing these trade-offs and how they are affecting our decisions. Interest Rates That brings me to my second topic, and that is the very low interest rates around the world. Reading through Melville's writings, it is pretty clear that he would have been perplexed about the current state of affairs, in particular the prevalence of zero and negative interest rates. Writing in the Economic Record in 1938, Melville said ‘Zero interest is a limiting, but unattainable, value analogous to infinity.’ [6] He went on to argue that ‘the notion that a zero rate of interest is possible assumes that there is a practicable limit to the amount of useful material which can be profitably employed by society’. To reinforce this point, he went on to write that at zero interest: ‘Roads would be levelled and straightened regardless of cost. In some places mountains would be dug away and valleys filled to provide residential and agricultural land. Deserts would be watered, beaches would be built in places accessible to cities and provided with artificial sea and sunlight.’ I found it surprising to read this – not just because of the obvious engineering challenges – but because in other writings, Melville was very sceptical about public works and public debt. Understandably, he wanted public money to be spent wisely. So this was quite a contrast. But it reflected his strong view that zero interest rates were an impossibility, because at zero interest rates, people would just borrow, invest and consume and satisfy all their wants. So as I said, he would be perplexed at the current state of affairs. As things currently stand, the entire Swiss government nominal bond yield curve is in negative territory (Graph 2). Most of the German, Dutch, French and Japanese yield curves are also in https://www.rba.gov.au/speeches/2019/sp-gov-2019-10-29.html 5/18 10/30/2019 Some Echoes of Melville | Speeches | RBA negative territory. The Swiss government, for example, can borrow for 30 years at an interest rate of −0.2 per cent. If it were to issue a zero coupon security at this yield, it would mean that the buyer would give the Swiss government 106 Swiss Francs today and receive back just 100 Swiss Francs in 30 years' time, with no other payments between now and then. That is remarkable. There have certainly been other periods when real bond yields were negative, but such widespread negative nominal yields is unprecedented. Graph 2 It is not just governments that can borrow at negative yields. Over recent times, private companies including Coca-Cola, Orange and Siemens have issued unsecured bonds with zero coupons and negative yields. It has also become common for European banks to issue covered bonds with negative yields. And in Denmark, at least one bank has offered residential mortgages at a negative rate of interest: −0.5 per cent, although after fees the effective interest rate is just in positive territory. All up, there are now US$14 trillion of bonds trading at negative yields around the world (Graph 3). And around a quarter of all government bonds globally are now trading at negative yields. Back in 1938, Melville would have struggled to understand this. And, today in 2019, many people also wonder how things could have come to this. In a moment, I will offer some explanations. https://www.rba.gov.au/speeches/2019/sp-gov-2019-10-29.html 6/18 10/30/2019 Some Echoes of Melville | Speeches | RBA Graph 3 Before I do so, though, it is worth pointing out than even back in 1938, Melville's views about zero interest rates were contested. Following Melville's article, Brian Reddaway and Richard Downing published a conflicting view in the Economic Record with arguments that still have resonance today. [7] They pointed out that even with zero interest rates, there is a limit to borrowing by both individuals and governments. This is because, even if the interest rate is zero, the principal does need to be repaid. And this means that projects undertaken with borrowed money still need to generate a return that is sufficient to repay that principal and also compensate for risk. I suspect that some of Melville's engineering ideas wouldn't have met this test. So how then do we explain these low interest rates around the world? Like many questions in economics, a reasonable place to start is supply and demand. Over recent times, the global supply of savings has been high relative to the demand to use those savings to invest in new productive capital. As a result, the return to savers, especially those who save in low-risk assets, is low. The question is then: why is the global appetite to save high relative to the appetite to use those savings to invest in new productive capital? Let me start with savings, and I will focus on three issues. These are: demographic trends; the integration of Asia into the global economy; and the legacy of high levels of borrowing in the past. https://www.rba.gov.au/speeches/2019/sp-gov-2019-10-29.html 7/18 10/30/2019 Some Echoes of Melville | Speeches | RBA First, demographics. Globally, some very large shifts are taking place. In particular, the population in many countries is aging rapidly and life expectancy is continuing to increase (Graph 4). After increasing for many decades, the share of the global population that is aged between 15 and 64 is now declining and this is expected to continue. The United Nations estimates that average life expectancy has increased from just 55 years in 1970 to over 70 years now, and this trend too is expected to continue. While retirement ages have also increased as people live longer, retirement ages have not increased to the same extent as life expectancy, so people are having to plan for more years in retirement, and have been saving more to finance this. Graph 4 A second important factor influencing global saving outcomes is the rise of Asia. Asian countries now account for around one-third of global GDP, up from just 10 per cent in the early 1980s (Graph 5). People in Asia tend, on average, to save a fairly high share of their incomes. This partly reflects the less extensive social safety nets and the nature of the financial systems. As incomes have risen in Asia, average savings rates in the region have fallen a little in recent years, but they remain higher than in most other parts of the world. https://www.rba.gov.au/speeches/2019/sp-gov-2019-10-29.html 8/18 10/30/2019 Some Echoes of Melville | Speeches | RBA Graph 5 A third factor affecting savings outcomes in many economies is the high level of borrowing in previous years (Graph 6). While the experience differs across countries, at the global level, the stock of debt outstanding relative to GDP has steadily increased for the past 50 years, and is now around a record high. The big shift has been in private debt, particularly in the advanced economies, but public debt has also trended higher over recent decades, after declining following World War II. https://www.rba.gov.au/speeches/2019/sp-gov-2019-10-29.html 9/18 10/30/2019 Some Echoes of Melville | Speeches | RBA Graph 6 One probable consequence of high levels of debt is that people are more careful with their spending and are less inclined to take on yet more debt. This is especially so when income growth has disappointed, as it has over recent times. In a number of countries, both government and households feel constrained by their previous decisions to borrow and are seeking to put their balance sheets on a sounder footing. One way they can do this is by spending less and saving more. So these are some of the factors that are influencing global saving outcomes. I would now like to turn to the investment side of the equation. This is important as you might recall that Melville argued that at zero interest rates there would be an almost unlimited number of things to invest in. Today's reality, though, is somewhat different. Here again I will point to three inter-related factors. The first is the high level of uncertainty. The second is slower population growth. And the third is some pessimism about future productivity growth. It is well understood that there has been a high level of global economic policy uncertainty over recent times. This is evident in measures of policy uncertainty calculated from news stories in https://www.rba.gov.au/speeches/2019/sp-gov-2019-10-29.html 10/18 10/30/2019 Some Echoes of Melville | Speeches | RBA leading media around the world (Graph 7). The sources of this uncertainty are well known. The long list includes the trade and technology disputes between China and the United States, the Brexit issue, the ongoing tensions in the Middle East, the problems in Hong Kong and the tension between Japan and South Korea. Not surprisingly, these events are making businesses nervous and they are responding by putting off investment decisions. Many would prefer to wait until some of the uncertainties are resolved before proceeding. Graph 7 As important as these current geopolitical tensions are, they are not the full story. Businesses face a range of other significant uncertainties, including from the rapid pace of technology change, increased competition as a result of globalisation and ongoing changes to regulatory arrangements. It is probable that the uncertainties generated by these structural changes are interacting and being amplified by the geopolitical issues. In this context, it is worth noting that despite the marked decline in global interest rates (and some decline in the cost of equity), average hurdle rates of return for new investments in many countries have not changed much (Graph 8). It seems that there is a global norm for hurdle rates somewhere around the 13 to 14 per cent mark and it is hard to shift this norm, even at record low interest rates. https://www.rba.gov.au/speeches/2019/sp-gov-2019-10-29.html 11/18 10/30/2019 Some Echoes of Melville | Speeches | RBA Graph 8 There are a couple of possible explanations for this. The first is that the reduction in the cost of borrowing has been offset by a rise in the required risk premium due to the uncertainties that I spoke about. If this were so, the hurdle rate would be unchanged, with lower interest rates just compensating for the riskier environment. The second possibility is that some firms have been slow to adjust to the new reality of low interest rates. We hear reports that a hurdle rate of return of 13 to 14 per cent has been hardwired into the corporate culture in some companies. Changing this hard-wiring is difficult and time consuming. However, from our liaison with Australian companies, we do know that some companies have lowered their hurdle rates and this is opening up new opportunities for them. It would be good to hear more such reports. My view is that there is an element of truth to both explanations: risk premiums have gone up and, in some cases, hurdle rates of return are too sticky. A second explanation for lower levels of investment is a slower rate of population growth, especially in the advanced economies (Graph 9). In the late 1960s, population growth in the advanced economies was running at 1.2 per cent. Since then, population growth has steadily declined, and is now running at just 0.4 per cent. A number of countries in north Asia and in Europe have declining populations and other countries are forecast to join that group before too long. https://www.rba.gov.au/speeches/2019/sp-gov-2019-10-29.html 12/18 10/30/2019 Some Echoes of Melville | Speeches | RBA Graph 9 Slower population growth means there is less need to add to the capital stock to accommodate more people. Less home and other building is required, and there is less need to invest in infrastructure to meet the needs of a growing population. While there are some specific areas where more investment might be needed, the overall effect of lower population growth is to reduce investment. A third explanation for lower investment demand is that people are less optimistic about future economic growth. The slower population growth is part of the story here, but it is not the full story: there is less optimism about future productivity growth as well. One way of seeing this shift is in estimates of advanced economy potential growth (Graph 10). In the mid 1980s, estimates of potential growth were clustered around 3 per cent. They are now clustered around half of this. Similarly, there has been a downward shift in estimates of potential growth in Asia, especially in China and South Korea. With economies expected to grow less quickly than in the past, there is less incentive to invest. https://www.rba.gov.au/speeches/2019/sp-gov-2019-10-29.html 13/18 10/30/2019 Some Echoes of Melville | Speeches | RBA Graph 10 So these are some of the main factors influencing saving and investment globally and that help to explain low global interest rates. But this is not the full story. Central banks are also playing a role. While our regular explanations for interest rate decisions typically don't reference the broader structural factors that I have just discussed, these structural factors have had a powerful influence on the setting of interest rates over recent times. [9] In addition, central banks have responded to the cyclical position by lowering interest rates and also by buying large quantities of government and long-term securities (Graph 11). Before the financial crisis, the central banks held only around 5 per cent of government securities on issue. Today, they hold nearly 30 per cent. In Japan, the Bank of Japan holds almost 50 per cent of government securities on issue, with these holdings equivalent to 80 per cent of Japanese GDP. https://www.rba.gov.au/speeches/2019/sp-gov-2019-10-29.html 14/18 10/30/2019 Some Echoes of Melville | Speeches | RBA Graph 11 Another significant purchaser of government securities over recent times has been pension funds, particularly in Europe. As prudential regulation has been strengthened, the funds have purchased additional long-dated assets to maturity match their long-dated pension liabilities. One way of seeing the effect of these various purchases is the term premium (Graph 12). Normally, when an investor purchases a 10-year security, a risk premium is earned over and above the return that is expected from rolling a short-term investment for 10 years. This premium, which historically has averaged around 1½ per cent, is now negative at around minus 1 per cent. This is directly related to purchases of government securities by central banks and others. So this is part of the story too. https://www.rba.gov.au/speeches/2019/sp-gov-2019-10-29.html 15/18 10/30/2019 Some Echoes of Melville | Speeches | RBA Graph 12 Taking into account all these factors, the key to a return to more normal interest rates globally is to improve the investment climate. While Melville turned out to be wrong about zero interest rates, he was right in another sense. At low interest rates, many investments that didn't make sense at higher interest rates should now make sense. This is especially so for investments with long-term payoffs, because future returns no longer need to be discounted as highly. This means that low interest rates give us the opportunity to lengthen our horizons and think about projects with really long-term payoffs. There are two central elements in improving the investment climate. The first is the reduction in some of the geopolitical and other concerns that have led to higher risk premiums being required. The second is structural measures that give people greater confidence about future economic growth, so that they are prepared to expand, invest and innovate. Both elements are largely beyond the control of central banks. They are a matter for government and for business. So this is the environment in which the Reserve Bank Board is setting interest rates. We can't ignore these global trends in savings and investment and the responses of other central banks. If we did seek to ignore these trends, the exchange rate would most likely appreciate. In the current environment, this would be unhelpful for both jobs growth and for achieving the inflation target. It is important to point out, though, that while we need to take account of these global trends, there is no automatic mechanical link between what is happening elsewhere and our own https://www.rba.gov.au/speeches/2019/sp-gov-2019-10-29.html 16/18 10/30/2019 Some Echoes of Melville | Speeches | RBA monetary policy. At each meeting of the Reserve Bank Board we are asking ourselves what is best for the Australian economy and for the welfare of the Australian people. Over the course of this year we have lowered interest rates three times to a record low of ¾ per cent. We are confident that these reductions are helping the Australian economy and supporting the gentle turning point in economic growth. In doing so, low interest rates are supporting jobs and overall income growth. At the same time, though, we recognise that monetary policy is not working in exactly the same way that it used to. We also recognise that low interest rates hurt the finances of many people, particularly those relying on interest income. So there is a balancing act here. The Board is prepared to ease monetary policy further if needed. Having said that, it is extraordinarily unlikely that we will see negative interest rates in Australia. It is likely though that we will require an extended period of low interest rates to reach full employment and for inflation to be consistent with the target. As is the case internationally, the focus needs to be on an improvement in the investment environment, so that investors are prepared to take Melville's cue and use low funding costs to build new productive assets. Not only would this help assist with a return to more normal interest rates, but it would be good for our collective welfare too. Thank you for listening. I look forward to answering your questions. Endnotes [*] I would like to thank Ellis Connolly, Selwyn Cornish and Greg Tyler for assistance in the preparation of this talk. Macfarlane IJ (2002), ‘Sir Leslie Melville: His Contribution to Central Banking in Australia’, Inaugural Sir Leslie Melville Lecture, Canberra, 22 March. Schedvin CB (1992), The Reserve Bank is also responsible for issuing of banknotes, operates the core of Australia's payments system, is the banker to the Australian Government and has regulatory responsibilities in the payments system. Melville LG (1936), ‘Statement’ in In Reserve: Central Banking in Australia, 1945–75, Allen & Unwin, Sydney, p 63. Royal Commission to inquire into the Monetary and Banking Systems at Present in Operation in Australia, Minutes of Evidence, vol. 2, Commonwealth Government Printer, Canberra, p 1117. Cornish S (2002), ‘Leslie Galfreid Melville 1902–2002’, 478 at 473. Melville LG (1938), ‘The Theory of Interest–I’, Economic Record, Vol. 78, No. 243, December, pp 471– Economic Record, June, pp 1–13. Reddaway WB and RI Downing (1939), ‘Zero Rates of Interest’, Economic Record, June, pp 94–97. The estimates for potential growth are from: Holston, Laubach, and Williams (2017), ‘Measuring the Natural Rate of Interest: International Trends and Determinants’, Journal of International Economics, 108, supplement 1 (May), S39–S75, updated at <https://www.newyorkfed.org/research/policy/rstar>; IMF World Economic Outlook; OECD Economic Outlook; and national source estimates by the European Commission, Bank of Canada, Bank of Japan, the US Congressional Budget Office and UK Office of Budget Responsibility. https://www.rba.gov.au/speeches/2019/sp-gov-2019-10-29.html 17/18 10/30/2019 Some Echoes of Melville | Speeches | RBA The paper by Òscar Jordà and Alan Taylor at this year's Jackson Hole Symposium provides one way of decomposing this structural and cyclical response. See Jordà and Taylor (2019), ‘Riders on the Storm’, Federal Reserve Bank of Kansas City Economic Policy Symposium, Jackson Hole, Wyoming, 22-24 August. Available at: <https://www.kansascityfed.org/publications/research/escp/symposiums/escp-2019>. © Reserve Bank of Australia, 2001–2019. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2019/sp-gov-2019-10-29.html 18/18 | reserve bank of australia | 2,019 | 11 |
Remarks by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the FINSIA Signature Event "The Regulators", Sydney, 15 November 2019. | 18/11/2019 Mortgage Arrears | Speeches | RBA Speech Mortgage Arrears Guy Debelle [ * ] Deputy Governor Remarks at FINSIA Signature Event: The Regulators Sydney – 15 November 2019 Today I am going to talk about mortgage arrears. Arrears are an important indicator of the financial health of households and so have implications for our assessment of current economic conditions and the economic outlook. They clearly are also an important indicator of the financial health of those writing mortgages, be it banks or non-banks. I will draw on material published in the October Financial Stability Review and a speech given by my colleague Jonathan Kearns. The mortgage arrears rate, at 1 per cent, is low by both historical and international standards. Arrears in the US peaked at around 10 per cent in the financial crisis. Non-performing loans currently pose little risk to the health of financial institutions. This is not surprising in an environment where the unemployment rate is low and interest rates have been declining. Nonetheless, the arrears rates have been increasing steadily over recent years to the highest it has been for around a decade, and so warrants some scrutiny. While the national arrears rate is low, in some parts of the country households have found it harder to keep up with their mortgage repayments. The largest increase in housing loan arrears has occurred in Western Australia and the Northern Territory, where economic conditions have been weak and the unemployment rate has risen (Graph 1). Developments in those two regions show how arrears can evolve in adverse economic circumstances. In Western Australia the unemployment rate has risen from 4 to 6 per cent, housing prices have fallen by 20 per cent, incomes have declined and strong inward migration turned to outward migration such that population growth declined from over 3 per cent to under 1 per cent. These conditions have seen the mortgage arrears rate rise from 0.7 per cent to 1.8 per cent. This is a significant rise and associated with financial stress for a number of households. But it is still not that high given the economic circumstances. https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-15.html 1/6 18/11/2019 Mortgage Arrears | Speeches | RBA Graph 1 Borrowers can fall behind on their mortgages for a number of reasons. The vast majority of people who fall behind on their mortgages do so because of an unexpected loss of all or part of their income. Common reasons for this are the loss of a job, ill health or relationship breakdown. These occur even when economic conditions and lending standards are good. So there will always be some baseline level of mortgage arrears. Indeed, from a system-wide perspective, a mortgage arrears rate of zero would be undesirable, because it would imply that lending standards were too tight and that credit-worthy borrowers were being denied access to credit. Widespread increases in arrears are driven by macroeconomic factors, in particular: rising unemployment rates, which lead to a widespread loss of income; rising interest rates, which create a higher regular expense for borrowers; and falling housing prices, which can make it more difficult for borrowers who are behind on their payments to get out of arrears by selling their property. Appropriate lending standards that ensure that borrowers have reasonable income and equity buffers can mitigate the impact of macroeconomic factors on arrears, while poor lending standards amplify their effect. In all states, increases in the share of housing loans that are 90+ days in arrears have been mainly driven by loans remaining in arrears for longer rather than by more loans entering arrears (Graph 2). This suggests households are finding it harder to resolve their situation than previously and is consistent with the softer housing market conditions. This is especially so in Western Australia, where housing prices have been falling for some time. Liaison with banks suggests that more lenient https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-15.html 2/6 18/11/2019 Mortgage Arrears | Speeches | RBA forbearance and foreclosure policies have also contributed to the increase in longer-term arrears rates. Graph 2 Financial Stability Review In the recent , we used the Bank's securitisation dataset to look at how different types of home loans have performed in Western Australia over the past few years. As might be expected, loans that were originated with higher repayments relative to income, and loans with higher starting loan-to-valuation ratios have had larger increases in arrears in Western Australia. Larger increases in arrears have been seen for self-employed borrowers, who tend to have more volatile income than salaried employees. Arrears rates for investors have also risen by more. Investors in housing in Western Australia have faced falling rental income and the highest rental vacancy rates in nearly 30 years, though this has declined more recently. We also found that the increase in arrears for interest-only (IO) and principal and interest (P&I) loans have been similar. While IO loans have similar repayment performance to P&I loans, they are more risky for the lender as they can lead to larger losses. Since IO borrowers are not required to make principal payments, their outstanding loan balance need not decline over time. Because of this, IO loans increase the chance the loan ends up in negative equity if housing prices fall, and so expose the lender to a loss if the borrower cannot make their repayments. In Western Australia, around half of loans that were originated on interest-only terms and are in arrears also have negative equity. This compares to around 40 per cent of P&I loans in arrears. https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-15.html 3/6 18/11/2019 Mortgage Arrears | Speeches | RBA Moreover, IO borrowers are less likely to have buffers in the form of prepayments or balances in offset accounts. A bit more than 40 per cent of IO borrowers have no buffers of this sort at all, compared to around 20 per cent of principal and interest borrowers. [2] Some of this difference arises because IO loans tend to be newer, and so have had less time to accumulate buffers. IO loans are also more likely to be taken out by investors, who may have other liquid assets. But even controlling for these factors, a significant difference exists. That said, those IO borrowers who have buffers, generally have much larger buffers. Nationally, around 15 per cent of loans that are in arrears are also in negative equity (Graph 3). However, this is equivalent to just 0.1 per cent of all housing loans and the risks that mortgage arrears currently pose to bank profitability are low. Graph 3 Tighter lending standards should lead to lower arrears but this can be hard to discern in the raw data. One reason is that borrowers' circumstances tend not to change so quickly that they fall behind on their repayments soon after taking the loan out, so newer loans tend to have lower arrears rate than older loans. For example, a three-year old loan is four times more likely to go into arrears than a one-year old loan. When credit growth is higher, the share of new loans also tends to be higher, so the arrears rate tends to be lower. This is in addition to the effect on the denominator. Another issue is that macroeconomic conditions, which also affect arrears, are constantly evolving. https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-15.html 4/6 18/11/2019 Mortgage Arrears | Speeches | RBA When we control for the age of loans and the state of the economy, we find that the more recent cohorts have lower arrears rates than earlier cohorts. Specifically, those loans originated in the past two years have an arrears rate that is almost 40 basis points lower than loans originated prior to 2014 (Graph 4). The lower arrears rates for more recent loans suggests these tighter lending standards have been effective. Graph 4 I trust that that has given you some perspective on the recent evolution of arrears and some of the factors behind it. The experience in Western Australia provides an insight as to how housing lending in the rest of the country may perform if there was an economic downturn. An economic downturn is definitely not our forecast. Rather, it seems unlikely that the national arrears rate will increase substantially from here. Improvements to lending standards have placed downward pressure on arrears. In addition, the recent reductions in the interest rates will reduce the interest payments of indebted households and support employment growth and housing market conditions more generally. Endnotes https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-15.html 5/6 18/11/2019 Mortgage Arrears | Speeches | RBA [*] Thanks to Penny Smith and Paul Ryan for their help. Kearns, J (2019), ‘Understanding Rising Housing Loan Arrears’, Address at the 2019 Property Leaders' Summit, Canberra, 18 June. IO borrowers may have other assets that can serve as buffer, as indeed is the case for P&I borrowers. © Reserve Bank of Australia, 2001–2019. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-15.html 6/6 | reserve bank of australia | 2,019 | 11 |
Speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the Australian Council of Social Service (ACOSS) National Conference 2019, Canberra, 26 November 2019. | 11/26/2019 Employment and Wages | Speeches | RBA Speech Employment and Wages Guy Debelle [ * ] Deputy Governor Australian Council of Social Service (ACOSS) National Conference 2019 Canberra – 26 November 2019 Over much of the past three years, employment has grown at a healthy annual pace of 2½ per cent. This has been faster than we had expected, particularly so, given economic growth was slower than we had expected. Employment growth has also been faster than the working-age population has been growing. As a result, the share of the Australian population employed is around its all-time high, which is a good outcome. Normally, we would have expected this strong employment growth to lead to a decline in the unemployment rate. But the unemployment rate has turned out to be very close to what we had expected and has moved sideways around 5¼ per cent for some time now. So what is going on here? Strong employment growth but little change in the unemployment rate means that the strength in labour demand has been met by strong growth in labour supply. This increase in labour supply has come from more people joining the labour force and from some of those with jobs putting off leaving the labour force. These trends have been particularly pronounced for females aged between 25 and 54 and older workers of both sexes. The surprising strength in labour supply has been one of the factors that has contributed to wages growth being slower than we had expected. But at the same time, the lower growth in wages has probably contributed to the strength in employment growth. My undergraduate honours thesis at Adelaide Uni examined the aggregate labour demand curve in Australia which was a much debated topic at the time. [1] So more than 30 years on, I will discuss similar issues today. I will look at the rise in participation rates of females and older workers and discuss some of the factors that have been contributing to it. I will also look briefly at what jobs have been created. In doing so, I will make use of the micro data in the monthly labour force survey (LFS) as well as https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html 1/21 11/26/2019 Employment and Wages | Speeches | RBA micro data from the HILDA survey. [2] That is, we are examining the micro data to understand the macro trends in the labour market. By and large, the new jobs created over the past few years have been representative of the existing stock of jobs. There have been low wage and high wage, lower skilled and higher skilled jobs created, but about average on both counts. The jobs growth has been in household services jobs such as health care, social assistance and, education, as well as in business services. Twothirds of the employment growth over the past two years has been in full-time jobs. Then I will look at wages growth and show that the lower average wage outcomes of the past few years have reflected the increased prevalence of wages growth in the 2s across the economy. Finally, I will look forward and talk about the RBA's forecasts for the labour market. Two of the critical influences on that forecast are how much further labour supply will increase and how entrenched are wage outcomes. Participation An increase in the number of people in employment can be met either by an increase in people entering from outside the labour market or a decline in unemployment. The increase in people coming from outside the labour force, causing an increase in the participation rate, is known as an ‘encouraged worker’ effect – when economic conditions improve, there is a tendency for people to enter or defer leaving the workforce. [3] Historically more of the increase in employment has translated into a reduction in the unemployment rate than by a rise in the participation rate. However, the past couple of years have been unusual. The increase in employment has been met disproportionately by an increase in the number of people participating in the labour force (Graph 1). The share of the population participating in the labour force is at a record high. The two main groups contributing to this rise in participation are females and older workers. I will discuss each of these in turn and some of the forces driving the outcomes over both the recent past and from a longer perspective. An understanding of these forces can help us assess how much further these trends are likely to continue. https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html 2/21 11/26/2019 Employment and Wages | Speeches | RBA Graph 1 Female participation Female employment growth has accounted for two-thirds of employment growth over the past year. The female participation rate is now at its highest rate, and the gap between female and male participation is now the narrowest it has ever been (Graph 2). https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html 3/21 11/26/2019 Employment and Wages | Speeches | RBA Graph 2 The female participation rate has steadily increased over recent decades (from 40 per cent in 1970 to 61 per cent in 2019), and a similar upward trend is evident across other advanced economies. Changing societal norms and rising educational attainment have contributed to more women moving into paid employment or employment outside the home. Female participation has also been influenced by the increasing flexibility of working-time arrangements, the availability and cost of child care and policies such as parental leave. Nearly half of employed females work part time, often to care for children. Over recent decades, the participation rate of mothers with dependent children has trended higher, rising by 10 percentage points since the early 2000s to 73 per cent. Over the past decade, the rise in participation has been most pronounced for mothers with children aged between 0 and 4 (Graph 3). Of those returning to work within two years after the birth of a child, an increasing majority are citing ‘financial reasons’ as their main reason for doing so. Other mothers returning to work cite ‘social interaction’ or to ‘maintain career and skills’ as their main reason. Financial reasons could be capturing a number of different considerations including low income growth, the rise in household debt or child care costs. https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html 4/21 11/26/2019 Employment and Wages | Speeches | RBA Graph 3 Research suggests the cost and quality of child care does have a significant effect on the labour supply of women. [4] Data from the HILDA survey show that the share of households using formal child care for young children has increased notably over the past decade (Graph 4). However, access to child care places and financial assistance with child care costs remain ‘very important’ incentives for females currently outside the labour force. https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html 5/21 11/26/2019 Employment and Wages | Speeches | RBA Graph 4 Another factor that is linked to higher rates of female participation over recent decades is the increase in the level of mortgage debt of home owners (Graph 5). The rise in debt levels has broadly coincided with the increase in the participation rate of females. However, it is difficult to establish which way causality is going. Are debt levels higher because more households have two incomes and can afford to borrow more? Or does the need to borrow more to afford housing drive the decision to participate more? Or is it the case that the low level of income growth in recent years has meant that households have more debt than they anticipated and need to work longer to pay it down? Research to establish causality has usually found some evidence of a causal relationship running from higher debt levels to higher participation. [5] However, the analysis indicates that the effects are not that large at an aggregate level. https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html 6/21 11/26/2019 Employment and Wages | Speeches | RBA Graph 5 The rollout of the National Disability Insurance Scheme (NDIS) may also have encouraged increased participation of female carers. We know from a detailed survey of NDIS participants and their families that parents of those with disabilities work fewer hours on average and are more likely to be in casual employment. [6] It is probably too early in the rollout of the scheme to see a material increase in the number of parents re-entering the labour market. The survey suggests there has been a slight increase in the average number of hours worked since the start of the scheme, but the percentage of families/carers of NDIS participants who wanted to work more hours has not changed. Thus two significant drivers of the increase in participation rates of females aged between 25 and 54 over a long period of time are child care costs and other financial factors. The open question is how much more the participation rate of this group will rise. Older workers The share of the Australian population aged between 15 and 64 years has continued to decline, and is expected to continue to decline. This is due to the ongoing transition of baby boomers into retirement ages. All else being equal, an ageing population will result in a fall in the supply of labour, since the generation retiring is larger than the generation entering the workforce. But there has been a long-term trend for each cohort to participate more than previous cohorts did at the same age. That trend has accelerated recently, and more than offset the effect of ageing on https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html 7/21 11/26/2019 Employment and Wages | Speeches | RBA its own. The share of 55 year olds and older that are employed is 35 per cent, compared to 22 per cent 20 years ago. This cohort effect is particularly clear in the third panel of Graph 6. The much larger rise in female participation than males over the past two decades is a stark illustration of the effect, as the other drivers of participation in this age group should have similar influences on both male and female participation. Graph 6 Why are older people working longer? [7] One contributing factor is improved health. People are working longer because they can, both because of their own health and also because the nature of work has changed over the years towards services and away from manual work, which means most people are in less physically demanding jobs. It used to be the case that many older workers would have to choose between working full time and retiring. From a labour economics point of view, the labour/leisure trade-off has much more choice than it used to. [8] In the past, it was often an all or nothing decision. As the labour market has become more flexible over recent decades, older workers may be able to reduce their hours but still participate in the labour market. Indeed, around one-third of workers aged 55 years and older are working part time, with over half doing so because they prefer to do so. The ABS Retirement and Retirement Intentions survey suggests that of people aged 45 years and older, https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html 8/21 11/26/2019 Employment and Wages | Speeches | RBA around one-third of workers intend to cut down from full-time work to part-time work as they get older. As people live longer, they may want to work longer voluntarily, depending on the value they get from working. But they also may need to work longer to achieve the necessary income to support the standard of living they would like in retirement. Access to a retirement pension or superannuation is a very significant element in the decision to retire. More than half of all retirees over 60 cite that reaching retirement age or becoming eligible for the pension/superannuation as the main reason they retired from work. The male participation rate begins to decline around age 50 and there is a noticeable change in the rate of decline around 65; the historical pension age for men. For women there is a similar pattern, although in the past there was also a change in the rate of decline around age 60. Accordingly, announced and actual increases in pension ages are also likely to have contributed to increased participation. This has been documented in the past for females after the government increased the female pension age from 60 to 65 between 1996 and 2013 (in 6 month increments every 2 years). Currently the pension age is being raised to 67 years for both sexes; a process that began in 2017. The average age of job leavers over the age of 55 has increased slightly in recent years. Our analysis of LFS micro data provides tentative evidence that the 2017 changes to the pension age had an impact on workers' retirement decisions. The participation rate of those born in 1952 and 1953 (who were affected by the changes in 2017) does not decline as quickly when they turned 65, compared to the earlier cohort groups that were not affected by the pension age increase. [10] In aggregate, this analysis suggests that the pension changes boosted the participation rate by around 0.1 percentage point. As I said above, some older workers are working for financial reasons. As we all know, one of the major considerations for those contemplating retirement is their wealth and ability to fund their retirement. Increasing house prices and share prices over much of the last decade are likely to have reduced participation of older individuals. [11] The recent decline in house prices may have resulted in some individuals delaying their retirement and not withdrawing their labour supply. However, the price declines were modest compared to the earlier increase, so that those considering retirement would have experienced a net gain in house prices and a decline in their debt. Similar to females, the rise in the participation rate of persons aged 55 years or older is also likely to have been related to developments in household debt. Over recent decades there has been a trend towards greater indebtedness for these persons. The proportion of older households with owner-occupied home loans has risen from around 20 per cent in the early 2000s to around 37 per cent today. The increase in debt has also been associated with a change in the retirement intentions of older workers. Over time, the gradual shift towards later retirement has been more noticeable for those with debt (Graph 7). As with the female participation story, there is a question of causality. Are people working later in life because they have an unexpectedly high https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html 9/21 11/26/2019 Employment and Wages | Speeches | RBA level of debt? Or had they always intended to work longer and hence were more willing to borrow more and carry more debt later in life? Graph 7 To draw this together, participation rates have risen as employment has grown over the past three years. This increase in supply has been unexpected, so it is important to try to understand what is driving it to have some sense on how much further these trends are likely to run. The two major shifts in participation have been amongst females aged 25–54 and older workers. These trends have been there for a while and have been even stronger recently. I have presented some of the insights from our analysis of various micro data sources but there is still more to understand. We will continue to focus on this given its importance to the outlook, which I will come to later. Employment What sort of jobs have been created in recent years? Some have assumed that the jobs that have been created in recent years are lower-skilled or lower-paid jobs. However, when we break down the occupation-level data by skill type or pay level, this is not the case. The strongest growth in employment over the past decade has been in highest-skilled (as defined by the ABS) jobs. There has also been solid growth over the same https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html 10/21 11/26/2019 Employment and Wages | Speeches | RBA period in lower-skilled jobs (Graph 8). Similarly, the growth in employment has been broadly distributed across the pay spectrum (Graph 9). Graph 8 https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html 11/21 11/26/2019 Employment and Wages | Speeches | RBA Graph 9 Another often stated view is that much of the job creation in recent years has been in the public sector, rather than the private sector. According to the Labour Account data, the number of jobs created in the private sector has far outnumbered the number of jobs created in the public sector (Graph 10). [12] Private sector job creation has been particularly strong in health care and education (which partly, but a long way from entirely, due to government spending in these areas), but also in business services and industries like construction and hospitality. is https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html 12/21 11/26/2019 Employment and Wages | Speeches | RBA Graph 10 We have also used the micro data to look at the people that have moved into some of these growth areas. For example, the share of employment in the health care & social assistance industry has increased from 9 to 13 per cent over the past decade. Those entering or leaving health care and social assistance tend to do so from a small number of other industries such as public administration, support services, education and training and other services into health care and social assistance. Around 10 per cent of people entering employment from outside the labour market are moving into health care, while a slightly smaller share move into this sector from unemployment. A large share of workers between the age of 55 and 69 years of age work in health care and social assistance, so this is likely to be related to individuals delaying retirement. Wages Wages growth has declined noticeably since around 2012. As wages growth has fallen, the distribution of wages growth has also become increasingly compressed. This fall in the dispersion in wages growth across jobs mainly reflects a sharp fall in the share of jobs receiving ‘large’ wage rises. The Bank has highlighted this previously, but I will update that analysis and illustrate the increased pervasiveness of wage outcomes between 2 and 3 per cent across the labour market. https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html 13/21 11/26/2019 Employment and Wages | Speeches | RBA The share of jobs that experience a wage change of more than 4 per cent has fallen from over one-third in the late 2000s to less than 10 per cent of jobs in 2018 (Graph 11). Given that firms are also unwilling or unable to reduce wages, this has meant that the vast majority of wage growth observations in the labour market are now tightly clustered in the range of 0–4 per cent. Graph 11 There is growing evidence to suggest that wage adjustments of 2 point something per cent have now become the norm in Australia, rather than the 3–4 per cent wage increases that were the norm prior to 2012. The rising prevalence of wage outcomes in the 2s can be seen in the official data and in the Bank's liaison with firms. https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html 14/21 11/26/2019 Employment and Wages | Speeches | RBA One notable example is the large increase in the share of enterprise bargaining agreements that provide annual wage rises in the 2–3 per cent range. The share of such agreements has risen from around 10 per cent over the 2000s to almost 60 per cent in 2019 (Graph 12). Over the same period, the proportion of agreements providing wage increases of 3 per cent or more has fallen sharply. Graph 12 A similar picture emerges when we look at the job-level data that underlie the ABS's wage price index (WPI). These data, which also provide insights on wage outcomes for jobs where pay is set according to individual arrangements, also show that the share of jobs getting wage rises in the 2–3 per cent mark has risen noticeably. The Bank's liaison with firms also confirms that the share of firms reporting wages growth of between 2 and 3 per cent has increased to around 45 per cent in recent years. Prior to 2012, fewer than one in 10 firms were reporting wages growth in this range. Another way to see this shift in wage setting over time is to look at the median rates of wages growth across all jobs in the labour market (Graph 13). Unlike the mean, the median is less affected by the large decline in ‘large’ wage rises in recent years and the changing prevalence of wage freezes. Prior to 2012, median wages growth was firmly anchored at 4 per cent. In recent years, median wages growth has fallen to 2½ per cent, and has remained at that level. https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html 15/21 11/26/2019 Employment and Wages | Speeches | RBA Graph 13 Different measures of wages growth capture slightly different concepts of labour costs. The WPI, which is one of the main measures that the Bank monitors, tracks wage outcomes of individual jobs over time, rather than tracking particular employees. [14] This feature of the WPI makes it useful for gauging developments in wages growth after abstracting from any changes in the nature of work or the composition of employment. However, this feature also means that the WPI does not capture wage rises that come from getting promoted or changing firms. But other surveys suggest that promotions can be a key source of earnings growth for individuals. On average, a promotion leads to a 5 per cent boost in hourly wages, which is comparable to the wage rise a worker gets when switching firms. Since 2012, there has been a broad-based decline in the proportion of employees that are getting promoted at work or switching jobs (Graph 14). This means that a smaller fraction of the workforce are receiving these wage rises. https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html 16/21 11/26/2019 Employment and Wages | Speeches | RBA Graph 14 Why have wage outcomes in the 2s become so prevalent? [15] One phenomenon that could explain it is the well-known tendency for workers to resist reductions to their wages terms. in real This phenomenon, also known as ‘downward real wage rigidity’, leads to a clumping of employees' nominal wage changes in the vicinity of their expected rate of inflation, particularly when nominal wages growth is tracking at a low level. In that sense, the RBA's inflation target of 2–3 per cent on average over time provides a strong nominal anchor in wage negotiations. When my colleagues looked at the job-level WPI data they did find evidence of a clumping of wage outcomes either at, or just above, expected inflation. While wage increases in the 2s have become very common for many employees, those whose wages are set according to an award have generally been receiving wage increases in excess of 2 per cent in recent years. This reflects the Fair Work Commission adjustments, which have provided support to wages growth at the lower end of the skill distribution, given the prevalence of award-reliant jobs in this part of the labour market. Wages growth for the least-skilled jobs has outpaced all other skill groups since around 2013. This contrasts with the commodity price boom period, when wages growth was strongest for higher-skilled jobs. Consistent with this, the ratio of average hourly earnings of award-reliant employees to those of other employees has risen since 2012, largely reversing the falls seen in the earlier period. https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html 17/21 11/26/2019 Employment and Wages | Speeches | RBA Outlook The recent Statement on Monetary Policy provided the Bank's latest forecasts for the labour market and wages growth. GDP growth is forecast to gradually increase over the next couple of years, which should result in a small decline in the unemployment rate from its current rate of 5¼ per cent. As Graph 15 shows, there is always uncertainty around that central forecast. One of the key sources of uncertainty currently around the outlook for the unemployment rate as well as wages growth, is whether labour supply will be as responsive to labour demand as it has been in recent years. That is, will the expected increase in labour demand encourage as much participation as it has most recently? How much further do some of these drivers of increased participation for older and female workers have to run? That is a difficult question to answer. Graph 15 The dynamics of participation and unemployment flows will have an important bearing on wages growth as well as household income growth. We expect wages growth to remain largely unchanged at its current level over the next couple of years. Why don't we think wages growth will pick up over the next couple of years? What we know from our liaison program is that the proportion of firms expecting stable wages growth in the year ahead is around 80 per cent and only around 10 per cent anticipate stronger wages growth. Of those firms expecting stable wages growth, the share reporting wage growth outcomes of 2– https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html 18/21 11/26/2019 Employment and Wages | Speeches | RBA 3 per cent has steadily risen over time. This supports the case that lower wage rises have become the new normal (Graph 16). Graph 16 Recently there has been a rise in the proportion of new EBAs with a term of three years or more. The lower wages growth incorporated in those agreements suggests that wages growth of around 2½ per cent for EBA-covered employees will persist for longer than in the past. The more wages growth is entrenched in the 2s, the more likely it is that a sustained period of labour market tightness will be necessary to move away from that. At the same time, I don't think there is much risk in the period ahead that aggregate wages growth will move any lower. Conclusion Today I have provided an overview of the current state of play in the labour market and the Bank's expectation about how it might evolve in the period ahead. I have highlighted some of the key forces that have shaped these developments, in particular, the rise in the participation rates of female workers and older workers. The Bank is trying to understand what has been driving these macro developments using some newly available micro data sources. This greater understanding should help inform our outlook for the labour market. https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html 19/21 11/26/2019 Employment and Wages | Speeches | RBA This increase in labour supply has meant that the strong employment outcomes in recent years has not generated the pick-up in wages growth that might otherwise have occurred. At the same time, I have highlighted the increased prevalence of wages growth in the 2s across the economy. A gradual lift in wages growth would be a welcome development for the workforce and the economy. It is also needed for inflation to be sustainably within the 2–3 per cent target range. Endnotes [*] Thanks to James Bishop, Natasha Cassidy and particularly Blair Chapman for embedding himself at the ABS to analyse the micro data. My fantastic thesis advisers were Dick Blandy and Bill Mitchell, who have contributed much to labour market analysis in Australia over many years, though from quite contrasting perspectives. The RBA and ABS have been working together on a micro-level labour force database. The ABS will release an experimental version of 6602.0 Microdata: Longitudinal Labour Force, Australia, 1982–2019 on 6 December. The data contains over 26 million responses to the monthly labour force survey between 1982 and August 2019. The previous release of the data only covered 2008 to 2010. I would like to thank the ABS for making this data available to us. Ehrenberg R, R Smith (1981): , Taylor & Francis Group, New York. Evans R, A Moore and D Rees (2018), ‘The Cyclical Behaviour of Labour Force Participation’, RBA , September, viewed 22 November. Available at <https://www.rba.gov.au/publications/bulletin/2018/sep/thecyclical-behaviour-of-labour-force-participation.html>. For evidence on the relationship between child care costs and female labour force participation see Gong X, R Breunig and A King (2010), ‘How Responsive is Female Labour Supply to Child Care Costs – New Australian Estimates’, Treasury Working Paper 2010-03, Australian Treasury, Canberra and Gong X and R Breunig (2012), ‘Estimating Net Child Care Price Elasticities of Partnered Women with Pre-school Children using a Discrete Structural Labour Supply-Child Care Model’, Treasury Working Paper 2012-01, Australian Treasury, Canberra. Most recent studies for Australia find evidence that there is a negative and statistically significant relationship between the labour force participation of mothers and the price of child care. Atalay K, G Barrett and R Edwards (2016), ‘Housing Wealth Effects on Labour Supply: Evidence from Australia’, Mimeo, University of Sydney and Belkar R, L Cockerell and R Edwards (2007), June, ‘Labour Force Participation and Household Debt’, RBA Research Discussion Paper 2007-05. National Disability Insurance Agency (NDIA) (2019), ‘NDIS Family and Carer Outcomes 30 June 2018’. Available at: <https://www.ndis.gov.au/media/1548/download>. See P Lowe ‘The Labour Market and Spare Capacity’, Address to a Committee for Economic Development of Australia (CEDA) Event, Adelaide, 20 June 2019 See Hamermesh D (1996), Labor Demand, Princeton University Press, New Jersey and Killingsworth M (1983), Labor Supply, Cambridge University Press, New York. See Atalay K and G Barrett (2015), ‘The Impact of Age Pension Eligibility Age on Retirement and Program Dependence: Evidence from an Australian Experiment’, , 97(1), pp 71– 87. Modern Labor Economics: Theory and Public Policy https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html Bulletin The Review of Economics and Statistics 20/21 11/26/2019 Employment and Wages | Speeches | RBA For those born between 1 July 1952 and 31 December 1953, the pension age was raised by six months to 65.5 years on 1 July 2017. For those born between 1 January 1954 and 30 June 1955, the pension age was raised by six months to 66 years on 1 July 2019. Some studies find that the participation of older married women responds to house prices, see: Atalay K, G Barrett and R Edwards (2016), ‘House Prices, Household Debt and Labour Supply in Australia’, Final Report No. 266, Australian Housing and Urban Research Institute, July. If the LFS data is used, the increase in private sector employment is still larger over recent years, but not by as much. The Labour Account data is gathered from businesses, the Labour Force data from workers. The ABS's view is that the Labour Account data provides a more accurate account of which industry the job is actually in. See Bishop J (2016), ‘Feature Article: The Size and Frequency of Wage Changes’, Wage Price Index, Australia, September 2016, November. Available at <https://www.abs.gov.au/AUSSTATS/[email protected]/Previousproducts/6345.0Feature%20Article1Sep%202016? opendocument&tabname=Summary&prodno=6345.0&issue=Sep%202016&num=&view=> and Bishop J (2018), ‘Feature Article: Update on the Size and Frequency of Wage Changes’, Wage Price Index, Australia, September 2018, November. Available at <https://www.abs.gov.au/ausstats/[email protected]/0/d04bd311916d748dca25806c001408a8?OpenDocument> and Lowe P (2016) ‘Inflation and Monetary Policy’, Address to Citi's 8th Annual Australian & New Zealand Investment Conference, Sydney, 18 October and Bishop J and N Cassidy (2017), ‘Insights into Low Wage Growth in Australia’, RBA , March, pp 13–20. Bulletin The WPI is designed to measure change in wage rates for a given quantity and quality of labour. See Okun A (1981), Prices and Quantities: a Macroeconomic Analysis, The Brookings Institution, Washington. and Mitchell D (1985), ‘Shifting Norms in Wage Determination’, Brookings Papers on Economic Activity, 2:1985, pp 575–599. The view that firms may be unwilling to cut nominal wages originated with Keynes J (1936), , Palgrave Macmillan, London. It has been documented in McLaughlin K (1994), ‘Rigid Wages?’, , 34(3), pp 383–414, Kahn S (1997), ‘Evidence of Nominal Wage Stickiness from Microdata’, , 87(5), pp 993–1008, Altonji J and P Devereux (1999), ‘The Extent and Consequences of Downward Nominal Wage Rigidity’, NBER Working Paper No. 7236, Wilson B (1999), ‘Wage Rigidity: A Look Inside the Firm’, Finance and Economics Discussion Series 1999–22, Board of Governors of the Federal Reserve System and Dwyer J and K Leong (2000), ‘Nominal Wage Rigidity in Australia’, RBA Research Discussion Paper No 2000-08. of Employment, Interest and Money Journal of Monetary Economics The American Economic Review The General Theory © Reserve Bank of Australia, 2001–2019. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2019/sp-dg-2019-11-26.html 21/21 | reserve bank of australia | 2,019 | 11 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Australian Business Economists Dinner, Sydney, 26 November 2019. | 26/11/2019 Unconventional Monetary Policy: Some Lessons From Overseas | Speeches | RBA Speech Unconventional Monetary Policy: Some Lessons From Overseas Philip Lowe [ * ] Governor Address to Australian Business Economists Dinner Sydney – 26 November 2019 Thank you for the invitation to address this year's Annual Dinner of the Australian Business Economists. This is the fifth time I have had the privilege of joining you. Thank you for having me back. One recurring theme of my talks over the years has been the likelihood that interest rates will remain low for an extended period – certainly, much lower, on average, than before the global financial crisis. This theme remains highly relevant today. As I discussed in the Sir Leslie Melville lecture at the ANU a month ago, low interest rates are not a temporary phenomenon. Rather, they are likely to be with us for some time and are the result of some powerful global factors that are affecting interest rates everywhere. Given this assessment, it is not surprising that there is a lot of discussion internationally about the use of so-called ‘unconventional’ monetary policies. People are rightly asking: if interest rates are going to stay low and be constrained by a lower bound, what other monetary policy options are there? I have been part of these international discussions through chairing the Committee on the Global Financial System (CGFS) at the Bank for International Settlements in Basel. Last month, the Committee published a report titled: ‘Unconventional Monetary Policy Tools: a Cross-country Analysis’. [2] The report reviews the experience with the use of unconventional policy tools and discusses how these tools can be used by central banks to achieve their objectives. If you are interested in these issues and have not looked at the report, I encourage you to do so. https://www.rba.gov.au/speeches/2019/sp-gov-2019-11-26.html 1/12 26/11/2019 Unconventional Monetary Policy: Some Lessons From Overseas | Speeches | RBA This evening I would like to summarise some key observations of the report and then explore how those observations might be applied to Australia. The CGFS Report – the ‘Unconventional’ Policy Tools The report discusses four unconventional policy tools. The term ‘unconventional’ monetary policy has now become the conventional shorthand for a wide range of policies, although I am not sure it is the best terminology. I say this because most of these tools have always been in the toolkit of central banks and have been used in one way or another in the past. What has been unconventional over recent times is the way these tools have been used. Negative interest rates The first of the four tools discussed in the report is negative policy rates. This is one tool that is truly unconventional. Prior to the financial crisis, it was widely thought that zero was the lower bound for the policy interest rate – so it was common to talk about the ‘ZLB’, or the zero lower bound. It was thought that if interest rates went below zero, people would hold their savings in banknotes rather than be charged by their bank to deposit their money. But zero has not turned out to be the constraint that it was once thought to be. So we now talk about the ELB – the effective lower bound – not the ZLB. While countries with negative interest rates have seen some shift to banknotes, it has been on a limited scale only. This reflects the use of bank deposits for making transactions and the fact that most banks in countries with negative interest rates have set a floor of zero on retail deposit rates. These banks have judged that it doesn't make sense, either commercially or politically, to charge households and small businesses negative interest rates on their deposits. It is worth pointing out that negative policy interest rates have largely been a European phenomenon. Policy interest rates have been negative in the euro area, Denmark, Sweden and Switzerland. Rates have been lowest in Switzerland, at minus ¾ per cent (Graph 1). The only country outside of Europe that has had negative policy interest rates is Japan, but even there it is only a very small share of bank reserves at the Bank of Japan that earns a negative rate, at minus 0.1 per cent. https://www.rba.gov.au/speeches/2019/sp-gov-2019-11-26.html 2/12 26/11/2019 Unconventional Monetary Policy: Some Lessons From Overseas | Speeches | RBA Graph 1 Extended liquidity operations The second unconventional policy discussed in the report is the extended use of central bank liquidity operations. In response to the financial crisis, many central banks made significant changes to their normal market operations to deal with strains in financial markets that were impairing the supply of credit to the economy. While the specifics differ across countries, the changes to market operations included: expanding the range of collateral accepted; providing much larger amounts of liquidity; extending the maturity of liquidity operations; increasing the range of eligible counterparties; and providing funding to banks at below the cost that was then prevailing in highly stressed markets, sometimes on the condition that the banks provide credit to businesses and households. This graph shows the size of the extended liquidity operations of the major central banks (Graph 2). The biggest operations were during the crisis period of 2008 and 2009, with significant liquidity support also being provided in 2011 and 2012 to support bank lending during the European sovereign debt crisis. https://www.rba.gov.au/speeches/2019/sp-gov-2019-11-26.html 3/12 26/11/2019 Unconventional Monetary Policy: Some Lessons From Overseas | Speeches | RBA Graph 2 It is worth recalling that during these periods of stress, banks had become very nervous about their access to liquidity. This, in turn, made them nervous about lending to others, making the possibility of a severe credit crunch very real. By providing financial institutions with greater confidence about their own access to liquidity, central banks were able to support the supply of credit to the economy. The CGFS report recognises that there were some side-effects of doing this, but the strong conclusion of the report is that these measures eased liquidity strains in highly stressed bank funding markets and helped restore monetary transmission channels to the broader economy. Asset purchases – quantitative easing The third policy tool discussed in the report is the outright purchase of assets from the private sector, paying for those assets by creating central bank reserves – also known as quantitative easing or QE. These asset purchases were on an unprecedented scale and led to very large expansions of central bank balance sheets (Graph 3). Before the financial crisis, the major central banks owned securities equivalent to around 5 per cent of GDP. In recent years, this has risen to nearly 30 per cent. This is a very large change. https://www.rba.gov.au/speeches/2019/sp-gov-2019-11-26.html 4/12 26/11/2019 Unconventional Monetary Policy: Some Lessons From Overseas | Speeches | RBA Graph 3 As part of their QE programs, central banks bought a wide range of assets, but the main asset purchased was government securities. Central banks now hold nearly 30 per cent of government securities on issue, which is equivalent to around 20 per cent of GDP. The largest purchases have been made by the Bank of Japan, which holds almost 50 per cent of Japanese government bonds on issue. In the United States, the Federal Reserve also bought large quantities of agency securities backed by the US government. Elsewhere, central banks bought private securities such as covered bank bonds, corporate bonds and commercial paper. And the Bank of Japan bought equities via exchange traded funds (ETFs) and real estate investment trusts. The precise motivations for these asset purchase programs varied across countries, but a common motivation was to lower risk-free interest rates out along the term spectrum, well beyond the shortterm policy rate. Buying government bonds was seen as reinforcing policy rate cuts and/or acting as a substitute for further reductions in the policy rate once it was at its lower bound. The expectation was that lower risk-free rates would flow through to most interest rates in the economy, boost asset prices and push down the exchange rate. https://www.rba.gov.au/speeches/2019/sp-gov-2019-11-26.html 5/12 26/11/2019 Unconventional Monetary Policy: Some Lessons From Overseas | Speeches | RBA A related motivation for buying government securities was to reinforce market expectations that policy rates were going to stay low for a long time. This ‘signalling channel’ added to the downward pressure on long-term bond yields. Another motivation in some countries was addressing problems in specific markets. In the United States, for example, the Federal Reserve purchased government-backed agency securities to support mortgage markets. And the Bank of England purchased commercial paper to ease highly stressed conditions in corporate credit markets. Finally, the expansion of the central bank's balance sheet through money creation should, in theory, have stimulatory effects through the so-called ‘portfolio balance channel’. The idea here is that as the central bank purchases securities with bank reserves, investors seek to rebalance their portfolios, and in so doing push up other asset prices and lower risk premiums for borrowers. It is difficult, though, to isolate this effect from the other channels I just spoke about. Forward guidance The fourth policy response was forward guidance. This took two forms: calendar based and state based. Under calendar-based guidance, the central bank makes an explicit commitment not to increase interest rates until a certain point in time. Under state-based guidance, the central bank says it will not increase rates until specific economic conditions are met. We have seen examples of both in practice. Some central banks also have provided forward guidance regarding their asset purchase programs. A primary motivation of forward guidance is to reinforce the central bank's commitment to low interest rates. A related motivation is to provide greater clarity about the central bank's reaction function and strategy in unusual times. The experience has mainly been positive, with the guidance helping to reduce uncertainty. There are, however, some examples where a change in guidance caused market volatility. The ‘taper tantrum’ in the United States in 2013 is an example of this. Some Observations Before I discuss the relevance of all this to Australia, I would like to make three broad observations, drawing on the report as well as my own reading of the evidence. The first is that there is strong evidence that the various liquidity support measures and targeted interventions in stressed markets were successful in calming things down and supporting the economy. When markets broke down and became dysfunctional, the actions of central banks helped stabilise the situation and helped avoid a damaging gridlock in the financial system. They also helped contain risk premiums in highly stressed markets. It is also worth pointing out that many of the measures to support liquidity were successfully unwound once the job was done – so they proved to be temporary, rather than a permanent intervention. https://www.rba.gov.au/speeches/2019/sp-gov-2019-11-26.html 6/12 26/11/2019 Unconventional Monetary Policy: Some Lessons From Overseas | Speeches | RBA The CGFS report also documents the positive effects of some of the other unconventional measures. In general, though, I find this evidence less compelling. These various measures certainly pushed down long-term yields and provided monetary stimulus in the depths of the crisis when it was needed. But these extraordinary measures have continued way past the crisis period. In some countries, asset purchases have yet to be unwound and it remains unclear when, and even if, this will happen. So a full evaluation is not yet possible. This brings me to my second general observation. And that is that there have been some side-effects of the various unconventional measures. I will touch on a few of these that the CGFS report discusses. The first is that the extensive use of unconventional monetary tools can change the incentives of others in the system, perhaps in an unhelpful way. It is possible that the willingness of a central bank to provide liquidity reduces the incentive for financial institutions to hold their own adequate buffers, making episodes of stress more likely in the future. [3] It is also possible that the willingness of a central bank to use its full range of policy instruments might create an inaction bias by other policymakers, either the prudential regulators or the fiscal authorities. If this were the case, it could lead to an over-reliance on monetary policy. A second side-effect is the impact on bank lending and the efficient allocation of resources. Persistently low or negative interest rates and a flattening of the yield curve can damage bank profitability, leading to less capacity to lend. In some countries, there are concerns that low interest rates allow less-productive (zombie) firms to survive. There are also financial stability risks that can come from low interest rates boosting asset prices (and perhaps borrowing) at a time of weak economic growth. A third side-effect is a possible blurring of the lines between monetary and fiscal policy. If the central bank is buying large amounts of government debt at zero interest rates, this could be seen as money-financed government spending. In some circumstances, this could damage the credibility of a country's institutional arrangements and create political tensions. Political tensions can also arise if the central bank's asset purchases are seen to disproportionality benefit banks and wealthy people, at the expense of the person in the street. This perception has arisen in some countries despite the strong evidence that the various monetary measures supported both jobs and income growth and thereby helped the entire community. These are all side-effects we need to take seriously. The third general observation is that experience suggests that a package of measures works best, with clear communication that enhances credibility. Exactly what that package looks like varies from country to country and depends upon the specific circumstances. But clear communication from the central bank about its objectives and its approach is always important. The report also notes that there may be better solutions than monetary policy to solving the problems of the day. It reminds us that when there are problems on the supply-side of the economy, the use of structural and fiscal policies will sometimes be the better approach. We need to remember https://www.rba.gov.au/speeches/2019/sp-gov-2019-11-26.html 7/12 26/11/2019 Unconventional Monetary Policy: Some Lessons From Overseas | Speeches | RBA that monetary policy cannot drive longer-term growth, but that there are other arms of public policy than can sustainably promote both investment and growth. Application to Australia I would now like to turn to what this all implies for us in Australia. I will make five sets of observations. The first is that the Reserve Bank has long had flexible market operations that allow us to ensure adequate liquidity in Australian financial markets. We have used this flexibility in the past, particularly during the global financial crisis, and we are prepared to use it again in periods of stress if necessary. At the moment, though, Australia's financial markets are operating normally and our financial institutions are able to access funding on reasonable terms. In any given currency, the Australian banks can raise funds at the same price as other similarly rated financial institutions around the world, and markets are not stressed. So there is no need to change our normal market operations to do anything unconventional here. Having said that, if markets were to become dysfunctional, you can be reassured by the fact that we have both the capacity and willingness to respond. But this is not the situation we are currently in. Things are operating normally. The second observation is that negative interest rates in Australia are extraordinarily unlikely. We are not in the same situation that has been faced in Europe and Japan. Our growth prospects are stronger, our banking system is in much better shape, our demographic profile is better and we have not had a period of deflation. So we are in a much stronger position. More broadly, though, having examined the international evidence, it is not clear that the experience with negative interest rates has been a success. While negative rates have put downward pressure on exchange rates and long-term bond yields, they have come with other effects too. It has become increasingly apparent that negative rates create strains in parts of the banking system that can impair the ability of some banks to provide credit. Negative interest rates also create problems for pension funds that need to fund long-term liabilities. In addition, there is evidence that they can encourage households to save more and spend less, especially when people are concerned about the possibility of lower income in retirement. A move to negative interest rates can also damage confidence in the general economic outlook and make people more cautious. Given these considerations, it is not surprising that some analysts now talk about the ‘reversal interest rate’ – that is, the interest rate at which lower rates become contractionary, rather than expansionary. [5] While we take the possibility of a reversal rate seriously, I am confident that here, in Australia, we are still a fair way from it. Conventional monetary policy is still working in Australia and we see the evidence of this in the exchange rate, in asset prices and in the boost to aggregate household disposable income. My third observation is that we have no appetite to undertake outright purchases of private sector assets as part of a QE program. https://www.rba.gov.au/speeches/2019/sp-gov-2019-11-26.html 8/12 26/11/2019 Unconventional Monetary Policy: Some Lessons From Overseas | Speeches | RBA There are two reasons for this. The first is that there is no sign of dysfunction in our capital markets that would warrant the Reserve Bank stepping in. The second is that the purchase of private assets by the central bank, financed through money creation, represents a significant intervention by a public sector entity into private markets. It comes with a whole range of complicated governance issues and would insert the Reserve Bank very directly into decisions about resource allocation in the economy. While there are some scenarios where such intervention might be considered, those scenarios are not on our radar screen. My fourth point is that if – and it is important to emphasise the word if – the Reserve Bank were to undertake a program of quantitative easing, we would purchase government bonds, and we would do so in the secondary market. An important advantage in buying government bonds over other assets is that the risk-free interest rate affects all asset prices and interest rates in the economy. So it gets into all the corners of the financial system, unlike interventions in just one specific private asset market. If we were to move in this direction, it would be with the intention of lowering risk-free interest rates along the yield curve. As with the international experience, this would work through two channels. The first is the direct price impact of buying government bonds, which lowers their yields. And the second is through market expectations or a signalling effect, with the bond purchases reinforcing the credibility of the Reserve Bank's commitment to keep the cash rate low for an extended period. Currently, the government bond yield curve sits around 20 basis points above the overnight indexed swaps (OIS) curve, which represents the market's average expectation of the future monetary policy rate (Graph 4). Purchasing government securities could compress this differential and could also flatten the OIS curve through the expectations effect I just mentioned. A lower term premium would lower borrowing costs for both governments and private borrowers, and would bring the benefits that come with that. An exchange rate effect could also be expected. https://www.rba.gov.au/speeches/2019/sp-gov-2019-11-26.html 9/12 26/11/2019 Unconventional Monetary Policy: Some Lessons From Overseas | Speeches | RBA Graph 4 Our current thinking is that QE becomes an option to be considered at a cash rate of 0.25 per cent, but not before that. At a cash rate of 0.25 per cent, the interest rate paid on surplus balances at the Reserve Bank would already be at zero given the corridor system we operate. So from that perspective, we would, at that point, be dealing with zero interest rates. My fifth, and final, point is that the threshold for undertaking QE in Australia has not been reached, and I don't expect it to be reached in the near future. In my view, there is not a smooth continuum running from interest rate reductions to quantitative easing. It is a bigger step to engage in money-financed asset purchases by the central bank than it is to cut interest rates. There are, however, circumstances where QE could help. The international experience is that in stressed market conditions, the central bank can help stabilise the situation by buying government securities. That experience also suggests that QE does put additional downward pressure on both interest rates and the exchange rate. In considering the case for QE, we would need to balance these positive effects with possible side-effects. We would also need to consider the effects on market functioning. We are conscious that government securities play a crucial role as collateral in some of our financial markets. Given the limited supply of government debt on issue, the Reserve Bank and APRA have already had to put in place special liquidity arrangements for the banking system. We are also conscious that the https://www.rba.gov.au/speeches/2019/sp-gov-2019-11-26.html 10/12 26/11/2019 Unconventional Monetary Policy: Some Lessons From Overseas | Speeches | RBA Australian government's fiscal position means that the gross stock of government debt is projected to decline relative to the size of the economy over the years ahead. These considerations are not impediments to undertaking QE, but we would need to take them into account. It is a reasonable question to ask what might be the threshold to undertake QE in Australia. It is difficult to be precise, but QE would be considered if there were an accumulation of evidence that, over the medium term, we were unlikely to achieve our objectives. In particular, if we were moving away from, rather than towards, our goals for both full employment and inflation, the purchase of government securities would be on the agenda of the Board. In this world, I would hope other public policy options were also on the country's agenda. At the moment, though, we are expecting progress towards our goals over the next couple of years and the cash rate is still above the level at which we would consider buying government securities. So QE is not on our agenda at this point in time. It is important to remember that the economy is benefiting from the already low level of interest rates, recent tax cuts, ongoing spending on infrastructure, the upswing in housing prices in some markets and a brighter outlook for the resources sector. Given the significant reductions in interest rates over the past six months and the long and variable lags, the Board has seen it as appropriate to hold the cash rate steady as it assesses the growth momentum both here and elsewhere around the world. The Board is also committed to maintaining interest rates at low levels until it is confident that inflation is sustainably within the 2 to 3 per cent target range. The central scenario for the Australian economy remains for economic growth to pick up from here, to reach around 3 per cent in 2021. This pick-up in growth should see a reduction in the unemployment rate and a lift in inflation. So we are expecting things to be moving in the right direction, although only gradually. The Board continues to discuss what role it can play in ensuring that this progress takes place and how it might be accelerated. It recognises the benefits that would come from faster progress, but it also recognises the limitations of monetary policy and the importance of keeping a medium-term perspective squarely focused on maximising the economic welfare of the people of Australia. There may come a point where QE could help promote our collective welfare, but we are not at that point and I don't expect us to get there. Thank you for listening. I look forward to answering your questions. Endnotes [*] I would like to thank Ellis Connolly for assistance in the preparation of this talk. Lowe P (2019), ‘Some Echoes of Melville’, Sir Leslie Melville Lecture, Canberra, 29 October. Committee on the Global Financial System (2019), ‘Unconventional Monetary Policy Tools: a Cross-country Analysis’, CGFS Papers No 63, Bank for International Settlements. Available at <https://www.bis.org/publ/cgfs63.htm>. https://www.rba.gov.au/speeches/2019/sp-gov-2019-11-26.html 11/12 26/11/2019 Unconventional Monetary Policy: Some Lessons From Overseas | Speeches | RBA This risk has been reduced by the strengthening of liquidity regulation. It is also worth recalling that one role of the central bank is to support the liquidity of the system as a whole and that it is neither possible, nor desirable, for financial institutions individually to insure against system-wide shocks. Debelle G (2018), ‘Lessons and Questions from the GFC’, Address to the Australian Business Economists Annual Dinner, Sydney, 6 December. Brunnermeier M and Y Koby (2019), ‘The Reversal Interest Rate’. Available at: <https://scholar.princeton.edu/markus/publications/reversal-interest-rate-effective-lower-bound-monetary-policy>. Large-scale asset purchases would increase settlement balances, which would likely result in the cash rate moving below 0.25 per cent. © Reserve Bank of Australia, 2001–2019. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2019/sp-gov-2019-11-26.html 12/12 | reserve bank of australia | 2,019 | 11 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the 2019 Australian Payments Network Summit, Sydney, 10 December 2019. | 10/12/2019 A Payments System for the Digital Economy | Speeches | RBA Speech A Payments System for the Digital Economy Philip Lowe [ * ] Governor Address to the 2019 Australian Payments Network Summit Sydney – 10 December 2019 Thank you for the invitation to address this year's Australian Payments Network Summit. This summit has become an important fixture on the Australian payments calendar and this is the third time I have had the privilege of joining you. A recurring theme across these summits has been the need to improve customer outcomes. I am very pleased to see that this focus has been continued at this year's summit. The focus on customer outcomes aligns very closely with the focus of the Payments System Board. The Board wants to see a payments system that is innovative, dynamic, secure, competitive, and that serves the needs of all Australians. Increasingly, this means that the payments system needs to support Australia's digital economy. With the digital economy being an important key to Australia's future economic prosperity, we need a payments system that is fit for purpose. We will only fully capitalise on the fantastic opportunities out there if we have a payments system that works for the digital economy. The positive news is that we have made some substantial progress in this direction over recent years and in some areas, Australia's payments system is world class. However, in the fast-moving world of payments, things don't stand still and there are some important areas we need to work on. In my remarks today, I would like to do three things. The first is to talk about some of the progress that has been made over recent years. The second is to highlight a few areas where we would like to see more progress, particularly around payments and the digital economy. And third, I will highlight some of the questions we will explore in next year's review of retail payments regulation in Australia. https://www.rba.gov.au/speeches/2019/sp-gov-2019-12-10.html 1/12 10/12/2019 A Payments System for the Digital Economy | Speeches | RBA Progress Is Being Made Over recent years there have been significant changes in the way that we make payments. We now have greater choice than ever before and payments are faster and more flexible than they used to be. The launch of the New Payments Platform – the NPP – in early 2018 has been an important part of this journey. This new payments infrastructure allows consumers and businesses to make real-time, 24/7 payments with richer data and simple addressing using PayIDs. After the NPP was launched, it got off to a slow start, but it is now hitting its stride. Monthly transaction values and volumes have both tripled over the past year (Graph 1). In November, the platform processed an average of 1.1 million payments each day, worth about $1.1 billion. The rate of take-up of fast retail payments in Australia is a little quicker than that in most other countries that have also introduced fast payments (Graph 2). Graph 1 https://www.rba.gov.au/speeches/2019/sp-gov-2019-12-10.html 2/12 10/12/2019 A Payments System for the Digital Economy | Speeches | RBA Graph 2 I expect that we will see a further pickup in usage once the CBA has delivered on core NPP functionality for all its customers. The slow implementation has been disappointing and we expect the required functionality to be available soon. There are now 86 entities connected to the NPP, including 74 that are indirectly connected via a direct NPP participant. There are at least six non-ADI fintechs that are using the NPP's capabilities to innovate and provide new services to customers. All up, approximately 66 million Australian bank accounts are now able to make and receive NPP payments. Use of the PayID service has also been growing, with around 3.8 million PayIDs having been registered to date. If you have not already got a PayID, I encourage you to get one. I also encourage you to ask for other people's PayIDs when making payments, as an alternative to asking for their BSB and account number. It is much easier and faster. One specific example of where the NPP is bringing direct benefits to people is its use by the Australian Government, supported by the banking arm of the RBA, to make emergency payments. During the current bushfires, the government has been able to use the NPP to make immediate payments to people at a time when they are most in need, whether that be on the weekend or after their bank has shut for the night. https://www.rba.gov.au/speeches/2019/sp-gov-2019-12-10.html 3/12 10/12/2019 A Payments System for the Digital Economy | Speeches | RBA One other area of the payments system where we have seen significant change is the take-up of ‘tap-and-go’ payments. Around 80 per cent of point-of-sale transactions are now ‘tap-and-go’, which is a much higher share than in most other countries. This growth has been made possible by the acquirers rolling out new technology in their terminals and by the willingness of Australians to try something different. There has also been rapid take-up of mobile payments, including through wearable devices. Progress has also been made on improving the safety of electronic payments, particularly in relation to fraud in card-not-present transactions. The rate of fraud is still too high, but it has come down recently (Graph 3). I would like to acknowledge the work that AusPayNet has done here to develop a new framework to tackle fraud. This framework strengthens the authentication requirements for certain types of transactions, including through the use of multi-factor authentication. [1] This will help reduce card-not-present fraud and support the continued growth in online commerce. Graph 3 As our electronic payments system continues to improve, we are seeing a further shift away from cash and cheques. The RBA recently undertook the latest wave of our three-yearly consumer payments survey. We are still processing the results, but ahead of publishing them early next year, I thought I would show you the latest estimate on the use of cash (Graph 4). As expected, there has https://www.rba.gov.au/speeches/2019/sp-gov-2019-12-10.html 4/12 10/12/2019 A Payments System for the Digital Economy | Speeches | RBA been a further trend decline in the use of cash, with cash now accounting for just around a quarter of day-to-day transactions, and most of these are for small-value payments. Given the other innovations that I just spoke about, I expect that this trend will continue. Graph 4 Further Progress Needed The progress across these various fronts means that there is a positive story to be told about innovation in Australia's payments system. At the same time, though, there are still some significant gaps and areas in our payments system that need addressing and where progress would support the digital economy in Australia. I would like to talk about four of these. NPP The first of these is further industry work to realise the full potential of the NPP, including its datarich capabilities. The NPP infrastructure can help make electronic invoicing commonplace and help invoices be paid on time. It can also support significant improvement in business processes, as more data moves with the payment. Real-time settlement and posting of funds also enables some types of delivery-versushttps://www.rba.gov.au/speeches/2019/sp-gov-2019-12-10.html 5/12 10/12/2019 A Payments System for the Digital Economy | Speeches | RBA payment, so that the seller can confirm receipt of funds and be confident in delivering goods or services to the buyer. The layered architecture of the system was designed to promote competition and innovation in the development of new overlay services. Notwithstanding this, one of the consequences of the slowerthan-promised rollout of the NPP by some of the major banks is that there has been less effort than expected on developing innovative functionality. Payment systems are networks, and participants need to know that others will be ready to receive payments and use the network. Some banks have been reluctant to commit time and funding to support the development of new functionality given that others have been slow to roll out their ‘day 1’ functionality. The slow rollout has also reduced the incentive for fintechs and others to develop new ideas. So we have not yet benefited from the full network effects. The Payments System Board considered this issue as part of its industry consultation on NPP access and functionality, conducted with the ACCC earlier this year. As part of that review we recommended that NPPA – the industry-owned company formed to establish and operate the NPP – publish a roadmap and timeline for the additional functionality that it has agreed to develop. The inaugural roadmap was published in October and NPPA also introduced a ‘mandatory compliance framework’. Under this compliance framework, NPPA can designate core capabilities that NPP participants must support within a specified period of time, with penalties for non-compliance. This is a welcome development. One important element of the roadmap is the development of a ‘mandated payments service’ to support recurring and ‘debit-like’ payments. This new service will allow account-holders to establish and manage standing authorisations (or consents) for payments to be initiated from their account by third parties. This will provide convenience, transparency and security for recurring or subscriptiontype payments and a range of other payments. Another element of the roadmap that has the potential to promote the digital economy is the development of NPP message standards for payroll, tax, superannuation and e-invoicing payments. The standards will define the specific data elements that must be included with these payment types, which will support automation and straight-through processing. We would expect financial institutions to be competing with each other to enable their customers to make and receive these data-rich payments. Less positively, there is still uncertainty about the future of the two remaining services that were expected to be part of the initial suite of Osko overlay services. These are the ‘request-to-pay’ and ‘payment with document’ services. We understand there are still challenges in securing committed project funding and priority from NPP participants to move ahead, even though BPAY has indicated it is ready to complete the rollout. The RBA strongly supports the development of these additional NPP capabilities, which are likely to deliver significant value for businesses and the broader community. Digital identity A second area where the Payments System Board would like to see further progress is the provision of portable digital identity services that allow Australians to securely prove who they are in the digital https://www.rba.gov.au/speeches/2019/sp-gov-2019-12-10.html 6/12 10/12/2019 A Payments System for the Digital Economy | Speeches | RBA environment. Today, our digital identity system is fragmented and siloed, which has resulted in a proliferation of identity credentials and passwords. This gives rise to security vulnerabilities and creates significant inconvenience and inefficiencies, which can undermine development of the digital economy. These generate compliance risks and other costs for financial institutions, so it is strongly in their interests to make progress here. It is fair to say that a number of other countries are well ahead of us in this area. The Australian Payments Council has recognised the importance of this issue and has developed the ‘TrustID’ framework. The Government's Digital Transformation Agency has also been working on a complementary framework (the Trusted Digital Identity Framework), which specifies how digital identity services will be used to access online government services. The challenge now is to build on these frameworks and develop a strong digital identity ecosystem in Australia with competing but interoperable digital identity services. The rollout of open banking and the consumer data right should bring additional competition among financial services providers, and digital identity is likely to reduce the scope for identity fraud, while providing convenient authentication, as part of an open banking regime. A strong digital identity system would also open up new areas of digital commerce and help reduce online payments fraud. It will also help build trust in a wide range of online interactions. Building this trust is increasingly important as people spend more of their time and money online. So we would like to see some concrete solutions developed and adopted here. Cross-border retail payments A third area where we would like to see more progress is on reducing the cost of cross-border payments. For many people, the costs here are still too high and the payments are still too hard to make. It is important that we address this. It is an issue not just for Australians, but for our neighbours as well. I recently chaired a meeting of the Governors from the South Pacific central banks, where I heard first-hand about the problems caused by the high cost of cross-border payments. Analysis by the World Bank indicates that the price of sending money from Australia has been consistently higher than the average price across the G20 countries (Graph 5). And a recent ACCC inquiry found that prices for cross-border retail payment services are opaque. Customers are not always aware of how the ‘retail’ exchange rate they are being quoted compares with the wholesale exchange rate they see on the news, or of the final amount that will be received in foreign currency. [2] There are also sometimes add-on fees. https://www.rba.gov.au/speeches/2019/sp-gov-2019-12-10.html 7/12 10/12/2019 A Payments System for the Digital Economy | Speeches | RBA Graph 5 As part of the RBA's monitoring of the marketplace, our staff recently conducted a form of online shadow shopping exercise, exploring the pricing of international money transfer services by both banks and some of the new non-bank digital money transfer operators (MTOs). This exercise showed that there is a very wide range of prices across providers and highlighted the importance of shopping around. The main results are summarised in this graph (Graph 6). In nearly every case, the major banks are more expensive than the digital MTOs. For the major banks, the average mark-up over the wholesale exchange rate is around 5½ per cent, versus about 1 per cent for the digital MTOs. https://www.rba.gov.au/speeches/2019/sp-gov-2019-12-10.html 8/12 10/12/2019 A Payments System for the Digital Economy | Speeches | RBA Graph 6 The graph illustrates why the cost of cross-border payments is such an issue for the South Pacific countries. These costs are noticeably higher than for payments to most other countries. This is a particular problem as many people in the South Pacific rely on receiving remittances from family and friends in Australia and New Zealand. In many cases, low-income people are paying very high fees and it is important that we address this where we can. As is evident from the graph, most digital MTOs do not service the smaller South Pacific economies, which limits customers' choice of providers. In part, the high costs – and slow speed – of international money transfers is the result of inefficiencies in the traditional correspondent banking process. It is understandable why some large tech firms operating across borders see an opportunity here. Where people are being served poorly by existing arrangements, new solutions are likely to emerge with new technologies. This represents a challenge to the traditional financial institutions to offer better service at a lower cost to their customers, while still meeting their AML/CTF requirements. Central banks have a role to play here too, and there is an increased focus globally on what we can do to reduce the cost of cross-border payments. One example of this is the promotion of https://www.rba.gov.au/speeches/2019/sp-gov-2019-12-10.html 9/12 10/12/2019 A Payments System for the Digital Economy | Speeches | RBA standardised and richer payment messaging globally through the adoption of the ISO20022 standard. The RBA is also working closely with the Reserve Bank of New Zealand, AUSTRAC and other South Pacific central banks to develop a regional framework to address the Know-YourCustomer concerns that have limited competition and kept prices high. Operational resilience A fourth area where we would like to see more progress is improving the operational resilience of the electronic payments system. Disruptions to retail payments hurt both consumers and businesses. Given that many people now carry little or no cash, the reliability of electronic payment services has become critical to the smooth functioning of our economy. We understand that, given the complexity of IT systems, some level of payments incidents and outages to services is inevitable. But it is apparent from the data we have that the frequency and duration of retail payments outages have risen sharply in recent years. In response, the RBA has begun working with APRA and the industry to enhance the data on retail payment service outages and to introduce a suitable disclosure framework for these data. These measures will provide greater transparency around the reliability of services and allow institutions to better benchmark their operational performance. The 2020 Review of Retail Payments Regulation The third and final issue I would like to touch on is the Payments System Board's review of retail payments regulation next year. The review is intended to be wide-ranging and to cover all aspects of the retail payments landscape, not just the RBA's existing cards regulation. As the first step in the process, we released an Issues Paper a couple of weeks ago and have asked for submissions by 31 January. [5] There will also be opportunities to meet with RBA staff conducting the review. The review will cover a lot of ground, including hopefully some of the issues that I just mentioned. There are, though, a few other questions I would like to highlight. The first is what can be done to reduce further the cost of electronic payments? Both the Productivity Commission and the Black Economy Taskforce have called for us to examine this question. It is understandable why. As we move to a predominantly electronic world, the cost of electronic payments becomes a bigger issue. The Payments System Board's regulation of interchange fees and the surcharging framework, as well as its efforts to promote competition and encourage least-cost routing, have all helped lower payment costs. At issue is how we make further progress: what combination of regulation and market forces will best deliver this? Relevant questions here include: whether interchange fees should be lowered further; how best to ensure that merchants can choose the payment rails that give them the best https://www.rba.gov.au/speeches/2019/sp-gov-2019-12-10.html 10/12 10/12/2019 A Payments System for the Digital Economy | Speeches | RBA value for money; and whether restrictions relating to no-surcharge rules should be applied to other arrangements, including the buy-now-pay-later schemes. A second issue is what is the future of the cheque system? Cheque use in Australia has been in sharp decline for some time. Over the past year, the number of cheques written has fallen by another 19 per cent and the value of cheques written has fallen by more than 30 per cent, as the real estate industry has continued to shift to electronic property settlements (Graph 7). At some point it will be appropriate to wind up the cheque system, and that point is getting closer. Before this happens, though, it is important that alternative payment methods are available for those who rely on cheques. Using the NPP infrastructure for new payment solutions is likely to help here. Graph 7 Third, is there a case for some rationalisation of Australia's three domestically focused payment schemes, namely BPAY, eftpos and NPPA? A number of industry participants have indicated to us that they face significant and sometimes conflicting investment demands from the three different entities. This raises the question of whether some consolidation or some form of coordination of investment priorities might be in the public interest. Fourth, and finally, what are the implications for the regulatory framework of technology changes, new entrants and new business models? https://www.rba.gov.au/speeches/2019/sp-gov-2019-12-10.html 11/12 10/12/2019 A Payments System for the Digital Economy | Speeches | RBA The world of payments is moving quickly, with new technologies and new players offering solutions to longstanding problems. At the same time, expectations regarding security, resilience, functionality and privacy are continually rising. Meeting these expectations can be challenging, but doing so is critical to building and maintaining the trust that lies at the heart of effective payment systems. The entry of non-financial firms into the payments market also raises new regulatory issues. As part of the review, it would be good to hear how the regulatory system can best encourage a dynamic and innovative payments system in Australia that fully serves the needs of its customers. So these are some of the many issues on our agenda. We are looking forward to receiving your input. For now, thank you for listening and I am happy to answer your questions. Thank you. Endnotes [*] I would like to thank my colleagues in Payments Policy Department for assistance in the preparation of this talk. See AusPayNet's CNP Fraud Mitigation Framework, available at <https://www.auspaynet.com.au/insights/initiatives/CNP-Fraud-Mitigation-Framework>. ACCC (2019), ‘Foreign currency conversion services in Australia’, July. For example, bank customers may also incur additional fees charged by the ‘correspondent banks’ that intermediate the payment to its final destination on behalf of the sending bank. These fees may not be known at the point of the transaction and can result in less foreign currency being received than expected. See Bullock M (2019), ‘Modernising Australia's Payments System’, Speech to the Central Bank PaymentsConference, Berlin, 25 June. Reserve Bank of Australia (2019), ‘Review of Retail Payments Regulation: Issues Paper PDF ’, November. © Reserve Bank of Australia, 2001–2019. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2019/sp-gov-2019-12-10.html 12/12 | reserve bank of australia | 2,019 | 12 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the National Press Club, Sydney, 5 February 2020. | Speech The Year Ahead Philip Lowe [ * ] Governor Address to the National Press Club Sydney – 5 February 2020 Thank you for inviting me back to address the National Press Club. It is an honour to be here again. At this lunch a year ago, I spoke about the year ahead. I would like to do the same again today. Twelve months ago, I reminded you that we do not have a crystal ball that can be used to see the future with certainty. Since then, some things have turned out as expected, but there have been plenty of surprises as well. No doubt, the same will be true this year. Today, though, I would like to talk about the Reserve Bank's central scenario for the global and Australian economies and some of the factors that we will be watching over the year ahead. I would also like to touch on monetary policy. The Global Economy The central scenario for the global economy over the next couple of years remains reasonable and growth is expected to be a little stronger than it was in 2019. The IMF estimates that the global economy expanded by 2.9 per cent last year and in its latest published forecasts is predicting economic growth to lift to 3.3 per cent this year and 3.4 per cent in 2021 (Graph 1). Graph 1 Looking back, though, global growth in 2019 was not as strong as we had expected. This was largely because the trade and technology disputes between the United States and China and the Brexit debate had a sobering effect on investment around the world. The trade disputes also led to some reconfiguration of global supply chains and resulted in very soft conditions in the manufacturing sector and a contraction in international trade. Some of these dark clouds that were hanging over the global economy last year have lightened a little recently. With the progress on the trade and Brexit issues, there have been some signs that the downswing in manufacturing activity and international trade is coming to an end (Graph 2). The down cycle in the global semiconductor industry also looks to be running its course. Graph 2 These are encouraging developments and provide a reasonable basis to expect that this year will be better than last year. Having said that, it remains possible that the expected pick-up in growth is derailed by a re-escalation of the trade and technology disputes. Another, more recent source of uncertainty is the outbreak of the coronavirus, which I will discuss shortly. One other unexpected development over the past year was the easing of monetary policy by most central banks. This easing was in response to both the disappointing growth outcomes in some countries and the continuing accumulation of evidence of low and stable inflation. This evidence suggests that the previous relationship between the unemployment rate and inflation has changed. Many countries have unemployment at the lowest level in decades – in the United States it is the lowest since 1969, and in the United Kingdom it is the lowest since 1974 (Graph 3). Yet inflation remains subdued. Graph 3 The reasons for this change are complicated. But my view is that it largely reflects some structural changes related to technology and globalisation, which together have increased competition and uncertainty about the future. With our economies seemingly less inflation prone than they once were, it is now possible to sustain lower rates of unemployment than previously thought to be the case. This is a good thing. Partly as a result of this shift, investors have a high degree of confidence that interest rates will stay low for a long time. This assessment is reinforced by the fact that the global desire to save is high relative to the desire to invest in new capital. When a lot of people want to save and there is weak demand by businesses to use those savings, the return to savers – that is the interest rate – is going to be low. This means that we find ourselves in a world of low unemployment, low inflation and low interest rates. I expect that we are going to remain here for quite some time given the structural factors at work, although it does remain possible that a re-acceleration of growth in economies with little spare capacity could see inflation re-emerge. One consequence of interest rates being lower for longer is that asset prices have increased as investors discount future returns by less. The most obvious example of this is global equity prices, which have recorded strong gains over recent times (Graph 4). Some investors are also taking on more risk as they search for higher returns in a low interest rate world. Both higher asset prices and a willingness to take more risk can be good for the global economy, especially if they lead to more investment, not just more borrowing. We do, though, need to remember that it is possible to have too much of a good thing. So this is also an issue that international bodies, including the Financial Stability Board, are keeping a close eye on. Graph 4 The Australian Economy I would now like to turn to the Australian economy. We will be releasing an updated full set of forecasts on Friday in the . Ahead of that I can provide you with the main numbers and highlight some of the issues shaping the outlook. Statement on Monetary Policy Our central forecast is for the Australian economy to expand by 2¾ per cent over 2020 and 3 per cent the following year (Graph 5). These growth rates are a little above our current estimate of medium-term growth in Australia, so some inroad into spare capacity should be made. These growth rates are also higher than the outcomes for 2018 and 2019. As I have been saying for some time, we are passing through a gentle turning point for the better. Graph 5 There are a number of factors contributing to this outlook. The expected pick-up in world growth should help us, the resources sector is in expansion mode again and we are expecting consumer spending to pick up. The outlook is also being supported by ongoing high levels of investment in infrastructure and the likelihood that the downswing in residential construction will come to an end later this year. Further increases in resource exports and continuing solid growth in public demand will also help. In terms of the labour market, we are expecting the unemployment rate to remain around its current level for a while yet, before declining below 5 per cent late next year as growth picks up (Graph 6). One consideration here is the outlook for labour force participation. Over the past couple of years we have seen a very large lift in participation, especially by women and older Australians. This is a positive development but it has meant that very strong employment growth has not resulted in a lower unemployment rate: strong demand for labour has been met with strong supply of labour. Graph 6 In terms of inflation, we continue to expect a gradual increase, with underlying inflation expected to approach 2 per cent over the next couple of years (Graph 7). The recent inflation data were in line with our expectations and show contrasting trends with higher prices for groceries and continued subdued outcomes for housing, especially rents and utilities. Graph 7 With that broad overview I would like to focus on three issues: 1. the ongoing adjustment in household balance sheets 2. the bushfires, the drought and the coronavirus outbreak 3. the importance of continuing to invest in our future. Household Balance Sheet Adjustment Looking back at last year, economic growth was weaker than we had expected. The global slowdown is part of the story, but the most important factor is a domestic one, and that is subdued consumer spending as households adjusted to slow wages growth and falling housing prices. The downswing in residential construction was also a factor. Over 2019, household consumption looks to have increased by only around 1 per cent (Graph 8). Given that Australia's population is growing at 1.5 per cent a year, this represents a decline in per capita terms. This is a highly unusual outcome in an economy that has recorded the type of strong jobs growth that we have experienced in Australia. Graph 8 For some time now, households had been gradually adjusting their spending to the slower trend rate of income growth. This adjustment accelerated last year in response to falling housing prices. Faced with the reality of slow growth in wages and falling housing prices, many households scaled back their spending to put their finances and their balance sheets on a sounder footing and the effects have been felt across the economy. On the wages front, Australians have been getting used to increases of 2 point something (Graph 9). This is a noticeable step down from the 3–4 per cent range we experienced previously and we are forecasting the current rate of wages growth to continue for the next couple of years. As this period of low wages growth has run on, many people have adjusted down their expectations of how fast their own income will grow in future. Graph 9 At the same time, households have been dealing with another adjustment – that is in housing prices. Between late 2017 and mid last year, nationwide housing prices fell by 8 per cent, and in Sydney and Melbourne housing prices fell an average of 13 per cent (Graph 10). The speed and extent of this decline came as a shock to many people, although it did follow an earlier very large run-up in prices. It reminded us all that housing prices can, and do, fall substantially. For some people the salutary effect of that reminder has been amplified by lower wage increases and high levels of debt. Graph 10 As part of the Reserve Bank's efforts to understand how households are adjusting we have been looking carefully at the data on mortgage repayments and I would like to share these updated data with you. This graph shows housing loan repayments as a share of outstanding credit, broken down into interest payments and repayments of principal, including through higher balances in offset accounts (Graph 11). Graph 11 There are three points that I would draw your attention to. The first is that as monetary policy has been eased since late 2011, interest payments as a share of credit have come down (top panel). This has freed up income to be spent on other purposes. The second is that the rate of repayment of principal (bottom panel) has moved up and down over time. These fluctuations partly reflect trends in the housing market. In particular, the increase in repayments around 2014 and 2015 was associated with strong growth in offset accounts and coincided with a period of high turnover in the housing market and strong growth in loan refinancing. And the third point is that over the second half of 2019, principal payments have increased, more than offsetting the decline in interest payments. Households have made larger voluntary repayments and they have also maintained higher balances in their offset accounts. Partly, this has been made possible by the higher tax refunds for low- and middle-income earners which have boosted disposable income. It is entirely understandable that households faced with low growth of wages and falling housing prices sought to repay their debts a bit faster. I am going to speak about monetary policy shortly, but ahead of that I would like to address one point that I hear frequently: that the Reserve Bank's decision to cut interest rates last year dented consumer confidence and that this is what lies behind the weak consumption growth. I certainly understand that having interest rates at very low levels has unsettled some people. But I don't accept the idea that this is what is driving weak consumption. There is something deeper going on. While the Reserve Bank's decisions reminded people of what is going on, Australians were already adjusting their spending to the reality of a combination of subdued wages growth, the fall in housing prices and high debt levels. Consumer confidence and monetary policy were both responding to this reality. My judgement is that if the Reserve Bank had not eased monetary policy last year, this adjustment by households would have been harder, the balance sheet repair would have been more difficult, and the economy would have been weaker. The lower interest rates have assisted with both sides of the balance sheet. They have allowed people to pay down their liabilities more easily, and they have also boosted asset prices. So they are helping, not hampering, the process of balance sheet adjustment. In doing so, they are also bringing forward the day when households feel comfortable to lift their spending again. As I said when discussing the global situation, we need to remember that it is possible to have too much of a good thing. We are aware of the risk of low interest rates encouraging too much borrowing and driving excessive asset valuations. So we will continue to watch borrowing, in particular, very carefully. The main point here, though, is that we expect consumption growth to strengthen as households become more comfortable with their balance sheet positions. Assisting with this, disposable income is expected to grow more strongly over the next couple of years than it has over the past couple of years. Housing prices are also now rising, not falling, and a pick-up in residential construction activity is in prospect. The unemployment rate is also expected to decline, which should give people the confidence to spend. So it is reasonable to expect that things improve from here, although it is hard to be precise about how much longer this period of balance sheet adjustment will continue. The Fires, the Drought and the Coronavirus Outbreak Other issues that we have examined carefully in putting together the forecasts are the devastating bushfires over the summer and the drought. On behalf of the Reserve Bank Board and staff I would like to extend our thoughts to all those who have been affected, especially to those who have so tragically lost loved ones. I would also like to extend our deep gratitude to all those who have worked so tirelessly to control the fires. The economic impact of the fires in the areas affected is very large. There have been very significant disruptions to normal activity in these areas and there has been large-scale destruction of homes, farms and businesses as well as public infrastructure. In assessing the impact of this on the Australian economy as a whole we have taken into account that there will be a material rebuilding effort and that government grants and insurance payments will assist many people. On this basis, our assessment is that GDP growth for 2020 as a whole will be largely unaffected. There is, however, likely to be a noticeable effect across the December quarter last year and the current quarter. While it is still difficult to be precise, we estimate that the effects of the bushfires will reduce GDP growth by around 0.2 percentage points across the two quarters. We are also continuing to assess the effects of the drought on the economy. Farm output declined by 16 per cent between 2017 and 2019, and farm exports fell by 13 per cent. A further decline of around 10 per cent in farm output is expected in 2020, representing a drag on GDP growth of around a quarter of a percentage point. This is a stark reminder that the economic effects of these climate events are material. A new uncertainty affecting the outlook is the outbreak of the coronavirus. It is too early to tell what the overall impact will be, but the SARS outbreak in 2003 may provide a guide. On that occasion, there was a sharp slowing in output growth in China for a few months, before a sharp bounce-back as the outbreak was controlled and economic stimulus measures were introduced. Today, China is a larger part of the global economy and it is more closely integrated, including with Australia, so the international spillovers could be larger than they were back in 2003. Much will depend on the success of the various efforts to control the virus so we are monitoring developments closely. The Importance of Continuing to Invest in our Future The third issue I would like to discuss is the importance of continuing to invest in our future. Australia's economic fundamentals remain very strong and they provide a solid foundation for us to be optimistic about our future. The strong fundamentals include: world class endowments of natural resources; a highly skilled and innovative workforce; an established and predictable regulatory system; sound public finances; a diverse and growing population; and being well placed to benefit from the strong growth in Asia, not just in China, but also in the populous countries of Indonesia and India. So we have a lot to feel fortunate about. We enjoy a set of fundamentals and a standard of living that few other countries enjoy. It's important that we do not lose sight of this. Strong fundamentals, though, can take us only so far. If we are to turn these fundamentals into strong and consistent growth, we need to keep investing in our future. The level of investment spending, relative to the size of the economy, has trended lower over recent years, although there has been some increase in public investment (Graph 12). We have also experienced a troubling decline in productivity growth. While the reasons for this are complex, it is hard to escape the conclusion that higher levels of investment spending would promote productivity growth and our collective living standards. The list of areas where further investment would improve our future prospects is well known. It includes investments in infrastructure, in human capital, in energy production and distribution, in new data technologies, and in measures to deal with climate change and its effects. Businesses, as well as governments across Australia are addressing these areas and it is important that they remain focused on them. Graph 12 Both public and business sector balance sheets are in good shape and so are strong enough to take advantage of these investment opportunities. As I have said on other occasions, low interest rates should make it easier for both the public and business sectors to contemplate long-term investments, given that future returns don't need to be discounted as much. They also mean that financing costs are lower. With interest rates at record lows and likely to remain low for quite some time there are plenty of opportunities here. Monetary Policy I would like to finish by returning to monetary policy. At its meeting yesterday, the Reserve Bank Board decided that, given the current outlook, the best course was to hold the cash rate steady at 0.75 per cent. The recent inflation and unemployment data were both in line with our expectations and show things moving in the right direction, although only very gradually. Over the next couple of years we expect further progress to be made towards full employment and the inflation target, although that progress is likely to remain quite slow. The gradual nature of this progress reflects some significant structural shifts in the global economy related to technology and globalisation and, as I discussed earlier, a period of adjustment in household finances in Australia. Monetary policy has already responded to this and is providing considerable support to the Australian economy. Given the outlook I have outlined today, the Board has, however, continued to discuss the merits of further monetary stimulus in an effort to speed the pace of progress and to make it more assured. On balance, though, the Board has decided to hold the cash rate steady, recognising the significant monetary stimulus already in place and the long and variable lags associated with monetary policy. This decision also reflects a judgement about the benefits from a further reduction in interest rates against some of the costs and risks associated with very low interest rates. It certainly remains the case that a further reduction in interest rates would help with the balance sheet adjustment by households with existing debt, which should help bring forward the day that consumption strengthens. It would also have a further effect on the exchange rate, which would boost demand for our exports and therefore support jobs growth. On the other side of the equation though, there are risks in having interest rates at very low levels. Internationally, there are increased concerns about the effect of very low interest rates on resource allocation and their effect on the confidence of some people. Lower interest rates could also encourage more borrowing by households eager to buy residential property at a time when there is already a strong upswing in housing prices in place. If that occurs, this could increase the risk of problems down the track. So there is a balance to be struck here. The Board recognises that the nature of this balance can change over time and that it depends very much upon the state of the economy. So it is continually looking at both sides of the equation. If the unemployment rate were to be trending in the wrong direction and there was no further progress being made towards the inflation target, the balance of arguments would change. In those circumstances, the Board would see a stronger case for further monetary easing. We will continue to monitor developments carefully, including in the labour market, as we seek to strike the right balance in the interests of the community as a whole. Thank you for listening and I look forward to your questions. Endnotes [*] I would like to thank Ellis Connolly for assistance in preparing this talk. © Reserve Bank of Australia, 2001–2020. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. | reserve bank of australia | 2,020 | 2 |
Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 7 February 2020. | Philip Lowe: Opening statement to the House of Representatives Standing Committee on Economics Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 7 February 2020. * * * Good morning Chair and members of the Committee. These hearings are a central part of the accountability process for the Reserve Bank of Australia. As usual, my colleagues and I will do our best to answer your questions and to explain how we are discharging our important responsibilities on behalf of the Australian community. Later this morning we will be releasing a full set of updated forecasts in our quarterly Statement on Monetary Policy. Ahead of that I would like to highlight the main numbers and some of the factors that are influencing the outlook. I will then turn to monetary policy and finish with some remarks about the RBA’s payments system responsibilities. When we met six months ago, I said that there were signs that the Australian economy may have reached a gentle turning point. The data that we have received since then are consistent with this. Our central forecast is that economic growth in Australia will pick up from an average rate of 2 per cent over the past couple of years to 2¾ per cent this year and 3 per cent over 2021. This expected pick-up in growth is supported by accommodative monetary policy, a new expansion phase in the resources sector, stronger consumer spending and a recovery in dwelling investment later this year. High levels of spending on infrastructure and strong growth in public demand are also helping the economy. The outlook is also supported by an expected modest lift in global growth. The global economy has clearly suffered over the past year from the uncertainty and interruption to international trade caused by the US–China trade and technology disputes. More recently, though, there have been signs of stabilisation, especially in the manufacturing sector. Consistent with this, in its latest public forecasts the International Monetary Fund has predicted global growth will be stronger this year and next than it was last year. Notwithstanding this, there are still some significant areas of uncertainty. One of these is the possibility of a re-escalation of the US–China disputes. The ‘phase one’ deal has alleviated some of the earlier uncertainties, but it has not eliminated them. There are also a number of other trade disputes that are simmering elsewhere around the world. And more recently, the outbreak of the coronavirus represents a new source of uncertainty. It is too early to tell what the impact will be, but the SARS outbreak in 2003 may provide a guide. On that occasion, there was a sharp slowing in output growth in China for a few months, before a sharp bounce back as the outbreak was controlled and economic stimulus measures were introduced. Today, China is a larger part of the global economy and it is more closely integrated, including with Australia, so the international spillovers could be larger than they were back in 2003. Much will depend on the success of the various efforts to control the virus so we are watching developments carefully. In terms of the domestic issues, perhaps the most significant one at the moment is that household spending has been very soft. For some time now, households had been gradually adjusting their spending to the slower trend rate of income growth. This adjustment accelerated last year in response to falling housing prices. Faced with the reality of slow growth in wages and falling housing prices, many households scaled back their spending and adjusted their finances. 1/4 BIS central bankers' speeches Looking forward, we expect this adjustment in household finances to continue for a while yet, but for consumption to pick up gradually. As households become more comfortable with their finances they should have the confidence to spend. Continued growth in employment, stronger growth in disposable income than in recent years and the recent increases in housing prices will also help here, as will an upswing in residential construction. So we are expecting stronger growth in consumption over the course of this year, although there is some uncertainty about how long this period of balance sheet adjustment will continue. The other significant domestic issues are the bushfires and the drought. The fires have had a devastating personal and economic impact on the areas affected. In addition to the tragic loss of life, many people have lost their homes and there has been extensive damage to farms, businesses and public infrastructure. Our current estimate is that over the December and March quarters, the fires will have reduced Australian GDP growth by around 0.2 percentage points. The rebuilding effort is expected to broadly offset that effect over the rest of this year. The drought is also continuing to act as a drag on the economy and is expected to reduce GDP growth by a quarter of a percentage point this year. Turning now to the labour market, we are expecting the unemployment rate to hold steady for a while at around its current level of just over 5 per cent before declining to a little below 5 per cent as economic growth picks up. Employment growth slowed a little towards the end of last year, but most of the forward-looking indicators – including job vacancies – suggest reasonable employment growth over the months ahead. In terms of wages, we are expecting a continuation of the current pace of increase. Wage increases of 2 point something have become common across much of the country and we do not see this changing in the near term. The recent inflation data were in line with our expectations, with CPI inflation running at 1.8 per cent. Within the overall CPI there are contrasting trends. The prices of many food items are rising more quickly than they have for some time, largely because of the drought. In contrast, housing-related costs remain subdued, with rents increasing at the slowest rate on record and electricity prices falling in most places. Looking forward, we are expecting inflation to pick up to 2 per cent over the next couple of years. I would now like to turn to monetary policy. Since the previous hearing, the Reserve Bank Board has cut the cash rate by a further ¼ of a per cent, bringing the total reduction last year to ¾ percentage point. Since last October, including at our meeting earlier this week, the Board has maintained the cash rate unchanged at 0.75 per cent. I understand that some people in our community have concerns about interest rates being at very low levels and that low interest rates makes it more difficult for people relying on interest income. I would like to assure these people that we did not take those decisions lightly. Rather, we have been responding to two major developments. First, the low interest rates globally. And second, a period of balance sheet adjustment by Australian households. As we have discussed at previous hearings, world interest rates have moved lower over the past decade. This is mainly because of structural factors related to ageing of the population, productivity growth, slower population growth and high rates of saving in Asia. Since we live in an interconnected world, we cannot ignore this shift in world interest rates. On the domestic front, as I discussed earlier, households have been responding to the period of low wages growth and a fall in housing prices. This has resulted in a period of low consumption growth and below-average economic growth. If interest rates had not been reduced last year this adjustment in household finances would have been more difficult and the overall economy would have suffered. The lower interest rates have made it easier for people to manage their debts and, on the other side of the balance sheet, they have boosted asset values. In doing so, they are 2/4 BIS central bankers' speeches bringing forward the day when households feel sufficiently comfortable to increase their spending again. The easing of monetary policy is also supporting a turnaround in housing investment and has also had an effect on the exchange rate, which boosts demand for our exports. So, it is working. Looking forward, we are expecting progress to be made towards the inflation target and full employment, but that progress is expected to be only gradual and there are uncertainties. Given the only gradual nature of the progress, the Board has been discussing the case for a further easing of monetary policy in an effort to speed the pace of progress and to make it more assured. In considering this case, we have taken account of the fact that interest rates have already been reduced to a low level and there are long and variable lags in the transmission of monetary policy. The Board also recognises that a balance needs to be struck between the benefits of lower interest rates and the risks associated with having interest rates at very low levels. Internationally, there are increasing concerns about the effect of very low interest rates on resource allocation in the economy and their effect on the confidence of some people. Lower interest rates could also encourage more borrowing by households eager to buy residential property at a time when housing debt is already quite high and there is already a strong upswing in housing prices in place. If so, this could increase the risk of problems down the track. After considering this balance, the Board decided to maintain the cash rate unchanged. We recognise, though, that the nature of this balance between benefits and risks can change over time and it is dependent upon the state of the economy. If the unemployment rate were to be moving materially in the wrong direction and there was no further progress being made towards the inflation target, the balance of arguments would tilt towards a further easing of monetary policy. So we are continuing to watch the labour market carefully, as we seek to strike the right balance in the interests of the community as a whole. While on the topic of interest rates, I would like to draw your attention to some new analysis of lending rates that will be included in today’s Statement on Monetary Policy and updated each month on the RBA website.1 In particular, the newly published data show that households that took out their mortgage four or five years ago are paying noticeably higher interest rates than those who took out their mortgage more recently. This reflects the fact that the discounts offered to lenders’ standard variable rates have risen over recent years and these discounts tend to be fixed for the life of the loan – what might have once seemed a big discount might not be so big now. As I have said a number of times recently, if you took your loan out a while ago it is worth shopping around and checking in with your lender to see if it can now give you a bigger discount. New data being published by the RBA and ASIC should help with this shopping around. On a different matter, you might recall that at our previous hearing we had a discussion about quantitative easing (QE). Shortly after that I gave a public speech on the issue. Given the Committee’s previous interest in the topic I thought it would be useful to summarise the main points for you. The first is that negative interest rates in Australia are extraordinary unlikely. This is not a direction we need to go in. The second point is that Australia’s financial markets are currently operating normally so there is no need for any special liquidity operations. If liquidity pressures did emerge in our markets, though, we have the capacity and the tools to respond. We have done this in the past, and would do so again to support the smooth operation of Australia’s financial markets. The third point is that the threshold for undertaking QE – that is, the RBA purchasing assets 3/4 BIS central bankers' speeches through balance sheet expansion – has not been reached in Australia and I do not expect it to be reached. So, it is not on our agenda at the moment. The fourth point is that we would consider QE only if there were an accumulation of evidence that, over the medium term, we were unlikely to achieve our objectives of full employment and the inflation target. As I have said on other occasions – including before this Committee – in the event that the country did find itself in that position, I would hope that policy options other than monetary policy were also on the country’s agenda. The fifth and final point is that QE would be considered only at a cash rate of 0.25 per cent. Our focus would be on purchasing government securities to put downward pressure on longer-term interest rates. We have no appetite to purchase private sector assets as part of any QE program. Doing so would represent a major intervention by the RBA into resource allocation in our economy and come with a whole host of governance issues. So this is not a direction we are inclined to go in. Finally, I would like to highlight a few payments matters. Australia’s new fast payments system is continuing to grow, with most of the major banks now close to offering the agreed initial functionality. The RBA – as banker to the Australian Government – has been using this new system recently to get money immediately into the bank accounts of people affected by the bush fires. More generally, most people in Australia are now able to move money between bank accounts in a matter of seconds. The Payments System Board is hoping to see banks, fintechs and others use this new infrastructure to develop innovative payment solutions that help individuals and small businesses. Another priority for the Payments System Board over the year ahead is to complete its periodic review of payments regulation in Australia. We are currently reviewing the initial submissions to this review and it is clear that the world of payments is moving quickly, partly driven by new technologies. One of the issues that the Council of Financial Regulators has already raised with government is the regulatory arrangements for so-called stored value facilities, which could include digital payment ‘coins’. The Council is seeking some changes to current regulatory arrangements that would provide stronger protections for consumers as well as creating a simpler regulatory system that encourages innovation. Another issue on which the Council of Financial Regulators will provide advice to government this year is the resolution arrangements that apply to Australia’s systematically important financial infrastructures, including central counterparties and securities settlement facilities. We need to make sure that our arrangements for dealing with problems in these critical parts of Australia’s financial infrastructure are strong and that they meet international standards. This will likely require some changes in current legislation. Thank you. My colleagues and I are here to answer your questions. 1 See ‘Lenders’ Interest Rates’, available at: www.rba.gov.au/statistics/interest-rates/. 4/4 BIS central bankers' speeches | reserve bank of australia | 2,020 | 2 |
Keynote address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the Australian Financial Review Business Summit, Sydney, 11 March 2020. | 11/03/2020 The Virus and the Australian Economy | Speeches | RBA Speech The Virus and the Australian Economy Guy Debelle [ * ] Deputy Governor Keynote Address at the Australian Financial Review Business Summit Sydney – 11 March 2020 Thank you for the opportunity to speak to you today. I had been intending to talk about investment, the theme of this conference. But, given the circumstances, instead I will provide a summary of how the Bank is seeing developments in the economy at the moment. [1] I will provide our assessment of where the economy was ahead of the onset of the coronavirus as well as an assessment of the effect of the virus to date, including on financial markets. The December quarter national accounts confirmed our assessment that the Australian economy ended 2019 with a gradual pick-up in growth. Growth over the year was 2¼ per cent, up from a low of 1½ per cent. Consumption growth was a little stronger in the quarter, although still subdued. We had estimated that the bushfires will subtract around 0.2 percentage points from growth across the December and March quarters, but besides that, economic growth was set to continue to pick up supported by low interest rates, the lower exchange rate, a rise in mining investment, high levels of spending on infrastructure and an expected recovery in residential construction. On the global side, around the turn of the year there were indications that the global economy was coming out of a soft patch of growth. The trade tensions between China and the US had abated, surveys of business conditions were picking up and industrial production was improving. Financial conditions were very stimulatory and supporting the pick-up in global growth. Since then, there is no doubt that the outbreak of the virus has significantly disrupted this momentum, initially in China and now more broadly. We do not have a clear picture yet on the disruption to the Chinese economy caused by the virus and the measures put in place to contain the virus. But the following two graphs provide some sense of the significant disruption to the Chinese people and economy. https://www.rba.gov.au/speeches/2020/sp-dg-2020-03-11.html 1/12 11/03/2020 The Virus and the Australian Economy | Speeches | RBA The coal consumption graph (Graph 1) shows the regular significant decline in production around Chinese New Year. But this year, the return to normal production has been significantly delayed. There was no ramp up in production after the holiday period, and we are now more than four weeks past the point where the Chinese economy is normally back to full-scale production. The straight arithmetic of losing a substantial amount of output over a period of several weeks implies a significant hit to economic activity. The road congestion graph (Graph 2) tells a similar story of a protracted period of low output. Graph 1 https://www.rba.gov.au/speeches/2020/sp-dg-2020-03-11.html 2/12 11/03/2020 The Virus and the Australian Economy | Speeches | RBA Graph 2 Both show that the Chinese economy is now only gradually returning to normal. Even as this occurs, it is very uncertain how long it will take to repair the severe disruption to supply chains. In the meantime, the virus has spread to other countries. They too are beginning to suffer significant disruptions, the extent and duration of which is unknown at this time. The conclusion is that the global economy will be materially weaker in the first quarter of 2020 and in the period ahead. In terms of the effect on the Australian economy, we have estimated the direct impact on the education and tourism sectors in the March quarter. Graph 3 shows the normal profile of visitor arrivals into Australia. Since January, inbound airline capacity from China has declined by 90 per cent, which gives a guide to the size of the decline in arrivals from China. Up until recently, tourist arrivals from other countries had held up reasonably well but that may no longer be true. From our liaison with the education sector, including the universities, as well as student visa numbers, we have information on the number of foreign students who have been unable to resume their studies. Graph 4 shows the country of origin of foreign students in Australia. https://www.rba.gov.au/speeches/2020/sp-dg-2020-03-11.html 3/12 11/03/2020 The Virus and the Australian Economy | Speeches | RBA Graph 3 https://www.rba.gov.au/speeches/2020/sp-dg-2020-03-11.html 4/12 11/03/2020 The Virus and the Australian Economy | Speeches | RBA Graph 4 We have used this information to estimate the impact of the virus in these two sectors of the economy. The estimate is approximate, but at this stage we think the decline in services exports in the March quarter will amount to at least 10 per cent, roughly evenly split between lower tourism and education exports. As service exports account for 5 per cent of GDP, this translates into a subtraction from growth of ½ per cent of GDP in the March quarter from these two sources. Through our business liaison program we are gathering information on supply chain disruptions which are affecting the construction and retail sectors in particular. Clearly we are still only in the early weeks of March, so the picture can change from here. It is just too uncertain to assess the impact of the virus beyond the March quarter. Our liaison with the resources sector does not indicate any material disruption to exports of iron ore and coal at this stage. Indeed, iron ore and coal prices have been resilient. Disruptions to Chinese domestic production of iron ore and coal have been a factor in this, which has resulted in more use of imported resources. Another is the expectation that the Chinese policy response will involve a significant amount of infrastructure spending which will benefit bulk commodities. The movements in these commodity prices stand in contrast to the large decline in the oil price, which will flow through to LNG prices (Graph 5). https://www.rba.gov.au/speeches/2020/sp-dg-2020-03-11.html 5/12 11/03/2020 The Virus and the Australian Economy | Speeches | RBA Graph 5 I will now summarise recent developments in financial markets. There has been a large increase in risk aversion and uncertainty. The virus is going to have a material economic impact but it is not clear how large that will be. That makes it difficult for the market to reprice financial assets. Policy interest rates have been reduced in some countries, including Australia, and further reductions are expected where that is possible. Currently market pricing implies a reduction of between 75 and 100 basis points in the Fed's policy rate at their meeting next week. Government bond yields have declined to historic lows, because of the shift downwards in actual and expected policy rates, reduced expectations for growth and a flight to safety (Graph 6). The 25 per cent fall in oil prices on Monday morning has also led to lower expectations of inflation. The 10 year US treasury yield reached a low below 35 basis points on Monday, including a 25 basis point decline at the opening of trade in Asia. It has since risen to be around 65 basis points at the time of writing. Australian government bond yields have been driven by the global developments. They haven't declined as much as US Treasuries, such that the spread between the 10 year yields is now slightly positive, having been negative over the past two years. At the time of writing, the Australian government can borrow for 10 years at 75 basis points. https://www.rba.gov.au/speeches/2020/sp-dg-2020-03-11.html 6/12 11/03/2020 The Virus and the Australian Economy | Speeches | RBA Graph 6 Equity prices have fallen by as much as 20 per cent since their all-time peak of less than a month ago, although the Australian market rebounded on Tuesday (Graph 7). The falls have been particularly large for companies in the oil sector, as well as tourism. https://www.rba.gov.au/speeches/2020/sp-dg-2020-03-11.html 7/12 11/03/2020 The Virus and the Australian Economy | Speeches | RBA Graph 7 Corporate bond spreads have widened. Through the first part of this move, the widening in large part reflected the rapid shift downwards in the risk free (government bond) curve. Investment grade bond spreads widened but investment grade yields actually fell (Graph 8). In the last few days though, we have seen yields rise along with the spreads. The high yield sector has seen a marked rise in yields and spreads, particularly in the US reflecting the prevalence of energy companies in that market. Bond issuance has been extremely low, in part because issuers do not want to appear to be in desperate need of funds in a dislocated market. It is also worth noting that just as equities prices have fallen from historic highs, so too have corporate bond prices fallen from historic highs. https://www.rba.gov.au/speeches/2020/sp-dg-2020-03-11.html 8/12 11/03/2020 The Virus and the Australian Economy | Speeches | RBA Graph 8 Liquidity in fixed income markets has been poor at times, including in US Treasuries. The liquidity environment has changed considerably in the past decade in response to changed regulations. The banking sector is much less willing and able to warehouse risk and provide liquidity than in the past. The Australian banking system is well capitalised and is in a strong liquidity position. The Australian banks had raised a significant amount of wholesale funding before the disruption to markets and deposit inflows are robust. They are resilient to a period of market disruption. Spreads on Australian bank bonds have widened, although yields remain at levels that are still very low historically. We have not seen any particular sign of pressure in our daily market operations to date. The spread between the bank bill swap rate and the expected policy rate (OIS) has risen in recent days but remains low, nothing at all like what occurred in GFC. Exchange rate volatility has been very low for a considerable period of time, but has picked up in the past few days. However it still remains considerably lower than volatility in other financial markets. The yen has appreciated by as much as 10 per cent against the US dollar, as Japanese investors repatriate funds, as normally occurs in these type of situations (Graph 9). More surprisingly, the euro has also appreciated against the US dollar. Market intelligence indicates that part of the reason for this is the liquidation of trades that were funded in euros and invested in higher yielding assets such as emerging market bonds. The sharp narrowing in the interest differential with the US has also contributed. https://www.rba.gov.au/speeches/2020/sp-dg-2020-03-11.html 9/12 11/03/2020 The Virus and the Australian Economy | Speeches | RBA Graph 9 The Australian dollar has depreciated by 6 per cent since the beginning of the year to decade lows against the US dollar and on a trade-weighted basis (Graph 10). This will provide a helpful boost to the Australian economy and has occurred despite the prices of the bulk commodities, iron ore and coal, remaining resilient. https://www.rba.gov.au/speeches/2020/sp-dg-2020-03-11.html 10/12 11/03/2020 The Virus and the Australian Economy | Speeches | RBA Graph 10 Turning to monetary policy, the Board met last week and decided to lower the cash rate by 25 basis points to 0.5 per cent. This decision was taken to support the economy by boosting demand and to offset the tightening in financial conditions that otherwise was occurring. The reduction in the cash rate at the March meeting was passed in full through to mortgage rates. The cash rate has been reduced by 100 basis points since June. This has translated into a reduction in mortgage rates of 95 basis points. This has occurred through the combination of a reduction in the standard variable rate of 85 basis points, larger discounts to new borrowers and existing borrowers refinancing to take advantage of larger discounts. While a lower and flatter interest rate structure puts pressure on bank margins, it is important to remember that the easing in monetary policy will help support the Australian economy which in turn supports the credit quality of the banks' portfolios of loans. The virus is a shock to both demand and supply. Monetary policy does not have an effect on the supply side, but can work to ensure demand is stronger than it otherwise would be. Lower interest rates will provide more disposable income to the household sector and those businesses with debt. They may not spend it straight away, but it brings forward the day when they will be comfortable with their balance sheets and resume a normal pattern of spending. Monetary policy also works through the exchange rate which will help mitigate the effect of the virus' impact on external demand. The effect of the virus will come to an end at some point. Once we get beyond the effect of the virus, the Australian economy will be supported by the low level of interest rates, the lower exchange https://www.rba.gov.au/speeches/2020/sp-dg-2020-03-11.html 11/12 11/03/2020 The Virus and the Australian Economy | Speeches | RBA rate, a pick-up in mining investment, sustained spending on infrastructure and an expected recovery in residential construction. The Government has announced its intention to support jobs, incomes, small business and investment which will provide welcome support to the economy. The combined effect of fiscal and monetary policy will help us navigate a difficult period for the Australian economy. They will also help ensure the Australian economy is well placed to bounce back quickly once the virus is contained. Endnotes [*] Thanks to Lachlan Dynan, David Lancaster and Mark Chambers for their comments and input. I will revisit the topic of investment at a later date. See https://www.rba.gov.au/speeches/2018/sp-dg-2018-12-06.html and https://www.rba.gov.au/speeches/2015/sp-ag-2015-09-16.html © Reserve Bank of Australia, 2001–2020. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2020/sp-dg-2020-03-11.html 12/12 | reserve bank of australia | 2,020 | 3 |
Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, Sydney, 19 March 2020. | Philip Lowe: Speech Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, Sydney, 19 March 2020. * * * Good afternoon. The Reserve Bank Board met yesterday and decided on a comprehensive package to help support jobs, incomes and businesses as the Australian economy deals with the coronavirus. I would like to use this opportunity to explain this package and to answer your questions. We are clearly living in extraordinary and challenging times. The coronavirus is first and foremost a very major public health problem. But it has also become a major economic problem, which is having deep ramifications for financial systems around the world. The closure of borders and social distancing measures are affecting us all and they are changing the way we live. Understandably, our communities and our financial markets are both having trouble dealing with a rapidly unfolding situation that they have not seen before. As our country manages this difficult situation, it is important that we do not lose sight of the fact that we will come through this. At some point, the virus will be contained and our economy and our financial markets will recover. Undeniably, what we are facing today is a very serious situation, but it is something that is temporary. As we deal with it as best we can, we also need to look to the other side when things will recover. When we do get to that other side, all those fundamentals that have made Australia such a successful and prosperous country will still be there. We need to remember that. To help us get to the other side, though, we need a bridge. Without that bridge, there will be more damage, some of which will be permanent, to the economy and to people's lives. Building that bridge requires a concerted team effort, with us all pulling together in the country's interest. On the economic front, there is very close policy coordination between the Australian Government, the Australian Treasury, the Reserve Bank and Australia's financial regulators. We are all in close contact with one another and are working constructively together and we will continue to do so. This coordination is evident in the various policy statements today. Governments across Australia are playing their important role in building that bridge to the recovery, with the various fiscal initiatives from the Australian and state governments providing very welcome support. Rightly, the focus is on supporting businesses and households who will suffer a major hit to their incomes. It is increasingly clear that further help will be required on this front and the Australian Government has indicated that additional policy measures will be announced shortly. Australian public finances are in good shape and the country's history of prudent fiscal management gives us the capacity to respond now. The banks too have an important role to play in building that bridge to the recovery by supporting their customers. Without this support, it will be harder for us all to get to the other side in reasonable shape. Australia has a strong financial system, which is well placed to provide the needed support to businesses and households. The system has strong capital and liquidity positions and our financial institutions have invested heavily in resilience. As APRA confirmed this afternoon in a public statement, the current large buffers of capital and liquidity are able to be used to support ongoing lending to the economy. 1/5 BIS central bankers' speeches The financial regulators have also confirmed that they are examining how the timing of various regulatory initiatives might be adjusted to allow financial institutions to concentrate on their businesses and work with their customers. APRA and ASIC both stand ready to assist institutions work through regulatory issues arising from the virus. The Council of Financial Regulators is meeting again tomorrow and will also meet with the largest lenders to discuss how they can support their customers and whether there are any regulatory impediments in the way. The Reserve Bank itself is also playing a role in building that bridge to the recovery. I will now turn to that. Our major focus is to support jobs, incomes and businesses, so that when the health crisis recedes the country is well placed to recover strongly. Supporting small business over coming months is a particular priority. Prior to today's announcement, we had already taken several steps over recent days to support the Australian economy. Over the past week or so we have been injecting substantial extra liquidity into the financial system through our daily market operations. As part of this effort, we will be conducting onemonth and three-month repo operations each day. We will also conduct repo operations of sixmonth maturity or longer at least weekly, as long as market conditions warrant. As a result of these liquidity operations, Exchange Settlement balances have increased from around $2.5 billion a month ago to over $20 billion today. The Reserve Bank also stands ready to purchase Australian government bonds in the secondary market to support its smooth functioning. The government bond market is a key market for the Australian financial system, because government bonds provide the pricing benchmark for many financial assets. Our approach here is similar in concept to our longstanding approach to the foreign exchange market, where we have been prepared to support smooth market functioning when liquidity conditions are highly stressed. We now stand ready to do the same in the bond market and we are working in close cooperation on this with the Australian Office of Financial Management (AOFM). In addition to these previously announced measures, today's package has four elements. They are: a reduction in the cash rate to 0.25 per cent; a target of 0.25 per cent for the yield on 3-year government bonds; a term funding facility to support credit to businesses, particularly small and medium-sized businesses; and an adjustment to the interest rate on accounts that financial institutions hold at the RBA. I will discuss each of these in turn. 1. A Further Reduction in the Cash Rate to ¼ Per Cent This brings the cumulative decline over the past year to 1¼ percentage points. This is a substantial easing of monetary policy, which is boosting the cash flow of businesses and the household sector as a whole. It is also helping our trade-exposed industries through the exchange rate channel. At the same time, though, low interest rates do have negative consequences for some people, especially those relying on interest income. The Reserve Bank Board has discussed these consequences extensively, but the evidence is that lower interest rates do benefit the community as a whole, although I acknowledge that the effects are uneven. With this decision today, the policy rates set by the Reserve Bank of Australia, the United States Federal Reserve, the Bank of England and the Reserve Bank of New Zealand are all effectively at ¼ per cent. Each of us are using all the scope we have with interest rates to support our economies through a very challenging period. 2/5 BIS central bankers' speeches At its meeting yesterday, the Board also agreed that we would not increase the cash rate from its current level until progress was made towards full employment and that we were confident that inflation will be sustainably within the 2–3 per cent range. This means that we are likely to be at this level of interest rates for an extended period. Before the coronavirus hit, we were expecting to make progress towards full employment and the inflation target, although that progress was expected to be only very gradual. Recent events have obviously changed the situation and we are now likely to remain short of those objectives for somewhat longer. I am not able to provide you with an updated set of economic forecasts. The situation is just too fluid. But we are expecting a major hit to economic activity and incomes in Australia that will last for a number of months. We are also expecting significant job losses. The scale of these losses will depend on the ability of businesses to keep workers on during this difficult period. We saw during the global financial crisis how flexibility in working arrangements limited job losses and this benefited the entire community. I hope the same is true in the months ahead. It is also important to repeat that we are expecting a recovery once the virus is contained. The timing and strength of that recovery will depend in part upon how successful we are, as a nation, in building that bridge to the other side. When that recovery does come, it will be supported by the low level of interest rates. We will maintain the current setting of interest rates until a strong recovery is in place and the achievement of our objectives is clearly in sight. 2. A Target Yield on 3-year Australian Government Bonds Over recent decades, the Reserve Bank's practice has been to target the cash rate, which forms the anchor point for the risk-free term structure. We are now extending and complementing this by also targeting a risk-free interest rate further out along the yield curve. In particular, we are targeting the yield on 3-year Australian Government Securities (AGS) and we have set this target at around 0.25 per cent, the same as the cash rate. Over recent weeks, the yield on 3-year AGS has averaged 0.45 per cent, so this represents a material reduction. We have chosen the three-year horizon as it influences funding rates across much of the Australian economy and is an important rate in financial markets. It is also consistent with the Board's expectation that the cash rate will remain at its current level for some years, but not forever. To achieve this yield target, we will be conducting regular auctions in the bond market. We published some technical details earlier today and we will keep the market informed of our operations. Our first auction will be tomorrow. As part of this program, our intention is to purchase bonds of different maturities given the high level of substitutability between bonds. We are also prepared to buy semi-government securities to achieve the target and to help facilitate the smooth functioning of Australia's bond market. I want to make it clear that our purchases will be in the secondary market and we will not be purchasing bonds directly from the Government. I would also like to emphasise that we are not seeking to have the three-year yield identically at 25 basis points each and every day. There will be some natural variation, and it does not make sense to counter that. It may also take some time for yields to fall from their current level to 25 basis points. I understand why many people will view this as quantitative easing – or QE. This is because there is a quantitative aspect to what we are doing – achieving this target will involve the Reserve Bank buying bonds and an expansion of our balance sheet. 3/5 BIS central bankers' speeches But our emphasis is not on the quantities – we are not setting objectives for the quantity and timing of bonds that we will buy, as some other central banks have done. How much we need to purchase, and when we need to enter the market, will depend upon market conditions and prices. Rather than quantities or the size of our balance sheet, our focus is very much on the price of money and credit. Our objective here is to provide support for low funding costs across the entire economy. By lowering this important benchmark interest rate, we will add to the downward pressure on borrowing costs for financial institutions, households and businesses. We are prepared to transact in whatever quantities are necessary to achieve this objective. We expect to maintain the target for three-year yields until progress is being made towards our goals of full employment and the inflation target. Our expectation, though, is that the yield target will be removed before the cash rate is increased. 3. A Term Funding Facility for the Banking System with Support for Business Credit, Especially to Small and Medium-sized Businesses The scheme has two broad objectives. The first is to lower funding costs for the entire banking system so that the cost of credit to households and businesses is low. In this regard, it will complement the target for the three-year yield on AGS. The second objective is to provide an incentive for lenders to support credit to businesses, especially small and medium-sized businesses. This is a priority area for us. Many small businesses are going to find the coming months very difficult as their sales dry up and they support their staff. Assisting small businesses through this period will help us make that bridge to the other side when the recovery takes place. If Australia has lost lots of otherwise viable businesses through this period, making that recovery will be harder and we will all pay the price for that. So it is important that we address this. Under this new facility, authorised deposit-taking institutions (ADIs) in total will have access to at least $90 billion in funding. ADIs will be able to borrow from the Reserve Bank an amount equivalent to 3 per cent of their existing outstanding credit to Australian businesses and households. ADIs will be able to draw on these funds up until the end of September this year. Lenders will also be able to borrow additional funds from the Reserve Bank if they increase credit to business this year. For every extra dollar lent to large business, lenders will have access to an additional dollar of funding from the Reserve Bank. For every extra dollar of loans to small and medium-sized businesses they will have access to an additional five dollars. These funds can be drawn upon up until the end of March next year. There is no extra borrowing allowance for additional housing loans. The funding from the Reserve Bank will be for three years at a fixed interest rate of 0.25 per cent, which is substantially below lenders' current funding costs. Institutions accessing this scheme will need to provide the usual collateral to the Reserve Bank, with haircuts applying. The first drawings under this facility will be possible no later than four weeks from today. This scheme is similar to that introduced by the Bank of England. Unlike the Bank of England's scheme, though, the interest rate is fixed for the term of the funding. This is consistent with our view that the cash rate is likely to stay at its current level for some time. Another difference with the Bank of England's scheme is that we have not included a higher interest rate if credit contracts. While a decline in credit would be undesirable, including a penalty may act as a disincentive for institutions to take part in the scheme. 4/5 BIS central bankers' speeches We are encouraging all ADIs to use the term funding facility to help support their customers. I welcome APRA's confirmation this afternoon that it also supports ADIs using this scheme. I also welcome the Australian Government's announcement that it will support the markets for assetbacked securities through the AOFM. This support is important as it will help non-bank financial institutions and small lenders to continue to provide credit to Australian households and businesses. 4. An Adjustment to the Interest Rate on Exchange Settlement Balances Under our longstanding framework, the RBA operates a corridor system around the cash rate. Under that system, the balances that banks hold with the RBA overnight in Exchange Settlement accounts earn an interest rate 25 basis points below the cash rate. And on the other side of the corridor, in the event that a bank needed to borrow from the RBA overnight, it would be charged 25 basis points above the cash rate. Under this arrangement and with the cash rate now at 25 basis points, the interest rate on Exchange Settlement balances would have been zero. We have decided to increase this to 10 basis points. We are not making any change to the arrangements for the top of the corridor. This adjustment to the corridor reflects the fact that there will be a significant increase in the balances held in Exchange Settlement accounts due to the combined effect of the Bank's enhanced liquidity operations, bond purchases and term funding program. Maintaining a zero interest rate on these balances would increase the costs to the banking system. In the current environment, this would be unhelpful. The increase in settlement balances is also expected to change the way that the cash market operates. In other countries, where there have been large increases in balances at the central bank, the cash rate equivalent has drifted below the target and transaction volumes in the cash market have declined. It is likely that we will see the same outcome in Australia. The Reserve Bank will continue to monitor the cash market closely and is prepared to adjust arrangements if the situation requires. So these are the four measures announced earlier this afternoon. Together, they represent a comprehensive package to lower funding costs in Australia and support the supply of credit. Complementary initiatives by APRA and the AOFM are also working towards those same objectives. The term funding scheme and the three-year yield target are both significant policy developments that would not have been under consideration in normal times. They both carry financial and other risks for the Reserve Bank and they both represent significant interventions by the Bank in Australia's financial markets. The Reserve Bank Board did not take these decisions lightly. But in the context of extraordinary times and consistent with our broad mandate to promote the economic welfare of the people of Australia, we are seeking to play our full role in building that bridge to the time when the recovery takes place. By doing all that we can to lower funding costs in Australia and support the supply of credit to business, we will help our economy and financial system get through this difficult period. Thank you for listening and I am here to answer your questions. 5/5 BIS central bankers' speeches | reserve bank of australia | 2,020 | 3 |
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