Transcript of Question & Answer Session Address at ‘Governor Talk' event at the International Monetary Fund

Thank you Governor for the very informative talk. Before I open the floor, let me ask you one or two quick questions. Let me focus on your second issue, low r-star. This is actually a big topic in this annual meeting. The interest rate is too low for too long and monetary policy seems to be overburdened, and as a solution it looks like you suggested some structural reform including investment to make r-star go up. But … I believe structural reform will take a longer time. In between, to avoid some negative side impact of this low interest rate, do you think any macro-prudential policies or micro-regulation or even the role of fiscal policy will address the issue in the short term?

Thank you, that's a good question. As I said, the underlying issue is an imbalance between saving and investment intentions. A lot of people want to save and not many people want to use those savings to invest in new capital. Structural reform certainly can improve medium term growth prospects.

But I think it can actually make a difference in the short run as well because if a country has a comprehensive program of structural reform, firms are more likely to want to invest now and in the next little while. So I don't think it's just about long term growth. It's about creating an environment today where firms feel confident to invest, expand and innovate. And if we can do that, I think you can change the dynamics quite quickly, particularly if we can reduce the risk premium that firms require for new capital investments. Because you can think about what's happened in the global economy. The risk premiums have gone up and the central banks have lowered interest rates. So that's left the hurdle rate of return unchanged. The lower interest rates are just compensating for the higher risk premiums. So if somehow we can reduce the risk premiums, we can get the benefit of the lower interest rates. But unless we reduce the risk premiums, we cannot get the benefit of the lower interest rates because firms' hurdle rates of return on investment don't change.

You asked about whether macro-prudential policies can offset some of the negative effects of lower interest rates. And I think the answer to that is basically, no. I'm not particularly optimistic that macro-prudential policies can work. And I say that for a couple of reasons. The first is that many of the risks that people are identifying are really outside the banking system. They're in market-based finance and we don't have macro-prudential instruments to deal with market-based finance, or not very effective ones. And the second point I'd make here is that it would seem curious to me to lower interest rates to stimulate our economy and simultaneously say we're very worried about borrowing. Because the way that low interest rates work is to encourage borrowing. So to say we want to offset the effect of low interest rates with macro-prudential instruments, which basically limit borrowing, seems to be working against the effect of low interest rates. So I'm not confident that macro-prudential policies can work to offset the negative effects of low interest rates.

You asked about fiscal policy and, in some countries, I think there is a role for fiscal policy, because fiscal policy is one of the things that's affecting both savings and investment. Now with properly designed fiscal policy, you can encourage the private sector to invest and the government can reduce public sector savings where there's scope to do that. So I think if we could do this globally, we'd change the saving-investment balance and ultimately a return to higher interest rates because firms want to invest. Fiscal policy would be part of the story there.

So I have many things, but I'm expecting that my fund colleagues will challenge you later, but I move to my second question. You mentioned flexibility of exchange rate worked very well for Australia. Many of my colleagues in ASEAN countries and East Asian countries are very jealous about that, because they usually believe FX flexibility sometimes can be a sharp amplifier … So what kind of recommendation can you make for them to change this sharp amplifier situation …

I don't know that I can give them any advice but I can reflect on our own experience because we are really the poster child, as I said, for a country that benefits from a floating exchange rate. For us, the exchange rate is the great stabiliser. I don't like saying this but I think the exchange rate is a better stabiliser than our own monetary policy. There are a few reasons why we're in that position.

The first is that our exchange rate tends to move very closely in line with commodity prices, so when commodity prices are high and there's a lot of income coming into the country and investment is higher, the exchange rate tends to appreciate, and so that's a stabilising force. A second factor is that the exchange rate pass through to prices is fairly limited. That's partly because of the credibility of the monetary policy framework and the institutional credibility the country has, so that helps. Another thing that helps is that Australian businesses aren't really well integrated into global supply chains because of the structure. Our exports are largely commodities, so that's not something that many countries in Asia face. And another thing that's been really important for us is that while Australian companies borrow offshore in foreign currency as do many companies in Asia, they are always able to hedge those foreign currency borrowings back into Australian dollars in the swaps market.

So they effectively turn their foreign currency borrowings into Australian dollar borrowings using the foreign currency swaps market. That's a really important element of our setup, and that ability to do that has emerged over time. When we first started floating, it didn't really exist because the hedging markets didn't exist. When we started floating in the early 1980s, there was a tendency to try and control the exchange rate. We used to do … Well it wasn't called intervention, it was called smoothing and testing. And we did that a lot, but over time we felt like it was actually better to let the exchange rate move a lot. And I say that mainly because it affected people's incentives. When the exchange rate starts moving a lot, businesses know they have to hedge, they learn, the psychology develops, they have to hedge and the markets developed to support that hedging.

So … my advice, to the extent that I ever give it, is you've got to let the exchange rate move and it's always uncomfortable when it's moving, even in our flexible system. Sometimes you look at the exchange rate and say, well, we don't really like that, but in the end it's good for you. And one reason it's good for you is that it creates the incentives for both businesses and the institutional structure to develop. That then allows you to later live with a flexible exchange rate. But if you don't let the exchange rate move, the culture and the institutions don't develop to allow you to live with a floating exchange rate and you say it's all too hard.

Well noted. We have about eight minutes, less than eight minutes, so why don't I open the questions. The gentleman over there?

Thank you … I have a question on monetary policy. You mentioned that NAIRU might be even below 4.5. You're now of 5.2% unemployment rate. You're below the inflation target. It sounds like the RBA has still a lot of work to do in terms of delivering monetary policy easing, and you might be soon hitting the zero lower bound. Should we assume you're soon going to go to negative rates or other forms of less orthodox monetary policy implementation? Thank you.

That wouldn't be the assumption I'd encourage you to make. Actually, the economy has been through a very soft patch over the last year, but it's actually gradually improving. The lower interest rates are working. The commodities cycle is now in a slight upswing, so the resource sector, which has been a contraction on the economy for the last six or seven years is now in expansion phase.

We've had some tax cuts and the housing market, which had been in decline for the last year and a half has now turned around so that's going to support household consumption. I think it's quite probable that we'll see a return to trend growth over the next year, which will be good, which will help get the unemployment rate down and gradually wages will pick up. So I don't think it's the right assumption to make that we're going to have a lot more work to do to get inflation back to target and growth back to trend. It's possible but I wouldn't assume it.

Other questions? Actually, while we are waiting for questions, I have one immediate question. While listening to your speech, you mentioned that you think about the global environment, given the global interest rate goes down, you're worrying about some spill overs for the exchange rate appreciation, so you adjust the interest rate to be consistent with the inflation target, right?

Is that the kind of trend that will cause some kind of competitive devaluation across the world? If everyone is thinking about the lower global interest rate's impact on the exchange rate appreciation, whatever the monetary framework they have to adjust it, then everyone cut the interest rates. So in some sense, indirectly they are worrying about appreciation. So it's a kind of competitive devaluation?

No, I don't see it in those terms. It's not like we're trying to compete to get the exchange rate lower, but no one wants, or very few countries that I know, want a higher exchange rate. Most people would like more jobs and a bit more inflation and a lower exchange rate helps with that. So if the major countries are cutting interest rates because global rates are coming down and as a small open economy you don't cut your interest rate as well. What happens to your currency? It goes up and that's not helpful.

I don't see this as a competitive depreciation. It's really the way that the system's responding to shifts in global interest rates. And I think there is an issue about the effectiveness of monetary policy here though, because one of the channels through which monetary easing works is through the exchange rate. We all know that. But if we all ease monetary policy at the same time, which is broadly what's happening, there is no exchange rate effect for any of us. We don't trade with Mars, we trade with one another. So we all ease monetary policy hoping to get the exchange rate channel, and if we all do it, it doesn't work. So we're left with the other channels of monetary policy transmission, which at the moment are pretty muted.

Sorry, this is why I'm kind of sceptical about the benefits of monetary easing to deal with the global problem we face, which is high risk premiums. You can't offset high global risk premiums with adjustments in interest rates.

I was a little bit impatient, I should have waited for questions. Given that we have only four minutes, why don't I take three questions all together and ask one or two answers all together please. So Tony and the gentlemen over there and the gentlemen over there. So quick questions, okay.

Very illuminating speech. My question is on the risk premiums. So what's your view on the role of monetary policy in influencing risk premiums and also is there any difference between risk premiums in taking risks in real investment? You seem to be alluding to that but also, we seem to have this view that risk premiums and financial risk taking has been actually quite low.

And then, another gentleman. Sorry, I cannot see …

A question about how you think about the trade-offs between, say, negative rates and QE. Should you need to go there? What are the costs and benefits of both of those options in Australia specifically?

And one more question there and then we'll close the floor.

Thanks so much, Governor. My question has to do with the channels that you suggest for resolving the imbalance between investment and savings. And I wonder what you make of the more pessimistic theories that most of them has to do with demographics in advanced economies. So even if you resolve geopolitical uncertainties, that imbalance might still be there: Less need for investment and more need for savings.

Now, Governor, you have three minutes … so please.

On whether monetary policy is driving the higher risk premiums. I don't really think that's the underlying issue here. There's an endless list of geopolitical uncertainties, which I'm not going to recite them all in this building, but there are also large uncertainties about technology and about the effect of globalisation on firms and businesses. They're the underlying uncertainties that businesses talk about, not monetary policy. I think you're right in identifying a distinction between the risk premiums required on new capital investment and the risk premiums required in investing in existing assets, particularly financial assets. Those risk premiums are compressed partly because of what's going on with monetary policy, but what's ultimately important for the real economy is the risk premiums that firms acquire on investing in new physical assets and they're very high for the reasons I just talked about. The solution to the problems we face is to reduce those risk premiums and to give firms the confidence to invest again.

If you don't mind, I'm not going to speculate on negative interest rates and quantitative easing in Australia other than to say I think negative interest rates are extraordinarily unlikely in my country. And on savings and investment issues, demographics is really important in driving the rising global savings. Populations are ageing, people are living more years in retirement and if you look at the global demographics, the share of people in the working age years had been steadily rising for decades and now it's declining. So there are more and more people in peak saving years and we know we're going to be in retirement for more years and people haven't saved enough for that. Particularly with income growth having slowed down, people are not generating the income that they used to, so they're having to save more for their retirement. And that's having a first order effect on global saving outcomes.

I think the rise of Asia as well with the high saving rates, that's driving global savings higher. So that suggests that interest rates are going to be low globally for a long period of time unless we can change the dynamics about investment. And I'm optimistic that that can be done. Now if we can reduce the risk premiums, reduce some of the global uncertainties and governments commit to comprehensive programs of structural reform, businesses will start investing again at a rate we haven't seen for a long period of time.

After all, since the financial crisis, there really is a shortfall of investment. So the capital stock in many of our countries is getting depleted, not just business capital stock, but the infrastructure capital stock, is being depleted. So if we can reduce the risk premiums and we have low rates, I think investment could pick up quite quickly even with the elevated global savings. But the fact that global savings is high mean interest rates are going to stay low for a long period of time. Let's not hope as low as they are now though.

Yes, thank you. I think I have to close this wonderful learning opportunity given the time constraint … Thanks very much, Governor.