Reserve Bank of Australia Annual Report – 1967 Objectives and Problems of Policy

The year began with some slight excess domestic capacity and, allowing for exceptionally heavy capital inflow, a fairly favourable balance of payments. It was clear that both spending and domestic capacity to produce would rise but there was less certainty about the rate at which the relationship between these two items might change. Some deterioration was clearly to be expected in the balance of payments and a fall in international reserves seemed to be inevitable but its expected size was not immediately worrying.

Policy was therefore confronted with some conflict between the objectives of domestic and external equilibrium but the conflict was not very great. In the light of the economic situation at the beginning of the year, the stimulus required to achieve domestic equilibrium was only small and did not seem to be likely to cause any substantial deterioration in the balance of payments.

With activity at about the desired level, variations from month to month in the major economic indicators kept raising doubts about the direction in which the economy might be moving. Lags before policy becomes effective make it desirable to act quickly but on the other hand there is, particularly during periods such as that under review, always the risk that action taken too early later proves to have been unwise.

The general policy framework for the year was set by a moderately expansive Budget. Monetary policy complemented fiscal policy by making a number of small adjustments to the cost and availability of finance. A strong rise in bank and public liquidity was permitted but relative interest rates were such that a sizeable part of loanable funds was attracted into channels most subject to influence by the monetary authorities.

Bank Lending

In 1965/66 monetary policy had required trading banks to exercise restraint on new lending apart from lending to alleviate effects of the drought. These restraints were largely removed during the first half of 1966/67. By means of this action it was hoped to provide a modest stimulus to expenditure and, in particular, ensure that investment projects were not unnecessarily restricted by a shortage of finance in a situation where capital inflow from overseas was falling.

At the beginning of 1966/67 there were also some qualitative controls on bank lending. Thus banks had been requested to favour lending for productive purposes rather than for consumption, to refrain from adding to pressure on the construction industry and to avoid lending for speculative stock building, particularly of imports. Since the easing in activity during 1965/66 had been fairly widespread these requests were no longer appropriate and consequently were withdrawn. The only specific requests retained were for banks to continue to favour lending for drought relief and to maintain their lending for housing.

To ensure that a high level of finance was available for housing, the Bank also requested the savings banks to continue their aggregate housing loan approvals at a rate not less than that in the six months to June 1966.

Graph 3

Selected Interest Rates

Since a high level of unused overdraft limits could make it more difficult to impose effective restraints on lending if pressure on resources re-emerged, the trading banks were also requested to continue to maintain a high level of cancellations and reductions so as to avoid the emergence of excessive unused limits. In the event there was little change in the ratio of undrawn overdraft limits to total limits over the year as a whole and the undrawn limits at the end of the year included some amounts which will be drawn over a fairly lengthy period.

Early in the final quarter of the year, when trading bank lending had increased substantially and activity was rising more rapidly and was being reflected in a rising level of imports, trading banks were requested to moderate their new lending. This request also took into account the decline in bank liquidity that seemed likely in the closing months of the year.

Statutory Reserve Deposits

Apart from a reduction to provide part of a replenishment of the Term Loan Fund Accounts the Statutory Reserve Deposit determination was not changed during the year. In order to ensure that banks were in a position to meet reasonable demands for finance there was no change in the determination for monetary policy purposes during the upswing in liquidity even though this was expected to be stronger than usual. Over the closing months of the year it was felt that the decline in liquidity resulting from the Government's financial transactions and falling Rural Credits advances adequately reinforced the modest restraints that had been placed on lending without, at that time, requiring the further support of a rise in the Statutory Reserve Deposit determination.

Interest Rates

Short and medium term interest rates tended to decline during the first half of the year but almost all long term rates were unchanged throughout the year. The decrease in rates was largely a reflection of market pressures in a situation where there was a strong increase in private sector demand for highly liquid short term investments.

Interest rates on trading bank fixed deposits for periods up to 18 months were reduced by 0.25 per cent per annum in August. Government security yields remained steady until October, but in a situation where the private sector was running a substantial financial surplus and at the same time there were expectations of a fall in yields, there was a strong demand for Government securities and sales from the Bank's portfolio, subscriptions to loans and issues of Treasury notes were all very high. During November and December short term Commonwealth bond yields fell by almost 0.45 per cent per annum while yields in the ten year area fell by about 0.15 per cent. The issue yield on Treasury notes was cut by 0.32 per cent per annum at the end of December. Over these two months a significant part of the demand for short dated Government securities was reflected in subscriptions to Treasury notes. Since the beginning of 1967 there has been little further change in Government security yields.

In recent years and especially in 1966/67 the annual fluctuation in liquidity has become more pronounced, with the upswing being accompanied by a strong demand for Government securities, in particular short dated issues but also medium term maturities. This has involved the Reserve Bank in large net sales of securities over the period of rising liquidity. Thus in each of the past two years between July and the annual peak in liquidity net sales were about $375 million; in 1964/65 net sales had been about $130 million. These transactions require the Bank to have a volume and variety of securities appropriate to the specific demands of the private sector. Action has been taken, from time to time, to increase the size and improve the suitability of the composition of the Bank's portfolio for this purpose. Operations to increase the size of the portfolio have taken the form of the issue to the Bank of bonds in lieu of Treasury bills, and the composition of the Bank's portfolio has been improved by exchanges with other official holders of securities of one maturity for securities of some other maturity. During 1966/67 there were several of these transactions. At the end of the year the Bank's portfolio of marketable securities was almost $115 million higher than at the beginning of the year.

The balance of payments argued against a reduction in long term interest rates during the year. Capital inflow was falling and, in addition, during the first half of the year interest rates in overseas capital markets were rising. A reduction in domestic rates would have decreased the incentive to use funds from overseas sources at a time when domestic rates were not inhibiting borrowers from entering into additional commitments in Australia. These considerations were given support by the fact that, at existing interest rates, an increasing number of overseas-controlled organisations were proposing to borrow in Australia.

In formulating interest rate policy it was also necessary to keep in mind the strong rise in liquidity expected during the year. While an economy is operating at less than full capacity high levels of liquidity are unlikely to give rise to immediate problems and may help to achieve in-increased expenditure. However, high liquidity can be a potential source of instability as the economy approaches the limits of its physical capacity. In these circumstances an increase in the willingness of individuals to raise their expenditure can put excessive pressure on supplies and lead to inflationary conditions. Policy action necessary at this stage is likely to be more effective if the claims held by asset holders are with institutions whose policies are less likely to support sudden upsurges in credit-financed expenditure. For these reasons and the long run issues discussed in the next section interest rates on bank deposits and yields on Government securities should be kept at competitive levels; banks' lending policies can be more directly controlled and government expenditure is not in the short run affected by increased demand for their securities.

During the year under review, prices of goods and financial assets, other than short term issues remained fairly steady. Asset holders seemed content with enlargements in their portfolios of safe assets, particularly those with high liquidity. Even so, these portfolios did not rise much faster than Gross National Product. The table on page 9 shows recent changes in some selected categories of such financial assets relative to Gross National Product.

Longer-run Issues

In the long run the banking system's share of total financing should be determined by the banks' relative efficiency in performing financial services and it is desirable that this is not distorted too much by the application of monetary policy.

The banks' share of financing, in fact, continued to increase during 1966/67. This was partly due to some hesitancy in demand in areas of expenditure more commonly financed by non-bank intermediaries. An apparent shift of preferences towards holding financial assets in more liquid and safer forms probably also contributed. However, specific policy actions in recent years would also have played a part. The most significant of these was the higher level of fixed deposit interest rates which have applied since the end of 1960. Since then banks have been offering a range of deposits which has been attractive and asset holders have been willing to hold a significant amount of their assets in such forms.

Banks have also been extending the range of their lending activities. Term loans and farm development loans had been introduced earlier and during 1966/67 banks were permitted to make personal instalment loans and to provide bridging loans at reasonable interest rates but above the maximum overdraft interest rate. These developments further increased the competitiveness of banks in relation to non-bank financial intermediaries.

A rise in the banks' share of financing increases the direct influence of monetary policy, provides competition to higher cost lenders and can increase the indirect impact of policy on the operation of financial intermediaries by affecting the cost and availability of funds.

In all of these matters the Bank has had the benefit of frequent discussions with trading and savings banks. Apart from these meetings there have been many opportunities for informal, but useful, exchanges of view. Regular meetings with pastoral finance companies, life offices, finance companies and other sections of the financial community have also proved to be helpful.

The simultaneous achievement of domestic and external balance and rapid growth is likely to continue to pose a challenge for policy. Since our foresight is limited, we would do well to encourage the flexibility and competitiveness which makes for easier adjustments to domestic and overseas developments.

Over the next few years policy will be confronted with problems in our international payments. Exports seem likely to continue to grow rapidly with exports of minerals and manufactured goods becoming increasingly important. Imports, however, will probably also follow a significant upward trend as demands associated with rising defence commitments are superimposed on the rising level of imports generated by increasing domestic activity. Redemptions and repayments of official debt abroad will be very high in coming years. Official raisings will be influenced by conditions in overseas capital markets. Australia is likely to remain an attractive investment outlet but the inflow of funds to the private sector will also vary to a large extent with financial conditions overseas.

Some forces may moderate possible conflicts between the various objectives of policy. Thus conflicts between domestic and external balance tend to be mitigated, in the long run, by changes in relative prices; price levels may be sticky downwards but prices relative to those abroad can change in a situation where prices in most countries are following an upward trend. Changes in growth rates may also provide an adjustment to balance of payments difficulties.While it is advantageous for an economy to grow rapidly, the potential rate of growth is limited by the capacity of domestic resources and the resources that can be attracted from overseas, and rapid growth is unlikely to be sustained in the absence of a manageable balance of payments.

Prospective levels of exports will depend to a large extent on the growth of world markets and productive capacity overseas. Increases in domestic productivity would assist our balance of payments by making increased exports possible and reducing the relative advantage of imports. Positive action to increase demand for our exports includes the continued development of trade with a wider range of countries and reducing the effect of restrictive export franchises. Our competitive position in world trade requires effective use of our considerable endowments of natural resources and our human skills.

Encouraging capital inflow can help to overcome temporary balance of payments difficulties. In addition, the stimulation of capital inflow seems to be advantageous in the long run since it is likely to enable the rate of growth to be faster than would otherwise be possible. In view of the resources available in Australia increased capital—and population—could be used profitably and the incidence of debt burdens could well diminish as larger-scale production becomes practicable.

The availability of capital from overseas does not mean that we should be indifferent to domestic choices between consumption and saving. An increase in domestic saving increases the potential growth possible with a given rate of inflow. At the same time it increases the possibility of local participation in ventures being undertaken by overseas affiliated companies. However, measures to stimulate domestic saving should not be carried to the stage where aggregate spending is inadequate to sustain domestic balance.