Reserve Bank of Australia Annual Report – 1977 Economic Management and Monetary Policy

Progress in restoring stability in the Australian economy was slow in 1976/77, and, at the start of 1977/78, inflation and unemployment were still at high levels. Policy actions taken over the past two years have gone some way towards correcting some of the problems basic to the economic instability of recent years; reflecting the extent and nature of those problems, a sustained reduction in inflation and a strong recovery in economic activity has been slow to emerge. In the meantime, a firm and balanced setting of policies remains essential to the restoration of better conditions; attempts to reflate activity too quickly could, in present circumstances, lead to renewed economic difficulties.

Inflation remains at the root of Australia's economic difficulties. Its persistence in recent years at high levels has undermined efforts to resolve other problems affecting the economy. Inflation has been a contributing factor to a rate of unemployment substantially above that of earlier post-war years. It has caused consumers generally to be cautious in their spending; it has eroded business confidence, and investment — particularly of a longer term kind — has been seriously depressed. Rapid inflation has also worked to increase the penetration of imports in domestic markets, has raised exporters' costs, and has led to reduced confidence in the future course of the Australian economy and a much reduced rate of foreign investment.

While inflation is fundamental to the economic malaise, persisting high and rising unemployment is a matter of deep concern. It is involving personal hardship for many, especially the young, through loss of income and job experience and through inability to achieve a stable self-reliant role in the community. It also involves a cost to the community, not just in loss of potential output but, importantly, in a deterioration of the social environment. Causes can be identified on both the demand and cost sides. Although the weakness and hesitancy in aggregate demand are important factors, the current unemployment, particularly that of females and juniors, appears to be reflecting also influences on the cost side. The steepness of the rise in numbers unemployed during the initial part of the most recent economic downturn appears, in part, to have been related to the way in which increases in labour costs in 1973 and 1974 outstripped the increase in final prices of goods and services. To some extent, unemployment has stayed high because real labour costs have remained high. Additionally, the recent sharp changes in the pattern of relative wages may be contributing to high unemployment rates for particular groups, notably young people.

A policy aimed at providing a strong stimulus to aggregate demand can reduce the level of unemployment in the short run. However, the complex nature of the current unemployment problem is such that a policy of this kind at present would be unlikely to lead to a substantial sustained pick-up in employment or a sizeable reduction in unemployment — such as might have occurred in previous upturns — without a marked strengthening of inflationary pressures. This would, in turn, ultimately depress activity and employment prospects even further. In short, success in achieving a sustained reduction in inflation is essential to success in dealing with unemployment.

An important aspect of Australia's inflationary difficulty relates to the way inflation is being allowed for explicitly in many forms of economic behaviour. Examples are in the award wages area and in various kinds of government outlays (such as social services and — indirectly — grants to States) and receipts (personal income taxes and some deductions from corporate tax payments). Some of these arrangements may be desirable for a number of reasons, such as equity, or they may be intended to dampen the general level of inflationary pressures. Without offsetting measures, however, they can also tend to slow the possible pace of a decline in inflation. As far as the Budget is concerned, a major consequence of the effective indexation of outlays and taxes is that the task of reducing the budget deficit becomes even more formidable.

Deficit spending by a government can be financed in a number of ways. The more the government finances its deficit through money creation (rather than by borrowing from the private sector), the greater will be the likely inflationary impact of the deficit spending. Financing of the deficit through the sale of government paper to non-bank groups is generally less inflationary, though there is unavoidably a net impulse towards inflation inherent in a large deficit, partly because of its effects on expectations, and partly because some forms of government paper are very liquid. The inflationary impact of a substantial government deficit financed by the non-bank sector tends, in general, to be stronger than that of a smaller budget deficit.

A deficit which is financed by sales of government securities carries with it the need for the government to float debt issues that compete with private debt instruments in financial markets. At a time when the authorities are seeking to restrain growth in the monetary aggregates, this tends towards continuing upward pressures on interest rates, particularly if there are also strengthening private sector demands for funds. High interest rates have selectively depressing effects on activities that depend on longer term borrowing — notably, private spending on consumer durables, housing activity and business fixed investment. Higher levels of interest rates also work to reduce the value of some existing assets and to accentuate strains in financial markets.

When an unduly large budget deficit is the dominant factor of expansion in the financial sector, the position of monetary policy can be invidious. By raising interest rates and operating with various direct controls there is the possibility of preventing the injections of liquidity from feeding into an excessively high rate of monetary expansion. However, where interest rates are already high, concern about the effects that further increases may have on financial markets and on activities that depend heavily on credit is likely to halt the process well short of adequately compensating for the budgetary imbalance. Equally, the scope for expanding finance with the aim of increasing the level of activity is circumscribed, because to press such action far would be to rekindle the inflation.

The problems of very heavy use of direct monetary policy controls are well known. The controls tend, in time, to be circumvented by the development of new channels of financing because needs for finance are not being directly met through the normal outlets. However, this process of adaptation can be slow, and, at the initial stage, the controls generally result in increases in the cost of finance as the queue of borrowers lengthens. Increased costs and reduced availability of funds may have some benefits on stabilisation grounds, but there can also tend to emerge various non-price rationing devices having effects that are unsatisfactory on both distribution and efficiency grounds. Such controls also invite the establishment or extension of schemes which fragment financial markets by seeking to give favoured allocation of scarce credit for “preferred” or “desired” purposes. The aim of such schemes is to insulate certain sectors from moves to tighten the overall stance of monetary policy. Among the consequences are a weakening in the overall thrust of anti-inflation policy whose success is often particularly important to the very groups being shielded.

As 1977/78 begins, with the persistence of weak activity and of high unemployment, the crucial task remains that of bringing down inflation. Appropriately firm stabilisation policies are an important element in achieving this goal. If activity and confidence are to grow, stability and consistency in policy-making are needed as part of an environment in which the private sector can plan ahead with more certainty. Stable policies are more readily maintained when there is a suitable balance between fiscal and monetary policy.

An essential element of anti-inflationary policy in 1976/77 was reduction in the rate of growth in the monetary aggregates. In that year, the expansion of the money supply was substantially reduced, though there were some large within-year variations in the pace of growth. While the budget deficit for 1976/77 was lower than that for the previous year, it was still large and monetary policy had to carry much of the task of bringing down the growth rate of monetary aggregates. The sequence of policy actions included both increases in interest rates and an extension of direct controls. But it was clear that limits existed to the use of monetary policy; it could not alone hope to compensate where changes were needed in the settings of other policies (particularly in the first part of the year) without imposing strains on financial markets or inducing substantial distortions in credit allocation.

In 1977/78, a containing of the budget deficit remains an essential ingredient in restoring a more balanced mix of policy. Though firmness in fiscal policy runs the risk of engendering lower activity and employment in the short run, a smaller deficit assists the desired easing downwards of the rate of growth of monetary aggregates to an acceptable pace, and reduces the pressures towards further tightening of monetary policies such as escalation of official interest rates or restraint on lending to the private sector. A suitably balanced mix of domestic demand management policies also can strengthen the external position and moderate cost pressures to provide a sound basis for recovery. As recovery proceeds, private demand for finance will expand, and this will require that budgetary policy provides scope for adjustment of the balance between the Government's call for finance and the pace at which private sector lending can be increased.

Although the process of redressing imbalances in the economy continued in 1976/77, the extent of the damage suffered by the economy has been such that much remains to be done. The private sector, as well as government, will have a role in restoring sustainable growth, price stability and full employment; this is not a simple process, and the goals are unlikely to be fully achieved quickly. The emphasis on ending the inflation needs to be maintained because continued inflation is incompatible with a healthy Australian economy. The return to economic prosperity will be quicker and sounder if overall economic policy continues to be firm and if there is continued improvement in the balance between fiscal and monetary policy.