Reserve Bank of Australia Annual Report – 1979 Economic Developments and Monetary Policy
Overseas developments
During 1978/79, there were, in many countries, set-backs to efforts to reduce inflation. Price rises quickened markedly in the United States and stepped up in several other countries. As well as general pressures in price levels, there were substantial increases in prices for oil and for several other major commodities.
In response, governments moved to tighten economic policies. During the first half of 1978/79 the United States, with its currency suffering heavy pressure on exchange markets, tightened monetary policy with sharp increases in interest rates. Japan and West Germany, which early in the year had announced the adoption of more expansionary budgetary policies, later lifted interest rates in the wake of faster rises in prices.
The tightening in policies appeared to reflect a concern to avoid an acceleration of inflation with the harm it can do to longer-run stability, employment and economic growth. During 1978/79, the major industrial economies seem to have grown moderately, at about the same rate as in 1977/78. Unemployment declined in several of the major economies during the year, but remained at historically high levels.
Foreign exchange markets were unsettled for much of 1978/79; in the early months, markets were particularly disturbed, with the U.S. dollar falling heavily against the yen and some European currencies. The adoption by the United States of restrictive domestic policies and, concurrently, the arrangement of a major international support package for the dollar, checked and partly reversed the decline in its value on foreign exchange markets. The effective value of the dollar increased through much of the second half of 1978/79, though late in the year it weakened again.
Developments in Australia
In Australia, some aspects of the economy showed improvement in 1978/79. Gross domestic product, in real terms, expanded more rapidly than in other recent years. Farm production rose strongly and contributed substantially to the overall rise; in particular, wheat production was very high. Prices for farm products were generally firm and rural incomes grew rapidly.
1. ECONOMIC INDICATORS
Aggregate consumer spending for the year increased moderately and private capital expenditure rose. Figures on employment of wage and salary earners in private industry increased after falling for some years.
The balance of payments also improved; as the year progressed, the current account strengthened and private capital inflow picked up. Australia's terms of trade were more favourable than in 1977/78, and there were indications of enhanced international competitiveness in parts of industry. The trade-weighted exchange rate showed a net decline of 3.6 per cent during 1978/79; it was raised a little towards the end of the year. Supported by a Commonwealth borrowing programme smaller than in 1977/78, and aided by substantial changes in the value of gold and foreign currencies, Australia's international reserves rose.
In common with overseas experience, some aspects of the economy presented a less happy picture. Inflation, after moderating for three years, stayed about the same as in 1977/78. Particular influences on prices included increases in wages, rises in meat and oil prices and the higher indirect taxes announced in the 1978 Budget. Despite some rise in employment, numbers looking for work did not fall.
Early in the year, it was considered possible that prospects would be consistent with growth in the monetary aggregates no higher than in 1977/78. In the event, these aggregates grew a good deal more rapidly than in that year. An important contribution to the over-run came from the Commonwealth Government's deficit, which ended up about $650 million above the $2.8 billion for which it had budgeted. Until the end of October, there were strong expectations that interest rates would continue to decline, and bonds were eagerly sought. Soon after, these expectations changed and there was a marked falling away in demand by non-bank groups for Government securities; this further added to monetary growth. As well as this, the improved balance on private external transactions meant, in comparison with 1977/78, a much smaller offset to the expansion of monetary growth from domestic sources. In the second half of 1978/79 official interest rates, which had declined over the previous year or so, increased.
Elements in economic policy
The gains in spending and production during 1978/79 probably owed a good deal to the firmer and steadier course of domestic policy in recent years. On the other hand, factors largely beyond the influence of domestic policy (such as the record wheat crop and improved terms of trade) also helped make the year a better one.
Some of the causes of problems during 1978/79 also lay beyond the reach of domestic economic policy. The task of containing inflation was made tougher by developments in some overseas prices, particularly for meat and oil. The tightening of monetary policies overseas, at a time when there were still expectations that domestic interest rates could decline further, added to difficulties for policy.
But, in the interests of improved conduct of policy in the future, it is useful also to look for the places where economic policy may have had a part in some of the less welcome developments in 1978/79. There has for some years been a general acceptance that budgetary settings have contributed less than was desirable to firmness in monetary conditions; as a consequence, over these years, interest rates were higher than would otherwise have been necessary, and the flow to the private sector of bank, and at times other, credit had to be restricted.
A major source of difficulty for policy in the year just past was the persistence of this imbalance in the monetary thrust of budgetary and of other policies. In framing its Budget, the Government acted to contain outlays, and some hard decisions were taken to raise tax revenue. The task of reducing the deficit was the more difficult because of commitments from past expenditure programmes, and because of indexation of various categories of outlays and of personal income tax scales. Notwithstanding the efforts to cut the budgeted deficit, it remained large in 1978/79.
The hopes that were held at about Budget time for policy outcomes during 1978/79 were ambitious ones. It was envisaged that monetary growth would be no higher than in 1977/78. At the same time itwas thought that there would be a further decline in inflation, which would be conducive to further reductions in interest rates. Similar expectations had led to large purchases of bonds in the previous year.
An important element in achieving modest growth in the monetary aggregates was to be substantial financing of the Commonwealth's deficit by sales of securities to non-bank groups. But, even with the large August Commonwealth cash loan subscription on the record, the task set for sales remained formidable. The need—in a year when borrowing requirements of public authorities in total increased—was for net purchases of Commonwealth securities by non-bank groups similar in volume to the high take-up in each of the previous three financial years.
As 1978/79 developed, it became clear that in the hopes held early in the year too little provision had been made for contingencies. Expectations of further reductions in bond yields receded after October. With private portfolios heavily stocked with Government securities following the succession of big budget deficits, and as the indications gradually emerged of over-run in the deficit for 1978/79, public demand for bonds disappeared. The balance of payments strengthened rapidly late in the year, and, for a time, large rural credits advances (mainly for wheat) from the Reserve Bank also fuelled monetary growth.
The Bank sees the requirements for further improvement in domestic economic conditions and the maintenance of a stronger balance of payments as closely related. Both would benefit from smaller budget deficits. Reduced demands by the public sector help create a suitable monetary environment, with more scope to permit private financing and without the needs—both adverse to activity—for high interest rates or for an exchange rate above the rate which might otherwise be appropriate. It is desirable, in present circumstances, to aim for a rate of monetary growth which keeps a downward pressure on increases in money incomes and expectations about inflation. This rate of growth should not, of course, be so low that it unduly restricts expansion in activity.
2. ECONOMIC POLICY: SOME INDICATORS
Monetary stability
Many countries, seeking to stabilise economies which still have problems inherited from the turbulent earlier years of this decade, have considered it useful to announce an expected rate of growth for certain monetary aggregates. In Australia, announcement of a range for the rate of increase in money, which is expected to be consistent with the economic outlook and budgetary policy, has been the practice in Budget Speeches since 1976. This practice has been envisaged as playing a steadying role, influencing expectations and providing information to decision makers about the likely environment in which they will be setting prices, making wage bargains, and borrowing and lending. In this way it might also help moderate the various demands for higher incomes.
No country has regarded money targets as ends in themselves, to be achieved, unaltered, at any cost. Unexpected developments, and the relative costs of offsetting as against accommodating these, may make it sensible to accept a deviation for a period from the range initially desired. Events in Australia during 1978/79 provided examples of such developments. Some are discussed in the following paragraphs.
The pick-up in the balance of payments arrived late in the year. Only in the June quarter did the sharp improvement in the likely out-turn for the year in private foreign exchange transactions become evident. It added materially to the projected growth in monetary aggregates, but there was little opportunity, in the smooth handling of policy, to take quick and substantial steps to offset it.
A second important factor was the reversal in November of the expectations, which had been engendered in the bond market, of falling yields. Various groups became unwilling to add to their portfolios; many were concerned to reduce their holdings and the overhang of bonds was slow to be worked off. In these circumstances, bond sales virtually ceased, and yields were increased in the second half of the year.
Market transactions indicated that, if the Bank had been a willing buyer, its purchases could have been very substantial. Policy would of course have been well served by large net sales by the Bank; in the event, the most that was achieved was restriction of Bank purchases to moderate amounts.
The traditional official response to a bond market in which sales by the authorities are insufficient is to effect a sharp increase in yields. The increases which were made in the second half of 1978/79 were moderate and took place in stages.
In a climate of official encouragement of—and at times pressure for—interest rate reductions, official yields and interest rates of some major financial groups had been lowered toward the end of 1978. Notwithstanding that it was evident late in 1978 that further interest rate reductions were no longer appropriate, some difficulty was for a time felt in effecting a sudden reversal of the movement in rates. There was need to have regard to some weak positions among financial institutions; and early policy initiatives were the smaller and slower because of the fact that the size of the likely growth in monetary aggregates was not fully evident until the financial year was well advanced.
A third unexpected development which affected directly the rate of growth of the monetary aggregates and, indirectly, expectations about bond rates was the revision after December in the estimated size of the wheat crop. This large crop, together with an increase in the amount per tonne paid as a first advance to growers, added substantially to the amount of the total advance sought from the Bank's Rural Credits Department. The Bank was quick to press for offsetting action to be taken; eventually the Australian Wheat Board's debt to the Bank was reduced by $455 million between the end of March and early June by the sale to non-bank groups of commercial bills. This short-term paper was sold with little upward pressure on discount rates for commercial bills.
There were, of course, reasons on the demand side for accepting some rise in the rate of growth in money; as the year developed, activity looked to be increasing slightly more than had been expected at Budget time; and some exogenous factors (oil, beef, the ultimate impact of rises in indirect taxes) had lifted the rate of increase in prices above that contemplated when the Budget was framed. In these circumstances, pressure against endogenous price increases similar to that intended in projections made early in the year was likely to be consistent with a somewhat faster expansion in the stock of money.
Some of the unforeseen events pushed monetary developments well off a desirable course. The position at year's end was hardly an ideal one from which to enter 1979/80. In assessing the more relaxed monetary environment, it needs to be noted that there have been indications of a pick-up in inflationary expectations and that, although labour costs grew more slowly in 1978/79, wage demands are now becoming more insistent.
Monetary expansion needs to be moved back firmly. The Bank raised its selling yields for bonds in June; in the wake of this, and with the seasonal run-down in liquidity at an end, there have been some non-bank purchases of short securities. The outcome for monetary expansion and the need for further adjustments in the instruments of monetary policy during 1979/80 will be determined largely by decisions about the size of public borrowing.
Economic policy and unemployment
A deeply troubling fact in the year just past was the persistence for the fifth successive year, and despite some growth in numbers employed, of a rate of unemployment much higher than in any earlier post-war period. Of particular concern for society in the long term is the fact that average unemployment rates for young people have remained very high, three or four times the rates for adults.
Views on the best way to respond to this situation differ. Some people seek more stimulatory budgetary and monetary policies. Others seek better results, at least in the longer run, from firm and steady settings of macroeconomic policies.
Expansionary policies may offer some immediate relief through, for instance, more government employment. However, in assessing such proposals, there is need to consider the contribution that the firmer and steadier stance of policy in the previous few years made to the pick-up in private activity that did occur in 1978/79, and also to recognise the risks for inflation and confidence of the relaxation of financial conditions which in fact took place in that year. Proposals for easier policies have to take account of possible adverse sensitivity of the private sector to an enlarged budget deficit and to the monetary expansion which could ensue, with potential for a resurgence of inflationary expectations and of inflation itself. This is important because of the impact which inflation has been seen in past years to have on the willingness of consumers and businesses to plan forward, to spend and so to create more jobs. There is also the matter of the vulnerability of the balance of payments to faster growth in domestic liquidity. For these and other reasons there must be doubts about the extent to which unemployment can be reduced simply by demand stimulus.
As far as monetary, budgetary and external policies are concerned, their best contribution to reducing unemployment in the long run seems to be in fostering firm and stable conditions which will provide a basis for confident operations and for expansion in private industry, and which will go some distance towards giving pause to those who seek to raise prices and wages.
Although the case for this overall setting for policy cannot be bolstered by the promise of early or spectacular results, the alternatives seem to offer little in the way of a long term solution. The progress that has been made with inflation, international competitiveness and business and consumer confidence in the past few years is not yet cemented in place and would be a good deal more difficult to win a second time around. The real choice is not between tightening and relaxing; it is between on the one hand, tightening now and holding firm, and on the other, having to tighten again and perhaps more firmly some time in the future.