Reserve Bank of Australia Annual Report – 1980 Monetary and External Policies

1. The Economic Background

Disturbances in world economic conditions were a troublesome background to our monetary and external policies in 1979/80. Inflation worsened markedly in many western countries. A factor in this was the sharp increase in the price of oil, although earlier settings of macro-economic policies also contributed. Prices for commodities, including gold, rose sharply, reflecting international political tensions as well as uncertainty caused by economic developments.

In general, countries responded to the acceleration in inflation by tightening policy, especially monetary policy. Interest rates rose to high levels, particularly in the United States. In that country, they subsequently fell sharply late in the financial year. There were wide fluctuations in exchange rates over the year, in part reflecting differences in economic and monetary experience. Patterns of international payments changed substantially as a result of the increases in the price of oil. Economic activity tended to slow, particularly in the United States.

In the domestic economy, some aspects improved. Non-farm production grew firmly, and employment had its largest increase for some years. The current account of the balance of payments was strong, benefiting from the state of world markets, the large supplies of rural exports, and the gains in competitiveness generally that had been achieved over preceding years. Other aspects were less favourable. Unemployment remained high; it showed signs of improvement early in the year but later rose, reflecting an increase in the rate of participation in the labour force. Prices faced renewed upward pressure, partly as a result of higher world inflation and increases in the price of oil; the rate of inflation increased.

2. Patterns of Money and Finance

The immediate objective of monetary policy in 1979/80 was to achieve some slowing in the rate of growth of money and credit. The purpose of this was to support a more general aim of bringing about a lower rate of inflation. Achievement fell short of the objective.

In fact, in 1979/80, for the second year running, the monetary aggregates grew much faster than was needed to sustain activity and at the same time to control inflation. This was in part the other side of Australia's good performance in external trade and payments, and in part the result of some slowness in domestic policy reactions – even though the Commonwealth Budget deficit was nearly halved. Towards the close of the year, new arrangements for sale of Commonwealth securities enhanced the effectiveness of those market instruments.

The year's increase in money volume (M3) was nearly 13 per cent, more than in any year since 1975/76, and contrasting with the recent low of 8 per cent in 1977/78. This was despite the fact that the savings banks, whose deposit interest rates tended to lag behind competing rates, increased their deposit liabilities by only 7 per cent. Liabilities to the public of non-bank financial corporations (including building societies, finance and money market houses) – not included in M3 – grew by about 16 per cent.

VOLUME OF MONEY

For the major trading banks, faced by heavy demands from their customers for finance (often at the official maximum interest rate on overdrafts under $100,000), total advances rose by 17 per cent. The Reserve Bank's guideline for this figure, issued in September 1979, was no more than 10 per cent. Much of the over-run was accounted for by fuller use of overdraft limits; there is room in this area for attention to possibilities and techniques for getting results closer to intentions.

The cost of bank finance was a substantial factor affecting usage of bank loans in 1979/80. The rise in interest rates abroad tended to divert demand for finance to domestic, and in particular, banking sources. During the first half of the year, banks were able to finance lending at existing interest rates. As the second half of the year advanced, deposits became more costly and banks raised their interest rates on large loans, on which there is no official ceiling. They also raised rates on small non-housing loans to the ceiling of 10.5 per cent.

Banks made it known during the second half of the year that they were feeling strongly an operational need to raise the interest rates on their housing loans. The need stemmed from the loss of competitiveness of savings bank deposit investment accounts. Banks raised interest rates on housing loans to 10 per cent in April but, against a discouraging official attitude to such an increase, they refrained from raising these interest rates to the 10.5 per cent ceiling until, in July, the way was opened for them to do so.

At the end of the year, with interest rates paid and charged by banks pressing strongly on existing ceilings, banks' competitive position was restricted; the structure of relativities in interest rates did not reflect the risks and costs of lending. For these reasons, and because a greater measure of responsiveness in bank interest rates assists in establishing a suitable pace of bank lending, it remains desirable to give banks more flexibility in respect of interest rates.

Whereas for some years the balance of payments had been a net drain on the money supply, in 1979/80 it made a positive contribution. High private capital inflow and a large reduction in the current account deficit went a long way to offsetting the effects on the volume of money of the cut in the Commonwealth Budget deficit. With monthly movements of apparent private capital inflow erratic, it was late in the year that the full extent of the balance of payments turn-around was recognised.

Although this development in the external accounts may have provided some explanation for growth in money volume a little higher than was initially thought desirable, the recorded increase of almost 13 per cent does not contribute to containment of inflation. Most indicators on a broad front suggest that Australian domestic inflation at year-end was about 10 per cent per annum. At that rate, we have been doing somewhat better than many comparable countries, although less well than is consistent with continuing strength in the economy and in external trade.

For much of the year, a vital instrument of monetary policy was largely ineffective; there was a hiatus in net sales of Commonwealth Government securities, especially of those with all but the shortest maturities, to the non-bank private sector. As against $1,244 million in 1977/78, these sales (including Australian Savings Bonds and Treasury notes) were $720 million in 1978/79 and $775 million in 1979/80. With a larger non-bank take-up during the year, the volume of money would have been directly reduced. Indirectly, both bank lending and the lending of non-bank financial corporations would have been restrained, and private liquidity kept in hand.

PRIVATE NON-BANK NET TAKE-UP OF COMMONWEALTH GOVERNMENT SECURITIES

There was some marked uncertainty early in the year about the future of bond yields; factors in this included international uncertainties, booming commodity markets, and apprehensions of increasing inflation at home. With the leap in United States interest rates to the very high levels that existed between October 1979 and March 1980, domestic bond market activity decreased to very low levels.

It would have been possible to seek higher net sales of bonds during the course of 1979/80 by raising more quickly and sharply the yields at which the Bank made bonds from its portfolio available to the market. However, the major size and unpredictable duration of the violent upward swing of interest rates abroad clouded with uncertainty the judgments that had to be made about desirable changes in domestic interest rates. With the adverse expectations that this swing created amongst domestic investors, very large increases in domestic yields may well have been necessary to press sales of any substance.

In the event, the course chosen was to allow the market time to find its level – to follow the market rather than to jump ahead of it to try to reach a new selling platform. This episode showed the susceptibility of the Australian capital market to developments in international markets. It lasted longer than was comfortable, and when it became clear that there was need to restore a firm demand for bonds, it took a little time to locate and establish the level of yields required to do so. It was not until April, when interest rates overseas started to fall, and the initial tap stocks went on issue at yields well in line with the higher market, that the demand for bonds picked up. The experience with the tap system over the closing months of the year was satisfactory. However, viewing 1979/80 as a whole, and in retrospect, concern to avoid disruption appears to have been given more emphasis, and the need for flexibility in interest rates less emphasis, than was desirable. In the out-turn, 1979/80 was a year of too-strong growth in the monetary aggregates.

At the beginning of 1980/81,the need continues to be for firmer policies, a key part of which is greater restraint on monetary growth. Firmer policies will in the longer run contribute to reducing unemployment by promoting stable economic conditions. The pressure on the supply of some types of labour at prevailing levels of activity is an indication that progress in reducing unemployment remains more than a matter of simple demand management.

In the coming year, the demand for finance for business and governmental projects is likely to remain strong. Against this background, the Bank was looking to the major trading banks, as they entered 1980/81, to work to achieve an annual rate of increase in advances outstanding of not more than 10 per cent. The Bank will be aiming in the year ahead to keep liquidity conditions in financial markets firm enough to ensure that the loan outstandings of financial intermediaries do not grow as rapidly as in 1979/80. This will require flexibility in interest rawordination between monetary, fiscal and external instruments of policy.

GOVERNMENT SECURITY YIELDS*

3. The Course of the Year

Monetary Policy

At the start of the financial year, the aim was to continue to seek a reduction of the rate of growth in monetary aggregates. The balance of payments was showing signs of strength, particularly on trade account; although this was a welcome development in its own right, it suggested that the contribution to monetary growth from domestic factors should be correspondingly smaller. The contribution to be expected from the Budget was not known; in the year that had just ended the Budget deficit had been large. With any practicable deficit, there would be a need to sell government securities in volume over the year; yet demand for securities was not strong at existing yields.

The system for selling government securities at this time was an interim one pending the introduction of foreshadowed tap and tender arrangements, expected later in the year. As well as being continuously on sale at pre-determined prices, Treasury notes were at times sold at tender from the Bank's portfolio. Several series of bonds were made available continuously at named prices from the Bank's portfolio through an informal tap arrangement.

Sales of securities in the first few weeks of the year were small, and were mainly of Australian Savings Bonds. Of the other securities sold, most were short maturities.

In June 1979, the Bank had told the major trading banks that a policy of restraint should be kept in mind during the early months of 1979/80, and continued in effect the lending guidelines under which banks had been operating. The Bank also reminded other groups of financial institutions to have regard to the need for general restraint when making decisions about lending.

The Commonwealth Budget in August estimated growth in outlays at 9.1 per cent and growth in receipts at 15.4 per cent. The deficit was estimated at $2,193 million with a domestic component of $875 million. These projected deficits were well below the outcomes of the previous year – namely $3,478 million and $2,258 million respectively. The Budget Speech indicated that growth in the broadly-defined volume of money (M3) of about 10 per cent over the course of 1979/80 would be compatible with policy and that, on the basis of the information then available, it seemed that growth should be no more than 10 per cent.

The Budget was well received in the bond market; demand for securities picked up slightly, but sales were still concentrated in short maturities. Given the tightness in liquidity that was evident in the early months of 1979/80, the lack of strong demand for securities was not an immediate cause for concern. Sales seemed likely to increase as liquidity built up.

After the Budget, figures from banks continued to show lending on the high side. The Bank pressed upon the major trading banks the need to restrain their lending, and therefore firmed up lending guidance. This was that advances outstanding should grow by no more than 10 per cent over 1979/80; and, in line with this, net new lending commitments were to average no more than $30 million per week. Trading banks were also asked to exercise comparable restraint in respect of other means by which finance was provided or facilitated by them.

In October, the United States tightened its monetary policy, and short-term interest rates in that country rose. Rises followed closely in a number of other countries. Effects in Australia soon emerged. Despite higher discounts in forward exchange and currency hedge markets, the changes provided incentive to seek finance in Australia rather than overseas; the capital account of the balance of payments weakened and bank lending increased sharply. Additionally, demand for bonds fell away as apprehensions strengthened that interest rates in Australia might also rise.

This situation did not cause marked pressures at the time in the domestic economy. Domestic financing, particularly through the banking system, was achieved without much bidding up of interest rates; the weakening in capital inflow helped to moderate the growth of monetary aggregates; the effect on the balance of payments of the weakening in the private capital account was moderated by the healthy state of the current account and by some government borrowing abroad. With uncertainty about the length of the period of monetary tightness in the United States, and with investors very nervous at this time, bond yields were not lifted. The muted response of policy left investors, in effect, to form views about bond yields with little official intervention. Meanwhile, the authorities concentrated their selling efforts on Treasury notes, where the tender system provided the flexibility needed to achieve substantial placements.

The Bank pressed again at this stage to curb lending by trading banks. Figures then available showed that overdraft limits were still rising rapidly and that the proportion of limits used had increased substantially. Overall, banks' loans outstanding were increasing at an annual rate of close to 20 per cent. The Bank repeatedly stressed to the trading banks the need to contain lending in line with the overall monetary objectives. In support of this, the Statutory Reserve Deposit ratio of the major trading banks was raised from 5.5 per cent to 6.0 per cent on 6 December. Considering the path of liquidity and lending over the turn of the calendar year, this call was less than was appropriate.

By early 1980, upward pressure on domestic interest rates was increasing. A further rise in inflation in the United States, as well as other developments around the world, had deferred the hope of an early reduction in overseas interest rates. In the securities market, views about yields were showing little sign of settling, and bonds were not selling. Although sales of Treasury notes were absorbing funds from the market, there were risks for both monetary policy and debt management in undue reliance on sales of Treasury notes to finance the Government.

In seeking to achieve sales of bonds, the Bank increased the selling yield on the October 1982 interim tap stock from 9.98 per cent to 10.39 per cent on 14 January. It also replaced the May 1989 stock (for which there had been no demand at a yield of 10.09 per cent) with a February 1985 stock at an initial yield of 10.42 per cent. These changes brought yields up to those on the relatively small volume of bonds being traded between non-official parties, but sales by the Bank continued to be very small.

STATUTORY RESERVE DEPOSIT RATIO

At this time there was also evidence that the rate of increase in the money supply was accelerating. Against this background, the Bank offered by tender some of the bonds that it held in its portfolio. The first of these tenders was held in mid-February. In it, $70 million of May 1981 bonds were sold at an average yield of 10.78 per cent. Later in February, $10 million of February 1986 bonds were sold by tender at an average yield of 11.20 per cent. In view of these results, the Bank again increased the yields on the interim tap stocks towards the end of February. The yield on October 1982 bonds was increased by 0.57 per cent to 10.96 per cent; that on February 1985 bonds was increased by 0.78 per cent to 11.20 per cent.

Notwithstanding these increases in yields, demand for bonds remained subdued. Further increases in overseas interest rates at this time had again unsettled expectations regarding domestic interest rates and investors showed a preference for very short paper. The Bank continued to press sales of Treasury notes. Some large amounts were sold so that, despite heavy maturities and rediscounts, non-official holdings of Treasury notes were broadly unchanged over March. The yields at which these notes were sold rose.

With the onset in April of the large seasonal transfers of funds to the Government, the volume of Treasury notes offered in tenders was reduced. Heavy maturities, rediscounts, and sales to the Bank caused holdings of Treasury notes to fall sharply during April. There was also some decline in holdings of Australian Savings Bonds. In the previous month, a new series – Series 16 – had been introduced at an interest rate of 9.75 per cent; this was 0.5 per cent higher than the rate that had applied for nearly a year. Although subscriptions to this series were at times high, investors were at the same time redeeming earlier series. The net decline in holdings probably reflected both the use of Savings Bonds as a means of providing for tax commitments, and the strong improvement in the relative attractiveness of competing assets, particularly semi-government securities.

On 30 April, the initial tap stocks became available. Two stocks were offered: an April 1982 maturity with a coupon rate of 11.5 per cent, issued initially at par; and an April 1985 maturity, issued initially to yield about 11.84 per cent. The amounts offered were in the order of $500 million and $250 million respectively. The 1985 stock attracted strong demand; the issue sold out quickly and was closed in early May. Sales of the 1982 stock were slower.

In the first half of May, liquidity tightened further as tax payments continued to flow to the Government. There was a surge in capital inflow following the sharp reduction in interest rates in the United States that started in April; this partly offset the drain in liquidity arising from tax payments. Nevertheless, markets tightened appreciably; banks' margins of free liquidity were low and short-term interest rates continued to rise. The Bank had, early in the year, reminded financial institutions about the expected large seasonal run-down in liquidity, and for the most part, they had prepared sufficiently. The Bank took action as necessary to facilitate the transfer of funds to the Government by purchases of short-dated government securities, and at times bought commercial bills.

In the June quarter, a further increase in usage of overdrafts kept the growth in trading bank advances high despite the lower volume of new commitments. The extent to which trading banks were providing new bill facilities, which allowed customers access to non-bank finance, also gave rise to concern. Renewed requests were made for restraint in the growth in trading bank financing. These requests were underlined by maintaining extremely fine levels of trading bank free liquidity.

A new tap stock was placed on issue in early June. This was a May 1986 maturity, issued at an initial yield of about 11.79 per cent. It was envisaged that this stock would be available to an amount in the order of $400 million. This stock met a steady demand; by end-June about $100 million had been issued.

During June, the demand for the 1982 tap stock, on issue since late April,also picked up. By late June, the indicated amount of the issue had been subscribed and the stock was withdrawn from issue.

Conditions in the bond market at the close of the year were much better than they had been for some time; they offered a capacity to refinance maturing debt and to contribute, as the coming year develops, to keeping liquidity conditions sufficiently firm.

External Policy

The strength of the balance of payments on current account over the course of 1979/80 was in general a support to policy, particularly during the period when interest rate developments overseas reduced private capital inflow. Over the year as a whole, strength in the balance of payments permitted a much reduced level of Commonwealth Government borrowing abroad and, on balance, a small appreciation of the exchange rate. This outcome for the exchange rate gave marginal help towards reducing the impact in Australia of world inflation. It made little difference in the short run to Australia's international competitiveness, which had improved markedly in the previous two or three years.

The path of the trade-weighted index of the value of the Australian dollar over 1979/80 is shown in the calendar of official actions on page 50. During the first four months of the year, there was a small appreciation of the index, continuing the trend that had started in the closing months of the previous year. This upward movement reflected the improving condition of the balance of payments.

Following the tightening in monetary policy in the United States in October, the overall balance of payments was less favourable. The upward movement of the trade-weighted index was checked; in fact, by January, it had been partly reversed. In late 1979 and early 1980, reserves were supplemented from Commonwealth Government borrowings in Japan ($263 million) and Germany ($208 million) and by a placement (US$100 million) of funds with the Reserve Bank by the Bank for International Settlements. The foreign currency element in the reserves was also bolstered by the use of 130 million of our holdings of Special Drawing Rights at the International Monetary Fund.

EXCHANGE RATES*

February saw the trade-weighted index of the value of the Australian dollar appreciate slightly, a tendency which continued through to early April. The upward movement in the Australian rate followed a sharp jump in capital inflow in January and a further strengthening of the current account, in part coming from the boom in commodity prices. After early April, the United States dollar fell in value. The trade-weighted value of the Australian dollar was fairly steady over April and May, and resumed an increasing tendency over the final weeks of the year. On 30 June, the value of the index was 85.0, up 2.3 per cent on the figure a year earlier.

At the end of the year, with reserves at a more comfortable level, the Bank repaid to the Bank for International Settlements the placement of US$100 million made earlier in the year. At the same time, the International Monetary Fund was repaid the equivalent of $70 million stemming from the 1976 drawing on the Fund's Compensatory Financing Facility; a similar amount had been repaid six months earlier.

Conditions in the balance of payments have recently been better than they have been for some years and, notwithstanding short-run factors affecting trade and capital flows, prospects for the future seem satisfactory, provided there is an inflation performance that is relatively favourable.