Reserve Bank of Australia Annual Report – 1981 A Review of Monetary and External Policy

1. Background

Underlying recent Australian economic policy-making has been the view that, over time, economic growth and stability are best promoted by holding to firm and stable policies. There has also been wide recognition that slowing the growth of money and credit is desirable, in that it helps to contain inflation; high inflation and the uncertainty that it generates inhibit economic growth and distort the distribution of income and wealth.

GROWTH IN MONETARY AGGREGATES

Ability to restrain growth in money and credit through the instruments of monetary policy is affected by the settings of other policies. Appropriate budgetary policy is necessary to avoid imposing undue burdens on monetary policy. External policies should seek to complement efforts to restrain the expansion of money and credit through monetary policy.

In the long run, restraint in the growth of monetary aggregates is necessary for controlling inflation. In the short run, prices and activity are also affected by the budget, exchange rates and various other policies, and by expectations about economic conditions and policy that are held throughout the community. Lags in the response of prices to overall conditions of demand can also cause short-run movements in monetary growth and inflation to diverge.

At the beginning of 1980/81, the outlook for the economy was for strong expansion in activity, led by private demand. This seemed achievable with growth in monetary aggregates slower than in 1979/80; following a period of excessive monetary expansion, a slowing was desired to exert some downward pressure against the prevailing inflationary trend.

Two factors had played a part in the overrun of monetary aggregates in 1978/79 and 1979/80: insufficient flexibility in setting officially-controlled interest rates and, particularly in 1978/79, insufficient compatibility between the stances of monetary and fiscal policies.

Some improvement appeared likely in both of these areas in 1980/81. The new tap and tender systems for marketing Government securities were in place. With bonds available on tap continuously and Treasury notes available through weekly tenders, there was hope of greater flexibility in official interest rates. On the fiscal side, the reduced deficit in the Commonwealth Government's accounts offered the prospect of less pressure on the bond market. There were, however, relatively large quantities of Government paper due to mature during the year and the borrowing programmes of local and semi-government authorities were expanding.

The next section traverses policy actions in 1980/81. Some comments on the implementation of policy comprise the final section of this chapter.

2. Monetary and External Policy: The Course of the Year

Monetary Policy

The financial year began with inflation at its highest rate for three years. Private liquidity was still relatively tight following the June quarter of 1980. The deficit in the Commonwealth's accounts was expected to fall further in 1980/81 and the deficit on the current account of the balance of payments was expected to increase.

An additional factor in expectations was the prospective strength in private capital formation and the associated financing requirements. These were expected to outstrip the expansion in domestic sources of funds. Consequently, foreign capital was regarded as a major potential source of finance.

Early in the financial year, the Bank requested the major trading banks to manage their business so that growth in advances outstanding would not exceed 10 per cent per annum; lending had grown by almost 17 per cent over 1979/80. The Bank also asked for comparable restraint to be shown in other means by which banks provide or facilitate finance.

MAJOR TRADING BANKS: L.G.S. AND S.R.D.

The Budget in August estimated growth in Commonwealth outlays at 13.7 per cent and growth in receipts at 16.2 per cent. The deficit was estimated at $1,566 million with a domestic surplus of $39 million. The Treasurer, in his Budget Speech, indicated that growth in M3 of about 9 to 11 per cent over the year to June 1981 would be consistent with the requirements of economic policy. He also emphasised the need to monitor a range of monetary aggregates and indicators.

After heavy subscriptions to tap stocks in July, sales of Commonwealth bonds had, by late August, dwindled. There was increasing market nervousness, with unwillingness to buy other than very short Government paper. There appeared to be concern that a need for tighter policy and strong competition for funds would lead to rises in interest rates. This assessment was strengthened by rising interest rates in the United States.

The imminence of a Federal election late in 1980 increased the uncertainty. Many observers expected a rise in official selling yields after the election. These expectations were evident in the market's preference for short-term Government paper and its willingness to sell longer bonds in the secondary market at increasing yields. In the event, net sales of bonds to non-official groups in the two months after the Budget were negative.

As a first step towards ascertaining yields at which an acceptable flow of bonds to private groups might be achieved, the Bank, in late October, offered small parcels of bonds on the market. Following this, yields on tap stocks were increased. However, after a short revival in sales in mid November, the demand for bonds fell away again, with yields rising in the secondary market.

By this stage of the year, weakness in the bond market was being increasingly seen as linked to rigidity in officially-controlled interest rates in the banking sector. A situation had existed for some time in which market rates had moved materially out of line with interest rate ceilings on certain categories of bank borrowings and lendings. With both domestic and foreign interest rates rising, there was a growing conviction that the official ceilings would have to rise. Investors appeared to believe that further upward adjustments in bond yields would be necessary when the situation in the banking sector was sorted out.

During the first half of 1980, banks increased interest rates on larger loans and certificates of deposit, on which there were no official ceilings; they also raised rates on smaller loans and deposits to existing ceilings. Despite these moves, the ability of the banks to compete was restricted and relative interest rates did not reflect risks and costs of lending. The Bank has accepted the case for deregulation of banking interest rates, and sought over this period to provide banks with more flexibility in this respect. For a considerable time, it did not succeed in obtaining the necessary governmental concurrence with such action.

In the September quarter, the large increase in liquidity put downward pressure on market interest rates and the demand for bank lending. By late October, however, the matter had once again become pressing. The Bank approached the Government in August, September, and again early in November, but it was not until December that agreement was reached on a package of policy action.

GOVERNMENT SECURITY YIELDS*

At that time, ceilings on interest rates paid on trading and savings bank deposits were removed, and the remaining ceilings on interest rates charged by banks were raised generally by 2 percentage points (details of these actions are given in the Calendar of Official Actions). Exceptions from the increases were agreed between the Treasurer and the banks for certain customers affected by the drought. Trading banks also restricted increases in rates on housing loans to owner-occupiers to 1 percentage point – the maximum increase approved for such loans by savings banks. Under guidance from the Bank to implement the increases selectively and gradually, most lending rates stayed for a time below the new ceilings. Further details are given in the next chapter on page 26.

Sales of Commonwealth bonds remained depressed during December and the early part of January despite an increase in tap yields on 3 December and the introduction, on 8 December, of a new series of Australian Savings Bonds with a coupon of 11.5 per cent, up 1.25 percentage points on that of its predecessor. Uncertainty about future movements in yields persisted, and the relatively light trading in the secondary market took place at yields above those offered on the tap stocks. Heavy capital losses had dampened the enthusiasm of many market participants. Very high interest rates in the United States were another factor in their considerations. Sales of Commonwealth bonds were also affected by competition from heavy issues of securities to finance the large borrowing programmes of local and semi-government authorities.

In the first half of the year, private holdings of liquid assets and Government securities (private LGS) increased by $2,784 million, compared with an increase of $1,407 million for the same period in 1979/80. The large increase in private LGS was the result of two main influences: an expanded seasonal deficit on the Commonwealth Government's domestic transactions, and a substantial surplus on private external transactions. Smaller repayments of Rural Credits advances also contributed.

Sales of Commonwealth Government securities to private groups accounted for $2,480 million of the increase in liquidity in the first half of 1980/81. Sales of Treasury notes, however, dominated this total. Indeed, contrary to the needs of policy, bond holdings fell by $13 million. Among other things, these figures point to the marked difference in performance over this period of the tap system for the sale of bonds and the tender system for sales of Treasury notes.

The large increase in liquidity in the first half of the year passed through into rapid growth in money and credit. Growth in bank loans outstanding in this period stayed within the guideline of 10 per cent per annum. This was largely the result of a substantial fall in the overdraft usage ratio in conjunction with moderate net new overdraft approvals. At the same time, banks expanded their facilitation of finance through acceptance and endorsement of commercial bills. Strong expansionary pressure in financial markets in this period showed up in the growth of non-bank finance.

Against a strong build-up in bank liquidity, the Statutory Reserve Deposit ratio of major trading banks was increased, effective 6 January, from 6 per cent to 7 per cent. This involved a transfer of $246 million to the banks' SRD accounts with the Reserve Bank.

From around the middle of the year, growth in bank loans outstanding began to run ahead of the guideline. The banks were reminded of the need to keep a firm rein on financing, and of the need to prepare adequately for the expected large seasonal run-down in liquidity in the June quarter of 1981; the expected size of the Government's absorption of liquidity in the June quarter had been publicised several months earlier in the Bank's Bulletin.

MONEY AND PRIVATE LIQUIDITY

Net sales of bonds, through taps and from the Bank's portfolio, increased substantially during the March quarter; there was also a shift towards longer-dated securities through switching transactions. In large part, this reflected a favourable response to a further adjustment in yields on tap stocks in January, when rates on both short and long bonds were raised to 13.1 per cent. Market sentiment was also improved by the release, in January, of figures suggesting a slowing in the rate of inflation and by some easing in interest rates in the United States. Australian Savings Bonds, however, continued to record negative net sales. On 24 March, the yield on Australian Savings Bonds was raised to 12.25 per cent. Net sales remained negative for a while, but subsequently improved sufficiently to stem the outflow of funds. In June, net sales were $45 million, the highest figure for a year and a half.

Following the seasonal peak in March, liquidity fell as Commonwealth transactions moved into surplus. The large drain on funds arising from tax payments was partly offset by a large surplus on private external transactions. The reduction in liquidity due to repayments of advances from the Rural Credits Department of the Bank was also smaller than in 1979/80, reflecting smaller advances to the Wheat Board in 1980/81. In the process, markets tightened appreciably; banks' margins of free liquidity were low and short-term interest rates rose.

Activity in the bond market slowed markedly from mid March. Sales from the taps and from the Bank's portfolio were minimal. This was partly a response to the seasonal tightness of funds. There were also indications of a weakening in the underlying tone of the market. Some non-official trading occurred at yields above those offered on tap stocks, although quantities traded were small.

Bank financing grew strongly in the June quarter, following a slight slowdown in March. Overdrafts outstanding increased sharply, more than offsetting the seasonal decline in holdings of commercial bills. In the year to June, lending by major trading banks increased by 12.6 per cent.

On 21 May, the Bank wrote to the 54 money market corporations registered under the Financial Corporations Act pointing out that recent growth, of over 30 per cent per annum, in the group's financing had been far above a rate consistent with monetary policy. Each corporation was asked to put in hand a close review of developments in its business.

Financial conditions tightened in the closing weeks of the year; banks' margins of free liquidity were low and short-term interest rates rose. Bond sales remained depressed. Yields offered on tap stocks were raised early in July, bringing longer yields above those on shorter maturities.

External Policy

The overall balance of payments was in substantial surplus in 1980/81 for the first time since 1972/73. Over the year, external transactions added around $1,100 million to Australia's foreign reserves. This reflected strong capital inflow which more than offset a substantial widening of the current account deficit. The current account deficit added to supplies of goods and services, while capital flows were an important source of finance for investment in Australia. The appreciation of the exchange rate that accompanied the strong position on external account helped to moderate the influence on domestic prices of world inflation. On the debit side, the quantity and timing of incoming funds posed some problems for monetary management.

The path of the trade-weighted index of the value of the Australian dollar over 1980/81 is shown in the Calendar of Official Actions on page 51. The Australian dollar was appreciated substantially against the trade-weighted basket of currencies over the year. Movements in rates against individual currencies reflected extreme volatility in foreign exchange markets.

The appreciation of the Australian dollar over the September quarter was modest, and took place against a net drain on official reserves of foreign currency, arising from both private and Government transactions. Reserves were supplemented in September by a deposit from the Bank for International Settlements equivalent to $86 million. A decision was also made to roll over a Deutsche Mark loan equivalent to $96 million. During this period, the Australian dollar appreciated against most major currencies, with the exception of sterling and the yen.

EXCHANGE RATES*

The December quarter was a period of rapid change in international conditions. Interest rates fell in Japan and the United Kingdom. At the same time, interest rates in the United States, continuing a trend of several months, increased to very high levels. Net apparent private capital inflow to Australia in October was around $1,000 million. The inflow eased somewhat but remained positive in November and December.

The overall balance of payments strengthened in the early part of this period and the Australian dollar was appreciated further. There was also increasing volatility of rates for the Australian dollar against individual currencies, with substantial fluctuations against the United States dollar and the yen. Following a sharp rise in October, the level of foreign reserves fell in November and December, due largely to valuation effects; outgoings around this time included repayment of the $86 million deposit from the Bank for International Settlements.

The balance of payments remained strong through the first half of 1981. The Australian dollar continued to appreciate strongly against all major currencies except the United States dollar. Private capital inflow in this period remained strong, with some signs of an increase in short-term flows in response to seasonal pressures in the Australian economy.

The appreciation of the Australian dollar against the trade-weighted basket was accentuated in the June quarter of 1981. On 30 June, the value of the trade-weighted index was 92.9, up 9.3 per cent on the figure a year earlier. Despite appreciation against the trade-weighted basket of currencies, the Australian dollar continued to lose ground against the United States dollar. The appreciation against all other major currencies, however, was substantial.

3. Some Comments on Policy

Policy was implemented in 1980/81 against a background of sharp changes in external and domestic conditions.

Money and exchange markets overseas experienced extreme volatility, reflecting major policy and political developments in a number of countries. Partly because of these developments, and partly because of favourable prospects in Australian resource industries, the investment climate in Australia was increasingly perceived overseas to be attractive. The large domestic demand for finance, coupled with conditions overseas, led to substantial additions to liquidity through the external account. The high level and fluctuating pattern of these flows added greatly to uncertainty and made it difficult for domestic market operations to cope with fluctuations in financial conditions.

In the event, sales of Government bonds during the year did not match the task of restraining monetary growth. An important factor was the lack of flexibility in official bond yields. Delays in moving yields on primary issues of bonds in response to changing market conditions kept official yields, for lengthy periods, below the levels that the market was willing to accept. The poor performance of tap stocks and Australian Savings Bonds led to an undue reliance on sales of Treasury notes.

It is early for assessment of the effects on monetary conditions of the changes in interest rate regulation that took place in the banking sector in December. According to some indications, however, there may have been some changes in the relative roles of various intermediaries. Trading and savings banks may have slowed the downward trend in their market shares; permanent building societies, whose interest rate arrangements have, in the broad, been less flexible over recent months than those of their competitors, appear to have experienced a declining share.

Over time, relaxation of ceilings on interest rates paid and charged by intermediaries should assist monetary policy by reducing the conflicts inherent in seeking to influence both price and quantity in the same market. Longer-term gains should include a more efficient allocation of finance.

Growth in money and credit in 1980/81 was too rapid, even taking into account that growth in output was stronger than expected. The outcome cannot be viewed independently of events in preceding years. Since June 1978, the money supply, insofar as it is measured by M3, has increased by over 40 per cent. At the same time, consumer prices have increased by around 31 per cent, with the implicit deflator for gross domestic product showing a similar rise. On a broad view of these developments, it appears that monetary policy has been unduly accommodating to inflationary pressures.

Experience in the last three years has demonstrated weaknesses in the way policy has been implemented. One of these has been the tendency for money and credit to expand rapidly in the first half of the financial year, on the basis of seasonal accretions of funds. Much of this expansion has been through the non-bank sector, partly based on bank bills. This undue early expansion of finance has not been adequately reversed later in the year; ways have been found to finance the credits so extended through the seasonally tight part of the year. In the process, there has been upward pressure on interest rates and on the usage rate of overdrafts; borrowing from abroad has also been encouraged. The capacity of the authorities to tighten policy at the stage of the year when markets are seasonally illiquid has been insufficient to overcome the deficiencies of policy in the early part of the financial year. This pattern of developments has also contributed to increased variability in monetary growth rates within each year.

An element of policy for many years has been the tendency to hold interest rates constant for longish periods in key markets, leaving quantities traded to be determined largely by conditions of demand (or regulated by direct controls). These arrangements sit uneasily alongside the increasing attention being paid to quantities in implementing policy.

This price-setting approach generated fewer problems in times of relative stability. In more recent years, with expectations and external conditions much more volatile, the requirement – not sufficiently met in 1980/81 – has been for quicker and more flexible policy reactions. If the rate of growth in money and credit is to be smoothly and firmly restrained to desired levels in coming years, it is essential that the instruments of monetary policy be used with a flexibility that will allow much quicker response than in the past to changes in market conditions.