Reserve Bank of Australia Annual Report – 1985 Monetary Policy

Overview

Further major steps were taken during 1984/85 the process of structural change in the Australian financial system. Remaining official restrictions were removed from bank deposits and all bank interest rates (other than for owner-occupied housing). The number of authorised banks was expanded by three and the addition of sixteen new banks with foreign ownership is imminent. A further increase in the number of participants in the financial system is occurring as a result of the moratorium on the application of foreign investment policy to merchant banks. Competition among financial institutions to enhance market shares has been a natural outcome.

There was evidence of a substantial shift of business from non-bank financial intermediaries to banks. There was also evidence of an increase in intermediation generally, at the expense of direct financing. These shifts have added to the difficulties of assessing underlying monetary conditions and appropriate policy.

The financial system was still adjusting during the year to the many substantial changes wrought by earlier deregulation and innovation. None was more significant than the floating of the exchange rate and the removal of exchange controls in December 1983. These have transformed both the relationship between Australia's financial system and international markets and the nature of the Bank's involvement in the foreign exchange market – matters which were brought into sharp relief in 1984/85.

The floating exchange rate has also increased the influence of the Bank's market operations on domestic financial conditions – in particular, the extent to which these operations are able to modify seasonal influences. There were times in the past year when the market appeared slow to recognise these changes. Banks and other financial intermediaries, moreover, tended to rely heavily on liabilities management to handle their liquidity needs in the new environment, with the consequence that there were occasional intense pressures in money markets.

The economy continued to grow strongly in 1984/85. The strength of the economy was not, however, always obvious during the course of the year. Signals coming from available data were often unclear and at times misleading. Inflation fell to its lowest rate for a decade. The rate of unemployment, while still a source of concern, declined.

There were also some less welcome economic developments. In particular, the deficit on the current account of the balance of payments increased steeply to a level which could not be sustained for long. That was a major factor contributing to the very sharp depreciation of the Australian dollar in February and April this year.

Against this background of change, the Board's general approach was to try to maintain financial conditions which would support continuation of the recent downward trend in inflation without jeopardising the recovery of economic activity. This approach was seen initially as consistent with the Government's provisional projection of growth of M3 in the range of 8 to 10 per cent; this projection assumed no reinter-mediation. In the event, structural changes substantially distorted growth of monetary aggregates, leading to suspension of the M3 projection in January. The difficulty of assessing the true state of monetary conditions and periods of doubt about the strength of economic recovery resulted in monetary policy lagging behind events for part of the year.

Three phases can be identified:

• From late July, an optimistic mood emerged in financial markets. The news on inflation was good; the monetary aggregates for 1983/84 turned out better than many had expected; and interest rates in markets overseas were tending to fall. There was a consequent tendency for financial conditions to ease and the Bank did not move immediately to offset it.
• By September, it was becoming clear that growth in money and credit was stronger than had been thought, and the Bank moved to tighten financial conditions. While the money supply continued to grow strongly throughout the December quarter, it was not clear that policy was too loose. Changes in the financial structure were adding to growth in the measured aggregates although their influence could not be quantified. Growth of non-bank financial intermediaries slowed markedly from late October. There were also reasons at the time to doubt the robustness of the recovery in activity. Given the uncertainties involved in interpreting evidence on the state of the economy, monetary policy was held steady over the December quarter and into January, awaiting the outworking of the financial tightening already in train, or for the emergence of clearer signs that a change in policy was warranted.
• In February, and again in April, the Australian dollar fell abruptly. Nervousness evident first in the foreign exchange market spread to domestic financial markets. Uncertainties which had been important influences in previous months abated – the economy was shown to be stronger than had been feared earlier and it was now judged that money and credit were growing too strongly, even given the problems of interpreting the data. It was decided therefore that more vigorous tightening of financial conditions was needed. This tighter approach was maintained throughout the remaining months of 1984/85. During February and April, the Bank stepped up its dealing in foreign exchange, testing the strength of forces in the market and seeking to moderate the volatility of theexchange rate in periods of high uncertainty. It did not seek to sustain any particular rate of exchange. In the aggregate, the Bank was a large net seller of foreign exchange in those months.

It is still early to judge the effectiveness of monetary policy over the year as a whole. Deregulation and competition for market shares added to the pace of financial expansion throughout the year. Allowing for these influences, growth of money and credit was still stronger than desirable. The effects of tighter monetary policy since February may take time to become apparent in the growth of financial aggregates. The impact on interest rates, however, is evident; by the end of the year, most interest rates had risen substantially, with many rates at historically high levels both absolutely and relative to the rate of inflation. The Bank's judgement is that policy at the end of the year is appropriately firm and that this policy will need to continue.

Monetary Policy Issues in 1984/85

Deregulation has dominated Australia's financial conditions in recent years. The major measures mentioned above and the other deregulatory measures undertaken during 1984/85 are detailed later in the Report.

In the longer run, deregulation increases competition and efficiency in financial markets. Changes as extensive and rapid as have occurred in Australia's financial markets in recent years nevertheless create short-run disruptions as market participants seek to adjust to the new environment. The process of adjustment can also complicate monetary policy.

Deregulation generally, and the removal in August of remaining controls on bank deposits in particular, meant that acceleration in the growth of banking aggregates was to be expected. On this account, banks were expected to grow at the expense of both other intermediaries and direct financing. Competition from banks encouraged other intermediaries to seek business from areas previously financed directly, which added to the prospect of an increase in total intermediation. In the event, competition for market share was very keen.

These structural changes led the authorities to focus less on money and credit aggregates as guides to economic and financial conditions and to give greater attention to a wide range of regularly monitored indicators. These indicators, however, did not always point in the same direction; this was particularly so in the first half of the financial year. In that period, growth of imports and signs of wages drift pointed to a possible surge in domestic demand. Other indicators, particularly of employment and consumption, pointed to more modest growth in activity.Low inflation did not suggest that the economy was overheating. Added to this, the exchange rate was relatively strong and interest rates high relative to rates overseas; interest rates also provided a substantial margin over the prevailing rate of inflation.

Signals from this ‘checklist’ of indicators were more consistent in the second half of the year. It became increasingly clear that the economy was growing strongly. There were signs that the downward trend in inflation was beginning to reverse while growth of employment, previously subdued, increased sharply. Money and credit continued to expand rapidly. Added to these signals was the very sharp fall in the value of the Australian dollar.

The Government had foreshadowed a review around mid year of the conditional projection of M3 growth. As the time for the review drew near, it was clear that growth of M3 was running well above the projected range of 8 to 10 per cent. Structural changes in the financial system explained most, though not all, of the faster-than-expected growth and it was not possible to forecast the effects on M3 over the rest of the year. Other aggregates were also affected, to varying degrees, by changes in market shares between banks and non-banks and by shifts from direct to intermediated financing. The Bank saw no practical alternative to the Government's decision to suspend the projection in late January and to review its approach to conditional projections prior to the 1985 Budget.

At the time of the announcement, the Government reaffirmed its commitment to firm monetary policy. In fact, policy tightened considerably in the ensuing weeks. Nevertheless, markets were uneasy about the direction of monetary policy in the absence of the M3 projection or of any specific substitute for it. The decision to suspend the M3 projection has been better understood subsequently and has become more widely accepted as appropriate under the circumstances. The provision of considerably more information about policy and official operations relating to policy no doubt has provided reassurance.

There seems no prospect of an early end to the disturbances to financial aggregates arising from structural reform. Accordingly, the Bank will continue to monitor a wide range of financial indicators – together with developments in the economy generally – in its assessment and conduct of monetary policy.

The depreciation of the Australian dollar posed some important questions for monetary policy. A lowering of the exchange rate from the relatively high point reached just after the currency was floated in December 1983 was probably inevitable and not unwelcome from the viewpoint of the need for improvement in Australia's international competitiveness. The speed and extent of the decline in the exchange rate nevertheless caused some problems. There was greater uncertainty facing markets, and those with net foreign debts and industries reliant on imported inputs faced substantial cost increases.

Since the Australian dollar was floated in December 1983, the Bank has dealt in the market as necessary, to test trends and to smooth large transactions as well as to handle the business of the Bank's customers. With the foreign exchange market unsettled, it dealt in February, and again in April, more actively than it had at any time since floating commenced. The Bank did not take a view on where the dollar should settle, nor did it seek to support or produce any particular exchange rate outcome. The main objective was to keep in touch with the market, to ascertain the nature and strength of the factors at work and to reduce the degree of volatility. This approach still resulted in substantial net sales of foreign exchange by the Bank.

Events in the foreign exchange market in 1984/85 were influenced by a wide range of factors. No one of these can be singled out as the prime cause for the depreciation of the Australian dollar. The capacity of the exchange rate to move sharply and at times erratically nevertheless underscored the sensitivity of this market to views about economic conditions and policy. In particular, it emphasised the need for responsible policies and the need for those policies to be adequately explained.

Experience in 1984/85 also contained some lessons for markets. Before the currency was floated, foreign exchange flows were an important source of funds for the domestic cash market. At times they served as a ‘safety valve’, moderating the seasonal impact on financial markets of imbalances in the Government's revenues and expenditures. At other times they offset the impact of the Bank's market operations. The floating exchange rate, coupled with the Bank's approach to its foreign exchange operations, have virtually eliminated the influence of foreign exchange flows on domestic cash conditions. In this environment, the Bank sought to dampen the seasonal swings in financial conditions without detracting from the objectives of its overall monetary policy. On several occasions in 1984/85, sections of the financial community banked heavily on repetition of past seasonal patterns in cash flows and in related market rates. This tended to upset the smooth implementation of the Bank's policy and was expensive to many of those involved.

The removal of interest rate regulations on banks enabled them, for the first time, to bid directly for very-short-term deposits. Active short-term liabilities management gives banks greater scope to compete with other financial institutions. It also leaves them more exposed to volatility in the market through large fluctuations in their deposit bases in times of tightness. For much of 1984/85, banks managed their operations on very narrow margins of available liquidity. As corporations drew on short-term deposits and overdrafts to meet tax payments, particularly in the June quarter, banks (and some other financial intermediaries) were faced with the need to roll over and raise substantial sums on the short term money market. As a result, the cost of short-term funding rose steeply.

The greater range of business opportunities arising from deregulation adds to the need for prudent management. In 1984/85 there was plenty of evidence of efforts to increase or retain market shares, some of which may have been at the cost of taking on lower quality lending. The benefits of deregulation in increasing the access of borrowers at various levels of risk to lower-cost lenders are manifest. At the same time, intermediaries may incur additional costs in extending the range of their business.

At times of rapid change there is more interest in issues of supervision of intermediaries. While the Bank's responsibilities for bank supervision have not changed, the context has. Banking policy has moved away from regulating the terms on which banks provide services to supervising the substance and competence of banks in providing those services.

At the centre of the Bank's approach to prudential supervision is the view that community confidence in banks is a prerequisite for a stable financial system. The system of prudential supervision formalised in 1984/85 recognises, nonetheless, that the prime responsibility for prudent management of a bank's business lies with each bank. The Reserve Bank's role, apart from specifying minimal conditions for adequacy of capital and liquidity, is primarily to ensure that banks follow adequate practices in dealing with risks. A good deal of the Bank's resources in 1984/85 went into work associated with the entry of new banks.

Looking to the Future

Economic growth is expected to continue in the major economies over the next year or so, but at a reduced pace. The Australian economy is likely to grow strongly again in the year ahead. With prices starting to rise more rapidly, and the effects of the depreciation of the Australian dollar still to be felt fully, a major concern is that 1985/86 may see a resurgence of inflation.

Prospects for the Australian economy depend heavily on our competitiveness in international markets. This, in turn, depends importantly on the ability of Australian industries to contain production costs and to adapt flexibly to new markets and opportunities for new products. Provided the increase in competitiveness resulting from the depreciation of the Australian dollar during 1984/85 is not dissipated through higher wages and other costs, it should provide a strong impetus to growth.

The depreciation of the exchange rate will help correct the present imbalance on current account and, in the process, reduce the need to balance the external accounts by borrowing overseas. It is doubtful, however, whether exchange rate movements alone will be sufficient to restore an acceptable degree of balance in our transactions with the rest of the world. To achieve this, it is essential that the excess of domestic demands on capital markets, including those by Government, over the supply of domestic savings be reduced.

Predictions about financial conditions in 1985/86 are subject to a greater-than-usual degree of uncertainty. Money and credit are still growing strongly. It will be unhelpful to Australia's competitiveness in the short run and to prospects for stability and growth in the longer run if the pace of financial expansion is not contained sufficiently to prevent a resurgence of inflation. In seeking to maintain firm financial conditions the Bank will need to make allowance for further structural changes in financial relationships. These will continue to run strongly in 1985/86 as new banks commence operations and financial markets and institutions continue to adapt to recent deregulatory measures. Structural changes, while desirable in themselves, increase the need for the Bank to be adept in reading and responding to market signals.