Reserve Bank of Australia Annual Report – 1986 Overview

The economic and financial background to monetary policy in Australia underwent substantial, sometimes dramatic, changes during 1985/86. The year began with strong growth in economic activity and buoyancy in sentiment. This situation was largely reversed as the year progressed. Prospects for the balance of payments had looked tolerable at the beginning of the year. While the outlook for commodities was generally soft, falls during the year in prices for agricultural and energy-intensive commodities were considerably greater than expected. The result was a large decline in Australia's terms of trade, a marked deterioration in the current account and a substantial depreciation of the Australian dollar. Monetary policy was adjusted several times during the course of the year to contend with the rapidly changing circumstances.

At the outset of the year economic prospects were delicately poised. The economy was growing strongly, but inflation was double that in the major economies abroad and there was a rapidly growing external imbalance on current account. Some of the foundations for bringing Australia back into step with the rest of the world had been laid, but some major uncertainties remained.

There were a number of aspects to the external problems. For some time, the levels of public and private expenditure undertaken by the community had been higher than could be satisfied from the nation's productive efforts. The expectations on which those levels were founded proved to be unattainable, not least because of recurring, and at times sharp, weakness in the terms of trade. The outcome had been a decade or more of adverse experience on the balance of payments.

The large depreciation of the Australian dollar in the first half of 1985 had been a sharp reminder that this situation needed to be addressed. By the beginning of 1985/86 policies were moving in that direction. The general tightening of monetary policy in the first half of 1985 and fiscal measures in mid 1985 were expected to help restrain domestic spending. Further, steps were taken early in the financial year to prevent the impact of depreciation on domestic prices from flowing through to award wages. This bolstered competitiveness and offered the prospect of increased demand for and production of Australian goods in 1985/86.

While these adjustments to policy were along the right lines, they had yet to prove sufficient to ensure a sustainable turnaround in our external accounts. In particular, there were complications of timing. The exchange rate depreciation during 1985 seemed large enough to promise a major diversion of spending from imports to domestically-produced goods; it was also expected to stimulate exports. Such changes, however, require reallocation of resources, identification of new markets and creation of new productive capacity, all of which take time. Meanwhile, the depreciation was expected to add to the current account deficit by raising the cost of debt service and payments for imports already in the pipeline. With external indebtedness already substantial and the tendency for external debts and deficits to cumulate rapidly, there was a fine balance between the long-run and short-run forces at work.

In the event, the expectations on which the Government's economic strategy was based proved to be overly optimistic. Australia's terms of trade, which had weakened in the first half of 1985, deteriorated sharply in 1985/86. At the same time, industry responded rather cautiously to the earlier improvement in competitiveness. These factors were unfavourable to the current account deficit in the short run and put the exchange rate under continuing pressure.

Towards the end of 1985, it became apparent that the external deficit was considerably greater than had been expected, while the domestic economy was continuing to expand. With other policies unable to respond quickly, given existing institutional arrangements, monetary policy was tightened substantially. This step had elements of a holding action, to slow the economy and to provide time for the expected responses to earlier depreciation and policy adjustments to occur. The difficulties continued in succeeding months. The more deep-seated they appeared, the more obvious it became that responses needed to be found beyond monetary policy.

Late in 1985/86 the Government foreshadowed a wide-ranging adjustment of its policies. Action was taken to reduce the public sector deficit and steps for further wage moderation were foreshadowed, as were stringent further measures for fiscal policy.

However, with the terms of trade still weakening, policy is chasing a moving target, making it difficult to assess what will finally represent an adequate policy response.

Despite economic adversity in 1985/86, there were some bright spots. Employment rose strongly and the rate of unemployment declined. In the second half of the financial year, import volumes fell and export volumes rose (notwithstanding a fall in energy-based exports in the wake of falling oil prices). This suggests that the necessary responses in our overseas trade may be occurring, even though their impact to date on the current account has been swamped by movements in the terms of trade.

The outlook nevertheless remains dominated by the need to restore external balance. The period of adjustment appears likely to be longer and more difficult than previously thought. In particular, the need to further restrain public spending and borrowing, and the rate of increase of labour costs is likely to persist for some time yet. Growing awareness of these problems has tended to undermine confidence, but has contributed to a climate more conducive to achieving the necessary adjustments to both policies and attitudes. The task ahead remains formidable.