RDP 8805: The Relationship Between Financial Indicators and Economic Activity: 1968–1987 3. Financial Indicators and Real Private Demand: Graphical Comparisons

This section compares each financial indicator in turn with real private demand. In each graph, the bars represent quarterly growth in the smoothed series for real private demand.

(a) Interest Rates

Figure 4 shows the nominal bill rate and movements in real private demand. The relationship is clouded by an upward trend in interest rates for much of the 1970s. This can be attributed to a slow adjustment to the much higher rate of inflation which prevailed during that period than in the 1960s. There was a marked downward trend in real interest rates in the first half of the 1970s, and real rates were only just positive at the end of the 1970s (see figure 3).

Despite this, there is a clear inverse relationship between nominal interest rates and changes in real private demand. In particular, the three major falls in private demand – 1974/75, 1982/83 and 1985/86 – corresponded to the three major peaks in short-term interest rates. The slowdown of 1977/78 was also accompanied by a rise in the bill rate, but the relationship was weaker. There was also a small peak in the bill rate in 1970 which was not associated with a fall in demand, although there was a slowing in the rate of growth.

Apart from the small rise in 1970, the bill rate did not indicate any “false turning points”. Occasions where the bill rate showed a major rise were always associated with a fall in real private demand and major falls in the bill rate were consistently associated with a rise in demand.

There is also evidence from the graph that interest rates often tended to lead economic activity. This is particularly clear in the 1982/83 and 1985/86 episodes, where interest rates had been rising for some time before demand slowed and eventually fell. The slowdown in 1976/77 was also preceded by a rise in rates, though the relationship was coincident in 1974/75. In all these instances, the bill rate reached its peak in the first quarter that demand fell, and the decline in the bill rate led the pick-up in demand.

(b) Banking Aggregates

Movements in M1 appear to be closely related to movements in real private demand. This is shown in Figure 5. The three sharpest contractions in growth of M1 (where M1 in fact declined in absolute terms) corresponded with the three major falls in real private demand. Also, there was a slowing in 1977/78, corresponding with the slight fall in private demand at that time.

However, M1 does not appear to have performed in its usual manner in the most recent cyclical upturn, where its growth has been exceptionally strong. By 1987, M1 was growing at an annual rate of over 20 per cent, its highest rate since the early 1970s. This was noticeably faster, relative to the growth of real private demand, than in either of the two previous expansions.

Visually, it is difficult to detect whether the bill rate or M1 has the better cyclical relationship with real private demand. The comparison is made more difficult by the fact that the growth of M1 is heavily influenced by movements in interest rates, since the opportunity cost of holding M1 increases with rising interest rates. Holders of bank deposits are able to switch relatively easily between M1 (predominantly non-interest bearing deposits)^[7] and the other components of M3 (predominantly interest bearing) in response to changes in interest rates. Figure 6 shows that there is a very strong (negative) association between interest rates and M1. This being so, there is a possibility that movements in M1 do not provide independent information, but are mainly a reflection of already observed movements in interest rates.

The relationship between M3, bank lending and real private demand is shown in Figure 7. For M3, the relationship seems quite strong for the falls in demand in 1974/75 and 1977/78. There is also a good “fit” for the expansions in the early and mid 1970s.

However, the similarity of movement between M3 and real private demand broke down at the end of the 1970s. There was little variation in M3 growth from 1978 to 1983, although demand grew strongly in the early part of the period and fell sharply during the recession of 1982/83. Similarly, there was very little pick-up in M3 growth during the strong expansion in real private demand of 1983 and 1984. More recently, the relationship has looked better. In the slowdown in 1985/86 and the subsequent pick-up, M3 seemed quite good in its relationship to demand, although the lowest growth rate reached was noticeably higher than in the 1974/75 or 1977/78 slowdowns.

From figure 7 then, it is apparent that a close monitoring of M3 growth over the last decade has been helpful in predicting (or confirming) major movements in economic activity on some occasions, but unhelpful on other occasions. For example, in the most severe post-War recession (1982/83), it was of no help at all.

The dotted line in Figure 7 shows growth in banks' lending to the private sector. It shows a similar pattern to M3 but, if anything, has an inferior “fit”. It correlated well with real private demand over the expansion and contraction phases of the early 1970s but by the mid 1970s, when demand was very weak, bank lending was still growing very quickly. Its relationship to the fall in private demand in 1977/78 was not as close as for M3. It showed the same deficiency as M3 in the 1982/83 episode, and was noticeably less useful than M3 in 1985/86.^[8] (In 1986, bank lending was still growing at a faster rate than at virtually any time since the mid 1970s.)

(c) Broader Aggregates

Due to data limitations, there are only two cycles over which it is possible to compare movements in the broader aggregates and demand (figure 8). However, over this restricted period, it is clear that there was a good correspondence between the cycles in broader aggregates and in real private demand. The two falls in demand and the three expansions were reflected in corresponding movements in each of the three broader aggregates. There is also evidence of a relationship in the more moderate cycle in demand in 1979/80. Over the period since 1976/77 as a whole, the broader aggregates seemed to “fit” the movements in real private demand much more closely than did M3 or bank lending.

The other feature that stands out from figure 8 is that the movements in broader aggregates tended to lag movements in real private demand. For example, the trough in the broader aggregates in the 1982/83 downturn was not reached until demand had already fallen for four quarters and was beginning to rise again. The same situation occurred in 1985/86. If anything, lending and credit showed a greater tendency to lag than did broad money. The extreme was during the most recent downturn where credit did not reach its trough until the downturn in private demand had finished and the upswing was well underway.

There is some evidence of a shift in the relationship between lending and credit and demand in recent years. At its low-point in the most recent downturn, growth of credit was still running at an annual rate of about 18 per cent, which was higher than at most points in the previous expansion. The trend increase in use of bill financing, and its rapid expansion over the past three years, accounts for part of this change in relationship. Lending, which only includes loans that are funded on financial intermediaries' balance sheets, also exhibited particularly high growth over the recent cycle. Broad money did not suffer from this deficiency, because some of the growth of lending on intermediaries' balance sheets was funded by liabilities that do not show up in broad money.^[9]

Footnotes

Removal of bank interest rate and maturity controls has raised the share of interest bearing deposits in M1 in recent years, to around 20 per cent by end 1987. But, as the graph below shows, even the interest-bearing component appears to be sensitive to market interest rates.

[7]

There was a considerable divergence between growth of M3 and bank lending in 1985 and 1986, with lending growing much more quickly. In earlier periods, such as the mid 1970s, such differences were due to changes in holdings of LGS assets by banks. This was not the explanation in 1985–1986. The rapid growth of lending was financed in part by liabilities other than conventional $A deposits. In particular, new foreign banks funded part of their lending with capital, and banks (particularly the new ones) also increasingly used foreign currency borrowings (not included in M3). Declines in holdings of local and semi-government securities by savings banks (associated with changes in Prescribed Assets Ratio regulations) were also a factor. In other words, bank lending would appear to be a better indicator of movements in banks' balance sheets than M3 over this period. [8]

Broad money was affected by the same factors which hold growth of M3 below bank lending, namely the rapid growth of non-A$ and non-deposit liabilities. Borrowing from parent companies offshore by NBFIs was also a factor. [9]