RDP 8805: The Relationship Between Financial Indicators and Economic Activity: 1968–1987 2. The Indicators

(a) Indicators of Economic Activity

There is a range of indicators of economic activity which might be used in a study such as this. Previous Australian empirical work has used industrial production, labour force data, national accounts aggregates or combinations of variables as reference cycles.^[2]

In the present paper, to keep the analysis manageable, and to relate the financial indicators to easily recognisable and accessible indicators, attention is confined to national accounts aggregates. In particular, it concentrates on measures of private final spending (i.e. private consumption and investment, including dwelling investment).

Another possible indicator of activity is GDP. Figure 1 shows GDP and private demand, both in real terms, over the twenty-year period 1968–1987. The line in the upper part of each panel shows an index of the level. The line in the lower part of each panel shows quarterly growth, and the black bars a smoothed series^[3] for the growth rate.

A couple of similarities between the two measures are clear: the series grew at similar rates over the period as a whole (average annual rates in excess of 3 per cent); both encountered temporary interruptions to the upward trend (the shaded areas represent periods of decline in private demand). But there are important differences. From Figure 1, downturns in demand are invariably more severe, and usually longer lasting, than those in GDP.

It might be argued that GDP is more appropriate than private demand, since it is a more complete measure of activity. On the other hand, because it is a broader measure, it also reflects many other factors besides financial conditions. In particular, net exports, government spending and farm production all have important influences on GDP, but are likely to show little short-run relationship to domestic financial conditions. Accordingly, the reference cycle used in the remainder of this paper is growth in private demand^[4] The smoothed growth rate (black bars in figure 1) is used for the graphical comparisons, and the actual growth rate for the correlations.

There were four major interruptions to the upward trend in private demand – in 1974/75, 1977/78, 1982/83 and 1985/86. In each period there were several quarters in which private demand declined. These periods are usually accepted as recessions. There were two other episodes of slowing in growth – in 1971/72 and 1978/79. Although in the first episode there was one quarter of negative growth, in the second episode there were none; in neither period did the smoothed series for domestic demand show a fall. There was also one isolated fall in private demand in the fourth quarter of 1975, but this is probably best regarded as an aberration because the periods immediately to either side showed strong quarterly growth rates.

(b) Financial Indicators

The financial variables used in the study are of three types – interest rates, banking aggregates, and broader financial aggregates that include the liabilities or assets of both banks and non-bank financial institutions.

(i) Interest Rates

The study uses short-term interest rates as one indicator of financial conditions. Figure 2 illustrates the 90-day bill rate, the weighted average rate on banks' certificates of deposit, and the weighted average rate paid by authorised dealers in the short-term money market on overnight deposits. Clearly, for most of the period, these rates move together.

Accordingly, only one interest rate variable is used – the yield on 90-day bank-accepted bills (henceforth “the bill rate”). This is the main indicator of short-term interest rates in Australia. The bill market is very deep and yields are clearly market-determined and have been so over nearly all of the period under consideration. The bill rate has a direct impact on the cost of short-term funds to financial institutions. As is clear from the graph, the bill rate has moved closely with the rate on certificates of deposit since the deregulation of those rates in 1972. Hence, it is a good indicator of the cost to banks of short-term professional funds. The bill rate is also the major indicator of the cost of funds to merchant banks.

The other very important short-term interest rate for financial intermediaries is the rate on call and overnight funds (the “cash rate”). Unfortunately, this was not representative of short-term interest rates in general in the early part of the period because banks were excluded from this part of the short-term money market until August 1984. The yield on Treasury notes is not used in the study because for much of the period it was not market-determined.

The other issue of importance is whether to use a nominal or a real interest rate. Most of the analysis conducted in this paper uses the nominal rate. One question that might be raised is whether nominal rates are an accurate reflection of the true cost of borrowing in periods such as the mid 1970s, when inflation was high and variable. On the other hand, use of the real rate for analysis and description is complicated by the difficulty of measuring the expected rate of inflation. For the 1980s, when inflation was relatively stable, movements in the real rate were dominated by movements in the nominal rate, so it makes little difference which is used. One simple measure of the real rate of interest is brought into consideration where relevant.^[5]

(ii) Banking Aggregates

Three aggregates based mainly on banks' balance sheets are used. They are:

• M1, which is the sum of the public's holdings of currency plus current deposits of trading banks. This is the closest approximation to the “transactions medium” of traditional monetary theory;
• M3, which is the sum of the public's holdings of currency plus all deposits with banks (trading and savings banks). This series was the focus of monetary policy between 1976 and 1984, when conditional projections were announced at Budget time; and
• bank lending to the public, which is banks' loans, advances and bills discounted.

Both M3 and bank lending are approximately adjusted for the effects of transfers of deposits and loans when major non-bank financial intermediaries became banks,^[6] and the effects of foreign bank entry. This removes distortions created by changes in policy relating to bank entry. Effects not caused by such policy changes – for example the winning of business from non-banks by banks – will still be reflected in the data. M1 has not been so adjusted, but this is of little empirical significance since all of the large new banks were savings banks, whose deposits are not included in M1.

(iii) Broader Aggregates

Three aggregates based on the sum of banks' and non-bank financial institutions' balance sheets are used. These series are only available from 1976 when the statistical collections under the Financial Corporations Act started. The three aggregates are:

• broad money, defined as the public's holdings of currency, bank deposits and borrowings from the public by non-bank financial institutions;
• lending by all financial intermediaries (loans, advances and bills discounted), henceforth called “lending”; and
• credit, which is lending plus bank-accepted bills outstanding (other than those discounted by financial intermediaries). Put another way, this is all intermediated lending to the public plus the major form of securitised lending.

Figure 3 assembles the range of financial indicators (levels of interest rates and quarterly growth rates for the aggregates) for the period 1968–87. The bars show growth in nominal demand, with the black part of the bars the portion due to real growth. All financial aggregates and demand have been smoothed using a simple moving average.

Footnotes

See for example Davis and Lewis (1977), Sharpe (1975), Beck, Bush and Hayes (1973), Boehm and Defris (1977) and Boehm (1987). [2]

The series is smoothed by taking a three-quarter, centred moving average. See the appendix for more details. [3]

All the empirical work has also been done using GDP as a reference cycle. There are some differences in the results, reflecting the above factors. The more substantive of these are noted in the text or in footnotes at the relevant point. [4]

It is defined as the nominal interest rate less the four-quarter ended change in the consumer price index for the same quarter. [5]

Details of the procedure used are given in the appendix. [6]