Transcript of Question & Answer Session The Terms of Trade: Outlook and Implications

What's the outlook for 2016/17 when you've got about 200,000 people in the manufacturing sector going to lose their jobs, so what's the outlook then from you guys?

The outlook for the labour market has actually been improving over the course of this year. So one of the things that – if you want more detail on this, we've talked about it in the Statement on Monetary Policy – if you look at the sectors where the growth is occurring in terms of employment it's actually the household services sector that's been steadily adding to employment over the last couple of years and more recently business services, so I think this is part of a longer term structural change story. So the manufacturing industry, in terms of employment, has been in decline for some time. This is not a recent or a new development, this has actually been going for some time and I think it's a part of a process that will continue.

But it's not as if other sectors of the economy aren't growing and the opportunity to be employed in those sectors is actually pretty good. So in terms of our forecasts for employment and the unemployment rate, we actually see that the unemployment rate will probably stay in a sort of six to six and a quarter range for a while, but as the momentum in growth picks up we expect the unemployment rate to start falling.

Alex, I wonder if you might say a little bit about what the Bank's thinking is around India and how much effort you're putting into thinking about India in driving global growth. We know that its energy consumption per capita is very, very small; its intensity is similar. To what extent does India represent China mark 2 or are you downplaying that? I'd just be curious to know what you're thinking is about that area.

We actually have a team of people who focus very much on China and India, so the idea is that – well there's an accompanying graph to the terms of trade graph that shows that what we didn't really appreciate was quite how fast China would grow and I think it's quite clearly the case that one of the other economies that you need to pay a lot of attention to is India. There's a lot of potential for growth there and there's a lot of potential as it evolves and opens out, because it's a relatively closed economy, and this is what happened with China.

That they'll become a much more significant player both in terms of demand for commodities, they're also a significant commodity producer so there's the potential for them to be supplying commodities as well.

So I guess the answer to your question is we put a lot of effort into trying to follow developments in India. At this point in time it doesn't seem like over the next couple of years – which is the focus of our forecast horizon – that it's going to have a significant impact on the external demand conditions that we face, but we pay a lot of attention and keep alert to signs of things changing on that front.

Peter Morris Business Council of Australia. Thanks Alex for your presentation. Are you able to comment on any learnings from policy perspective over the past 15 years when we've gone through the boom-bust. I'm thinking for example the role of government and competition policy which has been a drag on investment and also the growth in regulation.

I would actually say that the main policy lessons that we've learnt from the past 15 years was captured by one of the last comments that I made which is that Australia has had previous episodes of significant structural change. The nature of that might have been different, we do have previous examples of significant terms of trade booms. But actually the Australian economy has adapted better in this episode than perhaps we might have expected from previous episodes. So it seems that the labour market has been more responsive and more flexible in the way that its adapted; relative wages have been able to sort of redistribute labour across sectors more effectively than in previous episodes. If we're thinking about the terms of trade specifically, this is one of the things that distinguishes this terms of trade boom from previous ones, is that we've had a flexible exchange rate and theories suggest that should do a very good job of buffering the domestic economy and I think that's the experience that we would come away, or that's the lesson we would come away, from the experience that a flexible exchange rate has served us very well.

And as I mentioned, I think one of the things that we have also benefited from is a macroeconomic policy framework, so that monetary policy is one element of that, that's very well articulated. It's been very well communicated and that's really helped everybody anchor their expectations of how macroeconomic policy is going to respond to things as the situation develops and that seems to also have served us well.

So if you go back to previous terms of trade episodes, the fixed exchange rate and the way monetary policy was run basically meant that we had very, very significant inflation issues arising from the terms of trade boom and we haven't seen that this time around.

So I think the main lessons are that some of the reforms that we've gone through and the policy frameworks that we've put a lot of effort into defining well and being very careful about have been very beneficial to us.

Tapas Strickland from the National Australia Bank. You mentioned the RBA looks at commodity prices and one commodity that international investors look at is the copper price, and that's recently been pulling new lows. I was just wondering whether you could speak to its relationship with global demand and what you think is going on there.

There's probably other people in the room who have views on this as well. So one of the interesting graphs from one of the previous presentations was the one that had the correlation between coal and oil prices and I thought that was very interesting because at the beginning of this year we actually had a situation where the oil price moved by a significant amount and we had to make a decision from a forecasting perspective about how we would think that would affect the terms of trade.

And as the graph that was presented shows, there's actually historically quite a strong correlation between oil prices and coal prices for example, or other energy products. So Australia is in a slightly interesting situation in that we're actually a net oil importer but we're a net energy exporter. So if we thought that the fall in oil prices was automatically going to flow through to a fall in coal prices, that actually had quite different implications for the terms of trade than if we thought it wouldn't. And so my point in here is we had to think very carefully about whether we thought what was driving oil prices was a demand shock, in which case you would expect it to be an increase the correlation of commodity prices, so if you have a generalised increase in demand for energy and commodities you would expect that to affect all commodities. Is it a localised demand shock? That seems unlikely with oil. Or was it a supply shock? So our assessment at the time was that a large part of the story about why oil prices were falling was connected to the increase in supply of oil; unconventional oil from the US more specifically. So we felt that that was an example where there wasn't going to be an automatic translation of the fall in oil prices to coal prices.

As I alluded to, every commodity has its own sort of supply story – and that's sort of one of the benefits of having the sorts of research that comes out of the Department is – is to try and understand what those particular things are. Our general assessment is that over the past year the demand element is a stronger force in explaining why commodity prices have been lower and we've seen a much stronger correlation across commodity prices. So that's a long way of saying I think movements in base metals or falls in base metals are probably telling us a similar story - that there is a significant demand element. It's very difficult not to look at the situation in China and look at the development of industrial production for example, and not think that there has been a slowing in demand for industrial products and that includes a whole range of base metals that includes iron ore and coal.

You mentioned that Australia's managing the transition through the resources boom pretty well and employment growth has been quite strong, but at the same time GDP growth has been a bit more tepid. What are your thoughts in the kind of divergence between the two and how can that be explained?

So if you go to the beginning of this year – so the forecast that we produced in the Statement of Monetary Policy in the beginning of the year – we very much had a view that if growth was going to be below trend, then it was likely that the unemployment rate would gradually increase.

Over the course of the year, we've revised our view of how these things fit together; partly because the information coming from the labour force kept saying well actually employment growth has been pretty reasonable and recently you'd almost go so far as to say it's been pretty strong. The unemployment rate wasn't increasing; it was sort of staying in a band of six to six and a quarter. So there's a number of ways to reconcile those two things. One is that we've had relatively low wage growth, so that has in some sense enabled service industries that have got demand to increase their employment to meet that demand. So this is a part of the story about the flexible labour market in operation.

Another part of the story is just the sectoral story, that if you look at where the growth is – and there's a whole range of indicators that you can look at and the labour market is one, you can look at business conditions, investment intentions and things like capacity utilisation measures from surveys – and these are all saying that the growth in the economy is coming from household services predominantly, but also business services to an extent as well.

And so it's just a part of the story, this handover process. We're undergoing a process of structural change – we're handing over from mining, it's being picked up in services – that process takes a bit of time to move labour and that also goes some way to reconciling those two pieces of information. And pretty much if you look at the forecast we're expecting that growth will start to pick up from here, that the economy will continue with this momentum and that all the pieces will align.