Semi-Annual Statement on Monetary Policycountries to resume growth via exports may increase...

November 1997Reserve Bank of Australia Bulletin

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Introduction

During 1997, the Australian economy hasbeen gradually emerging from a mildslowdown which began during 1995 andcontinued through 1996. At its low point, inthe second half of 1996, annualised growthin real GDP fell to around 2 per cent,according to the national income accounts.By the first half of 1997, growth increased toan annual pace of nearly 4 per cent.

As is usually the case with such episodes,several cyclical dynamics were at work. Thefirst was the working out of a mild inventorycycle, which now appears largely to have runits course. A second factor was that monetarypolicy began to ease in mid 1996 inrecognition that the outlook for inflation hadimproved. Inflation had begun to decline torates much more consistent with the Bank’smedium-term inflation target, having beenslightly above target for a year or so previously.This reduction in inflation was in turn a resultboth of the period of more subdued growth,and of the appreciation in the exchange rateduring early 1996. It was accompanied by afurther structural decline in inflationexpectations in various parts of thecommunity, resulting in a change in behaviourwhich opened up the scope for monetarypolicy to adopt a more expansionary stance.

As a result, the three reductions in officialinterest rates during 1996 have been followedby two further declines since the firstSemi-Annual Statement on Monetary Policy wasissued in May 1997. These changes are havingan impact on interest sensitive areas ofdomestic demand in the economy, which arenow contributing to the increase in growth,and there are some encouraging signs in thelabour market. In the period ahead, subjectto some caveats about export markets (dealtwith below) it is reasonable to anticipate thatthis will continue.

Until October, financial markets werereasonably steady, and generally in anoptimistic frame of mind. Interest rates paidand charged by financial intermediaries, andyields in money and capital markets, movedto low levels both by historical andinternational standards, and share prices roseto new highs. The favourable conditions inAustralian markets were supported bydevelopments in the main markets overseas,which were mostly buoyant as fears of apick-up in inflation receded. The instability infinancial markets in parts of Asia, whichaffected first Thailand, and then subsequentlyspread to Indonesia, Malaysia and thePhilippines, to that point had not generallyaffected Australian or global markets verymuch. Domestic capital markets remainedbullish, and while the exchange rate of theAustralian dollar eased against the US dollar,this was due mainly to the strength of the latter.

Semi-Annual Statementon Monetary Policy

Semi-Annual Statement on Monetary Policy November 1997

8

The situation has changed, however, inrecent weeks. The trigger was the spread ofcurrency pressures more widely in Asia,particularly to Hong Kong. They quicklyspilled over into share prices there,subsequently setting off a period of greatvolatility in global share markets. The size ofthe impact of the Asian problems on globalmarkets was something new, but it was mostlikely due to the fact that markets in somemajor countries had already reached very highlevels by historical standards. As share marketsfell, funds flowed into government bonds.Australian markets reflected these globaltrends, the impact here being, if anything,larger than in most other industrial countries,reflecting our close links to Asia. In addition,we have experienced a net fall in the exchangerate of the Australian dollar over the pastfortnight.

The outlook for Asia is the key uncertaintyin assessing prospects for the Australianeconomy over the next year or two. Recentevents are likely to result in a marked slowingin growth in some of Australia’s Asian tradingpartners, with consequent loss of export salesand reduced income flows from foreignoperations of Australian firms. The extent andduration of this is difficult to predict with anydegree of confidence, because asset price fallsand subsequent banking problems are acentral part of the unfolding events. Much willdepend on how successful the variouscountries are at confronting and dealing withthese and other problems, and how quicklythe confidence of financial markets can beregained. Assistance by the InternationalMonetary Fund to Thailand and Indonesiashould help this process, and provide a basisfor recovery. Australia’s participation in bothof these programs has helped in quicklyformulating these regional support packages.Developments in North America, wheregrowth remains strong, and Europe, where itis picking up, may also provide some partialoffset to the pessimistic news from our north.

Despite some precautionary rises in interestrates in Europe and North America, there arefew signs of inflationary pressures around theworld, and the Australian economy is sharing

in this good inflation performance. The forceswhich have acted to bring inflation down tounusually low levels over the recent period are,however, likely to wane over the coming yearto 18 months. Within that period, underlyinginflation is likely to edge up to be a little above2 per cent, and remain consistent with thetarget thereafter. While this remains the case,monetary policy will be able to maintain itspresent stance, which is moderatelyencouraging to growth.

The events in Asia are still unfolding, andfurther instability in financial markets cannotbe ruled out. The subsequent efforts of Asiancountries to resume growth via exports mayincrease international competition and furtherdampen prices in world markets. Thisenvironment underscores the need for costsin Australia to remain tightly controlled. It isdisappointing that earlier signs of slowing ingrowth of Australian labour costs do notappear to have continued, judging from themost recent data. While current rates ofgrowth of wages and salaries are still consistentwith achieving the inflation target, fasterreductions in unemployment would beachievable were wages growth to be slower.

Developments in East Asia

Since the 1960s, east Asia has recordedexceptional rates of economic growth. For themost part, this has been trade-orientedgrowth, underpinned by generally prudentmacroeconomic policies. Fiscal policies havebeen conservative, inflation has beenmoderate, and domestic saving has been high.The very strong rates of investment in anumber of Asian countries outstripped eventhe high domestic saving rates, withsubstantial current account deficits providingthe extra resources for investment. The inflowof foreign capital which financed these deficitsstepped up in the 1990s, reflecting changingperceptions in world capital markets aboutthese ‘emerging economies’. The flows werefacilitated by the financial deregulation and


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institutional development occurring in thesecountries. Encouraged by high rates ofexpected return characteristic of rapidlygrowing dynamic economies and the shift ofproduction capacity from high-cost countriessuch as Japan, these flows in some instancesamounted to 10 per cent of GDP over anumber of years (Table 1).

The combination of rapid growth and largecapital inflows was reflected in rapid creditexpansion, an over-extension of corporatebalance sheets, rising equity and propertyprices, over-investment in particular sectorsand some lowering of the quality of investmentundertaken. At the same time, the rapidgrowth of the financial sector outpaced thedevelopment of prudential regulation and leftthe financial sectors of these economiesvulnerable. The heavy recourse to foreignfinancing was often of a short-term nature,with the borrower bearing the foreignexchange risk in many cases.

This combination of circumstances gavethese economies an outstanding record ofgrowth, but also left them vulnerable tochanges in sentiment, and with financial

sectors which lacked resilience whenconfidence deteriorated. An initially modestreassessment of credit risk and exchange raterelativities has been enough to spark offsubstantial exchange rate changes and aprocess of widespread financial strains whichseem likely to cut growth rates in the‘ASEAN-4’ – Thailand, Malaysia, Indonesiaand the Philippines – for the immediate future.

The trigger was the emergence of exchangerate pressures, beginning in Thailand. Thepractice of keeping exchange rates reasonablyconstant against the US dollar meant thatseveral Asian countries had suffered a fall incompetitiveness in the past couple of years(Graph 1) as the US dollar rose stronglyagainst most other currencies, particularly theyen. The impact of this deterioration incompetitiveness on the east Asian economieswas exacerbated in 1996 by a world-wideslump in the semi-conductor market – amarket in which east Asia had increasinglyspecialised. Thus by late 1996 and early 1997,downward pressure was starting to be felt onthe exchange rates of the most exposed Asiancountries and capital inflow was drying up,

Table 1: East Asia

GDP Net private capital Domestic creditinflows (a)

Average Per cent of GDP Per cent of GDPannual growth

1990 – 1996 1990 – 1996 1990 1996

Indonesia 7.2 4.0 49 55Malaysia 8.7 10.4 78 103Philippines 2.8 6.1 23 66Thailand 8.6 10.6 70 99Singapore 8.4 -1.4 61 65China 10.5 3.2 90 95Taiwan 6.3 -3.0 104 165Hong Kong 5.1 n.a. 132(b) 156South Korea 7.7 3.2 57 65

(a) Average annual flows

(b) 1991

Sources: IMF International Financial Statistics, national governments


10

or in some cases turning to outflow. Thesituation was not helped by the increasingrecognition that difficulties were beingexperienced by banks and other financialintermediaries, particularly in Thailand.

Graph 1

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Real Effective Exchange RatesMonthly, January 1993 = 100

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Index

Source: JP Morgan1994 1995 1996 1997

Index

Malaysia

Indonesia

Thailand

Philippines

While the Thai authorities managed for atime to resist these pressures, they wereeventually forced to float the exchange rate inearly July. The baht exchange rate quickly fellby about 15 per cent. This intensifiedpressures on other countries and, in the weeksthat followed, the Indonesian rupiah andPhilippine peso were also floated. TheMalaysian ringgit was not formally floated, butwas managed much more flexibly and itsmovements broadly paralleled those of theother three currencies (Graph 2). By endAugust, the Thai baht had depreciated byabout 25 per cent from its pre-May level, theIndonesian and Philippine currencies weredown by around 20 per cent, and theMalaysian ringgit had fallen by about 15 percent.

This initial adjustment of exchange rateswas followed by a brief period of stability inSeptember, helped by the announcement ofthe IMF’s rescue package for Thailand. Thisinvolved a US$17 billion assistance package,encompassing IMF resources and bilateralassistance from other countries in the region(including Australia). As part of the package,Thailand agreed to implement economic

reforms, including fiscal measures, a reductionin reliance on foreign capital inflow andfurther restructuring of a number of ailingfinancial institutions.

By late September, however, exchange ratesof the four currencies in question began todepreciate again. One factor behind theresumption of exchange pressures was marketconcerns about some of the responses bygovernments to the emerging difficulties.Markets also focused on the possibleinter-relationships between the falls inexchange rates, capital flows, falls in propertyprices and the health of the financial systemsconcerned. The general increase in interest

Graph 3

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Asian Currencies Against US$

Index

1997M J S

South Korea

December 1996 = 100Index

Taiwan

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J F A M J A O N

Hong KongChina

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J F A M J A O N


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rates in the region, in order to supportexchange rates, was seen as adding to thedifficulties in asset markets. In some east Asiancountries, the likelihood that the exchange ratefalls would add to strains in financial systemswas heightened by the high levels of foreigncurrency borrowings by residents. Exchangerates in these four countries have now fallenby between 25 and 40 per cent since mid1997.

Until late October, the pressures wereconfined largely to the four ASEANeconomies but they then spread to othercountries, including Hong Kong. The stabilityof the exchange rate in Hong Kong is apolitical as well as an economic issue, as HongKong has promoted the fixed exchange rateto the US dollar as the corner-stone of stabilityand an essential part of the ‘one country-twosystems’ policy. Markets assessed that theauthorities in Hong Kong would resist anychange in the exchange rate despite the lossof competitiveness, and that the inevitable risein interest rates would have adverseimplications for economic activity and assetmarkets. On the day of most intense pressurein October, the Hong Kong authoritiespushed overnight interest rates to 300 percent, and the share market fell by over 10 percent. Given the importance of Hong Kong inworld financial markets, the impact quicklyspilled outside the region; sharp falls wereexperienced in equity prices around the globeand there was a ‘flight to quality’ intogovernment bonds.

Implications for Australian and worldmarkets

From the float of the Thai baht on 2 Julyuntil mid October, the problems in Asia hadno significant impact on Australian markets.While the Australian dollar has been fallingagainst the US dollar for much of 1997(Graph 4), most of the explanation for thiswas the strength of the US currency, althoughnarrowing interest differentials and lacklustrecommodity prices also played a part.

However, when the problems in Asia spreadin late October, Australian markets werecaught up in the ensuing global turbulence.Events in Asia seem to have had three main

effects on Australian markets. First, theycaused a fall in the exchange rate. Thespreading of the Asian instability to HongKong was responsible for the fall of theAustralian dollar from about US 74 cents toUS 71 cents. It probably also contributed tothe exaggerated response to the fall in the priceof gold at the end of October; the Australiandollar fell from US 70.5 cents to US 68.5 centsafter the Swiss made further announcementsabout possible changes in the managementof gold reserves. Speculators who had beenselling the Australian dollar earlier on Asianconcerns, were reinforced in their actions bythe fall in the gold price. While the Australiandollar staged some recovery towards the endof October as share markets and gold pricesshowed signs of stabilising, it has nonethelessfallen by 11 per cent against the US dollarsince the start of 1997. In trade-weightedterms, the Australian dollar has held up better,and is not far from its long-run average.

The second impact of the Asian crisis hasbeen on our share market. Australian shareprices fell sharply in October. The fall was partof a world-wide reaction on share markets(Table 2), though the Australian fall was a littlelarger than the average of other industrialcountries. This greater impact is a reflectionof our close economic links with Asia. Allsectors of the Australian market were affectedby the volatility in October, though resource

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Australian DollarDaily

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1997M JS DO J AJ J A N MF J A S O N

(RHS)

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Graph 4


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companies, with their large exposure to Asianmarkets, and which had underperformed inthe earlier rising market, fared the worst fromthe market fall.

This is probably the first time that sharemarket falls in Asia have had a significantimpact on industrial countries’ share prices.In large part this was because many marketparticipants felt that a correction in globalshare markets was overdue. Signs had beenapparent before the fallout from Asia ofincreasing nervousness in share markets.Share prices in most countries reached a peakin late July, when they seemed to lose upwardmomentum, as spirits were dampened bysome downward revisions to profit forecastsin the US. In this climate, a shock in any majorfinancial centre, either in Asia or elsewhere,had the potential to trigger substantialcorrections in prices in other markets, whichwere widely recognised as overheated.

The third area to be affected was the bondmarket. Here, the immediate impact waspositive, reflecting a ‘flight to quality’ by shareinvestors seeking stability of income flows andgreater certainty about capital values andcredit standing.

Prior to the escalation of the Asian crisis,world bond markets had begun to show signsof nervousness, and bond yields had begunto rise. This move started when FederalReserve Chairman Greenspan expressed

concerns about the potential for US inflationto rise, given the prevailing tightness of labourmarkets there. Financial markets saw this asa sign that the US was moving closer to thepoint of tightening monetary policy again. Therise in yields was reinforced by the tighteningof monetary policy by a number of Europeancentral banks in mid October.

The move up in world bond yields wasreversed when the Hong Kong stock marketfell sharply on 22 October, as investors soughtsafe haven in bonds. From 6.2 per cent in midOctober, US yields fell back to around5.8 per cent. Here in Australia, yields on10-year bonds fell from a high of almost6.5 per cent, reached after the publication ofdisappointing wage data on 23 October, toaround 6 per cent at present (Graph 5). As inthe US market, the key factor underlying thefall in local bond yields was the switch out ofequities.

The recent gyrations should not distractattention from some favourable longer-termtrends in interest rates, both in Australia andabroad. While the decline in bond yields inlate October reflects ‘safe-haven’considerations that might not be sustainedindefinitely, bond yields in Australia hadalready fallen to their lowest levels sincefinancial deregulation in the early 1980s,which allowed yields to be set freely by themarket. The fall in yields has resulted in a

Table 2: Change in Share PricesPer cent

Industrial countries Asia

Since end 1997 Since end 1997September 1997 to date September 1997 to date

United States -6 15 China 8 30Japan -8 -15 Hong Kong -25 -16Germany -11 29 Indonesia -8 -21Canada -3 15 South Korea -21 -21Italy -9 38 Malaysia -12 -42France -9 18 Philippines -11 -42United Kingdom -8 18 Singapore -13 -23New Zealand -7 2 Taiwan -12 10Australia -10 3 Thailand -18 -46


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further sharp narrowing of the premium overUS securities which investors used to require(Box A). While a number of influences,including the improvement in the fiscalposition of the Government, contributed tothis reduction, the primary factor is the lowlevel of inflation. Dormant inflationarypressures represent highly favourableconditions for bond markets.

Broader implications of the Asianfinancial instability

The exact extent of the financial difficultiesfaced in a number of Asian economies remainsextremely difficult to judge. Reliableinformation is scarce, and to a large extentquestions of asset valuation are inherentlysubjective and based on forecasts of futureprices. It is clear nonetheless that severalcountries in the region face a period ofadjustment to lower asset values andrebuilding of corporate and bank balancesheets.

The full resolution of problems in bankingsystems will take some time. Experience inother countries which have had suchdifficulties indicates that the speed with whichthese problems are identified, andarrangements set in place for resolving them,are critical in determining how quickly thebroader economy can be returned to betterhealth and the confidence of domestic andinternational financial markets regained.

However, even with a good policy response, aperiod of very weak economic growth can beexpected for these countries. During that time,their imports will be depressed, with adverserepercussions for countries exporting into thearea.

In the meantime, export sectors of a numberof countries will receive a boost fromdepreciated currencies. Here the experienceof Mexico after the 1994 crisis is instructive.The fall in the Mexican peso (which was,admittedly, of a larger magnitude than the fallsexperienced by the ASEAN-4 currencies) wasfollowed by export growth at an averageannual rate of 26 per cent over the subsequenttwo years. The ASEAN-4 countries have largerexport sectors, relative to the size of theireconomies, than Mexico (even when thecomparison is made on the basis of exportsto destinations outside the ASEAN-4 region),in some cases by a large margin (Table 3). Asa consequence, expansion of export growthcould be a considerable boost to theseeconomies.

The extent to which instability in Asianshare markets has fed back to markets in majorindustrial countries is a new phenomenon, butthe declines in share prices in those lattercountries have been smaller than pastcorrections. As such, the decline in wealth is

Graph 5

Table 3: Goods Exports of theASEAN-4 Countries (a)

Per cent of GDP

Total To non- To outsideASEAN-4 east Asiancountries region

Indonesia 22 20 10Malaysia 78 72 34Philippines 25 24 15Thailand 31 29 14

Memo item:Mexico 8 n.a. n.a.

(a) Data are for 1996, except for Mexico whichare for 1994

Sources: IMF International Financial Statistics, IMFDirection of Trade, national governments

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10-year Bond Rate

1994

%

Australia

1995 1996 1997

US

%


14

Over the past six months, bond yields inAustralia have continued to fall relative tothose in other countries, as markets havebecome more accepting of the sustainabilityof Australia’s low inflation (Graph A1). Whilethe improvement has been evident againstthe broad range of countries, the key marketagainst which Australian yields are judged isthe US.

Differences in the cyclical position of theAustralian and US economies have alsocontributed to the narrowing of spreads overthe past year or so. The US economy isfurther advanced in its economic cycle, andtherefore likely to be closer to experiencingupward pressure on inflation and monetarytightening, factors which would be helpingto lift bond yields there relative to those inAustralia.

Much of the yield curve in Australia hasmoved to a position below that in theUnited States in recent months (Graph A3).

Box A: Differentials in Bond Yields

The spread between Australian 10-yearbond yields and corresponding US yields hasfallen to an average of about 10 basis pointsin recent months. The fall in this spreadcontinues the trend evident for much of the1990s, the abrupt setback during the bearmarket of 1994 aside: in the second half ofthe 1980s, the spread of 10-year bonds inAustralia to US treasuries averaged about4.5 percentage points (Graph A2).

The sharp narrowing of the spread, to thepoint where it has almost closed, hasoccurred because Australia’s better inflationperformance relative to the US in the 1990s(2.7 per cent a year versus 3.4 per cent) isworking to offset other factors which wouldnormally result in a premium for Australianyields over US yields. These includeAustralia’s lower credit standing and thelesser liquidity of the Australian bondmarket.

Graph A2

Graph A3

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Ten-year Spread to Australia

1996

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US

1997J S D M J S

NZ

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Ten-year Bond Differential BetweenAustralia and US

% %

1987 1989 1991 1993 1995 1997

Graph A1

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Yield Curve%

End-June 1996

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Table A1: 10-year Bond YieldsPer cent, per year

Level of yields Spreads to United States1980s(a) Current 1980s(a) Current

United States 10.6 5.8 .. ..United Kingdom 11.3 6.5 0.7 0.7Canada 11.7 5.5 1.1 -0.3Australia 13.5 6.0 2.9 0.2New Zealand 14.0 6.7 3.4 0.9Germany 7.6 5.6 -3.0 -0.2France 11.7 5.6 1.1 -0.2Italy 14.5 6.3 3.9 0.5Sweden 12.1 6.4 1.5 0.6Netherlands 8.2 5.6 -2.4 -0.2Belgium 10.6 5.7 – -0.1Switzerland 4.6 3.6 -6.0 -2.2Spain 14.4 6.0 3.8 0.2Japan 6.7 1.6 -3.9 -4.2

(a) Decade average

6.0 per cent. The main factor in thisconvergence is that inflation is universallylow, although progress in reducing budgetdeficits in most countries, includingAustralia, has also helped.

Acknowledging the progress of othercountries does not diminish the benefits thathave flowed to the local bond market as aresult of the return to low inflation inAustralia. While bond spreads will no doubtcontinue to fluctuate, Australia’s record oninflation in the 1990s, good prospects thatthis performance will be sustained and theprogram of Budget consolidation have putAustralia in a much better position towithstand market pressures on bond yieldsthat may arise from time to time.

In mid 1996, before the latest easing ininflation and wage pressures, the yield curvein Australia was well above that in the UnitedStates at all maturities.

As well as domestic considerations, thenarrowing of the bond spread reflects theinternational setting: most countries’ spreadsto the US have narrowed (Table A1).Australia’s performance should be assessedagainst those of other previously highinflation countries, such as Italy and Spain,which have also done about as well. Apartfrom the United Kingdom, New Zealandand Sweden – on the high side – and Japanand Switzerland – on the low side – mostindustrial countries’ bond yields arecurrently in a band around 5.5 and


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beginning to recover in 1997; a significantfurther slowing would have a noticeable effecton aggregate exports. Nonetheless, the bulkof the growth in exports to east Asia has beento the north-east Asian countries, which aremuch bigger markets – accounting for over20 per cent of Australian exports. Since 1990,the total quantity of Australia’s exports hasgrown at an average annual rate of71⁄2 per cent; about 11⁄2 percentage points ofthis has come from the ASEAN-4 countries,and about twice that contribution has comefrom the other east Asian countries (Graph 6).

Graph 6

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Export VolumesContributions to growth, by destination

1997

%

Rest of theworld

%

ASEAN-4

OtherAsia*

199519931991* China, Hong Kong, Singapore, South Korea and Taiwan

unlikely to depress spending significantly inthose countries. Even after the 1987sharemarket correction, which wassignificantly larger, US and global growth in1988 was very strong – to the point thatinterest rates around the world rose that year.Speculative excesses subsequently occurred inproperty markets, with a subsequentdownturn in property markets exacerbating abusiness-cycle slowing.

Assessments of the effects of recent eventson the Australian economy are subject toconsiderable uncertainty. Much will dependon the size and duration of the slowing ingrowth in Australia’s Asian trading partners,and what happens in the rest of the world –where the other half of Australia’s exports aresold. While ever the acute difficulties werelikely to be confined largely to the fourASEAN countries initially hit by theturbulence, the implications for Australia werelikely to be reasonably contained. Thesecountries take about 10 per cent of Australianexports, and supply about 6 per cent ofAustralian imports (Table 4). They accountfor 10 per cent of short-term visitor arrivals,and a quarter of foreign students studying inAustralia. Merchandise exports to thesecountries have grown at a high average rateover recent years, slowing in 1996 but

Table 4: Australian Trade and Investment LinksPercentages

Goods and services Investment shares Inbound traveltrade shares for education

Exports Imports Australian Foreignto: from: investment investment

abroad in Australia

Japan 21 12 8 13 10China and NIEs(a) 25 15 8 6 34European Union 12 26 25 29 8United States 7 21 27 23 7ASEAN-4 10 6 3 0.4 27

(a) Hong Kong, Singapore, South Korea and Taiwan

Note: Trade data refer to 1995/96; investment data as at 30 June 1996; arrivals data refer to 1996/97

Sources: Balance of Payments and International Investment Position 1995-96 (ABS Cat. No. 5363.0) and ABS specialdata service


17

The slowing in ASEAN itself would notnecessarily lead to a major reduction in growthin north-east Asia: the trade exposures of thosecountries to ASEAN are generally no higherthan Australia’s (Table 5). Most of thenorth-east Asian countries have experiencedan acceleration in their own export growthover recent months, after a pronouncedslowing in 1996 (Graph 7). This has tendedto hold out some hope that Australian exportswould in turn grow more quickly, and on themost recent data, this appears to have beenhappening (Graph 8). The danger now is thatfinancial fragility, and/or tight financialpolicies in the wake of the market volatility of

recent months, may retard growth in a broadergroup of countries. This risk appears to belargest in South Korea, where despite apick-up in export growth over recent months,and continued robust growth in industrialoutput, corporate insolvencies have sappedconfidence and strained the banking system.

While these events play out, the Japaneserecovery appears to have suffered anothersetback. The June quarter accounts showed amuch bigger than expected fall in GDP of2.9 per cent, and business sentiment, asrecorded in the Tankan survey, hasdeteriorated in recent months (Graph 9). The

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Exports of East AsiaYear-ended growth*

1997

% %

1995199319911989

Other eastAsia**

ASEAN-4

China

* Six-month averages; percentage change from year earlier** Hong Kong, South Korea, Singapore and Taiwan

Graph 8

Table 5: East Asian Exports by DestinationPer cent of total exports

ASEAN-4 Japan Other Asia US Europe Others

South Korea 9 12 28 17 15 19Japan 12 — 32 28 17 11China 3 20 34 18 16 8Hong Kong 4 7 44 21 17 8Taiwan 8 12 32 23 15 10Singapore 28 8 23 18 15 7Thailand 6 16 30 18 18 11Malaysia 7 14 37 19 15 7Indonesia 6 29 21 17 19 9Philippines 8 18 17 34 18 5

Sources: IMF International Financial Statistics, IMF Direction of Trade, national governments

Graph 7

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Exports by Destination

1997

$b

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199519931991

$b

Eastern Europe, MiddleEast, Pacific and other

Europe and US

Constant prices, sa

East Asia


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existing difficulties of the Japanese banks maybe exacerbated by the recent financial marketturbulence throughout Asia. The Japaneseeconomy has experienced weak economicperformance for some years now, andAustralian exports to Japan have recordedvirtually no growth over the past five years.This hindered overall export performancemuch less than might have been expected,because the considerable expansion in otherAsian countries allowed exporters to findalternative growth opportunities. Lookingforward, the likelihood that south andnorth-east Asian trading partners willexperience slower growth for a time, whileJapan remains weak, provides a difficultexternal environment for Australia.

Another effect on Australia could bethrough the property market as Asian investorshave been active in purchasing units inhigh-density residential developments over thepast few years. This activity might be expectedto slow.

The Australian economy is well placed,however, to weather the worst of the financialshock which has hit the region. An important

factor which determines the extent to whichdeclines in asset values have a broader impacton the economy is the extent of leverage.Holdings of equities in Australia are notroutinely financed with borrowed funds;property prices have not staged a large run-up,except in inner city residential areas, whichmakes the probability of a major, broadlybased decline reasonably low; lenders are wellcapitalised and the credit process is workingwell. So while there will almost certainly besome, as yet unquantifiable, dampening effecton the Australian economy operating throughtrade channels, this should not becompounded by financial difficulties.

United States and Europe

Also important in an overall assessment ofAustralia’s external environment aredevelopments in the United States andEurope. In contrast to the situation in eastAsia, the United States economy continuesto record good growth, while growth in themajor European economies appears to bepicking up after a prolonged period of weakerperformance. These trends will help to providea base of support for external demand andmay, to some extent, mitigate some of theeffects on Australia of the east Asiandifficulties.

The United States economic expansion hasbeen a remarkably steady one, with year-ended growth rarely outside the 2 to 4 per centrange since 1992; over the past year, growthwas 4 per cent (Graph 10). Theunemployment rate has been on a trenddecline throughout the expansion, reaching4.9 per cent in September 1997. Despite thetightening labour market, inflation has so farremained subdued, with core consumer pricesrising by only 2.2 per cent in the year toSeptember, their lowest annual rate of increasesince 1966.

Activity in the three largest continentalEuropean economies (Germany, France andItaly), after having been sluggish for several

Japan

Real GDPYear-ended percentage change

%

0

3

6

0

3

6

Tankan survey – business sentimentNet balance

%

% %

Small firmsLarge firms

**

* Forecast for December quarter

1987 1989 1991 1993 1995 1997-80

-40

0

40

-80

-40

0

40

Graph 9


19

years, now appears to be picking up a littlefaster than had been expected. The EuropeanCommission has recently revised upwards itsforecasts for growth across the EuropeanUnion by 0.2 percentage points in both 1997and 1998, to 2.6 per cent and 3.0 per centrespectively. Signs of strengthening in the largecontinental economies are particularlyapparent in their industrial production data.Consumer price inflation remains relativelysubdued, although a pick-up in import pricesin Germany has pushed up inflation ratesthere a little. This prompted a r ise inshort-term rates in Germany in October,which was followed by France and severalsmaller countries. In the United Kingdom,output rose by 3.9 per cent in the year to theSeptember quarter, underpinned by strongdomestic demand and an unemployment rate

that continues to fall. The Bank of Englandhas gradually raised the interbank rate to itscurrent level of 7 per cent to resist inflationarypressures flowing from the tight labour marketand strong demand.

Domestic Economic Activity

The Australian economy has grown a littlefaster during 1997 than in 1996. In the firsthalf of 1997, real GDP expanded at anannualised pace of just under 4 per cent,following a relatively weak second half of 1996,when growth was about 2 per cent (Table 6).In the non-farm sector of the economy, theturnaround was a little more marked, fromaround 11⁄2 per cent in the latter half of 1996to 33⁄4 per cent in the first half of 1997.

Growth has been supported by a solidexpansion of private-sector final demand,which over the past couple of years has beenincreasing at a rate of about 4 per cent. Stronggrowth in business investment has continuedto be a major driver of the expansion to date,with dwelling investment now beginning toplay a more prominent role. Privateconsumption appears to have strengthenedrecently, after a weak showing in 1996. For atime, some of this growth of domestic demandwas supplied by running down inventories, sothat output ran behind. In addition, a slowingin export growth in 1996 and early 1997,particularly to a number of countries in north-east Asia, meant that net absorption ofAustralian output by the rest of the worlddeclined. More recently, however, theinventory correction appears to have largelyrun its course, while a stronger performanceof the north-east Asian economies during1997 to date has seen a pick-up in exportgrowth since March.

The latest available data suggest that theexpansion is continuing, with signs thatemployment growth may be starting torespond to the firmer trend in production. Ifso, the resulting growth in household incomeswill support ongoing growth in consumption.

Graph 10

Prices

6

8

6

8

6

8

6

8

United States

Year-ended percentage change%

0

2

4

0

2

4

0

2

4

0

2

4

Unemployment rate

Earnings and core pricesYear-ended percentage change

%

%%

%%

Earnings

0

2

4

0

2

4

Real GDP

19931991 1995 1997


20

Question marks remain over the outlook forexports, arising from a likely slowing in eastAsian economies next year and the possibilityof wider repercussions. The following sectionscover the household and business sectors andAustralia’s balance of payments.

Household income and expenditure

Consumer spending on goods has beenrising during 1997, after a period of weakeningdemand through the second half of 1996. Thestrength of the upward trend has been difficultto gauge, because of the effects generated byshifting timing of holiday-related spending.Retail sales around Christmas 1996 wereunusually weak. Demand then strengthenedappreciably early in 1997, only to slow againfrom March to May. More recently, strongergrowth has resumed, with retail trade in theSeptember quarter rising by 3.1 per cent inreal terms, after a decline of 0.3 per cent inthe June quarter (Graph 11). Over the year toSeptember, growth was 3.8 per cent,compared with a fall of 0.6 per cent over theyear to December 1996.

The detailed data for retail trade showdiffering patterns of growth between types ofexpenditure, with growth in demand forservices over the past year generally stronger,by a good margin, than for goods. This patternis even clearer in the national accountsestimates for private consumption, where theitems recorded in the monthly retail trade datamake up a little under half of consumptionoutlays for households. Estimates for spendingon the other half – the broad range of serviceswhich includes recreation, entertainment,telecommunications and financial services –suggest quite robust growth. This reflects thecontinuation of the structural change towardsservices which has been occurring in theeconomy for many years.

Demand for motor vehicles has increasedsubstantially over the past six months.Registrations of passenger vehicles in theSeptember quarter were 15 per cent higherthan a year earlier. Some of this expansion indemand has been prompted by highlycompetitive prices for imported vehicles,which have taken a large share of the increased

Table 6: Expenditure and ProductionAnnualised rates of change

Six months to: Year to

December 1996 June 1997 June 1997

Private demand(a) 2.6 4.8 3.7of which:Consumption 1.6 2.8 2.2

– Goods -0.2 2.9 1.4– Other(b) 4.1 2.3 3.2

Dwelling investment 1.6 15.8 8.5Business investment(a) 9.9 8.3 9.1

Public demand(a) 2.7 5.1 3.9Private non-farm stocks(c) -0.7 0.5 -0.1

Net exports(c)(d) -1.0 -0.4 -0.7GDP(E) 0.7 4.1 2.4GDP(A) 2.5 3.9 3.2

(a) Excluding asset transfers

(b) Excluding dwelling rent

(c) Contribution to growth in GDP(E)

(d) Excluding RBA sale of gold


21

expenditure. Nonetheless, demand forvehicles across the board has been increasing.This has been assisted by declining interestrates, as attested by a noticeable strengtheningin personal finance commitments for motorvehicles.

Growth in household income has been lowerthan usual over the past year, as a result ofsluggish employment. This trend may havebeen one factor in constraining spending byhouseholds, although the timing of the slowingsuggests that the deceleration in income wasas much a result of the slowing in consumerdemand as a cause of it. Households appearto have lifted their saving rate a little over thepast year or so, after a period of several yearsin which saving rates fell. They may havetended towards a rather cautious attitude toexpenditure, particularly under conditions oflabour market uncertainty. Over much of thepast year, information available from surveysof consumer sentiment has suggested heightenedpessimism about employment prospects,although this appears to have abated in themost recent surveys. Overall consumer

sentiment indexes have remained at levelsabove their historical averages throughout thepast couple of years. People remainconsiderably more optimistic about their ownpersonal financial situation than about theeconomy generally.

Demand for residential property has increasedsignificantly over the past year. Over the threemonths to August 1997, new loans totalling$17 billion were approved by housing lenders,some 38 per cent more than in thecorresponding period a year earlier. As isusually the case early in a housing upswing, alarge part of the finance has been for thepurchase of existing dwellings by owneroccupiers, but finance approvals forconstruction or purchase of newly erecteddwellings have also increased strongly over thepast nine months. In value terms, these arenow about 40 per cent higher than a year ago(Graph 12).

This increase in borrowing has beenfacilitated by the substantial reduction inmortgage interest rates which has occurredover the past year. With the reduction in cash

1

2

3

4

5

1

2

3

4

5

Housing

97/98

Loan approvals*$b

Total

* Excluding refinancing

Owner-occupiers

Investors

$b

0

3

6

9

12

15

0

3

6

9

12

15

0

3

6

9

12

15

0

3

6

9

12

15

Private building approvals

Total

Houses

Medium-density

95/9693/9491/92

'000 '000

Graph 12Graph 11

23

25

27

60

65

70

Household Spending and Income

97/98

$b

Retail trade(LHS)

$b

0

3

6

0

3

6

0

3

6

0

3

6

Saving ratio

% %

95/9693/9491/9289/90

Household disposable income(RHS)


22

The structural decline in inflation inAustralia during the 1990s has allowed amajor decline in interest rates. The fall ininterest rates for home borrowers has beenparticularly marked, due to the additionaleffect of increased competition in thehousing loan market. As a result, housingloan rates are now well below their lowpoints reached in the early 1990s, when theeconomy was much weaker than at present,and are at levels last seen in the late 1960sand early 1970s.

Quite important implications have flowedfrom this structural change. The first is thatthe ‘affordability’ of housing has increasedconsiderably. Servicing costs on a standardvariable-rate loan relative to averagehousehold disposable income have fallensharply, and are currently lower than at anytime since housing loan rates werederegulated in the mid 1980s (Graph B1,upper panel). It would be possible to findperiods prior to deregulation when theservicing costs for the standard loan werelower than at present, but that is not arelevant comparison since loans were muchless widely available (at least from banks)and borrowers often needed to take outmore than one loan in order to fund a housepurchase. Hence, it is safe to conclude thatthe accessibility of housing finance hasincreased markedly over the 1990s. It islikely that this change, other things equal,will prove to be of considerable advantageto low-income earners.

Households are tending, in manyinstances, to use the decline in interest coststo service much larger loans. The averagesize of new loans approved to owneroccupiers has increased by 60 per cent since1990, and is now about 21⁄2 times averageannual household income (Graph B1, lower

panel). It is also likely that more householdshave loans, though there are no timely datawhich measure that directly (and in fact, asof 1995/96, the majority of households werenot paying off a housing loan, either owningtheir home outright or renting). Therepayment burden would have fallen muchfurther in the absence of this increase in loansize.1 It is also likely that in some areas, thelower interest rates and larger loans areserving to accommodate upward pressure onhouse prices, though that is not widespreadat this stage (see main text).

These trends have lifted the levels of grossdebt carried by the household sectorconsiderably. For the purposes of makinginternational comparisons, it is necessary to

Box B: Inflation, Interest Rates and Household Debt

1. Results in Graph B1 are derived using average household disposable income, which is the national accountsmeasure excluding imputed rent on owner-occupied dwellings divided by the number of households in Australia,taken from Census data.

25

30

25

30

Per cent of household disposable income

100

150

200

250

30

40

50

60

Housing Affordability

Repayment burden

Average size of a new loan(LHS)

Total housing debtoutstanding

(RHS)

% %

%%

96/9793/9490/9187/88

Graph B1


23

rates and the increased competition amongstlenders in the market, interest rates forborrowers have fallen to their lowest levels ina generation. More generally, in the 1990s asa whole, the advent of low inflation, and themuch lower structure of interest rates whichhas occurred as a result, have eased the debtservicing burden of many households. In somecases, this is allowing households to pay offdebt faster than might otherwise haveoccurred – that is, to increase their saving; inthese instances, the potential to expandconsumption in the future would beenhanced. In most cases, however, householdshave made greater use of borrowing, andhousehold debt levels have increasedsubstantially in the 1990s (Box B), as lowerinterest rates have made it feasible to servicelarger loans.

This increased recourse to borrowingresulting from lower interest rates is beingreflected in the residential property sectorboth in the form of higher prices for existingdwellings, and increased construction of newdwellings. Price rises have been mostnoticeable to date in Sydney, particularly inthe inner suburbs, and in Melbourne. Anoverall measure of Sydney prices publishedby the REIA shows an increase of about10 per cent over the year to June 1997; forsuburbs reasonably close to the CBD, theincrease has been of the order of 25 per cent.

Areas further out have shown much smallerincreases. There also appears to be an upwardtrend in areas of Melbourne, where pricesoverall have risen significantly over the pastyear. An upturn in prices appears to havecommenced in some other cities as well.

Approvals to build private dwellings beganto increase around the turn of the year, androse quite quickly through to May. They thenfell away for a couple of months, but remainon a gradual upward trend. In September,approvals were 20 per cent higher than a yearearlier. Dwelling commencements began toincrease in the March quarter and, despite afall being recorded in June, should show a risein the September quarter and beyond.

There is little doubt that the housingupswing will continue. Several features of thecurrent cycle, however, are unusual. The firstis the prominent role of investors, whichaccount for about one-third of the total valueof lending approved for housing, about thesame as in the peak of the late 1980s, but upfrom one-sixth in the early 1990s. Associatedwith this, the indicators of construction showa higher proportion of approvals are formulti-unit dwellings than on most previousoccasions. This may reflect a structural changein the way Australians are choosing to housethemselves, with a trend towards higherdensity living, including in the inner areas ofthe larger cities. There has probably been some

40

60

80

100

120

40

60

80

100

120

Household Debt

40

60

80

100

120

Per cent of household after-tax income% %

1996199119861981

US

Sweden

Japan

France

Germany

UK

CanadaAustralia

Finland

Sources: Data are from OECD and national sources;households include unincorporated enterprises

199619911986

add other personal loans and loans tounincorporated businesses. Data compiledon this basis are shown in Graph B2. Untilrecently, Australian households andunincorporated businesses carried relativelylittle debt compared with those in otherdeveloped countries. As of 1996, Australiawas closer to the median for this group ofcountries. As such, the present level of debtis not a major concern, though its currentrate of increase (of around 10 per cent) isunlikely to be sustainable indefinitely in aneconomy where growth of nominal incomesis of the order of 5–6 per cent.

Graph B2


24

effect of the interest of Asian investors, whichis now likely to abate.

A second feature is a substantial increase inthe average real value of a building approval.This is not price inflation – indexes of pricesof building materials have shown only smallincreases in recent years, although they arenow increasing a little more quickly. It appearsto reflect an increase in the size and quality ofnew dwellings. In essence, new dwellings onaverage have more rooms and better qualityfittings than used to be the case; in real terms,the average value per dwelling of new buildingapprovals is now about 20 per cent higher thanit was at the beginning of the decade.

The third noteworthy feature of the presentupswing is its geographical unevenness. Thestrength in construction activity continues, onthe most recent data, to be concentrated inVictoria and New South Wales. Other areas,particularly Queensland, which has in the pastaccounted for about a third of the annualincrease in the dwelling stock, have not seena strong pick-up in activity as yet. This is likelyto be, in part, a reflection of lingering excesssupply of dwellings left over from the previousupswing. That upswing, which finished in1994, was unusually long, and over athree-year period saw more dwellingsconstructed than at any time since the early1970s. The excess supply will, in due course,be cleared, leading to increased constructionactivity in these other areas. A possibleimplication of these currently diverse trendsis that the housing cycle could be sequentialin nature, with less of the characteristics of anationwide ‘boom’, than seen in the past.

The business sector

Companies have found it harder to sustaingrowth in profits over the past couple of years,in the face of more moderate output growth,rising labour costs in some areas and thediscipline on prices arising from subdueddemand conditions and increased competitionin domestic and international markets. Forthose involved in exporting, a slowing inexport sales during 1996 also will have madefor more difficult trading conditions. In1996/97, operating profitability of the private

corporate sector, as measured in the nationalincome accounts (adjusted for privatisations),rose by about 1 per cent, after an increase of61⁄2 per cent in 1995/96. These figurescompare with an average increase of nearly9 per cent in the preceding two years. As ashare of GDP, corporate profits remain neartheir average level of the past decade or so,but have tended to decline a little over recentquarters. Net profits reported by major listedcompanies have in a number of instances beenreduced by the effects of writing down thevalue of assets, often those acquired ininternational expansion programs earlier inthe 1990s.

Companies have been responding to thesepressures on profitability in a variety of ways.One element of adjustment over the past yearhas been to control inventories tightly.Stronger demand early in 1997 for goods wassubstantially met from stocks. On the mostrecent data, the process of running downstocks appears to have been largely completed.Most industries have stocks to sales ratios inline with historical trends.

Another response to profitability pressureshas been labour shedding. Many large-scaleand medium-size enterprises continue torationalise their workforces, looking toeliminate past practices which led tooverstaffing, to contract out many non-coreactivities to specialist firms which can providethem more cheaply, and so on. Publicenterprises approaching or undergoingprivatisation have also tended to shed staff.In some areas where labour’s bargainingpower is relatively strong, such as parts ofmanufacturing and finance, substantial payrises have occurred simultaneously withsizeable workforce reductions.

These forces are, of course, always at workbut are more visible in periods where overalleconomic growth is weaker. The longer-runpay-off from rationalisation of corporateoperations is that productivity growthimproves, the economy’s potential growth rateincreases, and investment and employmentincrease. Aggregate data on productivityincreasingly confirm what anecdotal evidencehas been suggesting for some time: that the


25

trend productivity growth of the factors ofproduction in Australia, as summarised bytotal-factor productivity, has lifted noticeablyduring the 1990s (Box C). Productivitygrowth in Australia appears to be outpacingthe average for developed countries in the1990s, after many years of lagging behind.There is, nonetheless, much ground to makeup. Some questions also remain about therelationship between wages and labourproductivity, and these are taken up in thesection on labour markets below.

In the period ahead, firming growth offersthe prospect that profitability will be sustained,and improved. Inventory levels are wellcontrolled. Broader indicators of businesssentiment continue to suggest confidence aboutthe medium-term future, recent difficultiesnotwithstanding. If anything, in recent surveysthis confidence about expected tradingconditions has increased further (Graph 13).Indicators of current trading conditions havenot changed much, although it is worth notingthat while this fact sometimes is reported asthough conditions are weak, many of therelevant data series are at or above theirlonger-run average. These business confidenceindicators suggest that an expansion inemployment is more likely, provided growthin labour costs is contained, and some firmingof employment growth prospects is confirmedby the bulk of business surveys, and by higherlevels of job vacancies. The recent employment

data suggest that this growth may have begun,although it is too early to be sure of this yet.

A reflection of reasonable levels ofconfidence has been the fact that throughoutthe recent period of slower output growth,business investment activity has remained quitestrong. In the June quarter of 1997,investment spending was 9 per cent higher,in real terms, than a year earlier. This was aslower rate of increase than had been recordedin the preceding 12 months, but was muchfaster than the rate of growth of most othercomponents of spending in the economy.

Strength continued to be concentrated inequipment investment, which increased by13 per cent over the year to June. This cameafter a five-year period in which the averagerate of increase for equipment investment wasover 10 per cent in real terms. As a share ofGDP, investment spending on equipment hasreturned from quite low levels reached duringthe recession in the early 1990s to about itslonger-run average (Graph 14). Forwardlooking indicators for equipment investmenthave for some time been signalling that its rateof increase could slow during 1997/98. Initialestimates for 1997/98 in the ABS CapitalExpenditure Survey, in fact, suggested adecline in this component of investmentspending. The most recent estimates suggesta significant upward revision of intentions,such that a slightly higher level of investmentis now on the cards in the current year.

Graph 13 Graph 14

0

2

4

6

8

10

12

0

2

4

6

8

10

12

Business Fixed Investment*

% %Total

Equipment

Non-dwelling construction

96/97* Excluding transfers to and from the government sector

93/9490/9187/8884/8581/82

Per cent of GDP, current prices

-20

0

20

Expected Trading ConditionsNet balance*

97/98

NAB%

* Seasonally adjusted by RBA

-25

0

25

-30

0

30

60

-40

-20

0

20

-40

-20

0

20

%

%%

ACCI-Westpac

Dun and Bradstreet Colonial State Bank

94/9591/9297/9894/9591/92

10-yearaverage


26

85

90

95

100

105

85

90

95

100

105

85

90

95

100

105

85

90

95

100

105

Total-factor Productivity1989/90 = 100

1997

Index

1.6%

Index

0.8%

1.2%

19931989198519811977

The first Semi-Annual Statement onMonetary Policy, published in May this year,compared growth in labour and total-factorproductivity in the current economicexpansion with their growth in thecorresponding phase of the two previousbusiness cycles. The data presented showedgrowth in labour productivity in the currentexpansion to be substantially stronger thanin the 1980s expansion, but weaker thanin the 1970s. By contrast, growth intotal-factor productivity – which is a morecomprehensive measure of the efficiencywith which all inputs in the economy arecombined to produce output – was shownto be stronger in the current expansion thanin either of the previous two expansions.1

This was taken as evidence that the extensivestructural changes in the economy over thepast decade appeared to have led to animprovement in Australia’s underlying rateof productivity growth.

This box updates the results presented sixmonths ago. The addition of two morequarters of data, as well as revisions to thelatest national accounts, now imply a largerincrease in total-factor productivity growththan previously reported.2

There is some cyclical variation inmeasures of both labour and total-factorproductivity; when comparing productivityperformances between economic cycles, itis therefore appropriate to measureproductivity over common phases of thecycle. With the current expansion having nowrun for six years since the trough in outputin June 1991, a comparison of recentproductivity growth with that in the previoustwo business cycles can be conducted on acomparable basis by measuring productivityover the six years from successive troughs in

output. On this basis, trend labourproductivity growth in the current expansionis still estimated to have been weaker thanin the 1970s expansion, but significantlystronger than in the 1980s expansion(Table C1).

The changing capital intensity of theeconomy explains some of the differences inlabour productivity between business cycleexpansions. Labour productivity growth wasboosted in the 1970s as businesses tendedto substitute capital for labour following thelarge increase in real wages. In the 1980sexpansion, hours worked grew more rapidlythan the capital stock in a climate of real wagerestraint. When adjustments are made forthese changes in capital and labour inputsby calculating total-factor productivity, aslightly different picture emerges. Total-factor productivity grew at trend rates of1.2 and 0.8 per cent in the first twoexpansions; in the 1990s expansion, it isestimated to have grown significantly fasterat a trend rate of 1.6 per cent (Graph C1).

Box C: Productivity Growth – An Update

1. See the May 1997 Statement for discussion of labour and total-factor productivity and their measurement.

2. The revisions to the national accounts reflect changes in the measurement of output in several service-sectorindustries, the inclusion of businesses previously omitted from the ABS Business Register, and re-benchmarkingof components of output.

Graph C1


27

Nonetheless, this would represent a noticeableslowing in its rate of growth.

In some respects, such a pause in theinvestment cycle would not be altogethersurprising, given that a number of years ofstrong growth have occurred, and the fact thatin areas such as manufacturing, rates ofcapacity utilisation have tended to decline overthe past two years. Firms would have theoption of waiting for higher output growth totake up some of the existing capacity, beforefeeling the need to add to it. Investmentspending over the past year or two has alsobeen boosted to some extent by thetelecommunications sector, with cableroll-outs etc. Investment at that pace couldnot continue, although there can be littledoubt that reasonably high rates of investmentin communications and computer technologyare likely to be a feature of the economic scenefor the foreseeable future.

In contrast to equipment spending,spending on buildings and structures is recordedto have weakened in the middle of 1997. This

particular observation appears to reflect thecompletion of the Crown Casino inMelbourne, work on which had pushed upinvestment data for several previous quarters.The most recent ABS survey suggests that thistype of spending is likely to decline in 1997/98,although this component of the survey is likelyto be less reliable than that relating toequipment investment. Together, theseindicators could be taken as suggesting thatthe construction cycle has already peaked andturned down.

If such an outcome were to eventuate, itwould be surprising in several respects.Construction has been much slower to resumegrowth than was spending on equipment afterthe early 1990s recession, due in large measureto the over-investment of the late 1980s. Itwould seem unlikely for that upswing to havealready finished. The number ofnon-residential building approvals exhibitedweakness during the first half of 1997, but hasincreased strongly again in recent months withrises recorded in most categories. Taking into

Table C1: Comparison of Three Expansions

Annual percentage growth in:

Period (a) Trend Capital Labour Trendlabour stock hours total-factor

productivity (b) worked productivity (b)(c)

Mar 1975–Mar 1981 2.1 3.6 1.1 1.2Mar 1983–Mar 1989 0.7 3.2 3.4 0.8June 1991–June 1997 1.6 2.3 1.5 1.6

(a) Each period extends for six years from a trough in non-farm output.

(b) Calculated by fitting a trend through the quarterly estimates of the level of labour (or total-factor)productivity.

(c) Estimated from labour productivity growth assuming a standard production function with capital andlabour inputs.

Note: The method of calculation used in Table C1 differs from that in the corresponding table in the firstSemi-Annual Statement on Monetary Policy. For both labour and total-factor productivity, the table nowshows trend rates of growth, rather than the rate of growth implied by joining the first and last datapoints. Using the previous method over the six-year periods in the table gives labour productivitygrowth estimates in consecutive expansions of 2.2, 1.0 and 2.1 per cent, and total-factor productivitygrowth estimates of 1.2, 1.1 and 1.8 per cent. This method therefore confirms that total-factorproductivity growth has been much stronger in the current expansion than in the previous two.


28

account engineering construction, which ismuch more prominent in this cycle than inthe late 1980s, the pipeline of work to be doneis quite substantial (Graph 15), with severalinfrastructure projects and large amounts oflong-term investment in the mining sectorunder way. Hence it seems unlikely that asubstantial decline in construction activity willoccur over the next year; a modest furtherexpansion is more likely. This judgment isconsistent with persistent reports of skillshortages and pressure on wages in theconstruction sector.

While rates of investment growth seen inrecent years may not be sustainable, there islittle reason to expect a substantial decline ininvestment while the corporate sector and theeconomy generally remain free of majorimbalances. Firms’ financial situations arecertainly no constraint on their activities. Inregular business surveys, few firms nominatethe cost or availability of credit as a significantimpediment to their operations. Businessdemand for credit from financialintermediaries appears to have strengtheneda little over recent months. Business creditoutstanding rose at an annualised pace of over13 per cent in the six months to September,compared with 7 per cent in the precedingsix months. Data on commercial financecommitments also show an increase over thepast six months or so (Graph 16). Equityraisings have also been strong this year, helped

by a rising share market. Over the six monthsto August, raisings of new equity, apart fromprivatisations, totalled $6.6 billion, the highestrate for two years. Despite these increases,firms now appear to be in a phase whereleverage is starting to increase a little, after anumber of years when it was stable or falling.Competition amongst lenders has resulted ina slight decline in credit standards over thepast year or so. The impact of recent financialturbulence on these trends is not yet clear,although the volatility of the stock market maymake equity raising more difficult for a time.Uncertainty surrounding the internationalenvironment could also prompt a morecautious attitude to business investment insome areas.

Graph 16

Graph 15

3

4

5

6

7

8

9

3

4

5

6

7

8

9

Buildings and StructuresConstant prices

$b

(LHS)

* Seasonally adjusted – all other data are unadjusted

Work yet to be done

1.5

2.0

2.5

3.0

3.5

4.0

4.5

1.5

2.0

2.5

3.0

3.5

4.0

4.5

$b

(RHS)Work done*

(RHS)Commencements

96/9792/9388/89 96/9792/9388/89

0

15

0

15

Business Funding

97/98

Business creditSix-months-annualised growth

%

0

5

10

0

5

10

5

10

5

10

%

$b $b

$b $b

96/9795/9694/9593/9492/93

Business finance commitments

Equity raisings*Six-month-ended moving total

Monthly level

* Excluding financial institutions; adjusted for privatisationsSources: ABS Cat. Nos 5643.0 and 5644.0; Australian Stock

Exchange, Monthly Index Analysis

Reserve Bank of Australia Bulletin

The rural sector

Signs developed during 1997 of a strong El Niilo event, which involves a sustained warming of the central and eastern tropical Pacific Ocean, usually leading to drier-than-normal weather conditions over eastern Australia and south-east As ia. Consistent with the signs of El Nino, rainfall over much of eastern Australia was below average in the three months to the end of August (Graph 17). Against the odds, however, many parts of Australia received weB-above-average rainfall in September and October.

With the s igns of E l N ino still present, meteorologists continue to forecast belowaverage rainfall for eastern Australia into early 1998. But with the recent rai ns having occurred at a critical time for the winter grain crop, the Australian Wheat Board has revised

Graph 17

Ra infall Relative to Average Three months to August 1997

• Extremely low (boMom decile) Above average {eighth and ninth deciles)

• Below average (second •nd • Extremely h igh (top decile) third deciles)

Three months to September 1997

November 1997

up the 1997-98 wheat production forecast substantially.

Meat production, which accounts for about one-quarter of farm output, rose by 5 per cent in 1996-97 as farmers increased slaughterings in response to their expectations of drought. Beef exports to no rth-east Asia have strengthened, with the value of exports to japan - Australia's largest market- in the first nine months of 1997 up by 9 per cent over the same period last year. Live cattle exports continued to grow strongly in 1996- 97 , but have softened since then. Conditions improved in the wool industry, with stronger demand from China, Italy and Taiwan, which together accounted for about half of wool exports in 1996- 97.

Balance of payments

Import volumes have picked up as economic activity has strengthened in 1997. Following a relatively weak March quarter, the quantity of imports rose strongly in the June quarter, and into the second half of 1997, particularly in1ports of consumption and intermediate goods (Graph 18). The rise in consumption imports has been fairly broadly based, but with motor vehicle imports being particularly strong. Capital imports rose by 15 per cent over the year to june 1997 reflecting the strong investment in plant and equipment over this time; since then capital imports have flattened out at a relatively high level. Service imports have also been reasonably firm, growing by

Graph 18

Import Volumes*

$b Services $b

6 9

5

~ 8

4 7

3 6

$b Capital Consumption $b

6 6

5

/ 5

4 4

3 3

2 2 91192 94195 97198 91192 94195 97198

• 1989190 prices, excluding volatile Items

29


30

7.5 per cent in 1996/97, with strengthconcentrated in shipment and other transportservices.

Export volumes have also firmed. Excludingone-off factors (the sale of gold and a frigate),exports of manufactured and resource goodsappear to have been notably stronger in 1997than in the latter half of 1996. This seems toreflect improved demand from our majortrading partners in north-east Asia in the firsthalf of this year, following a period of weaknessin 1996. Rural exports rose by 13.5 per centin 1996/97 following a bumper wheat harvest.As yields return to more normal levels, ruralexports are expected to fall somewhatalthough, so far, they have shown surprisingresilience. As discussed above, recentdevelopments in east Asia raise someimportant risks to the outlook for exports tothe region.

Net payments on Australia’s externalliabilities – the net income deficit – rose from$4.6 billion in the March quarter to$5.1 billion in the June quarter. This rise wasdue primarily to stronger income debits,reflecting higher dividend payments on foreigninvestment in Australia; income credits alsorose marginally. The current account deficit alsorose somewhat, from a little over 3 per centof GDP in the March quarter to around33⁄4 per cent in the June quarter (afterexcluding the gold and frigate sales). This risereflected both the rise in the net income deficitand the strength in imports.

Commodity prices

Commodity prices in aggregate have shownlittle change over the course of 1997, havingpreviously risen to a level about half waybetween their recent low in 1993 and theirlatest peak in 1990 (Graph 19). Reflectingcontinued falls in import prices, Australia’sterms of trade have increased steadily sincethe trough in 1993.

Non-rural commodity prices have beenquite stable over 1997, with strength in basemetal prices, which have risen by more than10 per cent since December 1996, havingbeen offset by a weaker gold price; oil hastraded in a narrow range around US$20 abarrel since early in 1997. Rural prices areabout 10 per cent higher than they were atthe start of the year, mainly due to strongerprices for wool and sugar. The wool price hasrisen by 25 per cent since the end of 1996and is now more than 10 per cent above itsaverage level over the past five years, reflectingstronger demand from Europe and China. Incontrast, wheat prices have fallen since themiddle of the year, reflecting a particularlylarge expected US wheat harvest andexpanded production in Europe.

The labour market

Employment in the early and middle partof 1997 was weak, but seems to have improvedrecently (Graph 20). In the first half of theyear there was a shift in the mix of employmenttowards part-time work, continuing the

Commodity Prices and Industrial Production

% Index

All items(SDRs, RHS)

-8

-4

0

4

8

70

78

86

94

102OECD industrial

production*(LHS)

97/98* Year-ended percentage change

94/9591/9288/8985/8682/83

Graph 19 Graph 20

-1.4

0

1.4

-1.4

0

1.4

8.0

8.2

8.4

8.0

8.2

8.4

Employment

97/98

M

Quarterly percentage change

M

% %

96/9795/9694/9593/94


31

Graph 21

6.0

6.1

6.2

6.3

1.9

2.0

2.1

2.2

6.0

6.1

6.2

6.3

1.9

2.0

2.1

2.2

Employment

Sep97

M M

Mar97

Sep96

Mar96

Sep95

Mar95

Full-time(LHS)

Part-time(RHS)

longer-run trend in that direction, so that thedecline in full-time employment was greaterthan the total decline (Graph 21). Since June,however, this situation has been reversed, andfull-time employment has been picking up.For much of the past year, labour forceparticipation was declining, reflecting theweaker demand for labour in evidence untilrecently. The unemployment rate hascontinued to fluctuate around 81⁄2 per cent,as it has for the past two years.

Volatility of the monthly employment figuresmakes the trends difficult to interpret, but therecent pick-up in full-time employment maysignal some firming in the demand for labour.Alternative ‘matched sample’ estimates of totalemployment also point to some pick-up inrecent months. These estimates are a little lessvolatile than the published data, and suggestmodest increases in employment in both theJune and September quarters (Box D).

With employment growth normally laggingbehind developments in activity, the weakeremployment trend evident in early and mid1997 reflects, to an important degree, thesubdued pace of growth in 1996. Growth innon-farm GDP in 1996 was 2.6 per cent and,in the second half of the year, slowed to anannual rate of 1.6 per cent, well below theaverage growth rate in the course of thecurrent economic expansion to date, andbelow the economy’s growth potential. Giventhis slowing in GDP growth, it is not

surprising that the employment trend alsoweakened significantly. Conversely, althoughthe time lags are uncertain, the pick-up ingrowth under way in 1997 can be expected tobe followed by stronger employment growthin the latter part of the year.

The industry composition of employmentchanges over the year to August shows quitewide variations in labour market conditions(Graph 22). Relatively large employmentreductions over the year are recorded in publicadministration, while employment alsodeclined in other industries with traditionallyhigh public-sector involvement, namelyeducation, utilities and communication, aswell as in mining and construction. Incontrast, growth was relatively robust in theprivate-sector service industries such asproperty and business services, personalservices and recreation.

Consistent with the stronger growth inactivity occurring in 1997, there are a numberof signs from the forward-looking indicatorsthat the demand for labour may be firming.The number of job vacancies has beenshowing a modest upward trend for sometime, although both the ABS and ANZvacancies series have been subject to someshort-term volatility. Business surveys suggestthat hiring intentions have improved recently.In contrast, overtime hours worked haveremained flat at a level not far above last year’strough. In part, this may reflect continuing

-15 -10 -5 0 5 10

Employment by IndustryThree months to Aug 1997

-10 -5 0 5 10 15

Year to Aug 1997

% %

Mining

Utilities

Recreation

CommunicationAccommodation

Transport & storage

Property & businessCommunity services

Construction

Manufacturing

Retail tradeEducation

Personal & other

Agriculture

Finance & insurance

Wholesale trade

Public admin

Graph 22


32

The Australian Bureau of Statisticspublishes an estimate of employment inAustralia each month, based on the LabourForce Survey in which 30 000 people areinterviewed. The survey consists of eightsub-samples of roughly equal size. Eachmonth, one of the sub-samples is rotated outof the survey and replaced by a new groupof respondents, leaving seven sub-samplescommon to the survey in consecutivemonths. These seven common sub-samples,or cohorts, constitute the ‘matched sample’.

The level of employment in Australia eachmonth is estimated most reliably using thefull sample of respondents to the LabourForce Survey. By contrast, month-to-monthchanges in employment can be estimatedmore reliably using the matched sample. Thisis because the differences in employmentexperience between cohorts at any one timeare much bigger than the changes inemployment experience which occur in thetypical month within a cohort. Hence, thechange in the published employment figurebetween two adjacent months can bestrongly influenced by the differencesbetween the employment level characterisingthe cohort newly introduced into the sampleand that in the cohort being rotated out. Thematched sample eliminates this source ofvariability, and therefore provides a clearersignal of employment changes over shortperiods; over longer periods, these sourcesof variability do not matter as much becausethe random variations cancel out.

The matched-sample results can bederived from gross-flows data from theLabour Force Survey by calculating net flowsinto employment in those sub-samples

common to successive surveys. To obtainestimates of changes in employment that canbe compared with those from the full sample,a number of adjustments to the gross flowsdata need to be made.1 In the approach usedhere, the results are first scaled up to allowfor the smaller size of the matched sample.Second, the matched sample data areindependently seasonally adjusted, since theseasonal pattern of the matched and fullsamples differs somewhat. Finally, a constantis added to ensure that average monthlyemployment growth since 1980 is equal intwo samples.2 This avoids a slight tendencyof understatement stemming from theimplicit assumption of zero populationgrowth in the matched sample results, andalso allows for any systematic difference inindividuals’ responses when they aresurveyed for the first and subsequent times.

Box D: Employment Growth – ‘Matched Sample’Estimates

1. The adjustments made here are done at a high level of aggregation and more complicated approaches arepossible.

2. Seasonal adjustment and constant-addition are performed separately for respondents in full-time and part-timework, and the results are then aggregated.

Graph D1

0.0

0.5

1.0

1.5

0.0

0.5

1.0

1.5

0.0

0.5

1.0

1.5

0.0

0.5

1.0

1.5

EmploymentThree-month on three-month percentage change

Sep97

Full sample%

-0.5

0.0

0.5

1.0

1.5

-0.5

0.0

0.5

1.0

1.5

-0.5

0.0

0.5

1.0

1.5

-0.5

0.0

0.5

1.0

1.5

%

% %Matched sample

Mar97

Sep96

Mar96

Sep95

Mar95

Sep94


33

absorption of regular overtime into standardworking hours under the terms of manyenterprise agreements.

In addition to the cyclical behaviour ofemployment, which can best be explained bymovements in aggregate demand such as theslowing in 1996, there are other longer-terminfluences on employment which are moresubtle. Historically an important influence inAustralia has been the interaction between realwages and productivity. While the behaviourof real wages in the 1990s has been nothinglike the exceptional behaviour that occurredin the 1970s, real wages in the 1990s havenevertheless risen a good deal faster than inthe 1980s.

The average increase in weeklyordinary-time earnings in the six-year periodsince the cyclical trough in output has been3.3 per cent, compared with average growthof non-farm product prices of 1.7 per cent.This represents a cumulative increase in thereal wage measured in terms of producerprices of around 10 per cent. This is in sharpcontrast to the 1980s expansion when realwages were flat or falling (Graph 23). Thereare clearly a number of reasons for thedifferences in real-wage outcomes between thetwo cycles, including the role of the Accordin restraining real wages in the 1980s after asignificant lift early in the decade, as well asthe more rapid trend productivity growth inthe 1990s. Nonetheless, other things equal,relatively rapid increases in real wages will tendto increase the pressure on businesses todownsize their workforces, leading tosomewhat lower aggregate employmentgrowth than would otherwise be the case.Compared to the 1980s, the currentexpansion has been characterised by strongerreal wages and weaker average growth in

employment.This pattern is also evident in international

comparisons. In international terms,Australia’s economic growth performanceover the past five years has been good: averageGDP growth in Australia and New Zealandhas been higher than in any of the G7countries over that period (Table 7). WhileAustralia’s average growth rate of employmentof 13⁄4 per cent looks high by internationalstandards, it is not high when compared toour rate of growth of output. The Australianeconomy has not been good at convertingoutput growth into jobs growth. In the UnitedStates, employment growth has been nearlyas high as Australia’s, despite havingsignificantly lower GDP growth, whileNew Zealand, with roughly the same growthin output as Australia, produced substantiallyhigher employment growth. A corollary ofthese observations, of course, is thatproductivity growth in Australia has been

Graph 23

0 6 12 18 24 30 3695

100

105

110

95

100

105

110

Real Wages in Three Cycles*Over quarters from date shown

Index

Businesscycle peak

1970sIndex

(From Sep 1972)

1990s(From Dec 1988)

1980s(From Dec 1980)

* Re-weighted AWE deflated by non-farm GDP(E) deflator;estimate of price increase in the Sep quarter 1997 equal tothat in the underlying CPI

Estimates of employment growth from thematched sample developed, as describedabove, are compared in Graph D1 withestimates from the published employmentdata. Although the two estimates tend tomove together over the medium term, theycan differ from one another over short

periods. The matched sample estimates ofemployment growth were weaker than thepublished series in late 1996 and early 1997,presaging a weakening in the published serieslater in 1997. More recently, the matchedsample estimates have been suggesting amodest pick-up in employment growth.


34

-5

0

5

10

15

20

25

-5

0

5

10

15

20

25

-5

0

5

10

15

20

25

-5

0

5

10

15

20

25

Credit and GDPYear-ended percentage change

%

Credit

%

NominalGDP

97/9894/9591/9288/8985/8682/83

Graph 24

higher. However, to the extent thatproductivity gains are induced byuncompetitive wage outcomes rather thanstructural improvements in efficiency, they donot expand the scope for sustainable growthin activity and employment.

The relatively rapid increases in real wagesduring the current expansion seem to havereflected overly ambitious expectations bywage setters as to the increases that could besustained in a low-inflation environment. Bymid 1997 there were signs that this situationwas changing. Labour markets appeared tobe responding to continued low inflation andweak employment demand with a slackeningin the pace of aggregate wages growth,particularly in the private sector. Real wagesalso levelled out after the earlier period ofgrowth. As discussed in detail below, wageoutcomes in the September quarter cast doubton that assessment, showing a strong reboundin aggregate wages growth. If sustained, thatcould pose significant risks to employmentprospects. Although, in the near term, thelabour market will benefit from the strongergrowth in the economy now under way,resumption of a strong upward trend in realwages would tend to cut short the prospectsfor more rapid employment growth in thelonger term.

Table 7: Activity, Employment and Real WagesAverage annual per cent change, 1991–1996

Real GDP Employment Real wages (a) Working agepopulation

United States 2.6 1.5 0.9 1.0Japan 1.4 0.4 0.8 0.1Germany 1.4 -0.9 1.4 0.2France 1.2 -0.2 1.0 0.3Italy 1.0 -0.9 0.0 -0.1United Kingdom 2.3 0.1 1.1 0.3Canada 2.2 1.2 0.6 1.3Australia 3.7 1.7 1.7 1.1New Zealand 3.6 2.9 0.1 1.3

(a) Wages, salaries and supplements per wage and salary earner, deflated by GDP deflator

Financial Sector

The pace of financial intermediation hasremained quite strong throughout the past twoyears. Annualised growth in the stock of creditprovided by financial intermediaries to theprivate non-finance sector was 11.9 per centin the six months to September 1997, up from8.7 per cent in the previous six months. Theserates of credit growth have remained wellabove the rate of increase in nominal GDP(Graph 24).


35

All three major types of credit have grownstrongly (Table 8). Demand for housingfinance has seen housing credit outstandingincrease at about 11 per cent per annum,although this is well down on the rates of20 per cent or more at the peak of the housingupswing in 1993 and 1994. Personal creditand business credit have both picked up overthe past six months, particularly the latter.

The community’s gross holdings ofmonetary assets have increased in tandemwith this expansion in credit. Broad moneyincreased by 10 per cent over the year toSeptember, about the same as in the preceding12-month period. The more liquid part of thecommunity’s assets have increased morequickly, with M1 (mainly accounts withcheque facilities but low interest rates)increasing by almost 20 per cent over the pastyear. Demand for currency has also increased,with notes and coin in the hands of the publicrising by almost 6 per cent over the past year,up from 3 per cent in the preceding year. Thisacceleration in narrow measures of money isquite a common pattern in periods whereinterest rates decline, as the opportunity cost(in terms of forgone interest) of holding cashand low-yield cheque accounts declines. Therapid growth in M1 may also reflect ongoinginnovation, where cheque facilities areincreasingly offered in accounts which alsohave the characteristics of savings vehicles.Holdings in cash management trusts haveincreased strongly as well, rising by more than50 per cent over the year to September.Although rates on instruments such as bankbills (the main determinant of cash

management trust yields) have fallen, theflattening of the yield curve over the pastcouple of years has lessened the attractivenessof two- and three- year fixed deposits relativeto yields of cash management trusts. Overall,the community’s gross holdings of liquidassets have increased noticeably during theperiod of declining interest rates.

The adjustment to lower interest rates canalso be seen in increased flows of funds intosome other classes of assets. In addition torapid growth in cash management trusts, listedproperty trusts and equity trusts also recordedsignificantly higher growth over the year toJune 1997 than in either of the preceding two12-month periods (Table 9) although someof the increase in growth is likely to reflectrising asset values.

These data pre-date the recent instabilityin share markets. It remains to be seen to whatextent those events affect the size andcomposition of these flows. Up to now,however, these financial portfolio changes bythe private sector have illustrated well a partof the ‘transmission mechanism’ of monetarypolicy, whereby declines in short-term interestrates, if brought about by a credible policyregime, boost asset markets, and provide anenvironment conducive to ongoing investmentactivity.

Intermediaries’ interest rates

While developments in Asia, and beyond,dominated very recent developments incapital markets in Australia, the setting ofmonetary policy was the main influence onmovements in intermediaries’ interest rates –

Table 8: Financial AggregatesSeasonally adjusted annualised growth rates, per cent

Six months to: Three months to:

March 1997 September 1997 June 1997 September 1997

Total credit 8.7 11.9 11.7 12.1 – Personal 9.2 9.5 6.7 12.4 – Housing 10.5 11.0 12.8 9.2 – Business 7.3 13.4 11.9 15.0Currency 2.8 9.0 12.1 6.0Broad money 10.1 9.9 13.7 6.3


36

Graph 25

4.5

5.0

5.5

6.0

6.5

7.0

7.5

4.5

5.0

5.5

6.0

6.5

7.0

7.5

Short-term Interest Rates

M

%90-day bank bill yield

%

Target cash rate

19971996J S D M J S D

Graph 26

the interest rates most likely to influencehouseholds’ and businesses’ decisions toborrow and spend.

For the reasons explained earlier, monetarypolicy has been eased in two steps since theprevious Semi-Annual Statement, with thetarget for the cash rate reduced by a total of1 percentage point to 5 per cent. Themonetary policy moves since July 1996 havereduced the cash rate by 21⁄2 percentage pointsfrom 71⁄2 per cent (Graph 25).

Banks have reduced their borrowing andlending rates as a result of the latest twomonetary easings, although in some cases not

to the full extent of the fall in cash rates. Evenso, interest rates on offer to household andbusiness borrowers are below levels at theprevious cyclical low in 1993/94. Interest rateson housing loans are at their lowest level since1970, while those for business loans are attheir lowest since 1973 (Graph 26).

The predominant indicator rate on smallbusiness variable-rate loans has been cut by thefull percentage point reduction in the cash ratesince May, to a level of 8.75 per cent. This isnow 0.55 of a percentage point below its levelin 1993/94. The Reserve Bank’s SmallBusiness Finance Advisory Panel met in mid

Table 9: Assets of Managed FundsYear-ended percentage change

June 1995 June 1996 June 1997

Cash management trusts -4.9 25.1 52.3Unit trusts 9.5 16.3 38.5

of which:– Property trusts 11.7 14.4 22.7– Equity trusts 14.1 19.7 50.2– Mortgage trusts 0.5 24.4 42.6

Life offices 3.4 7.4 14.2Superannuation funds 10.0 15.2 19.9

Total 6.2 11.9 20.5

Sources: ABS Cat. Nos 5655.0 and 5645.0

1970 1973 1976 1979 1982 1985 1988 1991 1994 19975

8

11

14

17

20

5

8

11

14

17

20

Interest Rates% %

Small business indicator rate

Standard variable housing rate


37

1. The Bank has separately provided the House of Representatives Standing Committee on Financial Institutions andPublic Administration responses to their enquiries about aspects of small business financing. These notes werepublished in the Bank’s Bulletin of October 1997.

September and members reported that theywere generally satisfied with levels of interestrates and the availability of finance frombanks.1

For large businesses, reductions in banklending rates have been slightly less than thefall in the cash rate. Since the May easing, thepredominant indicator rate on variable-rateloans to large businesses has fallen by 0.85 ofa percentage point to 8.45 per cent. Banklending to large business is, however,concentrated in bill finance; bill yields havefallen in line with the cash rate.

For housing loans, taking the May and Julyeasings together, most banks have reduced theinterest rate on standard variable-rate loansby 0.85 of a percentage point, with thepredominant rate now at 6.7 per cent. SinceMay 1996, when banks began the process ofreducing the margin on the standard housingproduct to meet the fierce competition frommortgage managers, this rate has fallen by3.8 percentage points, 1.3 percentage pointsmore than the reduction in the cash rate.

In addition to the standard variable-rateproduct, banks generally offer a wide rangeof housing loans, including basic (or ‘no frills’)loans at variable interest rates as well as‘honeymoon’ and fixed-rate loans. Interestrates on ‘honeymoon’ loans and basic loanshave generally been cut by 0.75–0.85 of apercentage point since May, whereas rates onfixed-rate loans, which reflect funding costsin longer-term capital markets, have fallen by1.1–1.3 percentage points.

As was explained in the Bank’s ‘QuarterlyReport on the Economy and FinancialMarkets’ published in the August Bulletin,most banks’ decisions in May to reducestandard variable housing interest rates by lessthan the cash rate reflected several factors.One factor was the dynamics of the marketfor housing loans following the intensecompetition evident over the preceding yearor more. Over that period, banks had cuthousing interest rates by more than the cash

rate had fallen. These additional reductionstook banks’ standard housing rates to aroundthe level of rates charged by these institutions.As a result, banks had largely recovered theirformer market share by early in 1997, andtherefore felt under less intense pressure topass on to borrowers all of the May and Julyreductions in the cash rate. In the event,however, this action saw banks’ market sharefall away quickly again.

Another factor was that, while the cash rateis a reasonable guide to the cost of banks’funding in wholesale markets, their total costof funds is also determined by costs of othersources of funds, such as for retail deposits.By May, interest rates paid on banks’ retaildeposits were already very low, leaving littleroom for them to fall further (Graph 27). Thecost of retail funds was also held up by thedelay in reducing interest rates paid onso-called deeming accounts – which reflectinterest rates deemed by the Department ofSocial Security to be paid on pensionrecipients’ bank accounts for taxation andwelfare purposes. Deeming rates were notreduced until after the July easing, when theywere cut by a percentage point, to 5 per centon large deposits and 3 per cent on smalldeposits. In sum, the Bank estimates that

Graph 27

1991 1992 1993 1994 1995 1996 19970

2

4

6

8

10

12

0

2

4

6

8

10

12

Major Banks’ Deposit Rates

%

Cash rate

%

3-month fixed deposit

Deeming accounts

Retail deposits (excludingdeeming accounts)


38

The Bank monitors movements in banks’interest rate spreads – i.e. the differencebetween the average interest rate received andthe average interest rate paid – from a varietyof information supplied by banks. The mostcomprehensive data are from banks’published financial statements, though theseare at a very aggregated level and availableonly half-yearly, with a lag. The Bank alsocollects, on a quarterly basis, data on theaverage interest rate received on businessloans, together with ongoing data onindicator lending rates. These provide moretimely, though less comprehensive,information.

Graph E1 plots data on the average spreadof the four major banks for the period up tothe first half of 1997, the latest period forwhich annual report data are available. Theoverall spread has declined significantlyduring the period since deregulation, from5.0 per cent in 1980 to about 3.4 per cent.Since the mid 1980s, the graph also plotsthe spread on performing assets. The gapbetween this and the overall spread reflectsthe impact of non-performing loans. This wasmost significant in the early 1990s, when thespread on performing loans rose a little whilethe overall spread declined. As bad loans ranoff over 1993 and 1994, the overall spreadrecovered, and banks responded by reducing

the spread on performing loans. With thatperiod of adjustment over, a clear downwardtrend in both measures of the spread hasresumed since 1994.

An indication of what factors have beendriving the change in the spread can begained by comparing its two components –the average interest rate received and theaverage interest rate paid – to the cash rate.Over the period since mid 1996, as monetarypolicy has been eased, the average interestrate received by banks has fallen broadly inline with the cash rate. As discussed below,however, this average masks a divergentpattern among different loan products. Theaverage interest rate paid, in contrast, hasfallen by considerably less than the cash rate– hence the reduction in overall spreads.

As can be seen in Graph E2, over a longrun of years, the relationship betweenaverage rates of interest paid and received,on the one hand, and the cash rate, on theother, is only a loose one. In particular, thecycle in the average interest rates on loansand deposits is less pronounced than that inthe cash rate. The cash rate only provides anindication of the rates paid by banks forwholesale deposits. It can be thought of as ameasure of banks’ marginal cost of funds. Thegreater stability in banks’ average interestrates reflects two main factors: in addition

Box E: Banks’ Interest Spreads

Graph E1 Graph E2

Major Banks’ Interest Rates

%Cash rate

%

Average interestrate paid on

deposits*

* 1997 observations are for the first half year

1981 1983 1985 1987 1989 1991 1993 1995 19972

4

6

8

10

12

14

16

18

2

4

6

8

10

12

14

16

18

Average interestrate received on

loans*

1981 1983 1985 1987 1989 1991 1993 1995 19973.0

3.5

4.0

4.5

5.0

5.5

3.0

3.5

4.0

4.5

5.0

5.5

Major Banks’ Domestic Interest Spreads*

%

Overall spread

Spread on performingassets

%

* 1997 observations are for the first half year


39

to funds raised in wholesale markets, banksalso offer retail deposits where interest ratesdo not vary much; and they also have asizeable proportion of deposits and loans atfixed rates on which interest rates changeonly on roll-over, rather than when the cashrate changes.

Margins on Loans

As noted, not all interest rates on loanshave fallen in line with the cash rate: somehave fallen by more and some by less. Thisis illustrated in Tables E1 and E2, which showthe net change since the June quarter 1996,the period during which monetary policy hasbeen eased, in a variety of indicator lendingrates and, where available, the change in theaverage overall interest rates paid.

Variable-rate loans

Table E1 shows movements in interestrates on various types of variable-rate loans.The points to note from the table are asfollows:• The standard variable housing rate loan has

fallen by 3.8 percentage points over theperiod, which is 1.3 percentage pointsmore than the fall in the cash rate,implying a sharp contraction in margins;this is also evident, though to a lesserextent, for basic housing loans. Thisreflects the increase in competition in thehousing loan market, spurred on by thegrowth of mortgage managers. Againstthis, rates on honeymoon loans have fallenby less than the cash rate, as banks havepulled back from these types of loans.

• The indicator rates on small businessoverdrafts and term loans have fallenbroadly in line with the cash rate,consistent with these margins remainingsteady. However, as the interest rate onterm loans is lower than for overdrafts,there has been some shift out ofoverdrafts into term loans. Banks havealso introduced new products such asoverdrafts and term loans secured byequity in residential property. The rateon residential-secured overdrafts has fallen

by over 2 percentage points more thanthe cash rate, as banks have come torecognise more explicitly the quality ofsecurity supporting business loans. As aresult of the growing popularity of thesenew products, average interest receivedacross all variable-rate small businessloans has fallen by about 3 percentagepoints since mid 1996. This is larger thanthe fall in the cash rate, though this trendhas only become apparent in the latestpreliminary figures for the Septemberquarter 1997.

• In the case of large business loans, theindicator rate for overdrafts has fallen byslightly less than the cash rate while theindicator rate for term loans has fallenby a little more. Overall, the preliminaryfigures for the September quarter 1997suggest that the overall interest rate onloans to large businesses has fallen byslightly more than the cash rate since mid1996.

Bills

Interest rates on bill lines have moved inline with the cash rate, as they are priceddirectly off yields in the money market.

Fixed-rate loans

Interest rates on fixed-rate loans are pricedoff capital market interest rates of relevantmaturities, rather than the cash rate. Table E2shows movements for 3-year fixed-rate loansand the movement in their funding cost,proxied by the 3-year rate in swap markets.For small and large business loans, thechange in the average interest rate receivedon all existing fixed-rate loans outstandingis also shown.

Indicator rates have fallen broadly in linewith the swap rate since mid 1996. However,the average interest rate received on allexisting business fixed-rate loans has fallenby less than the swap rate. The smaller fallin the overall interest rate received than inthe indicator rates for new loans reflects thefact that the latter have not yet worked theirway through the stock of existing loans. Of


40

course, on the deposit side, banks would beexperiencing a corresponding phenomenon– i.e. the average cost at which existingfixed-rate loans are being funded has not yetfully reflected the recent falls in interest rates.As noted earlier, during periods of fallinginterest rates, these adjustment lags work tohold up both the average interest ratereceived and the average interest rate paid;during periods of rising interest rates, theywork in the opposite direction.

End Piece

In summary, banks’ interest margins havenarrowed over the past 18 months or so asmonetary policy has been eased. Their overalldeposit costs have not fallen in line with thecash rate, due importantly to the limitedscope to further reduce retail deposit interestrates. At the same time, competition hasnonetheless forced loan rates lower. This

competition was first evident in the housingloan market, particularly from mid 1996reflecting the expansion of mortgagemanagers into this market. It has now startedto flow through into small business loanrates, as reduced housing margins haveforced banks to look to increase market sharein other areas. This process has resulted inbanks introducing a range of new smallbusiness products offering discountedinterest rates and better reflecting the typeof security being offered. Until recently, theeffects of this competition in small businessfinance were not evident in banks’ aggregatefigures on interest received, suggesting thatthe switch to lower priced products was onlygradual. But the latest numbers from themajor banks, which remain preliminary, arestarting to show a more significant impact.

This competition should continue, thoughit is unlikely that margins on small businessloans will fall to the same level as those onhousing, due both to the higher risk on smallbusiness lending and to the greater difficultynew lenders are likely to face in contestingthis market.

Table E2: Fixed-rate Loans

Movement between June quarter 1996and September quarter 1997

Percentage points

HousingNew loans -2.5

Small businessIndicator rate on new loans -2.9Average rate on all existing loans -1.2(a)

Large businessIndicator rate on new loans -3.0Average rate on all existing loans -1.2(a)

Three-year swap rate (b) -2.9

(a) Figures for the average overall rate are basedon the four major banks, using preliminary datafor the September quarter 1997; they includecustomer risk margin

(b) 3-year swap rate is used as indicative fundingrate

Table E1: Variable-rate Loans

Movement between June quarter 1996and September quarter 1997

Percentage points

HousingStandard variable -3.8Basic -2.8Honeymoon -2.0

Small businessIndicator rates– Overdrafts -2.5– Residential-secured overdraft -4.7– Term loans -2.6Average overall rate(a) -3.1(b)

Large businessIndicator rates– Overdrafts -2.3– Term loans -2.6Average overall rate(a) -2.7(b)

Cash rate -2.5

(a) Includes customer risk margin

(b) Figures for the average overall rate are basedon the four major banks, using preliminary datafor the September quarter 1997


41

banks’ average cost of funds fell by a total 0.7of a percentage point from the adjustment todeposit rates after the May and July easings, aresult which is putting further downwardpressure on banks’ margins. Recentmovements in banks’ interest margins are setout in Box E.

In response to the two cuts in cash ratessince May, banks, on average, took about aslong to reduce their interest rates on particularproducts as with the three previous easings inthe second half of 1996; this is longer than ittook banks to raise rates during the tighteningphase of 1994. For housing loans, the averagelag in passing on the cuts in cash rates hasbeen over seven weeks; for small business,about five weeks. In both cases in 1994, thelag in raising rates was a little over two weeks(Table 10).

Inflation Trends andProspects

Recent developments in inflation

Consumer prices in underlying terms roseby 0.3 per cent in the September quarter andby 1.5 per cent over the year (Graph 28). Ona year-ended basis the underlying inflation ratehas fallen steadily from its most recent peakof 3.3 per cent, reached in the March quarterof 1996.

The headline CPI continues to be affectedby recent interest rate reductions which haveheld the headline inflation rate considerablybelow other measures. The September quarterfigure was also reduced by the effect of rebatesfor health insurance introduced on 1 July,

Table 10: Implementation LagsAverage number of days between changes in the cash rate

and effective change for borrowers

Easings 1990–93 Tightenings 1994 Easings 1996–97

Small business indicator rate 23 16 35Large business indicator rate 18 16 21Housing indicator rate 32 16 51

which are recorded as a reduction in the costof premiums. Reflecting these factors, theheadline CPI declined in the Septemberquarter by 0.4 per cent, and by 0.3 per centover the year. Mortgage interest ratereductions have detracted 13⁄4 percentagepoints from the movement in the CPI overthe past year.

Falling import prices have for some timebeen contributing to the subdued underlyinginflation results (Graph 29). This remainedthe case in the September quarter. Theimported goods component of the CPIdeclined by 0.5 per cent in the quarter andby 1.5 per cent over the year. The continuingdeclines in retail import prices reflect thegradual pass-through of the effects of earlierappreciation of the trade-weighted exchangerate, much of which took place over 1996. Thiseffect can be expected to fade as the pass-through becomes more complete. Thetrade-weighted exchange rate has shown little

Graph 28

Consumer Prices

Total CPI

Underlying CPI

Underlying CPI

% %

-2

0

2

4

6

8

-2

0

2

4

6

8

Percentage change

Tax effect

(Year-ended)

(Year-ended)

(Quarterly)

97/9895/9693/9491/9289/90


42

further net movement over the past year, risingin the early part of this year before returningto around the levels of late 1996 in the middlepart, then falling over recent weeks. Given thetypically gradual nature of the pass-throughinto final prices, these shorter-termmovements in the exchange rate over the pastyear are likely to have only relatively smalleffects on retail prices of imported goods inthe period ahead.

Prices of domestically produced consumergoods have also been more subdued recently.They fell slightly in the September quarterand rose by 1.8 per cent over the year toSeptember, continuing the general trend ofdeceleration evident in recent quarters(Graph 30). Strong competition fromimported goods is likely to have contributedto this trend. In contrast, private-sector serviceprice increases have picked up recently to berunning at 3.6 per cent over the latest year.

Producer prices have for much of the pasttwo years shown less tendency to rise thanunderlying consumer prices. Over the year toDecember 1996, manufactured output prices

-3

0

3

6

9

12

15

-3

0

3

6

9

12

15

-3

0

3

6

9

12

15

-3

0

3

6

9

12

15

Goods and Services PricesYear-ended percentage change

Domesticgoods

Importedgoods

% %

97/98

Private-sectorservices

95/9693/9491/9289/9087/88

-10

0

10

20

10

0

-10

-20

-10

0

10

20

10

0

-10

-20

Import PricesYear-ended percentage change

97/98

%

TWI(RHS, inverted scale)

-20

-10

0

10

20

-20

-10

0

10

20

-20

-10

0

10

20

-20

-10

0

10

20

%

Landed import prices(LHS)

Importedcomponent of CPI

Landed importprices

% %

94/9591/9288/8985/86

Graph 29 Graph 30

increased by only 0.2 per cent, while buildingmaterials prices were similarly flat. Morerecently producer prices have been somewhatfirmer, probably reflecting the strongerdemand conditions in 1997, although theirrate of increase to date remains moderate.Manufactured goods prices increased by0.5 per cent in the September quarter and by1.6 per cent over the year, while housing andnon-residential building materials prices roseby 1.5 and 1.2 per cent respectively over theyear (Graph 31). Imported input pricesshowed a sharper pick-up in the Septemberquarter, reflecting the recent exchange ratemovements, but this followed substantial fallsover the previous two years.

Trends in labour costs

Recent developments in wages continue tobe difficult to interpret. There have for sometime been divergent trends between measuresof private and public-sector wages, and to alesser extent between aggregate wagemeasures and more specialised indicators ofbargaining outcomes. The picture has beenfurther complicated by large fluctuations inthe estimates of aggregate wages growth inthe two latest quarters.

All measures of average earnings compiledin the Average Weekly Earnings survey showeda sharp jump in the three months to August.Average weekly ordinary-time earnings(AWOTE), the measure which should be leastaffected by changes in average hours worked


43

-3

0

3

6

9

-3

0

3

6

9

-10

-5

0

5

10

-10

-5

0

5

10

Producer PricesYear-ended percentage change

97/98

Manufacturing%

Imported

Building materials

%

% %

Domesticallyproduced

House

Non-residential

95/9693/9491/9289/9087/88

Graph 31

seems likely to reflect compositional changesin the public-sector workforce associated withongoing restructuring. The increase inprivate-sector AWOTE over the year to Maywas 2.5 per cent, having declined substantiallyfrom the peak of over 6 per cent reached in1995.

While the recent figures are difficult tointerpret, it seems clear that this trend declinein private-sector wage growth has now cometo an end, and that the figure for the year toMay overstates the extent of the trend decline.If the aggregate wage outcomes for the threemonths to August are at all representative forthe private sector, they imply a significantrebound in that sector’s annual wage growth;what is not yet clear is its extent. For the sakeof illustration, applying the aggregate quarterlyincrease in the three months to August equallyto both sectors would imply a rise in annualprivate-sector earnings growth to around31⁄2 per cent. These results must be considereddisappointing in an environment whereunderlying consumer price inflation is runningat 11⁄2 per cent, producer price increases arerunning at a similar rate, and demand for

0

2

4

6

8

0

2

4

6

8

0

2

4

6

8

0

2

4

6

8

97/98

0

3

6

9

0

3

6

9

0

3

6

9

0

3

6

9

Ordinary-time Earnings

%

Private sector

Public sector

%

Year-ended

Quarterly(sa)

% %

Percentage change

(Year-ended)

(Year-ended)

95/9693/9491/9289/9087/88

Graph 32

and compositional changes, increased by1.6 per cent in the quarter. This followed arise of 0.3 per cent in the previous threemonths (Graph 32). The other measuresshowed a broadly similar pattern. Taking theresults at face value, and averaging theincreases in AWOTE over the two quarters,they suggest that aggregate wages havecontinued to rise at around one per cent perquarter, about the same pace that has beenevident for the past two years. Over the yearto August they increased by 4.1 per cent.Flow-through of the recent safety-net decisionwill have contributed to the August outcomealthough the effect is relatively small.

Notwithstanding the flat trend in aggregateAWOTE growth, there has, at least untilrecently, been a decline in growth of theprivate sector component, offset by unusuallyhigh outcomes in the public sector. Overthe year to May (the latest period forwhich data are available at the disaggregatedlevel) public-sector AWOTE increased by7.2 per cent. This figure remains well abovethe increases applying under currently activeenterprise agreements in the public sector, and


44

labour has been flat.Wage increases negotiated under enterprise

agreements have continued to yield increasesof around 5 per cent on average, about thesame rate that has prevailed for the past year(Graph 33). While there has been no generaltendency for these increases to ease in the faceof lower inflation and the weaker labourmarket, there is some evidence of increasingdiversity of outcomes in response to differingconditions across industries. Wage pressureshave been relatively strong in the constructionsector, where skill shortages have emerged inline with strengthening activity. Constructionagreements reported annualised increases of6.1 per cent in the June quarter. Thesepressures appear to have continued in thesecond half of the year. In contrast, wageoutcomes in the metals and finance industrieshave eased a little during the past year,although they remain high.

Growth of executive salaries, as reported inthe Cullen, Egan and Dell survey, remainsstubbornly high at around 6 per cent, littlechanged from the rates of increase that havebeen reported for the past two years. Theseincreases seem increasingly unrelated totrends in business conditions, particularlygiven the weakness of selling prices over thepast year and the pronounced slowing of profitgrowth.

Award wages are now feeling the effect ofthe flow-through of the recent safety-netdecision, which increased awards by $10 aweek, equivalent to around 13⁄4 per cent forworkers on average award wages. Much of thisincrease is likely to have been paid in theSeptember quarter. The ACTU has nowforeshadowed an additional claim, which islikely to be heard early next year. The claimseeks in its initial stage to increase all awardwages by a flat dollar amount of $20.60 aweek, which represents a 5.7 per cent increasefor those on the minimum award but a smallerproportionate rise for those on higher awards.The claim also contains a second stage whichaims for an additional $38 increase in thesubsequent year.

Inflation expectations

On most measures inflation expectations areclose to historic lows, having declinedsubstantially in the early part of the 1990s andgenerally undergoing a further downward shiftin the past year. The general pattern has beenthat expectations have tended to follow trendsin actual inflation with a lag, and, as a trackrecord of low inflation has been built upduring the 1990s, this has been increasinglytaken into the public’s expectations.Recognition of the low inflation environmentmay have been reinforced by the fact that themost recent period of rising inflation, in1994/95, was successfully resisted and thatinflation has subsequently fallen. On someindicators, however, expectations of inflationremain higher than actual rates, and higherthan the target.

Consumers’ inflation expectations, asmeasured by the Melbourne Institute’smonthly survey, moved down in late 1996 andhave subsequently remained at around theirnew lower level (Graph 34). The Octobersurvey reported an expected inflation rate of3.4 per cent, representing the average expectedincrease in the Consumer Price Index overthe year ahead. Results for this survey duringthe past year have generally fluctuated in the3 to 31⁄2 per cent range, around a percentagepoint lower than the average that had prevailedover the previous couple of years.

Graph 33

2

3

4

5

New Federal Enterprise AgreementsAnnualised wage increases

96/97

Average*

Private*

Public

Source: Department of Workplace Relations and Small Business

% %

* RBA estimate for June quarter 1996

2

3

4

5

2

3

4

5

Metalsmanufacturing

Non-metalsmanufacturing

94/9596/9794/9596/9794/95


45

Medium-term inflation expectations ofbusiness respondents have shown quite asimilar pattern to the results of the consumersurvey. The NAB Survey recorded a sizeabledownward shift in medium-term inflationexpectations during 1996, but little furtherchange over the past year. Like consumers,business respondents typically expect inflationto be slightly above the target, with the mostcommon response being in the 3 to 4 per centrange.

Near-term price expectations of producershave remained low in recent months and seemto show little impact from the currentstrengthening in demand conditions. In thissense they give a somewhat more subduedpicture of price pressures than the recentresults for producer price increases discussedabove. According to the NAB business survey,retailers expect to increase their selling pricesby 0.5 per cent in the December quarter,following average quarterly increases of0.4 per cent according to the same survey in

the first three quarters of the year.Manufacturers have generally held weakerprice expectations than other industries forsome time. The latest ACCI-Westpac surveyof manufacturing businesses, taken inSeptember/October, suggests flat prices, withroughly equal numbers of businessesexpecting prices to rise as to fall in theDecember quarter.

Expectations of financial marketparticipants, as indicated both by surveys andby market-based indicators, have beendeclining during the past year. In contrast tobusiness and consumer survey results, theyare also at levels consistent with the inflationtarget. A long-term market based indicator,the indexed bond yield differential, currentlyimplies an expected average inflation rate overthe next ten years of around 2 per cent. Thisindicator has been declining steadily for sometime, in line with nominal bond yields, and isabout a percentage point below the levels thatwere typical a year ago. A survey of financialmarket participants conducted by the Bankpoints to continued downward revisions oftheir near-term inflation forecasts over the pastyear. Economists surveyed immediately afterthe September quarter CPI release returneda median forecast of 1.9 per cent forunderlying inflation over the year to June1998, having been forecasting a 2.9 per centunderlying rate a year earlier (Table 11).

Inflation outlook

In the near term, the climate remainsfavourable to a continuation of the low ratesof inflation seen over the past year.Notwithstanding the pick-up in growth thatis currently under way, the economy still hasample capacity to satisfy expanding demand,and price expectations are generally low. At

Graph 34

2

4

2

4

Inflation Expectations

97/98

Consumers*

* Melbourne Institute Survey of consumers

%

0

2

4

0

2

4

Market-based measure**

%

% %

** Difference between nominal and indexed bond yields, adjusted for indexation lag

95/9693/9491/92

Table 11: Market Economists’ Forecasts of Inflation

Year to June 1998 Year to June 1999per cent per cent

October 1996 survey October 1997 survey October 1997 survey

Underlying 2.9 1.9 2.6Headline 3.0 0.8 3.2


46

its current rate of growth, the economy is likelyto be absorbing surplus capacity at only amoderate pace which would not generate thesorts of bottlenecks that accompanied the veryrapid phase of the current expansion in1994/95. Producers and retailers still reportthat they expect only very modest priceincreases in the December quarter.

Given these circumstances the prospects arethat inflation will remain below 2 per cent inthe near future. Looking further ahead,however, there are signs that the trendreduction in inflation, which has reduced theunderlying rate from over 3 per cent to11⁄2 per cent over the past two years, may beclose to having run its course. The inflationreduction has resulted from three mainfactors: a significant slowing in the rate ofgrowth of demand and output, particularlyin 1996; appreciation of the trade-weightedexchange rate, which rose by nearly10 per cent over the same year; and a declinein growth of average wages, particularly in theprivate sector, over a two-year period runningto around the middle of 1997. Prospects inall three areas are for a smaller restrainingimpact on domestic prices in the period ahead.

As discussed above, the path of the exchangerate has exerted an important influence onrecent inflationary trends. To date, the mainimpact has come from the sharp appreciationthat occurred during 1996. The pass-throughof these effects to retail prices has beensufficiently gradual that the contribution ofimported goods prices to the CPI by theSeptember quarter 1997 was still negative, andthere may be some further price reductionsstill to flow through. Nonetheless the overalleffects of Australia’s earlier currencyappreciation will soon fade or begin to beoffset by more recent, although smaller,movements in the other direction. In net termsthe contribution of import prices tounderlying inflation can be expected to shiftfrom a negative to a broadly neutral positionover the year ahead.

The restraining influence from domesticdemand conditions evident over the pastcouple of years is also likely to become weaker.The economy is now growing at or close totrend after a period of slower growth thatundoubtedly contributed to restraint ofdomestic prices. With monetary policy nowin an expansionary setting, a continuation ofthe current stronger growth is in prospect.That in turn will mean that the cyclical forcesthat helped to bring the inflation rate belowthe target will, over time, be lessened.

With temporary exchange rate effects andcyclical factors having less of an influence,recorded rates of inflation can be expected tobe a little higher over the year ahead aslonger-term domestic forces reassertthemselves. After a period of below 2 per centinflation, the inflation rate is expected to moveback within the 2–3 per cent range, probablytowards the end of 1998.

An important determinant of the trend ininflation will be the extent of any pick-up indomestic labour costs. In this regard recentdevelopments have been less encouraging thanhad appeared likely a few months ago. Thestrong figure for earnings growth in theSeptember quarter, while most likely anoverstatement of ongoing wages growth, doessuggest that the downward trend inprivate-sector wages growth has probablycome to an end. On the latest reading, whichis subject to considerable uncertainty, privatewages appear to be growing at an annual rateof around 31⁄2 per cent, and economy-widewages at around 4 per cent. Wage increases ataround these levels would appear consistentwith the inflation target although, as notedearlier, the implied rate of increase in realwages is likely to be unhelpful to prospectsfor employment growth.

4 November 1997

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