The RBA shows an iron hand

Assistant Governor Philip Lowe has delivered a fantastic speech for those wishing to understand the current transition of the Australian economy and how the RBA thinks about it.

It’s a very long speech and I suggest you read it in full. But here, at least, are a few highlights. First on inflation and purchasing power of households:

In terms of manufactured goods, it has been common worldwide for their prices to fall over time relative to the price of services. This is the result of faster growth in productivity in manufacturing than in services, as well as globalisation. This long-term trend is clearly evident in the Australian data, but over recent years, as the Australian dollar has appreciated, the decline in the relative retail price of manufactured goods – many of which are imported – has been particularly pronounced. Indeed, over 2010, the difference in the CPI inflation rate for manufactured goods and the CPI inflation rate for other goods and services was larger than it has been at any time over the past two decades.

Graph 2: Consumer Price Inflation

Not unexpectedly, this decline in the relative price of manufactured goods has caught the attention of the household sector. In consumer surveys, the number of people that say now is a good time to buy major household items is around its highest level in more than two decades. But interestingly, households do not appear to have responded particularly strongly to this fall in both the absolute and the relative price of manufactured goods, with retail spending having been quite subdued recently. Many households have preferred to use the growth in their incomes to increase their savings rather than to buy more manufactured goods at lower prices. As the Bank has discussed on a number of occasions recently, whether or not this continues will have a significant bearing on how the economy evolves over the next year or so.

Graph 3: Buying Conditions for Major Household Items

The current large change in relative prices is also making it more difficult for households to assess the rate of overall inflation. This is because when relative consumer prices are moving a lot, the perceived inflation rate depends more than usual on the particular bundle of goods and services that one buys. Over the past year, people whose purchases are more tilted towards goods will have experienced a lower rate of inflation than those whose purchases are tilted towards services and utilities. But, importantly, for the community as a whole, consumer prices have increased by 2.7 per cent over the past year, consistent with the medium-term inflation target.

Then on structural changes to the economy:

Looking forward, the latest data from the Australian Bureau of Statistics on firms’ investment plans suggest that further very large increases in mining investment are in prospect. Taken literally, these data imply an increase in investment spending in the mining sector of over 50 per cent in 2011/12, from an already elevated level. The projected increases are particularly large in the gas and the iron ore sectors. If they were to occur, it would mean that the mining sector would account for over one quarter of all investment spending in Australia next financial year. This would be a remarkable change over a short period of time.

Graph 10: Mining Capital Expenditure

The high price of resources is also leading to very strong employment growth in the mining sector, with total employment in the sector up by around 20 per cent in 2010. But while this is very fast growth, it is important to remember that the sector still only directly accounts for less than 2 per cent of the overall workforce in Australia.

The main effects on employment of the resources boom are being felt elsewhere, particularly in the services sector where the vast bulk of Australians work. These indirect effects on employment from the resources boom arise through two main channels: one operating through a demand effect as investment ramps up, and the other through an income effect.

In terms of demand, the improved outlook for resource-sector investment has increased demand for a whole range of ancillary professional services. These include engineers, project managers, equipment lessors, lawyers, accountants, recruiters and IT specialists. As a result, employment in a number of these business services has grown strongly over recent years. In terms of the income effect, the higher prices we are receiving for our exports has delivered a tangible increase in national income. Over time, a substantial part of this will get spent. Right at the moment, spending on goods is relatively subdued, but with the population and aggregate incomes growing strongly, the demand for a range of services by households has also been growing strongly. As a result, employment growth in these areas has been robust.

Graph 11: Employment

In contrast to this relatively positive picture in a number of industries, the changes in relative prices that are occurring are contributing to subdued conditions in some other industries.

One very clear example is domestic tourism. Since the mid 2000s, the total number of nights that Australians spend away from home in Australia has fallen by around 12 per cent, despite the population increasing by 10 per cent. The high value of the Australian dollar has lowered the relative price of overseas travel and Australians have responded by travelling abroad in ever increasing numbers. Conversely, as Australia has become a more expensive destination, growth in overseas arrivals has slowed noticeably. Given these trends, it is not surprising that the tourist industry’s share of total employment has fallen over the past decade.

Graph 12: Australia – Tourism Indicators

Another area where the effects of the changes in relative prices are apparent is in the composition of Australia’s exports. During the 1990s, exports of manufactured goods and services grew strongly, at an annual rate of around 10 per cent. Growth then slowed in the early 2000s and it has been particularly weak over recent years. This weakness has been quite broad based, with exports of machinery and equipment, beverages and transport services all falling over the past three years. While there are a range of factors that account for this, an important one is the higher exchange rate which has increased the price of domestically produced goods relative to world prices. As a result, in a number of the affected sectors, employment growth has been relatively slow. Conditions have also been subdued recently in the retail and wholesale sectors, largely reflecting consumers’ more cautious approach to spending.

Graph 13: Australian Exports

These various shifts in the economy are occurring at a time where there is little overall spare capacity. This is quite different to the situation prevailing over most of the past 40 years. At times when there is a lot of spare capacity, all sectors can grow quite quickly without the overall economy butting up against capacity constraints. But this is not the situation we currently find ourselves in. Our favourable starting point means that faster-than-trend growth in some parts of the economy will inevitably be associated with slower-than-trend growth in other parts of the economy. And the movement in relative prices will be one of the factors that help determine which sectors grow more quickly than average, and which sectors grow more slowly than average.

The challenge we face is how best to accommodate these changes, and to capture the considerable benefits that they can bring, while minimizing the costs that can arise when the structure of the economy is changing. This is no easy task. But it is surely a better challenge to face than those confronting most other advanced economies. The most important contribution the Reserve Bank can make to this task is to keep inflation low and stable, so that firms can respond to the shift in relative prices without their decisions being distorted by concerns about inflation in the general level of prices. The inflation targeting regime that we have had for nearly two decades provides the right framework to do this.

Finally, in thinking about the implications of the recent changes in relative prices an important consideration is how persistent they are likely to be. There would seem to be little benefit in changing the structure of the economy to reflect the new relative prices, only for the old set of relative prices to reassert themselves quite quickly. As the Governor noted in a speech a couple of weeks ago, we cannot be sure how long the current boom in the terms of trade will last. However, given that it is being driven by structural changes in the global economy, it is likely that commodity prices will be above their average over recent decades for some time yet. If this is the case, Australia will do very well. History, however, does suggest caution and we cannot be sure what the future will hold. The best way of dealing with this uncertainty is to make sure that the economy retains its flexibility to deal with whatever set of relative prices the global economy delivers us.

Hmmm, yes, though I worry that being flexible may involve a massive drop in Australia’s standards of living should the structural shift turn out to have less longevity than hoped.

But that’s for another day. For now, the speech sends a clear message that the RBA is focussed on sustaining the structural shift, which means it’s got no intention of being soft on anyone when it comes to interest rates.

This is a bit more hawkish than I’ve been seeing for a while. It’s probably best described as a tightening bias, if not currently being used. If you don’t want rates to climb, don’t buy that glossy, new manufacture you’ve had your eye on.

David Llewellyn-Smith
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  1. That’s just about the most balanced, thoughtful speech I’ve read in a long time. Much better than Ken Henry’s bizarre effort. Phillip Lowe has gone up in my estimation.

    Of course he ends with the standard assumption that “it is likely that commodity prices will be above their average over recent decades for some time” but at least he acknowledges the possibility of a reversal in our terms-of-trade.

    Also, it would be nice if just once someone from the RBA or Treasury made a speech about the increasing risks in the Chinese economy. Lowe touched on it once saying “In China, the authorities face the difficult task of rebalancing growth away from exports and investment to domestic consumption” (and kudos for that) but how about a longer, more in depth speech?