Reserve Bank of Australia Bulletin June 2000

‘Speed Limits’, Growth and Monetary Policy

Remarks by Mr GR Stevens, Assistant Governor The Bank has recently released the (Economic), to Economic Society of Australia, Semi-Annual Statement on Monetary Policy and Canberra Branch Symposium on ‘Speed Limits the Governor has made his regular appearance to Growth: Interest Rate Adjustment and the before the House of Representatives Management of the Economy’, 31 May 2000. Committee on Economics, Finance and Public Administration, providing ample In a month’s time, the 1999/2000 financial opportunity for people to understand the year will end. It will be a further two or three Bank’s current thinking. I come with no new months until we get statistics for economic messages. So you can all relax from the start. performance in the June quarter, but we could Hopefully, I can do the same. expect that those data will show that the I would like to begin with some observations Australian economy has completed nine years about the growth performance we have of continuous growth, at an average rate of observed, as a way to giving us some basic just over 4 per cent per annum. It has been well building blocks for the purposes of discussion documented that this compares favourably about how to sustain growth in the period with earlier history, and with performance in ahead. many, in fact most, other countries. As good as this performance has been, attention is tending to focus on prospects for Growth in the sustaining that expansion into its tenth and eleventh years. This is as it should be: that we have a debate of this nature says a lot about the nature of economic performance in this I begin with a few pertinent facts. expansion, and the improvements in both the Average annual GDP growth has been institutional structure of policy making and remarkably similar over the past three decades. in policy execution. This average conceals substantial fluctuations, The advertised topic for today’s discussion of course. The 1970s saw faster growth in the is that of ‘speed limits’. I prefer to think in first few years than it did thereafter. The terms of managing the economy’s expansion, second half of the 1970s was a period of and so will come at things from that particularly poor economic performance. perspective. I do not wish to make any Each decade has included one serious comments about the short-term monetary , which explains why average growth policy considerations which may be rates here are lower than the averages which upper-most in the minds of policy-makers. 5 ‘Speed Limits’, Growth and Monetary Policy June 2000

Table 1: Macroeconomic Aggregates Graph 1 Average annual rates Expansions in GDP Cyclical trough = 100 1970s 1980s 1990s Index Index Average growth rate 140 140 Real GDP growth 3.5 3.3 3.5 1970s 3.1% 135 1980s 4.6% 135 Standard deviation of 1.4 1.1 0.7 1990s 4.1% 1990s quarterly GDP growth 130 130 125 125 CPI 10.1 8.3 2.3 1980s 1970s 120 120

Population growth 1.7 1.5 1.2 115 115 Labour force growth 2.1 2.4 1.4 110 110 Employment growth 1.6 2.4 1.3 105 105 Productivity growth 1.8 0.8 2.2 (per person) 100 100 95 95 GDP per capita growth 1.8 1.7 2.2 1 2 3 4 5 6 7 8 9 Years since trough result from computing growth only in the There are several possible explanations for periods when the economy was expanding. this outcome, which are not mutually The latter calculation shows an average exclusive. One is that the world economy was growth rate of GDP since the low point of more stable. It was, at least as measured by the early 1990s recession of 4.1 per cent. This the standard deviation of annual growth rates is somewhat lower than the corresponding for the IMF’s series for world GDP. This is figure for the 1980s, but higher than the 1970s despite the Asian crisis, which made for more figure. More importantly, the length of this instability in the growth performance of expansion exceeds those of the previous two, Australia’s trading partners. One element of with no sign that it is likely to end in the near that is that the US economy, in particular, was term. The obvious point bears repeating: more stable in the 1990s than in the 1980s. prolonging expansions, and being in a position Presumably at least partly as a result of these to ameliorate downturns if and when they factors, the variability of Australia’s export occur, makes a tangible difference to growth, and of our terms of trade, declined in economic performance over the long run. The the 1990s. So the world economy in this performance of the US economy, currently respect, though not perhaps in others, was enjoying the longest ‘peace-time’ expansion more benign. in its history, has rightly received accolades Another potential explanation is that policy in recent years. We should not forget, however, impulses to the Australian economy were also that this follows the second longest expansion more stabilising in the 1990s. This has played (in the 1980s), and that these two were an important role. The story is partly one of separated by what was a relatively mild improvements to the institutional structure of downturn by historical standards. Two good policy regimes – the gradual development of expansions had done a lot to make the the inflation-targeting regime is one example. US economy the pacesetter, even before talk The story also includes, I am prepared to of the ‘new economy’ became common. claim, better execution of policy. Another feature of Australia’s performance Forward-looking policy should usually result in the 1990s was that the variability of growth, in less need for aggressive policy adjustments as measured by the standard deviation of than otherwise, and therefore less economic quarterly growth rates in GDP, has been lower instability. All this was helped by clearer than in the 1980s, and about half that seen in articulation of goals and of the policy the 1970s. In other words, the economy has adjustments in pursuit of them, and by various been more stable. It is surprising that this is reforms in product and labour markets which not remarked on more often. made the economy more flexible. 6 Reserve Bank of Australia Bulletin June 2000 Of course, the domestic and international lessening in the rate at which female elements of the story may be related. For participation rates increased compared with significant periods of time in the 1990s, the 1980s, this meant that labour-force growth developments abroad may have made the was considerably lower in the 1990s than in environment for policy-making easier, at least the 1980s. Employment growth was similarly through the growth and trade channels lower. mentioned above. If the shocks emanating Productivity growth, on the other hand, from abroad were smaller, the policy actions increased. This meant that even though the responding to them could be as well. On the increase in the number of workers each year other hand, while overall exports and terms was smaller, output growth was actually of trade movements were less variable, the slightly higher on average than in the 1980s. 1990s was a decade of recurrent international With slower overall population growth, financial crises. One of these, the Asian crisis, per capita GDP growth picked up quite was a severe test of the robustness and noticeably, and in fact was at its highest since flexibility of the Australian economy and of the 1960s. This is another statistic which our policy processes. It was a test, I think should get more attention. A pick-up in everyone agrees, that we collectively passed per capita GDP growth of half a percentage in good fashion. point per year makes a tangible difference to All of this was accompanied by a very good living standards if it is extended over a long inflation performance. After twenty years of period. high single or low double-digit inflation, inflation as measured by the CPI averaged 2.3 per cent in the 1990s, or 2.8 per cent Speed Limits excluding interest changes. This was a good performance. For the period of the inflation target, since mid 1993, inflation has averaged about 2 per cent. The title of today’s seminar talks about To be sure, inflation has fallen in virtually speed limits. Here there is potential for every country in the 1990s. But it was already ambiguity, if not confusion, but I shall make on the way down globally in the 1980s, yet an attempt to give a perspective. Australia shared in that only at the margin. It The discussion of this kind of issue has to was not until the 1990s, and probably the confront, at least at the conceptual level, the second half of the 1990s, that inflation as a notion of the economy’s potential output. It part of life was removed from the Australian is clearest to think of the level of potential economy. output as being that which could be sustained, These results – both on growth and over an extended period, without any upward inflation – should give economists more or downward pressure on inflation.1 confidence in insisting that, even if getting Note that this is not the engineering concept inflation down is costly, maintaining low of potential output – which would perhaps be inflation carries no growth penalty, and in fact the maximum physical quantity of goods and is likely to assist long-term growth by helping services that the economy could produce if the price mechanism allocate resources more every worker and every piece of capital effectively. equipment were pushed to their limits. That A few other basic macro statistics of the past notion lacks the sustainability element, decade are of interest. Working-age population calibrated by price (or rather inflation) growth slowed in the 1990s, a result of the stability, that I think is critical in an economic baby boom effect waning, and a lower concept of potential output. Note also that immigration intake. Together with an apparent this is explicitly a level concept, but because

1. Note that this discussion takes expectations of inflation as given.

7 ‘Speed Limits’, Growth and Monetary Policy June 2000 the stock of productive resources grows each The Governor has laid to rest several times year, that level is increasing all the time: the perceptions which apparently existed in some path of potential output is an upward sloping quarters a few years ago that the Bank thought one. We can then say that the slope of that there was a GDP speed limit for Australia of potential path is the potential growth rate in 3.5 per cent growth. As the above analysis the longer term – assuming that all resources suggests, even if long-run potential growth was are ‘fully’ utilised. thought to be 3.5 per cent – and I do not Graph 2 endorse that (or any other) particular number – the economy can be allowed to grow faster than long run potential if the level of output is below potential to begin with. In fact Output it should be, and would be, encouraged to do so in an inflation-targeting framework, unless

Potential output inflation was forecast to exceed the target for some other reason. Slope = long run growth rate of potential Having considered that issue, are there output genuine speed limits?

Actual output Clearly, at some point there must be. Economies can overheat if the level of outstrips potential supply persistently. Concerns over this have increased

Time in the US in the past six months, even with greater optimism about supply potential than The distinction between levels and rates of used to be the case. Additional resources change here is very important. At any given cannot be conjured up indefinitely even in very time, the economy’s level of production may flexible economies. So if an economy were be below its potential. In such instances, there thought to be operating above potential, is the possibility of the economy growing faster growth would need to be held below the than the long-run growth rate of potential for long-run potential growth rate to re-align the a while, in order to narrow the gap between level of demand with that of potential output. the levels of actual and potential output. That Speed limit effects might also occur in is what happens in the recovery from economies where there is not a general sense recession. It can happen, in fact, for quite of persistent excess demand, but simply extended periods if the surplus capacity at the because the expansion in demand over a starting point is sufficiently large. It is what particular short period is so great that supply has been happening, on average, for most of cannot be increased quickly enough to match the past nine years in Australia. it in the short term, even though supply could In mid 1991, output was a long way below be increased in the long term. This, I think, is potential. Initially, the upswing in GDP was the way to understand the increase in inflation weak, so that the gap between actual and which occurred in Australia in the mid 1990s. potential output probably continued to widen A period of exceptional strength in demand until growth picked up. But the overall growth and output growth put upward pressure on rate since mid 1991 of just over 4 per cent the growth of labour costs, even though the appears to have been a little above the rate of was still quite high (at economy’s long-run potential growth rate, as 9 to 10 per cent). The economy was almost best that can be judged from the data of the certainly below its long-run sustainable level 1990s, so that the extent of spare capacity has of output, but the short-term dynamics gradually declined – as was intended. resulted in a noticeable increase in inflation. What then are the ideas people have in mind In other words, even with a large degree of when they talk of speed limits? spare capacity, there may sometimes be a limit

8 Reserve Bank of Australia Bulletin June 2000 to how fast that spare capacity can be reduced, then below, the target. By the time cash rates without creating inflation problems. had fallen to 5 per cent, in July 1997, we had To what extent are either of these two sorts become quite confident that policy was clearly of limits affecting Australia at present? expansionary, and would facilitate stronger We cannot be definitive, only approximate. growth and, in time, a return of inflation to There is less surplus capacity now than there the target. was, say, two or three years ago. At the sorts As it turned out, the Asian crisis hit at about of output growth rates which appear to be in that time. This reduced Australia’s national prospect for the next year or so, we will income sharply, and pushed down the probably continue to eat into the remaining exchange rate. Since the economy had ample spare capacity to some extent, though not as capacity for growth, and inflation was still quickly as we have done in the past couple of below the target, policy accepted the lower years. But while we have to be alert for signs exchange rate, which we expected to put some of bottlenecks and pressure on prices and upward pressure on inflation, and wages, there is no compelling reason to think accommodated very strong growth in that we will significantly exceed the potential domestic demand from 1997 to 1999. The level of output in the near term. Likewise, the expansionary setting was maintained for a anticipated growth rates do not seem likely to considerable time. In fact, at the time in late break the other kind of short-term speed 1998 when prospects for the world economy limit – on most people’s current forecasts they appeared to be most grim, rates declined a are likely to be well below what was seen in little further. 1994. By late in 1999, the scenario looked quite So there are no reasons to think, based on different. It was pretty clear that the world the outlook and policy settings prevailing at economy was in a fully-fledged upswing, with present, that the expansion will be cut off by above-average growth rates on the cards for having broken ‘speed limits’. 2000 and 2001. This growth is being led by, but is not confined to, the . The Australian economy had continued to record very robust growth. Inflation had increased Sustaining the Growth moderately, and was looking as though it would be back in the target zone in the period ahead. The Bank took the view, as did central There are good prospects for the expansion banks in many countries, that the low levels continuing. What is the role of policy in of interest rates appropriate for circumstances helping to realise these prospects? of downside risks to growth, inflation below The answer the Bank has given is that target, fears in some quarters of global monetary policy settings have to be adjusted, (and financial distress in some as the economy’s circumstances change. As countries, though not Australia) should not the press release of 5 April stated: be maintained in a period of strengthening world growth, likely waning of disinflationary The fundamental reason why interest rates have forces and renewed financial optimism. The risen in Australia and in most other developed interest rates which had facilitated inflation countries over the past year is that the degree of returning to our target were not likely to be monetary stimulus that was appropriate to the ones which would keep it there. earlier circumstances is no longer needed. Accordingly, rates have been increased over You know the general history of the past the ensuing six months. few years well, so I can be brief. Beginning in We do not believe that this sequence of mid 1996, and continuing through mid 1997, adjustments will stop growth in its tracks. It monetary policy was eased gradually as does mean that growth will not be as strong inflation appeared to be falling back to, and as it probably would have been, had we left

9 ‘Speed Limits’, Growth and Monetary Policy June 2000 rates at their lows. But it is appropriate that least some of the risks, and hence will help to domestic expenditure – where interest rates sustain growth in the medium term. have their main impact – slow from its 5–6 per cent growth pace of last year, given that the trade sector of the economy will be Conclusion turning from a major drag on growth to having a neutral or positive impact. I do not for a moment want to imply that we think we can fine-tune this shift in the sources of growth. Australia’s macroeconomic performance in But think about a scenario involving already the 1990s ought to give us reason for optimism strong growth getting a boost from the world about the future. Good growth, rising living recovery, not at an early stage of the expansion, standards, declining unemployment and low but at quite a mature stage, with inflation inflation have coexisted. These are good already tending to rise, however gradually. Add macroeconomic outcomes. A sensible to this a tendency at times for the exchange framework for monetary policy has played a rate to weaken. Should monetary policy hold part in this, and will continue to do so. overnight interest rates at the same levels as Are there, as today’s topic implies, speed seen in the immediate aftermath of the early limits to growth? There are some, but they 1990s recession (and even lower in the case still allow us to make pretty good progress of most borrowing rates)? along the economic roadway. Adjustments in The Board considered that a much more monetary policy have to play their part in prudent approach was to make early, keeping a reasonable speed for the economy. moderate adjustments to monetary policy That means interest rates move as settings, taking them to levels more in keeping circumstances change: the sensible driver, with changed circumstances. These moves having crested the hill, eases up on the were made not because things had gone accelerator as the car starts down the other wrong, but to reduce the probability that side. A careful approach to policy maximises inflationary imbalances would develop in our chances of sustaining economic future. That is, after all, the point of a expansion, helping set the pre-conditions for forward-looking approach to policy. Of course a durable further fall in unemployment, and policy makers can’t, and don’t, promise to be building on the progress made in the able to avoid all potential future problems. But 1990s. R they have acted in a way which will lessen at

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