Saturday, June 14, 2008

Governor Stevens: The slowdown we have to have

The head of the Reserve Bank has acknowledged that the Australian economy is slowing down but says it may have to slow more.

The speech, delivered to the American Chamber of Commerce in Melbourne yesterday, is seen as confirming that interest rates will remain high well into the future.

In an echo of the former Treasurer Paul Keating’s famous 1990 observation that Australia was in the recession it "had to have” the Bank’s Governor Glenn Stevens said that while economic growth was moderating there was not much doubt “about the need for moderation”.

At the end of a week in which employment figures turned down, consumer confidence fell to recession levels and lending for housing slid still further Mr Stevens acknowledged that “things are happening that suggest a moderation in growth in domestic demand is occurring”.

“At this stage, inevitably, the extent and likely duration of the moderation remains uncertain,” he added.

“There is not much uncertainty, though, about the need for a moderation"...

“Inflation increased over 2007, and in underlying terms reached the highest rate for 15 years or more,” he told his audience.

“Reductions of inflation usually require a period of slower demand growth, and this episode is no different.”

His remarks caught some financial analysts by surprise. Many had been expecting Mr Stevens to signal that he was concerned about the downturn in the economy and to indicate that further increases in interest rates were unlikely.

Instead, while not saying that the Reserve Bank would push up rates again, he did nothing to dispel the possibility.

“Stevens is suggesting, very sternly, that interest rates are going to remain high for a long time,” said the Commonwealth Bank’s chief currency strategist Richard Grace.

ICAP’s senior economist Matthew Johnson said Mr Stevens had tried to make the case for high, but not higher, interest rates.

The Australian dollar shot up from 93.85 to 94.12 US cents within minutes of the release of the text of the speech in the belief it meant that interest rates would stay high for longer than had been thought. The dollar later lost those gains.

Mr Stevens indicated that he was still concerned about spending pressure in the Australian economy by saying that “other things being equal” high oil prices should curb that pressure.

“But other things are not equal. Australians also receive higher incomes as a result of higher resource prices. As shareholders they experience higher profits. Employees in the resource sector, as well as in the construction sector or the various areas that supply goods and services to mining, are receiving larger pay packets. Governments are receiving higher revenue flows, which in some cases they will spend, at least in part.”

The Governor said that in the year ahead he expected Australia’s terms of trade (a measure of the prices Australia receives relative to the prices it pays) to climb a further 20 per cnet.

“Since 2002, the total rise in the terms of trade will, by the end of this year, be of the order of 65 to 70 per cent.”

“Some other countries are also experiencing significant terms of trade rises. But few will have seen anything bigger than Australia’s over a five-year period.”

“It falls to monetary policy to play its proper restraining role, dampening private demand not only because inflation has already picked up, but seeking to head off further problems that could easily emerge.”

"This is why a tight monetary policy setting is essential."

The governor said that without high interest rates Australia would be left with the legacy of ``embedded high inflation, commensurately higher nominal interest rates and so on''.

"That would be harmful for living standards over time. Allowing it to occur would be a policy mistake."