AUSTRALIAN MONETARY POLICY- THE LAST TWO YEARS

by BILL SHIELDS*

The Background To adequately discuss monetary policy over the past two years it is

necessary to take a somewhat longer time horizon. This paper takes 1984 as the appropriate place to begin.

Over this period there have been two dominant themes of the monetary policy debate: first, the traditional issue of the appropriate stance of monetary policy and its role in the overall mix of macroeconomic policies: and second, the more recent issue of the impact of financial deregulation on the conduct but particularly the effectiveness of monetary policy.

While it was generally agreed that financial deregulation would have an effect on the conduct of monetary policy, both in decision making and in the Reserve Bank's day-to-day operations, there was considerable uncer- tainty , and even confusion, about how deregulation would impinge on the effectiveness of monetary policy.

A common assertion was that it would be difficult to judge the effective- ness of monetary policy because established relationships between policy goals (for example, nominal GDP and inflation) and the usual indicators of the stance of policy (such as monetary aggregates and interest rates) would change as a result of deregulation. Moreover, because of the extent and pace of deregulation in Australia, these changes were expected to continue for some time! On the other hand, it was also argued that deregulation would enhance the effectiveness of monetary policy (by insulating domestic financial conditions from overseas influences as a result of floating the exchange rate). Both the 1984 Reserve Bank Annual Report and the 1984185 Budget Paper No. 1 argued this advantage of deregulation.

The fact that there was considerable confusion about how deregulation would influence monetary policy is perhaps not all that surprising given the enormous swings in financial conditions and in macroeconomic policy settings over recent years. Although this complicates any analysis of recent experience, it also makes it more important to do so. Because of the central role of monetary policy during the past two years or so, the lessons from this experience will provide guidance on the future role and conduct of monetary policy.

* Associate Director, Macquarie Bank. I wish to thank Mike Beck of Macquarie Bank for helpful comments on an earlier draft of this paper. The views expressed in the paper, however, remain mine alone and do not necessarily reflect the views of Macquarie Bank.

1. See, for example, P.D. Jonson and R.W. Rankin, "On Some Recent Developments in Monetary Economics", Economic Record, 62, September 1986.

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The Experience The experience of monetary policy over the past few years can be

categorised into three broad phases, as shown in Figure 1. The first phase was that of monetary “targets’l-in the official language, conditional projections for the annual growth in M3-which ended in January 1985. This was followed by a phase during which monetary policy took a more eclectic approach, with decisions based on a “checklist” comprising a broad range of indicators of the stance of monetary policy.

However, in my view, this phase did not last very long, in fact less than a year, and was succeeded by a return to an intermediate target, in this case the exchange rate. This third phase of monetary policy was very much determined by the macroeconomic policy of circumstances at the time and, although it had been initiated by the February 1985 depreciation of the $A, came to prominence following the second major fall in the exchange rate in early November that year.

FIGURE 1 THE THREE PHASES OF MONETARY POLICY

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6 JI

CHANGE ON PREVIOUS YEAR

- M3W n “TAAGET” RANGE

MONETARY “TARGET”

‘JUNE ‘YEAR ‘JUNE QUARTER -0N- -ON - -0N- JUNE YEAR JUNE QUARTER

J I 1 01 JUNE2 JUNE3 JUNE4

MONTHS

I EXCHANGE RATE

14

12

10

JUNE7

a ADJUSTED FOR THE ENTRY OF NEY EANKS AFTER FEBRUARY 1986

The End of Monetary “Targets” In mid-1984, the outlook for monetary policy looked reasonably bright.

The float of the $A in December 1983 had gone well and was not only progressing “cleanly”, with a general absence of official intervention, but the $A had continued to drift up after the float. This was accepted as consistent with “firm” monetary conditions. Moreover, for the first year in several the “target” range for M3, which admittedly had been adjusted

17

upwards in December 1983 to take account of somwhat faster growth in the economy, was met. Also, inflation was declining, economic activity was clearly picking up and there was fairly substantial (downward) pressure on interest rates, particularly after mid-year.

At the same time, there was an awareness that the process of deregulation in financial markets would be more or less completed with the removal of interest rate controls on current accounts in August 1984 and that this, combined with substantial deregulation over the preceding few years, would have an increasing impact on financial markets.* Buoyed by confidence that the floating exchange rate and the adoption of the tender system for lleasury notes and bonds would together enhance the conduct of monetary policy, the authorities chose to adopt a conditional projection for M3 growth in 1984/85. That “target” was, however, more heavily qualified than in earlier years; specifically, no allowance was made for the impact of “reintermediation” (the shift in financing from non-bank intermediaries to banks as a result of deregulation).

It is not necessary to recount all the history of what followed. Most impor- tantly, the sharp fall of the $A in February 1985 changed the focus of economic policies, although the exchange rate had not yet become the primary focus of monetary policy. This overall change in focus was spelt out in the 1985/86 Budget papers, which, for the first time in several years, espoused fiscal restraint, and outlined an economic strategy based on “exploiting the opportunities provided by the depreciation” of the $A.

The role of monetary policy was unclear, however. Prior to the February 1985 collapse in the $A, the authorities had become increasingly concerned about the impact of deregulation on monetary aggregates and their ability to rely on M3, in particular, as a meaningful indicator of the stance of policy. In January 1985, the M3 conditional projection for 1984185 was abandoned. Moreover, because of uncertainty about the continuing impact of deregula- tion (and innovation), they chose not to replace it with any other form of monetary “target”.

The “Checklist ”-An Eclectic Experiment This immediately raised an important question about just how monetary

policy should be measured and on what basis decisions to change the stance of policy would be made. The “checklist” of factors, about which the Bank talked a lot in that period, was never really very convincing as a guide to the actual stance of monetary policy but had the crucial advantage that it allowed the authorities much greater discretion in determining the appro- priate stance of policy than under the constraint of an M3 “target”.

Nevertheless, through the following six months the Reserve Bank probably did attempt to consider a fairly wide range of factors when reviewing the stance of monetary policy. The 1984185 Budget had been sharply expan-

2. “Monetary Aggregates as Monetary Indicators”, Reserve Bank, Bulletin, May 1984.

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sionary (for the second year in a row) and the economy appeared to be growing strongly, monetary aggregates and private demands for credit were rising rapidly, and inflation was again rising (and was expected to rise further under the impetus of the $A depreciation). However, the exchange rate appeared to have “stabilised” following its sharp fall in February and the terms of trade were not generally forecast to decline further.

Financial markets, interestingly, were not overly concerned with these complexities. The relatively simple rule that monetary policy was being set exclusively on the basis of the exchange rate worked well as a guide for those in the markets (Figure 2).

FIGURE 2 SHORT- TERM INTEREST RATES AND TRADE WEIGHTED INDEX

OFFICIAL CASH RATE (HTHLY) OFFICIAL CASH RATE IYKLY)

TWI (WEEKLY)

Exchange Rate Targeting Takes Precedence In fact, in November 1985 the primary focus of monetary policy almost

certainly narrowed to the exchange rate. This was partly obscured in the public debate by widespread commentary at the time on the continuing distortions to monetary indicators and the operation of monetary policy as a result of financial deregulation. Also, the authorities continued to refer to other factors (such as the prospect of an “overheating” economy, the balance of payments, and inflation) as influences on the conduct of monetary policy. Indeed, these other factors appear to have had an important influence

19

on events during the first half of 1986 when the authorities willingly acquiesced in a “bull run” in financial markets.

The fall in the exchange rate in early November had led to an immediate and sharp tightening of monetary policy with cash rates rising to above 18% for the first time since 1982. Although this resulted in a rise in the entire interest rate structure, the yield curve became even more inverse with a positive differential between short-term and long-term rates in excess of four percentage points by the end of 1985. This signified a general perception in financial markets that the sharp tightening in monetary policy would be short-lived and that short-term rates would ease once the $A had been “stabilised”.

This is precisely what occurred in the first few months of 1986. The “bull run” in financial markets was fuelled by some modest improvement in the balance of payments, the prospect of lower inflation as a result of falling crude oil prices and, crucially, to use official jargon of the time, by the authorities “validating” the lower interest rates by progressively easing monetary policy.

However, the $A had not recovered in trade-weighted terms, only against a weakening US dollar, and there was a continuing decline in Australia’s terms of trade. Moreover, despite assertions about a shift in the balance of macroeconomic policies towards greater fiscal and wage restraint, this was yet to be seen in practice, and monetary policy was still perceived as carrying the burden of necessary policy adjustments.

Inevitably, there was another $A crisis in mid-1986 following the Tkeasurer’s now famous “banana republic” comments and monetary policy had to be tightened yet again in order to “stabilise” the $A. The nexus between monetary policy and the exchange rate was now fully accepted by market participants and most commmentators.

Rather ironically, at the same time there was a significant change in official attitudes, most notably in favour of direct intervention in the foreign exchange market. Since July 1986 official intervention has been substantial, both to support and to hold down the exchange rate, although, on balance, the $A has steadily risen (Figure 3).

Despite the 40% fall in the $A between early 1985 and mid-1986, official intervention had been modest and the brunt of stabilising the $A had fallen on domestic market operations and interest rate differentials. The successive tightening of monetary policy had led to sharply wider differentials between domestic and overseas interest rates over that period, which, in a sense, reflected the “risk premium” that foreign investors placed on the $A. At its peak in July 1986 the short-term interest rate differential vis-a-vis the US dollar, for example, exceeded 12 percentage points which was more than double the difference in inflation rates between Australia and the US (Figure 4). The differential between long-term government bond yields also widened sharply to almost seven percentage points.

The decision by the Reserve Bank to revert to substantial direct intervention in the foreign exchange market was partly taken to combat what

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200c

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FIGURE 3 RESERVE BANK INTERVENTION AND THE $A

:ASME0 IN TERMS W US$ MILLIONS

RI)A NET OF US* (LHSI

OUARTERS

I FROM 12 DECEMBER 1983

FIGURE 4 INTEREST RATE DIFFERENTIALS: AUSTRALIA VS UNITED STATES

- 90 DAY SECURITIES 10 YEAR BOND YIELDS - _ _ _ _

100

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-3 /07/87

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were seen as disorderly market conditions. However, it also was clearly aimed at defending a particular level for the exchange rate. Although the initial objective was to put a “floor” under the exchange rate, it subsequently developed into a concerted effort to stabilise the $A within what appears to be a relatively narrow “target zone”.

This change in approach was also reflected in a change in financial market volatility away from exchange rate volatility towards increased interest rate volatility (see Figures 8 and 9). Nevertheless, exchange rate volatility remained higher than during the period prior to the floating of the $A (excluding March 1983), although interest rate volatility remained substantially below the extraordinary levels experienced in 1983.

The return to a substantially managed exchange rate after mid-1986 foreshadowed a lesser role for interest rate differentials in supporting the exchange rate, and a more passive role for domestic market operations in monetary policy. This was supported by changes to the mix of macro- economic policies which began to emerge in late 1986.

Although February and November 1985 clearly demonstrated the opera- tional capacity of the Reserve Bank to influence domestic financial con- ditions and “stabilise” the exchange rate, it once again highlighted the more traditional issue of what was the appropriate role of monetary policy. Indeed, November 1985 saw the initial seeds of what became a classic macro-policy dilemma between instruments and targets. This dilemma reached a peak in the first half of 1986, and forced the Government to eventually recast its macroeconomic policy goals.

The 1986187 Budget took a further substantial step towards fiscal restraint, at least on the part of the Commonwealth Government, and endorsed even more strongly the strategy of a recovery in the Australian economy on the basis of a restructuring of economic activity flowing from increased competitiveness as a result of the lower $A.

Although the Budget failed to impress financial markets, it was quickly followed by the Government’s decision to move towards greater wage restraint and flexibility under a new “two-tier’’ wages system. Again, initial claims of what the “two-tier” wages system would achieve were not fully realised during the protracted negotiations which followed, but they nevertheless contributed in the December quarter to an improved perception of economic policies, including, importantly, by overseas investors.

At last it appeared that the Government was addressing that macro- economic policy which would most directly contribute to the achievement of its economic strategy.

There is little doubt that the extent of support for the $A after mid-1986, with the one relatively modest (in hindsight) exception of mid-January 1987, surprised the authorities as well as the financial markets. However, with the authorities fully committed to direct foreign exchange market inter- vention to hold down the $A, monetary policy was eased substantially and most interest rates declined to their lowest levels since February 1985. The fact that the resulting increase in interest rate volatility has been modest,

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at least to date, perhaps reflects the improved perception of macroeconomic policy settings.

The Lessons The experience of the past few years raises a number of important

questions. This section canvasses six issues and suggests some lessons that could be drawn for the future.

Classical Monetary Policy Cycle or Deregulation-induced Uncertainty? The uncertainty about the impact of deregulation on the effectiveness of

monetary policy that was pronounced over the past two years appears to have been significantly exaggerated.

The experience of that period shows that financial deregulation (and innovation) has had some impact on financial markets. For example, there is little doubt that the competitiveness of banks was raised as a result of deregulation and that banks have been expanding substantially faster than non-banks since 1984. 'Ib what extent this has resulted from the entry of new banks is more debatable, particularly since many of the new banks were previously non-bank intermediaries and a substantial transfer of assets was involved as a result of their becoming banks.

Nevertheless, the difference in asset growth in recent years has been in marked contrast to the experience of the previous two decades (Figure 5).

FIGURE 5 LENDING TO THE PRIVATE SECTOR

30 30 X CHANGE ON PREVIOUS YEAR

I - BANKS

NON-BANKS

5 JUNE1 JANEP AUGE2 MAR83 OCTEJ MAY84 OECE4 JULES FEE86 S E W 6 MAY87

MONTHS

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Deregulation was also partly responsible for a widening discrepancy between the growth in Broad Money and total lending by all financial intermediaries (the “demand for credit”) after 1984. Although not incon- sistent with previous experience, the magnitude of the difference after 1984 was significantly greater than in earlier periods (see the top panel of Figure 6).

However, this can be reasonably explained by the nature of the recent monetary policy cycle. First, reliance on sharply wider interest rate differentials to support the $A for much of this period strongly encouraged domestic financial intermediaries towards offshore funding, particularly as more sophisticated opportunities to hedge currency risk arose. The initial definition of the Prime Assets Ratio (PAR) as a proportion of domestic liabilities also encouraged the use of offshore funding. Second, the high interest rates in effect over most of the recent cycle encouraged banks to increase nondeposit forms of domestic funding in order to avoid the costs of regulation, particularly of Statutory Reserve Deposits (SRD) on which the rate of interest remained fixed at only 5% per annum.

Of course, it is still necessary to explain the enormous growth in lending (largely to the private sector) between mid-1984 and early-1986. This can probably be explained by a combination of lags and the fact that some areas of the economy were experiencing sustained levels of growth and profit- ability, most notably in the services sector, reflecting the stimulus from the 1984185 Budget and the relatively easy stance of monetary policy in the second half of 1984. Employment data also point to a compositional shift in economic activity through this period.

“Intermediation’Lthe shift from direct financing to intermediated financing-as a result of deregulation has often been raised as an important distortion in the lending figures. However, this does not appear to be an adequate explanation, in particular of the sharp rise and subsequent decline in lending over the past three years.

In short, despite undoubted complications, the past few years appear to have shown all the elements of a classic monetary policy cycle. Beginning with relatively easy monetary policy in mid-1984 there was a sharp acceleration in monetary growth and demands for credit (Figure 6). The marked tightening of monetary policy in 1985, however, led, with a lag, to an equally sharp fall in monetary growth and, subsequently, in (private) demands for credit. Although changes in other policy settings also made a contribution to the recent cycle, in particular the progressive tightening of fiscal policy from 1985186, their impact was concentrated towards the end of the cycle.

The Pansmission Mechanism for Monetary Policy One of the uncertainties which was discussed often throughout recent

years concerned changes in the transmission mechanism for monetary policy as a result of deregulation.

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FIGURE 6 MONETARY GROWTH, THE “DEMAND FOR CREDIT” AND INTEREST RATES

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5 JUNE1 FEE82 OCT82 JUNE3 FEE84 OCTE4 JUN85 FEE86 MAY87

MONTHS

25 I PER ANNUM 25 - 9 0 DAY BANU BILL RATE

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:!!5 10 MAY87 10

JUNE1 FEE82 OCT82 JUNE3 FE884 OCT84 JUN85 FEE86

MONTHS

Despite all the hesitancy about the continued efficacy of monetary policy, there were views that monetary policy would remain effective in a deregulated environment, although the transmission mechanism would work more through the impact of interest rates on real economic activity [and associated demands for credit) than through the demand for money [and the traditional monetary aggregate^).^

In fact, this appears to have been the experience of the past two years with the predominant impact of monetary policy falling on real economic activity.

This raises a further important question. Earlier experience, admittedly under fixed or managed exchange rate regimes, had suggested that changes in monetary policy had their predominant impact on inflation and that any impact on real economic activity tended not to be sustained over the long term.4 However, if the transmission mechanism now works predominantly through the impact of changes in interest rates on real economic activity it is far less certain that the impact will be confined to the short term.

This concern also appears to have been accepted by the policy makers. Even though the 1986 Reserve Bank Annual Report discussed in some detail

3. M.A. Akhtar, “Financial Innovations and Their Implications for Monetary Policy: An

4. For a summary, see “Some Issues for Monetary Policy-An Information Paper Prepared International Perspective”. BIS Economic Papers, 9, December 1983.

for the Economic Planning Advisory Council”, Reserve Bank, Bulletin, May 1985.

25

the uncertainties raised by deregulation, that Report warned of the dangers of overly heavy reliance on monetary policy. Indeed, the Governor of the Bank reportedly had warned in a speech in July that year of the particular danger of overly heavy reliance on monetary policy for private investment activity.

An important aspect of this issue concerns the speed of the transmission mechanism in a deregulated environment. The 1986 Annual Report of the Reserve Bank noted that "the transmission of monetary policy depends, in the first instance, on the speed of adjustment of private sector lending rates to changes in cash conditions". The experience of the past three years confirms that lending rates adjust very quickly to changes in cash conditions (as measured in Figure 7 by the 90day bank bill rate). The principal exception has been the (still partly regulated) housing loan rate.

FIGURE 7 LENDING RATES A N D THE COST OF FUNDS

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1s

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- HOUSINQ INTEREST RATE (MTHLY) PRIME RATE IUKCY AVO1 SO DAY 0ANUlUKLY AVO) ! r '~ - -

I--- i-

r-1

I I I I

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20

10

16

14

12

10

The rapid transmission to lending rates of changes in the stance of monetary policy, coupled with the wide fluctuations in monetary conditions over the past two years, may have actually increased the impact on real economic activity of monetary policy. This would tend to have a particularly negative impact on expenditure decisions which cover a longer time horizon such as private investment. Moreover, the impact would be accentuated to the extent there was an asymmetry in the response of lending rates to changes in cash conditions, with such rates responding far more slowly to periods

26

of lower cost of funds, as the experience of the past few years also appears to suggest.

There is, finally, the issue of whether in a deregulated environment a higher level of interest rates, particularly in “real” terms, will be necessary for the same monetary policy impact. The experience of the past two years does not give any definite guidance on this issue. While, at face value, experience over the past decade suggests that a higher level of real interest rates is consistent with a deregulated environment, there have been significant changes in overall economic and financial conditions between the 1980s and earlier periods, not just financial deregulation, which undoubtedly have also had an influence on the general structure and level of interest rates.

The Economic Policy Mix The ultimate goals of monetary policy have always been perceived as “the

provision of a stable non-inflationary economic environment under which sustainable economic gmwth can occur”, although it has been acknowledged that “economic performance will depend on appropriate settings for all government policies, not just monetary policy”.s

The belief over the last two years that monetary policy could make a significant contribution to Australia’s economic difficulties always seemed to me to be misplaced, however. Our economic problems are clearly the result of the secular decline in the terms of trade, an economic structure that had become increasingly unable to take advantage of world developments, and macroeconomic policy shortcomings such as the push for growth in 1984/85 through sharply higher fiscal stimulus.

Against this background, and given an official economic strategy aimed at restructuring economic activity on the basis of the lower $A, the most appropriate policy responses should have come in fiscal and wages policies. However, the Government moved only reluctantly towards cutting public sector demands on the economy-the net PSBR declined only slightly over most of this period after reaching a post-war record in 1983184-and it steadfastly refused to acknowledge the necessity for much greater wage restraint in order to fully realise the potential improvement in competi- tiveness of domestic industry until well into the recent cycle.

The failure to restrain wages sufficiently (and to allow greater flexibility in relative wage levels between industries) meant that a substantial portion of the impact of depreciation was passed through to domestic costs and prices. This, in turn, meant that monetary policy had little or no chance of achieving its traditional goal of reducing inflation. As a result, Australia has been the notable exception to the general trend in industrial countries over recent years where “real” wage restraint has been reached through a combination of lower nominal wage growth and lower inflation. Rather,

5. Ibid.

27

our “real” restraint has been achieved almost exclusively through the failure to contain inflation.

For similar reasons, the current policy “trade-off” between greater fiscal restraint and easier monetary policy is unlikely to succeed in the absence of any further adjustment to wages policy. There is no doubt that greater fiscal restraint is desirable in itself. However, as long as the overall macro- economic policy mix remains inappropriate for the current economic circumstances and strategy, the response of some major economic variables such as private investment to lower interest rates could be muted.

The failure to achieve an appropriate economic policy mix will affect all policy settings. However, the relative “ease” of adjusting monetary policy, combined with its relative quickness in influencing financial conditions, and expectations, may mean that inadequacies in the overall policy mix will lead to greater distortions in monetary policy than in other policy settings.

What Should Be the Role of Monetary Policy? The appropriate role for monetary policy in the overall macroeconomic policy mix should depend largely on the source of any shocks to the economy. As argued above, the circumstances of 1985 and 1986 strongly pointed towards a policy mix dominated by adjustments to fiscal and wages policies. Moreover, there should have been much earlier emphasis on a variety of structural reforms, including lower tariffs and quotas to at least partly offset the effects of the sharp fall in the $A as well as many of those microeconomic issues which are only now coming to the fore in the policy debate.

Monetary policy should have played a less central but a more “supporting” role.

General demand restraint in support of the depreciation of the exchange rate would still have been one aspect of this role. While it is a matter of judgment as to how severe that demand restraint should have been, there seems to be little doubt that the accepted policy objectives could only have been achieved at a substantial cost in terms of economic activity given the relative rigidity of other policy settings. The fact that inflation is still running at a quarterly rate of 2% or more and the current account deficit is over 4% of GDP, but monetary policy has been significantly eased, attests to the limitations of monetary restraint as the most appropriate only policy prescription.

It could be argued, of course, that “tight” monetary policy involves a “political” price that needs to be paid in order to achieve-perhaps a better word is force-other (necessary) policy adjustments. A more passive view would see the role of monetary policy in these circumstances as “buying time” until the other policy adjustments are put in place.

A clear danger with this approach, however, is that there is no guarantee that the willingness to pursue “tight” monetary policy will force sufficient policy adjustments in other areas, particularly if, in the short term, it results in some stabilisation of financial conditions and an improvement in

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expectations. The apparently long (and probably variable) lags between a change in the stance of monetary policy and its impact on economic activity may also give the illusion that the costs of monetary policy are not that great, and therefore reduce the attraction of other, more politically difficult policy adjustments.

A major shortcoming of this approach in the medium term is that overly heavy reliance on monetary policy could actually result in more unstable, rather than more stable financial conditions. For example, the continued reliance on monetary policy to support the exchange rate over the last few years appears to have diminished its credibility over that period. One indication of this effect was the increase in short-term interest rates required to “stabilise” the $A after each of the four major currency “crises” in the past three years. Although the fall in the $A was generally smaller on each occasion, the extent of short-term interest rate adjustment remained roughly the same.

Around each of these occasions there was a marked increase in both interest rate and exchange rate volatility, perhaps reflecting the general uncertainty about macroeconomic policy settings during this period (Figures 8 and 9). Thus, rather than contribute to a more stable financial environment, monetary policy appears to have actually increased volatility during that period.

FIGURE 8 A$IUS$ EXCHANGE RATE MONTHLY VOLATILITY

STANDARD DEVIATION D I V BY MEAN

83 84 85 86 87 MONTHS

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FIGURE 9 90-DAY BANK BILL RATE MONTHLY VOLATILITY

STANDARD DEVIATION DIV BY MEAN

8

6

4

2

0 J F M A M J J A S O N D J F M A M J J A S O N D J F M A M J J A S O N D J F M ~ M J J A S O N D J F M A M J 83 84 85 86 87

MONTHS

The need to buttress interest rate effects with “announcement effects”, most notably the [always spurious) implication after July 1986 that the Reserve Bank’s rediscount rate was an indicator of the tightness of policy, was another indicator of monetary policy’s declining credibility in those circumstances.

The Exchange Rate as a Monetary Policy “Target” Most of the recent academic literature suggests that the exchange rate

can be a useful indicator of the stance of monetary policy, particularly relative to that in other countries. However, a far more difficult question is whether the exchange rate should be used as an intermediate “target” for monetary policy.

Measurement of the appropriate level of the exchange rate becomes essential if it is used as a “target” for monetary policy. This is fraught with difficulty. In the case of Australia during the past few years, the exchange rate was clearly in the process of adjusting down from what had been for many years a substantially overvalued rate. Although this downward adjustment was sudden and sharp, the more important question is whether the foreign exchange markets acted efficiently in 1985 and 1986, in terms of adjusting the exchange rate towards a more appropriate “equilibrium”

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level. “Over” (and “under”) shooting has often been regarded as a characteristic of freely floating exchange rates, but there is little evidence that foreign exchange markets did not behave efficiently over the past few years. Nor is it clear that the authorities were in any better position to judge the appropriate level of the exchange rate.

One rule that has been suggested for monetary policy is that it should react to those changes in the exchange rate which result from internal shocks, such as rapid expansion in domestic demand which shows up in a higher current account deficit and downward pressure on the exchange rate, but not to external shocks such as a secular decline in the terms of trade. The difficulty with this approach is that it is not easy to disentangle the two effects where they occur together, which was the case in Australia during the past two years. Recent experience shows the difficulties inherent in forecasting when, and how far, the terms of trade will decline.

Given that it is virtually impossible to assess or forecast the appropriate level of the exchange rate, a decsion to “stabilise” the exchange rate within a specific range (for whatever reason) may also be destabilising over time. For example, the decision in mid-1986 to put a “floor” under the exchange rate probably contributed to the subsequent strong capital inflow into Australia and the resulting appreciation of the $A. This in turn required the authorities to intervene heavily in order to “hold down” the exchange rate, consistent with the Government’s overall economic strategy.

It is necessary to ask what is the purpose in maintaining the exchange rate in such a narrow range when the balance of payments remains a major constraint on the economy and the outlook for the terms of trade is doubtful at best. If the exchange rate does need to decline further, the Reserve Bank may now face an even more difficult task in achieving an orderly decline in the rate. Indeed, by so explicitly attaching importance to “stability” over the past year, the Bank may actually have raised the probability of another exchange rate “crisis” in the period ahead, just as happened under the earlier managed exchange rate regime.

Should There be Intermediate “Targets” for Monetary Policy? There appears to have been considerable confusion about what should

have been the appropriate intermediate goals of monetary policy during the past two years. In November 1986, the Governor of the Reserve Bank stated that monetary policy could only be eased when there was “the prospect of a sustained improvement in both the current account deficit and inflation”.e

As noted earlier, the ability of monetary policy to achieve a sustained improvement in inflation was heavily circumscribed by the rigid wages policy in effect through most of the recent period. There is little doubt that monetary policy can lead to an improvement in the balance of payments if domestic

6. “Reflections on Some Issues for Monetary Policy”, Reserve Bank, BuUetin. November 1986.

31

demand is sufficiently restrained. The decline in import volumes over the past year or so confirms this view.

A more important question, however, is whether monetary restraint is sufficient to provide for a sustained improvement in the balance of payments, in particular through the substitutions of domestic production for imports. There are two reasons to doubt the effectiveness of monetary policy in this area.

First, because of Australia’s heavy dependence on imports, particularly of capital goods and material inputs, any pick-up in domestic demand at this time will lead to a substantial rise in import penetration (as well as domestic production). This was the experience following the 1982183 recession and could quite easily be repeated in the next year or so unless the notional gains in competitiveness from the earlier fall in the $A are fully realised through more appropriate policy adjustments. In fact, during the last couple of quarters there are emerging signs that the import cycle of the 1982183 recession could be repeated.

Second, despite the surge in export volumes late in 1986, restrictive monetary policy appears to have had little influence on an improvement in export activity. This is not surprising given the commodity structure of Australia’s exports. Moreover, sustained export volume growth in the years ahead is unlikely to occur without a substantial increase in private investment.

A more appropriate intermediate “goal” for monetary policy might be some measure of demand for credit by the private sector. Given the obvious distortions in the traditional monetary aggregates as a result of greater substitutability between liabilities following deregulation, and the apparent unwillingness of the authorities to redefine those aggregates to provide a better overall indicator of the growth in financial intermediaries’ liabilities, some measure of the demand for credit could be a better indicator of the stand of monetary policy. This would have the added advantage that it would be consistent with the transmission mechanism as currently understood.

Indeed, credit growth seems to have been a recurring theme of Reserve Bank statements over the past few years and, at times, has obviously been an important influence on monetary policy settings. Unfortunately, very little effort, at least publicly, appears to have been put into obtaining a better understanding of the sources of demands for credit and the ultimate economic purposes of bank and non-bank lending to the private sector. This should be given a higher priority in official research.

I am not necessarily advocating a credit “target” (or rule), although in a situation of extreme policy uncertainty there could be value in having a single, pre-announced guideline for the interpretation of monetary policy. This could limit volatility in financial markets as well as clearly signifying to the Government what could be expected of monetary policy. As such, it could hasten other policy adjustments.

Indeed, given the experience of the past two years, it is worth considering whether a “target” based on private demands for credit would not have

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provided more stable financial conditions, and improved the economic environment generally, although this might have been at the expense of greater exchange rate volatility, particularly in the first half of 1986.

Obviously, it would be preferable to have no necessity for such pre- announced rules. However, financial markets are only likely to have confidence that monetary policy would be set appropriately and provide stable financial conditions on the basis of a proven "track record". The experience of the last two years suggests that this is still lacking in Australia.

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