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Standing Committee on Economics - 20/08/2014 - Reserve Bank of Australia annual report 2013

KENT, Dr Christopher, Assistant Governor (Economic), Reserve Bank of Australia

LOWE, Dr Philip, Deputy Governor, Reserve Bank of Australia

STEVENS, Mr Glenn, Governor, Reserve Bank of Australia

Committee met at 9:32.

CHAIR ( Ms O'Dwyer ): I declare open this hearing of the House of Representatives Standing Committee on Economics and welcome representatives of the Reserve Bank, members of the public, school students and the media here today.

There have been some pleasing signs from recent economic indicators. As noted by the RBA in its August 2014 statement on monetary policy, growth in Australia's major trading partners has been above its historical average over the past year. The US and China performed well in the June quarter of this year and the overall outlook for trading partner growth is quite positive for 2014 to 2015. Although the prices of commodities such as iron ore and coal have declined over the past year, global demand remains robust and the terms of trade are anticipated to remain at historically high levels. Global financial markets are showing low volatility and global share prices have risen, particularly in the US.

At home, we are seeing a continuation of accommodative financial conditions, strong export growth in the resources sector and above average GDP growth in late 2013 and early 2014. The outlook for growth remains quite positive, a little below average for 2014-15 but then forecast to pick up to above average pace. Encouragingly, there are positive signs of growth outside of the resources sector, which is an important trend as we move to a post-mining-boom era in Australia. Dwelling investment has strengthened this year, which is another welcome development, and housing price inflation has been less rapid in 2014 compared with the second half of 2013. There are also some positive signs from labour market indicators which suggest that employment growth is picking up, although overall conditions remain subdued. Underlying inflation was 2¾ per cent over the year to the June quarter, half a per cent higher than a year earlier. However, the RBA notes in its August statement that inflation is projected to be 'consistent with the target over the forecast period'. Consumption growth appeared to have slowed in the first half of 2014, as did consumer sentiment.

It is notable from the RBA's August statement, however, that consumer sentiment has recently risen to above average levels. The Australian dollar continues to remain strong by historical standards and the RBA board decided at its most recent meeting this month to continue to hold the cash rate at 2½ per cent. The board judged this to be appropriate to foster sustainable growth in demand and inflation outcomes consistent with the target.

The committee will today in its discussions on monetary policy continue to talk about these domestic and global factors that impact on Australia's economy with the Reserve Bank. On behalf of the committee, I welcome the governor and senior officials of the Reserve Bank of Australia to this hearing. I remind you that, although the committee does not require you to give evidence under oath, the hearings are legal proceedings of the parliament and warrant the same respect as proceedings of the House. The giving of false or misleading evidence is a serious matter and may be regarded as a contempt of parliament.

Mr Stevens, would you now like to make your opening statement before we proceed to questions?

Mr Stevens : Thank you for the opportunity to meet with you. Since the hearing in March, the global economy has continued its expansion at a moderate pace, and Australia's trading partner group has been growing at about its long run average rate. With the abatement of the adverse winter weather, the US economy recovered in the June quarter and the labour market has continued to strengthen. Growth in China has remained close to the target of 7.5 per cent, though Chinese residential property prices have declined in recent months. Chinese authorities at various levels are responding to those developments with the aim of maintaining stable macro-economic and financial conditions. In Japan, consumption and output grew strongly in the March quarter ahead of the increase in the consumption tax in April, and then contracted sharply in the June quarter. That is quite a normal pattern around a tax change like that, but it does complicate reading the underlying pace of Japan's economy. Growth in the rest of East Asia has continued.

Commodity prices important to Australia have declined this year, as global supply, including particularly from Australia, has increased. The terms of trade have now fallen by about 18 per cent from their peak three years ago, though they remain more than 50 per cent higher than the 20th century trend average. But perhaps the most remarkable feature of the international environment just now is the exceptionally low volatility of financial prices—the lowest observed over the past 25 years for sovereign bonds, equities and foreign exchange.

Yields on sovereign debt of the major countries are also very low—the lowest on record in some cases. Spreads for investment grade and financial corporate bonds have reached multi-year lows, and in Europe yields on so-called peripheral sovereign bonds have in some cases fallen below previous historic lows.

Now it is not as though there has been a dearth of geopolitical or financial events which might ordinarily trigger more caution among investors, but compensation for risk on financial instruments at least remains scant. The reasons for those remarkable trends, including the extent to which they reflect the effects of the exceptional monetary policies being conducted in the major jurisdictions, or other things, could be debated at length. But what is clear is that a combination of forces has resulted in financial conditions remaining remarkably accommodative.

This has been reflected in a decline at the margin in interest rates in Australia, even though the Reserve Bank has not changed the cash rate for a year. Australian governments have continued to borrow at or around the lowest rates since Federation. Similarly, funding costs for financial institutions have been declining. This, and an increase in competition to lend, in an environment of still fairly moderate credit growth, has contributed to a reduction in the rates on housing and business loans over this period.

Economic growth, as you mentioned, Chair, was, as recorded, clearly above trend in the March quarter. That quarterly result was to a large extent driven by a substantial increase in resource exports as new mining capacity came online and mining operations experienced fewer weather disruptions than usual for that time of year.

Data for the June quarter suggest a payback of lower exports and also a period of more subdued consumer demand. There are relatively few readings as yet for the September quarter, though at least some that we have suggest that there may have been a reasonable start to the quarter.

Having printed lower for a few months, the rate of unemployment has recently been recorded at a higher level, though most leading indicators of the labour market seem to have improved a little this year. Consumer prices rose by three per cent over the year to June, higher than the pace a year earlier. This partly reflects factors like the increase in the tobacco excise, but measures of underlying inflation also increased. A faster pace of increase in prices for tradeable goods and services was a feature, and that is a reflection of course of the depreciation of the exchange rate since April last year. The rate of inflation for non-tradeables has actually declined a little over the past year, helped by a growth of labour costs falling to its lowest rate for many years. There is some evidence that productivity performance may be starting to improve, though, as you know, this is notoriously difficult to evaluate over periods less than several years.

When we look ahead, a key feature of the outlook, as everyone knows, is that the capital expenditure phase of the mining boom is winding down and the export phase is gearing up. The fall off in investment spending by resources companies has a long way to go yet, and it will probably accelerate in the coming year. This impending further fall is captivating most of the commentators right now. Meanwhile, growth in non-mining activity has been increasing. A recovery in dwelling investment is well underway, with spending in this area up by about eight per cent over the past year. Forward indicators for non-mining business investment suggest a modest improvement over the coming year, though intentions have so far remained somewhat tentative in this area.

Consumer spending, though soft in mid-year, could I think be expected to grow in line with income, or maybe a little faster given that we have had a significant rise in household net wealth over the past couple of years. But it seems unlikely, I think, that households will revert to their behaviour of a decade ago when they were expanding their balance sheets quickly, saving much less of their income and increasing their consumption well ahead of growth and income. Public spending is scheduled to remain subdued.

The overall growth rate of the economy is the sum of these forces and also affected by factors not confined to mining and for that matter not confined to Australia. Forecasting is an imprecise art at the best of times. At present, given the size of the mining event that we have had, given the extent of the shift in global relative prices that we have seen over past years and given the very unusual global and economic and financial environment in which we still live, forecasts I think are likely to be even less reliable. With that caveat—it is a very big caveat—my guess is that over the year ahead the growth of real GDP will be around two to three per cent. That is close to trend but probably a bit below trend in the near term. Further ahead, I think, there are reasons to feel that growth can speed up somewhat and be a bit above trend. This outlook would mean, if it comes true, that it will be a while before we see sustained reductions in the rate of unemployment.

Conditional on the usual set of assumptions about oil prices and the exchange rate—that is, that they do not change—inflation should be consistent with the two to three per cent target over the horizon relevant for monetary policy. The depreciation in the currency last year is likely to continue to contribute to higher prices for tradeables for a while yet, but domestic inflation we think is likely to remain contained given how slowly labour costs have been rising. The removal of the price on carbon will lower inflation temporarily over the coming year.

To say that growth is close to trend but probably a little below in the near term will no doubt be disappointing to many people, and that of course is with a very accommodative monetary policy: the cash rate is at its lowest rate for 50 years and has held there for a year now and is widely expected in the markets to be held at or close to these levels for some time yet. Certainly the low returns on offer on safe investments in Australia—and that is what the low cash rate is doing, it is lowering the return on safe investments—and the ultra low returns on such assets internationally are having an effect by prompting investors to search for yield. Not only are returns on financial instruments low, but yields on the stock of physical assets in the economy—houses, commercial property, infrastructure assets and so on—are being bid down as well. Some of the search for yield is coming from offshore. This is a big part of how accommodative monetary policy works: it prompts substitution by savers towards higher risk assets. It raises asset prices, and that increases collateral values and it makes credit extension more viable. It improves the cash flows of debtors and so on.

All of those things have been happening in Australia for some time now. Admittedly the exchange rate, another channel through which monetary policy works, is probably not doing as much as it might usually be expected to do in achieving balanced growth, but the thing that is most needed now is something that monetary policy cannot directly cause. What I mean is we need more of the sort of so-called 'animal spirits', or confidence if you like, that is needed to support not just a repricing of the existing stock of assets, but the investment that adds to that stock of physical assets. There are some encouraging signs here, as you said, Chair. Nonetheless, if reports are to believed, many businesses remain intent on sustaining a flow of dividends and returning capital to shareholders and are somewhat less focused on implementing plans for growth. Any plans for growth that might be in the top drawer remain hostage to uncertainty about the future pace of demand. That is actually not a new phenomenon; it is in some respects pretty normal at this point of the cycle. There is always a period in which people can see that many of the conditions for expansion are in place but are not yet fully confident that it will happen. This is not confined to Australia: the gap between financial risk taking, and there is plenty of that in the world, and real economy risk taking is a gap that we observe around the world.

I think it is reasonable to expect at some point that this will change. After all—and let me recount to you again a number of the positive factors here—not only are funding costs low, but banks want to lend and they are competing to do so I think more now than they have for some years. Net worth per household has risen by about $120,000 per household on average over the past two years. The community's aggregate holdings of monetary assets have risen by about 13 per cent—that is in excess of $180 billion over that same period. Productivity improvements in enterprises will continue, and it needs to, but there are actually now getting to be some runs on the board in this area. The level of gross investment in some sectors is barely above the depreciation rates for capital. The population is growing, so there will be more demand for housing, for infrastructure and for consumer goods and services. And of course the dynamic of our proximity to a rising Asia with all of its opportunities remains.

So businesses will need to respond to trends that foreshadow sustainable increases in demand and incomes. Not all of that response will come from the large, established players; a significant proportion of it may well and I think probably will come from smaller and newer players, most of whom operate below the radar. The financial capacity in the financial system to provide credit prudently will help all of that occur. And at some point if those sorts of responses start to gather pace, then the sorts of forecasts that we and others are setting out at the moment will likely prove to be too conservative. The frustrating thing, Chair, is that no-one can quite say when this will happen or just what the proximate trigger will end up being.

In the interim, what is our task? Monetary policy's contribution is to lend support to demand, consistent with its obligations to pursue full employment and price stability, as set out in the inflation target, and taking due account of financial stability considerations. That has resulted in very low interest rates and, as I noted earlier, financial conditions in Australia have in fact eased a little in recent times, even with the cash rate being held constant. In reaching its decisions the board has been mindful of allowing time for the measures already taken to have their effects and of the very considerable limitations that monetary policy has in finetuning outcomes over any short period. We have also seen some value in the present circumstances in maintaining a sense of steadiness and stability.

CHAIR: Thank you for that statement. In a speech you gave at the start of July you said of the Australian dollar that 'most measurements would say it is overvalued, and not just by a few cents' and 'we think that investors are underestimating the likelihood of a significant fall in the Australian dollar at some point'. Does that remain your view and the bank's view, notwithstanding some of the global tensions that we have seen in the intervening period, with the possible implications for safe haven demand? If so, what sorts of events or developments might trigger such a fall?

Mr Stevens : It is very hard to say what developments will at some point trigger a fall. It does remain my view that, on most metrics that you would look at—relative levels of costs adjusted for productivity; the relationship between the real exchange rate and the terms of trade; and even taking account of interest rate differentials and thinking about the fact that the terms of trade have been falling and, quite possibly, will fall further—it is going to be pretty surprising if it remains this high over a very long period. One has to always remember that perhaps the market is seeing something that I am not—that is always possible, it is always in my mind, and I question myself as to what that might be—but it would remain my view that the risk that it goes down materially at some point is being underappreciated. And I think there are a number of other risks in financial markets globally that are being underappreciated as well; it is, in a way, part of that broader phenomenon, I would say.

CHAIR: Could you touch on some of those other risks that you have just mentioned?

Mr Stevens : As I said in my opening remarks, if you look at the present time, we have remarkably little volatility in financial prices, we have very compressed spreads. We have countries in Europe which, only a year and a half ago, were on the brink of this sense that the fiscal position was completely unstable at the interest rates at which they were borrowing. But suddenly these countries are borrowing as cheaply as the United States and cheaper than the Australian government. Go figure. That, in part, is testament to the success that the Europeans have had in convincing people that the euro will not disintegrate, that it will stay together. It is a good thing that they have succeeded in that. Nonetheless, compensation for risk there is very small. I think everyone knows that the Fed is on a course which, unless something goes wrong, will see them start to raise the funds rate—sometime around the middle of next year seems to be the general expectation. Every time that has happened in the past, it has proven to be a bit disruptive. It is inevitable that they will have to do it. But these sorts of events typically send a few jitters around and, to my reading, little attention is being paid to that right at the moment. So there are a number of things.

On exchange rates, I suppose the other point to make is that we in Australia sit here a bit puzzled as to why the Aussie dollar is quite so high. But in Canada, New Zealand and Europe similar questions are being asked about their currencies. The common part there is: how come the US dollar is not higher given that, clearly, the US is recovering fairly well now? Clearly the Fed will be the first major jurisdiction to begin the tightening phase. They will do it very gradually but, nonetheless, they will be way ahead of Japan or Europe. I think a lot of people are surprised that the US dollar is not a bit higher than it is. The Aussie dollar being where it is—and this is the case with these other currencies—is the flip side of that.

CHAIR: What would it take for the bank to intervene in FX markets to get the Australian dollar to move lower? In the past we have had submissions about jawboning, but what about taking other measures?

Mr Stevens : I think we have probably canvassed some of these other measures in previous hearings—and I take it you mean direct intervention. I have said in the past that I regard that as a remaining part of the tool kit, if it was useful. We have not been minded to adopt that tool in this episode to date, and I think that has been the right call so far because there has been a pretty big wall of money coming in and I think you have to be prudent in thinking about how effectively you will be able to stand against that. There is, presumably, some set of events you could imagine that might prompt it. But put it this way: if intervention is to be a useful tool, in my opinion it is most useful when you do not set out in detail what conditions it would take to get you to do it because that might get people to relax just a little bit too much in the near term. My view is that it is on the table as a possibility if it seems appropriate. I am not going to give advance warning to the world's investors about when it might be done—if you don't mind! I think that would be a tactical mistake on my part.

CHAIR: In that speech you gave in early July, you were talking about fiscal repair and you said that 'over the next couple of years the estimated impact of the budget is actually not particularly large when compared with past episodes of fiscal tightening'. You then said:

Beyond that period, the measures in the budget will result in a more significant consolidation than earlier assumed. It was over that more medium-term horizon that the Commonwealth's finances, left unattended, looked like they were going to start going more seriously off course. So the timing of the intended consolidation seems broadly sensible.

So why is it necessary and desirable to set the budget on a sustainable medium course now, and what are the consequences of not doing so?

Mr Stevens : The reason I think the country should be having a conversation about the fiscal accounts in the medium term is fairly simple. This is no startling insight on my part; I think it has been set out quite clearly by the Secretary of the Treasury and others. It is in the medium term where we as a community have decided we want to do some very big, very costly and very good things in the public space, but we have not actually taken the decisions that secure the funding for those things, so far as I can see. That is not catastrophic today, but it is going to be a medium-term issue if we do not address it. I do not give gratuitous advice on fiscal policy, so I will refrain from going into detail. But I think we need a strategy that recognises that medium-term imperative, that recognises that the economy does not really warrant draconian fiscal tightening right now. So you have to get from that point to this medium-term point. How do you do that? You try to design some measures that will build up over time and address that medium-term issue. I think that is a prudent and sensible strategy.

On the risk of thinking that we do not even have to think about this for years yet, I think we would get away with that for a while; but then we will find that the day will come and it will be much harder. There is ample evidence around the world of countries which do not have this conversation until it is very late and then it is a very hard one to have, and that is when you do get really draconian measures almost forced on you. So why wouldn't we avoid that? That would be my general view here. I think that has been fairly clear from various things that we have said.

Mr HUSIC: I want to go to some words which I am picking up in relation to where you think growth is headed. Earlier in the year the suggestion was that GDP at best might hit trend, and now that wording has started to taper back a bit and the expectation for 2014 is that it will remain below trend. I want to get a sense from you of where you see growth going and why we need to adopt a different view on where it is headed. I also want to discuss at a later point, following this, where you see things are headed with unemployment.

Mr Stevens : I do not think we have had a radical rethink on growth. It is probably worth pointing out that we did not have a hearing in August last year. I did just recently go back and look at the forecasts we made for the period we have now ended, and we have in fact had noticeably more growth over that period than we predicted. We have also had higher inflation than we predicted. Under some circumstances one might look at that and say: 'Gee, there's more momentum here than we thought. Maybe we should be upgrading our forecasts, not downgrading them.' But the view we have taken is that, around the turn of the year—through late 2013 and early 2014—there has been genuinely a bit more growth than we had expected. And then we have had this accelerated rise in resource exports for the reasons I outlined earlier. We will keep doing those exports but the growth in them will not be the same.

There are one or two elements of the most recent data that we think in some sense overstate the ongoing trend in growth, and part of the message we have been trying to give is that growth has been good but the near-term growth just in the little while ahead will not be quite that good because some of those temporary things will not be helping in the same way. Beyond that period, I do not think we have changed our views very much at all. I am very much looking forward to the day when I can come here and say, 'I think growth is clearly going to be above trend now,' but I cannot quite say that about the next year just yet.

On unemployment, it is interesting that, until the most recent number, it seemed as though the unemployment rate was steadying. Had that been the peak it would have been a lower peak than we expected, and we puzzled over whether that was the right story or whether there would be a further pick-up. The most recent reading is clearly a weak one, and there are some interpretation difficulties with that. What I would say about the labour market is that there has been some improvement in employment growth this year and some leading indicators of the labour market have turned up. You would not call them strong. I am thinking about vacancy rates and survey responses from business on employment intentions—things like that. They have improved. They are not strong, but they are not getting worse; they are actually getting better. I think that is good, but, as I said earlier, I think prudently I would say it will be a while yet before we could expect sustained reduction in the unemployment rate.

Mr HUSIC: Just going back to the growth figures, in the Statement on monetary policy, they have dialled back, from what I can see, about 0.25 per cent from the December 2014 assessment or estimates.

Mr Stevens : That is about right, between the latest SMP and the one before. Do not forget that earlier in the year we upgraded it a bit. The forecasters always give us their best guess, and sometimes it goes up and sometimes it goes down. It has gone down a little bit lately. A quarter per cent difference—I do not really regard that as a terribly significant thing. If you keep doing it every quarter, obviously that will add up, but, by and large, the shape of the economy over most of the forecast period is not greatly different now than I would have thought six months ago. It is a little bit softer in the near term, but we are talking quarter points on a forecast where, frankly, if we are within one per cent of the outcome, that is actually a pretty good forecasting performance historically, when you look at the size of the errors.

Mr HUSIC: I take your words to mean that we should not then be excited about a 0.25 per cent increase in growth—referring to the fact that you have revised the growth figures upward for next year.

Mr Stevens : I do not get excited anyway, as you know, but—

Mr HUSIC: I have detected this!

Mr Stevens : That is very astute.

Mr HUSIC: Thank you.

Mr Stevens : I think the outlook that I am trying to describe is kind of okay but it is not quite as good as I would like. I think there are reasonable grounds to think it will get better in time, for the reasons I articulated. Predicting the timing of that is almost impossible. So all I can do for you is describe the broad contours and what I think are the forces at work. The actual numbers—to be perfectly honest, I think in the debate about economic forecasts in the country we spend too much energy on quarter points here and there and we ought to spend more energy on: what is the big picture; what are the big forces at work; what can we do about them, if anything? Quite often we cannot do much about them, but I think that is the more useful discussion. But the arithmetic that you describe is certainly correct.

Mr HUSIC: Going to unemployment, I have detected similarly some changes in the wording coming out of the RBA, in particular the Statement on monetary policy stating now:

The unemployment rate is likely to remain elevated for a time and is not expected to decline in a sustained way until 2016.

When we met back in March, Mr Kent indicated that it would not be until late 2015 that there would be sufficient growth for that growth to make inroads into unemployment. Are we in effect being softened to expect that the jobless rate will be stuck higher for longer? Is the RBA taking a view that unemployment will be a bit stubborn over the course of the next—

Mr Stevens : Chris can speak to the details of the forecast if he wants to do so. If you look at the language I have used in post-board statements and so on, even though we had some better labour market data for some months, we were saying, 'We think it will be awhile before there is a sustained reduction in unemployment.' That is a very consistent line. I do not know if you want to add to any of that, Chris.

Dr Kent : I guess I would just mention that we really have not changed the timing of when we might see the unemployment rate start to move lower, with all the uncertainty. That is around late 2015 or early 2016. But there is much uncertainty about that. Earlier in the year, we saw the unemployment rate drop somewhat surprisingly from six to about 5.8, and I think, prematurely, a number of people—not us—called it, and said, 'We've seen the peak.' The picture we paint of the economy is one where the economy will be generating employment growth but just not enough to make inroads into the unemployment rate. Remember, of course, that we have pretty strong population growth, so the labour force is growing at a reasonably rapid rate: at about 1.7 or 1.8 per cent per annum—that order of magnitude.

Mr HUSIC: I am conscious of the time I have left, but there are other areas I wanted to touch upon. Wages growth has demonstrated for quite some time that it is not as strong as it has been. It has stayed under the rate of inflation. Also, if you are expecting a change in the non-mining sector to lift growth, then, with wages remaining low or their growth not being as high as it once was, with savings rates remaining around 10 per cent and all this acting to potentially constrain consumption, do you see this as stunting domestic demand and broader non-mining investment?

Mr Stevens : Some people say that low wages growth will impair consumption, and that has to be arithmetically true if everything else remains constant. I do think, though, that if you think through more of the connections—low wages growth; low inflation; actually, cost of living goes up more slowly, which helps real income—it also helps save jobs. If you believe that the cost of labour matters—and I think it does matter; it is one of the things that matters—then one could argue, and I think I would argue, that what we are seeing in the behaviour of labour costs is that it is quite responsive to a soft-looking labour market. That is a good thing in the sense that it helps conserve employment. More people in jobs—that has to be a better outcome. And those people also consume. So there are a number of things going on in this rather complex equation, and, when you think through all those things, I do not see, at this point, a 2½ per cent rise in the wage price index, say, as a thing that is seriously impairing growth. In some ways, I think it is actually helping the economy deal with the situation that we face. So that does not worry me so greatly.

The other thing that is in my mind when I think about the consumer is: I do not think we can expect to go back to the consumer leading aggregate demand in the way that they did in the period up to 2006. You have all heard my sermon on this before. That was a very unusual period: falling savings, rising borrowing, et cetera. That is all fine, but it is not going to happen again. And I do not think we should try to make it happen again. I think that would be quite risky. So the consumer will play a part—a reasonable part—but not the same part that they once did. That is a legacy of the situation that we have come to. So they would be my views about those dynamics.

Mr HUSIC: My final question—and if I get a chance to come back later, I would like to explore that issue further in terms of consumer demand—is on something that I have raised with you previously. I have been concerned about two articles that have appeared this week in the Fin relating to what is happening in China, and you have made reference to residential property prices being a bit more subdued. There have been reports of a fairly significant contraction in lending growth through July. The previous two major contractions of similar magnitude were post-Lehman and post-September 11. Today we are getting reports that Macquarie may be stung by one of its trusts that has been caught by issues arising out of the growth of the shadow banking system in China. Has the RBA taken a view about what risks this might present to our trade and economic performance? Do you think it is better to interpret some of the contraction that China is taking steps to address the growth of shadow banking, and it is trying to deal with risk in a better way?

Mr Stevens : Let me make a couple of general comments. I think, and I have felt for a while—and I am sure I have said this before—that the relevant questions to ask about the Chinese economy and the kind of cyclical frequency is not really: what is the PMI doing this month, which is a huge obsession in markets and so on. The real economy is going along okay. The real issue is the financial part of the economy and whether they can manage that down. They certainly have been cognisant of the risks that have built up. It is called shadow banking—not that I have used that term—but it is a little bit inaccurate because a lot of these entities are actually connected to the banks. What is going on here is that you have a regulated sector and then you have an unregulated or less regulated sector where the action shifts to when the authority is trying to cool things down. It is a phenomenon not unknown in our own country back in the days of stronger regulation of the banks. The Chinese authorities have been cognisant of that and have been seeking to exert some restraint there; I think with some success.

China have also, over the past few years, had measures designed to try to come to calm down speculation in property. I think it would be true now, and Chris may correct me if I am wrong here, that they are in the process of starting to generally wind back some of the restrictive things in a fairly measured and targeted way. I think they are on the case. The slowdown in total social financing that I am looking at is quite noticeable but far from unprecedented in that series. Prices of properties are declining, that is true, and we cannot know whether that will escalate into something more dramatic. I would point out that this will be the third time in the last five or six years that we have seen property prices decline in China. It is a reminder that property prices can fall even in China. They have done so before and they are doing so now. I cannot really say with any accuracy at all just how this will unfold, only that I think that this is an issue that people have been alert to for a while and the authorities have been clearly alert to it for quite some time. Do you wish to add anything?

Dr Kent : I would just mention briefly about the property restrictions. They were put in place because China had prices rising too rapidly and essentially they were restrictions on transactions, such as things like stopping people borrowing too much to purchase a house, stopping people from buying too many houses as individuals. What has been happening is that they have been wound back somewhat. There are still many of them in place. They are winding back more in the smaller cities, cities of small sizes like Sydney or less. There are multiple millions of people still in these places. They are not winding back in the very, very big cities and many of those are still in place. If they felt the need, there is still room to ease these restrictions, stimulate and thereby bring forth a bit of demand.

Mr BUCHHOLZ: I welcome all you good gentleman from the Reserve Bank to Queensland. It has been a little while between drinks. I think the last time you graced our state was in 2007 on the Gold Coast, and prior to that it was 2003.

Mr Stevens : I hope that things that happen after today are not the same ones that happened after 2007.

Mr BUCHHOLZ: No, I'm sure they will not be. I acknowledge the school, St Francis College, and also Faith Lutheran College from Gatton. Welcome to you. The students from the Lockyer Valley got up early this morning to travel here to ask some questions. My questions also go to currency and around the influences of the Australian dollar. What are those influences? As a state we have a heavy reliance on exports through our coal—Galilee, Bowen Basin. The majority of the Australian cattle herd is in Queensland, with the majority of that product being exported whether frozen or live. The Aussie dollar is fundamental to growth. What, in your opinion, are the effects that are causing the Aussie dollar to stay high? You mentioned before that you were puzzled, and I want you to expand on that.

Mr Stevens : We could ask why the demand for the currency is so strong. I could go through a few factors there. One of them is that exports have been very strong, so exporters are exchanging proceeds in foreign currency for Aussie. That is a source of demand. The biggest source is that global capital finds Australia an attractive place to come to. You mentioned how important exports are for Queensland. I would imagine also that most people in Queensland think that foreign investment is a good thing. Foreign investment is capital flow that pushes up the Aussie dollar. Right now, for a whole host of reasons, various forms of capital have found it attractive to come to this country and to hold our assets. It is true that our short-term interest rate structure is higher than in America or in other places, and at the margin that has to be a factor. The whole gamut of returns on many forms of capital in Australia has been attractive for lots of different kinds of international investors—commercial property, infrastructure assets, government bonds. There is a whole host of things where the yields that we have in play here are attractive to foreigners, so in this world there is that attraction.

You have short-term speculative players as well who really often do not pay much attention to those longer run fundamentals. They are amongst the people that I have in mind when I say that I think they are underestimating the risk that it will go down at some point. I still think that. But I could be wrong for the next year, or more, who knows. Those people play on a very short-term tactical basis.

There is a range of reasons but the most fundamental one, I think, has to be that in some sense our country, in the eyes of the global capital market over the past five years, probably approaching 10, has had a re-rating. We are more attractive, partly because other countries are less attractive. It is also party because of our trade fundamentals with the terms of trade with mining, et cetera, look different to the way they used to. Some of that is going to be quite persistent and already has been quite persistent. All these things go to part of the story of why it has been quite high. That said, it still strikes me that I cannot see the logic for it not being a bit lower at some point than it is today. I cannot tell you when though.

Mr BUCHHOLZ: You raised the issue of the flight of foreign capital in the UK at the moment surrounding the domestic issues of independence. I do not want any commentary on that debate other than to ask whether there is a risk of flight of capital as a result of that debate going one way or the other, and what is the impact for us here domestically?

Mr Stevens : I think you are talking about Scotland.

Mr BUCHHOLZ: Yes.

Mr Stevens : It is hard to say. I do not think that itself would trigger large-scale global capital flows. But, on the broader question of whether investors will be seeking to flee something they do not like in the places where they have their money presently, it is conceivable. I have said this before: because the list of AAA countries is a bit shorter, and we are on that list, there is a portfolio reallocation that we have seen come to Australia as a result of that. Having said that, my guess would be that, if there is a sudden increase in risk aversion in global markets for some reason, if there is some event that triggers everyone to think, 'I will cut my risk positions and go back to home base,' it would be very unlikely that the Aussie dollar goes up in that scenario. I think it is far more likely that it would go down.

Mr BUCHHOLZ: Good.

Mr Stevens : You say 'good', but it depends what the shock is that causes it—that might not be good.

Mr BUCHHOLZ: Sorry, good from an exporter's position. I am totally cognisant of the fact that the higher Aussie dollar does affect our fuel costs, fuel which we import. While we are on flight of capital, in relation to the Japanese quantitative easing effect that is in place at the moment, what are the threats and the opportunities for us as a nation with respect to the Aussie dollar?

Mr Stevens : Japan is engaged in a very aggressive program of so-called quantitative easing. The Bank of Japan is actually doing more QE now than the Fed. The potential concern—I have felt this concern for a while now—is that they are pumping cash into their system in exchange for the bonds that they are buying, and what will the people who used to hold those bonds do with those funds? Possibly a lot of those funds will head offshore. Could some of them come here? The answer is that they could.

I do not know whether you remember, Phil, but the last time I saw the evidence there had not been a whole lot as yet, but potentially some of that freed-up capital might find its way in our direction. The bulk of it would probably go to the US if it goes offshore, but some of it might come here. That would chase various probably pretty low-risk assets like bonds, bank deposits and obligations and that sort of thing, I think. It is probably worth recording another way of looking at all this. On the one hand we can see the potential for flows of foreign capital to raise our currency. That makes it harder for exporters; that is certainly true. Another way of looking at it is that this is actually the world saying to Australia, 'Here is cheaper capital.' We are a capital-importing country, and the world is kind of saying, 'Here is cheaper capital for you.' One response to that might be to think about how we could use that productively. So, as usual, there are different prisms through which one could view this.

Mr CONROY: I would like to go to investment intentions in the broader economy, which have been alluded to in the Governor's statements and the minutes. A lot of the debate in the last two Governor statements has been that the Aussie dollar has not been as helpful in rebalancing the economy as you had hoped and as we had all hoped, quite frankly, and, secondly, that the rebound in non-mining investment has been tentative at this stage. What is your assessment if the Aussie dollar still remains stubbornly high, the non-mining investment remains very tentative and does not kick in and the so-called animal spirits that you have been appealing to do not eventuate? What will our economy look like in the next few years as mining investment drops even further?

Mr Stevens : The formal forecasts that we publish actually assume that the exchange rate will stay at its current level. That means that if the exchange rate were to behave at some point in the future a little bit more 'normally', as it has done on past occasions, you would expect more growth and a bit more inflation than in the central forecast we put in here. That would be, I am sure, one of the risks and uncertainties that we have flagged.

The outlook for non-mining investment that we have sketched is still pretty subdued for a little while yet before it starts to pick up. Growth is still a little bit on the disappointing side in the near term. If that persisted indefinitely, which I think is quite unlikely, that would mean by the end of the forecast period a weaker situation that we presently forecast and certainly weaker than we would hope to see. There is no way around that.

I find it difficult to see how you would get a combination of continually very moribund animal spirits and this exchange rate that is associated with an economy that you would normally have a lot more confidence in. It is pretty unlikely that you will get that combination. In the near term we still have things a bit on the subdued side and we still assume the exchange rate will remain high. But further out there is no doubt what direction things would go on the assumptions that you have set forth.

Mr CONROY: On those assumptions, as unlikely as they are to continue—but there is always a chance in this world; we have seen iron ore and coal mining falling rapidly and we will see LNG investment coming down as the plants come online in 2015 and 2016—could you see an unemployment rate closer to seven per cent than on the current forecast?

Mr Stevens : It will always be possible to construct a scenario that will deliver you that rate or even higher, if you want to do so. I would put a scenario where the animal spirits never recover, where non-mining investment stays as weak as it is now indefinitely—and it is quite weak—and the exchange rate stays at this high mark at a pretty low likelihood as an outcome myself.

Mr CONROY: I will just go to productivity for a second. In the July minutes, the RBA stated that labour productivity had improved markedly over the last few years, not just in mining but in the broader economy. I was wondering if you could provide a bit more commentary on that statement.

Mr Stevens : I would be happy to do so if you have the numbers. I think this was in a speech that Chris gave and that I stole for one of mine. Those numbers take labour productivity and plot the level and provide average rates of growth over various periods. Choosing the actual periods is kind of judgemental.

We have covered before in the hearings the fact that in the nineties, up until about 2002 or 2003, we had pretty good productivity performance and then we had quite some years where it was much more ordinary. So, if you take out mining, we were running at over two per cent per annum up until about 2003 or 2004. Then we had some years where it was only one percent and the most recent estimates are 1.6—that is to say that is better and that has been for a few years now—so it is looking like this is something real not just a statistical aberration.

As you know, with productivity, you really need quite long runs of data to do these assessments, but there is some evidence starting to emerge. That is why I said earlier that I think there are some runs on the board here now, but we would like to build a much bigger innings here yet but that is a start. The 1.6 is not the 2.2 that we had in the nineties but it is a fair bit better than the one percent that we had for and years.

Mr CONROY: How many years?

Mr Stevens : Probably only three—somewhere around there. The chart is public.

Mr CONROY: I appreciate that. Finally, could you just sketch out from the bank's point of view how real wages have been going for the last three or four years?

Mr Stevens : Measured by the wage price index, which I think is generally seen as the best fixed weight measure of labour costs, it is rising at about 2½. The underlying inflation rate is a little higher than that over the past year, so that is little or no change or a small fall in real wages over that year. Prior to that, they were probably growing a little bit but modestly. Do you want to give any detail?

Dr Kent : There are a range of measures of wages but the ones I have got here are slightly broader measures which pick up things beyond the WPI, the national accounts measures. But, in real terms, yes, wages have been falling a bit of late. That happens. That has happened in the past and it happened most recently in the GFC but, as the governor suggested earlier, this is part of the important adjustment. The labour market is showing a degree of response to the subdued conditions. Wage growth is lower than it otherwise would be and therefore employment is stronger than it otherwise would be.

Mr CONROY: So with the current regulatory frameworks we have had labour costs responsive to the labour market. We have had real wages steady or falling and we have had pretty decent productivity growth over the last few years. Thank you very much.

CHAIR: I think that was a comment. Thank you very much,

Mr HOGAN: I have three questions. Thank you for coming again today. It was mentioned a little earlier—you were talking about Japan and QE et cetera. We know now that the Fed are tapering that off. At previous hearings we have discussed this in more depth. It just may be an observation but there has been a comment made—obviously, the positive side of this was to improve liquidity in the system, and we have spoken about the increase in the balance sheets in the central banks on the back of that. A more cynical person may say, 'Gee. Most financial institutions have offloaded all their impaired assets to the central banks. Now that they have lifted those off their balance sheets, QE can stop.' Would you like to make a comment on that comment?

Mr Stevens : Let's look at what the central banks are actually buying. The Fed has been buying treasuries and agency securities, so these are government or quasi-government securities. I think the real problem assets that the American banks had were not those, so I think in a direct sense it is not obvious that that claim holds water for the US.

Europe is a little bit different. For various complicated reasons, it is not so straightforward for the ECB to just buy government bonds, and the things that they are doing are more in the direction of providing various forms of funding directly to the banks secured with collateral but in an attempt to provide bank funding and assist in banks expanding or at least contracting their balance sheets by less. So it is a little bit more complicated there. As to the story that it is just the central banks buying all the bad assets, I think it is probably bit more complicated than that.

Mr HOGAN: Capital flows were spoken about a bit today—and with currency related questions as well. Obviously capital flow into the country is a good thing. It may have effects on the currency that affect other areas, but it is obviously a positive. The RBA are involved in a lot of modelling, with looking at the economy and forecasting. I am interested in how difficult or easy it is to model capital flows and their effects. I am think about things that are almost a bit out of the box—for example, the events in the Ukraine and Russia and even comments that have been made by a certain absent member of this committee. So I am thinking about those sorts of things that are almost uneconomical. How difficult does that that make your job?

Mr Stevens : You cannot model these things—and Dr Kent will explain why.

Dr Kent : I was going to say that modelling capital flows is about as hard as modelling exchange rates. The one thing I think economists do recognise is that they are extremely hard to model and even harder to forecast—and that is why we do not forecast exchange rates and we do not place much stock in estimates of capital flows and so on. The way I like to think of the capital flows—and this is just my way of thinking, which is not always, I think, necessarily the best—is, amongst other things, to think about the investment and the savings opportunities in a country.

With, say, a country like Japan, which has had pretty high savings rates but less and less domestic opportunities for investment, that tends to mean they have surplus of savings and that savings goes to look elsewhere in the world for higher yields. It also is a means of diversifying, so that they do not have all their eggs in one basket at home. Those are the big sorts of features which allow you to say something about capital flows. Then, overlaying that, there are these searches for yield. The Japanese yields are extremely low, so that is an obvious case for capital outflows. Predicting the exact magnitudes, the timing and when those sorts of things might turn and change is very difficult.

Then, going the other way, for Australia, though we have higher savings rates of late—both for business and for households—we have got even more investment opportunities, and the mining investment boom has been one of those. So we have been attracting a lot of capital. Added to that, we still have slightly higher interest rates than elsewhere. So that yield differential attracts capital as well. But it is very hard to forecast or even model these things.

Mr HOGAN: Thank you for that. It is very interesting. The policy that you have, which is quite blunt, is that interest rates are just one thing and things like capital flows can have much more influence. At a previous hearing I asked you a question, Governor, and you said that you do not offer gratuitous advice. I get lots of gratuitous advice, and I am certainly happy to take gratuitous advice from you. As the central bank you are always looking at inflation rates and what types of policy measures can help full employment. We as legislators at this table, even though we may occasionally, or often, disagree on how to get there, also have the same aims, if you like. We want the economy to be growing, we want low employment and we want people to have stable jobs and feel as though they can spend and do things in confidence. Outside maybe even the realm of the Reserve Bank, what is one thing that you think there is from for us to move in a policy setting, whether it be a central bank policy setting or a legislative policy setting, where you think we as a country can improve our act and which may be holding us back from these types of things—something that you would say is a stand-out?

Mr Stevens : Let me not give gratuitous advice on fiscal policy—and monetary policy is not the answer really for some of the most fundamental things. I come back to what set of arrangements and what set of conditions are going to give people who are the risk takers the right set of incentives and confidence to say, 'I'm going to take that risk; I'm going to get that cheap money and build that plant, factory or whatever and employ the people.' That is really what we have got to be asking ourselves. This is not just about whether the unemployment rate will peak a bit higher or a bit lower; this is about where we are going to be five or 10 years from now. I think of things like entrepreneurialism, dynamism and animal spirit. I cannot quite tell you—there is not a switch for this. I know Philip has very strong views on some of this, so perhaps I can invite him to make a comment.

Dr Lowe : At the end of the day, monetary policy cannot be the engine of growth in the economy. We can help smooth out the fluctuations, but we cannot in the end drive the overall growth in the economy. It is really structural issues that do that. At the end of the day, I think Australia is going to be a high-wage, high-productivity, high value-added economy. That is where we want to be. That is where we can be. That is where we should be.

If we are going to sustain ourselves there, people need to be able to take risk, they need to be able to be rewarded for risk and we need to innovate to find new ways of doing things better. I think it is about somehow enlivening the entrepreneurial, risk-taking and innovation culture so that we can be the type of country that has high value-added, high wages and high productivity. I think culture is important here. From my perspective, our society is becoming too risk averse and that the way that we think about risk has got distorted. We are not paying enough attention to return and we are paying too much attention to risk. I think if we need to invest more and more effectively in education, in human capital accumulation and in infrastructure. Risk taking, education and infrastructure are the things that are going to help us be a high-wage, high-productivity, high value-added economy. The details here are not things that the central bank is expert in, but it seems to me that they are the ingredients to be a successful economy in the next 20 years.

CHAIR: Thank you very much. It seems appropriate on that note that, before we break, I invite two students from the Faith Lutheran College in Plainland—which is in the electorate of Mr Scott Bucholtz—to ask their questions. I welcome Mitchell and Cheneya Freese. Who wants to go first?

Mitchell Brimblecombe : Good morning, Governor, and committee. Thank you for having us here this morning. My name is Mitchell Brimblecombe and I am the college captain at Faith Lutheran College. Cheneya Freese is the community captain. My question this morning is: what measures have been put in place since the global financial crisis to ensure the Australian economy stays strong? How is this going? What provisions have been made for business and industry since the GFC? Does this reach beyond personal lending?

Mr Stevens : Thanks, Mitchell. That is a good question—'What has been done since the GFC?' Let's try to answer that in a few dimensions. Firstly, we have tried to keep macroeconomic policy such that we keep the economy growing. That is not without its challenges, but it is growing. We have tried to maintain an appropriate interest rate that helps keep inflation low but also helps support growth in the economy to the extent we can. Governments have been in the process of trying to repair the fiscal situation, so that if we face another crisis there is ammunition in that particular policy arm.

Other things have been done in the area of financial regulation. This was not a big problem in Australia but globally there were shortcomings in regulation. Internationally there is quite a big push to do a better job of regulating the banks and some other sectors of the financial sector so that we do not face a crisis of that severity again. We will probably have crises in the future, but hopefully they will be small ones and not ones of that size. So that is a very big work program that is ongoing.

I think another thing that is worth mentioning—and this is important for Australia—is the President of the G20 group of countries said this year that everybody is thinking about better infrastructure, as Philip has just mentioned. That is a big theme: how to do that, how to do it cost effectively and how to involve the private sector in that. I might add that efforts have continued but they probably need to be stepped up to improve trade globally. Everybody benefits from freer trade. That is an area where we need to keep putting energy in globally to keep that going. They are a few things anyway. Thanks for your question.

Cheneya Freese : Good morning, Governor and respected guests. I am community captain of Faith. Norco is exporting about 16,000 litres of fresh milk a week to China, however, no farmer in either Australia or New Zealand has been paid $8 to $9 per litre, which is the retail price of milk sold in China after freight, not the purchase price before processing. How does the Reserve Bank of Australia see Australia's competitive advantage to the world for export products? How is this linked to the currency exchange rate of the Aussie dollar? Further, how does the lowering Aussie dollar impact local exports?

Mr Stevens : I am not an expert in milk pricing, to be honest, but one thing to say is that Australian producers will have very large opportunities in the Chinese market over the years ahead, not just in milk but in many kinds of food products. That is an opportunity we should be grasping as quickly as we can. The exchange rate matters because if we presume that the price that the Chinese are prepared to pay is a price in their currency, which is a reasonable assumption to start with, the lower our exchange rate is relative to theirs the more of our dollars we get for one litre of milk that gets sold there, at least in a market where there is reasonable competition.

So the exchange rate does matter. It is not the only thing that matters. To be competitive of course we need cost-effective production, we need cost-effective and efficient transport, we need reliability of supply and I think in the modern world we also need a reputation for safety of the product. In China, milk has been an issue—not our milk but some of their other milk—so having a reputation for safety, reliability and quality is also very important.

CHAIR: Thank you very much. They were both very good questions.

Proceedings suspended from 10:53 to 11:05

CHAIR: The committee will now resume.

Dr CHALMERS: I join with my colleagues in welcoming the school students here today, particularly those from my own area—from St Francis College: Ms Rolf, Rachael, Melanie, Dorothy and Jess. It is a real honour to have them here for this hearing.

Governor, I would like to ask you about some of the comments of some of your counterparts in other jurisdictions. I would like to start with the Fed chair, Yellen. Particularly, I would like to get your thoughts on her view that she would rather see monetary policy being more accommodative for longer—she would rather fight inflation than fight a downturn. When the time comes for Australia to contemplate monetary policy change do you share that view that you would rather have it accommodative for longer rather than make a move and then have to retrace your steps?

Mr Stevens : I would rather get the policy setting right, whatever that is. The distinction that I would draw between the situation the US faces and the one we face is the following. Their interests rates are at zero. They have not experienced deflation but they felt there was a threat. In that scenario you can see why a tightening that turned out to be premature would be very hard to unwind, because you do not have the same ammunition. I do not think we face that problem, because we are not at risk of deflation, we are not at zero interest rates. So the situation is not the same. I want to be clear, though, that despite speculation in various quarters, we have not thought about raising rates any time lately. I think that should be reasonably clear.

Dr CHALMERS: One of your other counterparts—the Governor of the Bank of England—gave an interesting speech most recently about inequality. Would you agree with Carney, that 'a society that provides opportunity to all of its citizens is more likely to thrive than one which favours an elite'?

Mr Stevens : I do not really want to comment. I personally would agree with that but my personal views on those things are not really germane here, are they? I do not really want to get into a commentary on things that my counterparts say in different countries in different settings, in any great detail.

Dr CHALMERS: One of the things that the statement of monetary policy and other commentary has touched on is a development in monetary policy-making—where policy makers seem more likely to give very long time frames—to flag their intentions well in advance. You mentioned in your opening statement that there is a loss of stability in financial markets at the moment. What are the pros and cons of central banks flagging the intentions well in advance?

Mr Stevens : That is a very interesting question, because there are pros and cons. One of the interesting answers that you get from some market participants when you ask them why volatility is so low is, 'It's all due to the central banks, because the central banks have promised that nothing is going to happen for such-and-such a long time.' They say, 'It's actually your fault, in the central bank; it's not a market phenomenon.' If you look at the so-called forward guidance that has been given, it is highly conditional—as it has to be. They are really statements along the lines of: 'If things unfold as we think they will over some horizon, then we are likely to behave in such and such a way.' It is unspoken but clearly, if things are different to what we think, then we will have to behave differently. I think the latter part really goes to the heart of whether the apparent very subdued volatility and pricing for risk are very wise because unexpected things can and do happen, and there is no probability or very little probability attached to that outcome.

More broadly, if you look at the situation that the major jurisdictions were facing, they have had a big recession, and it is very hard to get the upswing going after a financial crisis. We know that it always true. Their interest rates are very low or zero, and they are looking for ways to be more stimulatory in the realm of prudence. How can they do that? In countries where the long rate matters—and this is less so in Australia than in the US and Europe—how does the central bank influence the long rate, given that the short rate cannot go down any further? The answer they have come to is: 'We promised to keep it lower for longer.' Since the long rate is just the market's expectation of the accumulation of short rates out into the future, the notion is that it brings the long rate down. I think that was reasonably effective, and in the setting of those economies and in the settings they faced, that was probably a sensible thing to do.

The danger comes where the highly-conditional guidance that the central bank gives in terms of 'Given this outlook we think we are going to behave like this for such and such a period.' If people condense that down to, 'They are not going to change, come what may, until day x, or they're not going to do anything until the unemployment rate gets to some number,' these over-simplifications tend to then cause trouble. The central banks concerned have had to recalibrate the guidance and make it more general and more overtly conditional. So you can get into trouble with these things, but, like all things, some of it is good as long as you recognise its limitations.

Dr CHALMERS: In your opening statement, you implied that the June quarter GDP outcome would be pretty soft because there would be a bit of payback from March. Can you be a little more specific about your expectations are for June?

Mr Stevens : The payback will be mainly in the form of exports. Our expectation for the June quarter will likely be—we are sitting here and it is two or three weeks till we find out and so this is really academic—a fairly subdued quarterly number and the year-to-June figure would be in the published forecasts. Having had quite a strong one, this will be a lower one—a more subdued performance. The real question is: what will it be after that? Which we do not know, of course.

Dr CHALMERS: The big conference this weekend in the US at Jackson Hole is about labour market dynamics. Can I get you to say a few things about the American labour market and ours? For the first time since 2007 our unemployment rate is higher than America's. What is the trajectory and reasoning for that?

Mr Stevens : They have been recovering, which is a good thing, and they have been, this year particularly, generating a pretty good pace of job growth. We have generated better job growth this year than we were in the second part of last year, but still I would like to see it a bit higher. So our unemployment rate has been drifting up while theirs for some years now has been drifting down, from quite high levels to in the low sixes. It is good that that is happening for them.

CHAIR: Thank you, Dr Chalmers; we will return to you if we had the opportunity to do that a little bit later on. I now call upon Mr Coleman.

Mr COLEMAN: Thank you, Chair. Thank you, gentlemen, for joining us this morning. Governor, I want to ask about exchange rates and specifically the desire or otherwise of the bank to intervene. I would say that one of the consistent themes of these hearings we have been having over the past nine months or so has been a gap between the bank's view on where the exchange rate should be and where it actually is, but equally, I guess, a seeming reluctance on the part of the bank to directly intervene. Is the situation that you are confident in the success of intervention in achieving your goals but are nonetheless reluctant to do so or is it more a case that you are unsure of the efficiency of intervention and whether it actually works?

Mr Stevens : I think intervention can work at certain times and when it is done in conjunction probably with other things that support it. What I do not think is very useful is intervention that is just completely invariant to circumstances and trying to draw lines in the sand on rates. I do not think that kind of intervention typically is very successful historically. Sometimes it works, but you are not playing the percentage game, I do not think, with that kind of strategy.

I think it is worth keeping in mind, when we contemplate intervention, what is intervention? What are we talking about here? What you are talking about is the central bank; in our case we would be exchanging a domestic asset for a foreign one, so we would be exchanging a domestic asset that is yielding two or three per cent and buying a foreign one that is yielding actually pretty much nothing in the expectation that we are going to influence the exchange rate. So we would be taking a bet. I am conscious that this is public money, it is not my money. You can make a case intellectually that at certain times that bet should be taken. You can certainly make that argument. But from my part I have not thus far felt the misalignment was so bad that the risk and reward equation for us—the likelihood of succeeding against the forces that we face—stacked up. I have not felt so, which is not to say we would not at some point.

There was a point when the exchange rate was much higher than it is now where I thought about it seriously, but then the exchange rate went down and we have not revisited that level. I am, I suppose, trying to strike the right balance between a decision which has certain risks with public money and the needs of the economy, and weighing those things. I think that is what we have to try to do. What we have said is we certainly do not rule out the possibility of intervention under some circumstances.

Mr COLEMAN: Presumably, if you do it, it has to be fairly sustained, because, once you withdraw, the market just goes back to doing what it was doing before.

Mr Stevens : Historically I think the case is that intervention is most successful when it manages to change the market's expectation about the future path of the exchange rate. If you do not change that, then the scenario you paint will be in place: we will do something, but expectations have not shifted, and it will go back to what it was doing before. If you do manage to change expectations, that is when intervention becomes more powerful. Your success in doing that hinges, to some extent, anyway, on how strongly held those expectations are to start with and why they are there.

Mr COLEMAN: An issue I wanted to raise was around small-business growth and entrepreneurialism. You have painted, I think, a reasonably optimistic picture about the medium term, but you have referred to the need for credit to be available to those small businesses. I think in your submission to the financial services inquiry you also touched on that issue—the availability of credit, particularly in the small business market. I was interested in your view on that and on any imperfections that you see in that market at the moment.

Mr Stevens : This is a perennial question. My starting point, I suppose, is that credit to small business is inherently hard. The credit assessment process is difficult to do for an entity that has no track record. That is presumably why a lot of the funding of small business is basically equity or it is debt secured against a dwelling. One of the problems with small businesses in the future might well be that the younger generation of entrepreneurs are less likely to have a home that they own than the previous generation; therefore, they do not have that thing to use as collateral for a loan. That issue comes up for some small business people that I have talked to.

There are various programs that countries around the world have tried. As far as I can see, they mostly involve some form of government subsidy, government underwriting of some of the risk. I do not know enough about how effective they are. I am not aware of cases where the countries concerned will say what an outstanding success they are. There may be some, but I am not conscious of them. I think it is just an inherently difficult area.

There are some innovative things being done in the United Kingdom. There is a scheme there that is basically funded by the large British banks. It is a kind of mezzanine finance type vehicle, I think, or an equity funding type vehicle. Because they have managed to convince the regulator that they have got more diversification by industry and geography than the standard loan portfolio, they have actually got slightly more concessional capital weightings. It is not that large a fund; it is a few hundred million pounds. I think that could be a promising avenue, but I am not able to say whether that will ultimately be successful or not.

So it is a very difficult area. I do think that in community discussion about credit funding and interest rates there is way too much attention on mortgages, where we will not be short of funding, and that it would be good to have more discussion about business, and small business in particular. But I do not have a magic-bullet solution to offer.

Mr COLEMAN: Just leaving aside government funds, new programs and so on, do you think there is some sort of structural or policy problem at the moment that is affecting the market for small business lending, or is it simply that banks are being conservative?

Mr Stevens : I think banks are getting less conservative, actually, at the margin on business lending. I think they are trying harder now than they were, because they want growth themselves. And I think to some extent that is a welcome development, provided that standards remain good. As for whether there is a structural problem, usually this discussion is I think couched in terms of whether the capital weights are too punitive on particular forms of finance. I think it is a fact that certain types of business lending are more risky, and if we are going to have capital assigned on the basis of economic risk there is no way around that. And if there is a public desire to somehow change that, then you are really arguing about whether you should have some kind of taxpayer intervention, quite explicitly. I would not try to do it through tweaking the capital rules. I do not think that is the best way to do it, personally.

Dr HENDY: Virtually all my questions have been asked. I had a great question on QE tapering, but you have been asked that. I had a great question on the Chinese economy and credit, but that has been asked. And I had a question on small business financing, and that was just asked. But I do have a variation on that—a more specific thing on small business financing—which is that in the Murray report, the financial system inquiry report, in chapter two they actually do talk about the Basel III implementation and they do make some reflections on that issue. In an overall sense, they say on page 2-78 that Basel III 'could limit banks’ ability to finance new projects and slow the rate of gross fixed capital formation'—although, I must say, they do not come to a conclusion. They then go on and actually do make a conclusion, which is with respect to small business. On page 2-79 they say:

In the view of the Inquiry, high-quality projects and viable enterprises would still be able to obtain funding through other channels if insufficient credit was available. But it acknowledges entities that are more reliant on loans, such as small businesses, would have some difficulty accessing funding.

So, I would just bring that to your attention, because I think since we last met this inquiry came out—in July—and I would just ask you to make a comment on that interim report finding.

Mr Stevens : As I read that page, this appears to be in a context of this vexed question of how we would fund credit growth if economic growth in the economy was higher—where would the banks get the funding to provide the credit to go with that faster growth? Personally, I think this problem of how we fund faster credit growth if we need it is a furphy, frankly. There was no problem funding credit growth at double-digit rates year after year after year when the demand for that credit was there. If they needed to fund more credit growth I would be very surprised if the funding was all that difficult to come by. After all, these are very sound banks. They are operating in a very efficient global capital market. They are very highly rated. I just cannot believe, frankly, that funding a bit more credit growth, if that is needed, is that big a problem.

I think this whole debate got a bit skewed when, through the financial crisis, the costs of wholesale funding escalated quite quickly because of global market developments. That is true. That was a very unusual shock. I do not think it contains a lot of information about the ability of the financial system to fund the credit growth that goes with normal healthy rates of growth in the economy in a non-crisis environment. So I do not think the problem that is being posited is really a problem.

Having said that, the other point that the inquiry is making here, which you read out, is valid. Even if you thought the banks were not going to be able to provide funding for business, a really big business can get it somewhere else, and that is true; a really small business cannot, and that is obviously right. So the real point there is the lack of alternative sources of funding for a small business that can only go to their bank. It is a constraint that they face that BHP does not face. There is no question that that is true. I just think it ought to be separated from the broader funding questions. I do not think the broader funding questions are really a problem. What you do about this narrowness of opportunities for small business is an acknowledged problem. I agree with that. I do not have an obvious solution.

Dr HENDY: I was recently at a function where a businessman asked me about the target for inflation. So this is a wider question that goes to the conduct of monetary policy statements. This individual simply said, 'We have a two to three per cent inflation target.' I have some personal knowledge about the background to all that, but I just thought I would put it to you. He said, 'On what basis had that two to three per cent been chosen'—I know it goes back to 1996—'and is it still valid?'

Mr Stevens : It was chosen before 1996. I actually have a lot of background here myself. It was chosen as a pragmatic objective in the light of experience. I did these exercises in the days when we had no inflation credibility or not enough anyway, after we had eight per cent inflation for 20 years. There was talk of 'Let's have a target.' There was the New Zealand target. There was the Fightback! package, which I think proposed zero to two per cent. Most people in the RBA felt that was going to be pretty hard to achieve; but, if you were going to choose a number, what would you choose? Who were the inflation fighters par excellence? Germany. So you go back and look at what did Germany actually achieve. For a long period of time they did not actually achieve less than two per cent but they did achieve around two, 2-point-something, and if it got above three you could guarantee the Bundesbank would get it down. In my view that is pretty good. It would be a good set of objectives. In our internal thinking—in my memory, and I was quite involved—that is where the two to three came from. Then in 1996 Peter Costello—and I think very properly—added more structure, more recognition, to this, and it has gone from there. That is the background. The background was not out of the textbook; it was out of pragmatic experience. I would have to say that the question I have been more often asked is: 'Why shouldn't it be lower?' I think there is an answer to that. Anyhow, that is my take on the background.

Dr LEIGH: Thank you, Governor Stevens, for your very thoughtful answers today. I want to press you a little bit more on the issue that Dr Chalmers raised around inequality. The United States now has a lower unemployment rate than us, and theirs is falling while ours is rising, and yet Fed chair Janet Yellen seems more concerned about unemployment than you appear to be. She has recently spoken about the Fed's goal very explicitly being 'to help Main Street, not Wall Street'. Are you really not concerned about the distributional consequences of monetary policy?

Mr Stevens : I do not think that is the right inference at all. I am quite concerned at the thought that unemployment is higher. I think we could sustain a lower one. I think there should be appropriate circumspection about our ability to just engineer that in a short period, but our mandate talks about full employment as well as price stability. I have to keep both these goals in mind and I think the inflation target framework is a good one for keeping both those goals in mind.

The fact that the US is falling and we are rising is a function of the state of the cycle that both of us are in. I would still observe that, even on the latest reading, it is not that many years ago that six point something was regarded as low. I regard it as not quite low enough, actually, but I think we need to keep a bit of historical perspective here on how high it is. I do not really have any comments on the way Janet has given her narrative on the Fed's approach to things, but I do not think our approach on either inflation or unemployment is any different now to what it has been for the past 20 years.

Dr LEIGH: What about the distributional consequences of monetary policy? The extent to which monetary policy can inadvertently affect the distribution of incomes seems to be an issue that others engage in quite a bit of research on. I have not seen very much coming out of the Reserve Bank on the topic.

Mr Stevens : Actually, I think the biggest, most direct effect on the distribution of income that we have is between savers and borrowers. Right now, the savers are feeling the pinch of very low rates of interest on the safe assets that they hold and they are being prompted in many cases to accept a little more risk to get the return they are seeking. That is part of how policy works. That distribution of income is something I think about a lot because, although popular commentary just regards lower interest rates as always better, that is not really true for significant parts of the economy; it is actually bad for significant parts of the economy. In evaluating what we should do, I think, in contemplating what is the pay-off and what is the cost and the risk in a particular move, those considerations need to be borne in mind, not just the interests of borrowers. There are actually more savers than borrowers, in fact.

So I think those distributional things matter. Unavoidably, when we change the interest rate we have an effect on that distribution. We do not resile from that; we cannot make it go away either. I think, other than under the most extraordinary circumstances, one might think that there may be some point at which you do not want to keep punishing the savers too much further.

Dr LEIGH: Thank you. Let me turn to another distributional issue. I asked you in a couple of past hearings about how the Reserve Bank is tracking on getting more women into senior management positions. Last year, I think your response to me was that 'the proportion of women in what we would call managerial positions has gone up a bit in the last five years to about 30 per cent'. How is the Reserve Bank proceeding on that?

Mr Stevens : It would be about the same.

Dr LEIGH: Moving onto a different issue, last month former Assistant Governor Guy Debelle said he was sceptical about the impact that Bitcoin would have on the macro economy. He said that it might have micro-implications on the payments system, but he seemed to be downplaying any potential for Bitcoin to have significant ramifications. Is the Reserve Bank still of that view—that it is still fairly sceptical about the power of algorithm-driven, peer-to-peer transactions to have large, transformative effects on the macro economy?

Mr Stevens : Technology in the payment space will continue to evolve. 'Evolve' might be the wrong word. It may continue to change quite quickly. I do not doubt that, over time, that will produce significant challenges for the incumbent players. Whether it is Bitcoin per se or some other technology, I do not really know. I would say that Bitcoin itself has probably struggled a little for credibility in recent times, for reasons we would all be familiar with, but there are many imitators and there will be various other forms of technology coming along. Maybe the question is not whether it will be Bitcoin per se, that it is some kind of transformative thing, but whether technological innovation in the payment space in general could prove to be quite transforming. I think the answer to that is yes. Which technology it will be, I do not know. Actually, the market will ultimately choose that.

Dr LEIGH: Turning to open-mouth operations. You have been doing a little jawboning of the Australian dollar, reflecting the fact that we have these two prices: an interest rate at historic lows and an exchange rate at historic highs. My read from the outside is that those jawboning operations are less effective, perhaps, than they were in the past. Has it caused you to reflect on your ability to talk down the dollar?

Mr Stevens : I have always had a fairly, I think, realistic opinion of my ability to utter something or wave a magic wand and make a price like that go somewhere other than where it was going. It has some effect, but, really, this is a market that turns over in excess of $100 billion a day and you have this little guy down here at a particular moment who says, 'I think it's a bit high,' or whatever. Let's be realistic about how much effect that has. That does not mean we should not do it. If I think that there is a risk that people are underestimating a material shift, I would say that. I have said things about house prices from time to time as well, in a similar vein. If you feel something might be a misalignment and that it could be costly, you probably should, if it is in our sphere of influence, speak up. People might ignore you; they probably will. Nonetheless, it is not inappropriate to say something. If it has some effect, that is all well and good, but I do not think jawboning is getting more effective. I certainly would not say that. I have always been fairly modest about the effects it was likely to have.

Mr CRAIG KELLY: I have three quick areas of questioning, if time allows. Governor, in your opening address you talked about the importance of the obligation of the Reserve Bank to consider price stability. The CPI is currently around three per cent for the June quarter. You also said in your opening address:

The removal of the price on carbon will lower inflation temporarily over the coming year.

If there were reintroduction of a price on carbon, would that put upward pressure on inflation? Is that upward pressure on inflation something that could potentially see an increase in interest rates?

Mr Stevens : The answer to the first part is: if you put the price on carbon back where it was, then the price level will go back to where it was before, roughly speaking. So that would be a repeat of the introduction of the carbon price in 2012. That had no implication for interest rates either up or down because, just as when we had the GST in 2000, when there is an identified policy change that clearly has a one-time price level effect, we do not think we can offset that by raising interest rates, or lowering them if it is going the other way, and nor should we. That is a temporary effect on the rate of inflation, not a permanent one, unless it feeds into expectations of ongoing inflation. That is always a judgement call as to whether that will happen, but it does not seem to have. So the introduction, the removal and the mooted reintroduction of the price on carbon have basically no bearing on—

Mr CRAIG KELLY: So the economy will have to simply wear that additional increase in inflation?

Mr Stevens : Well, it is a temporary rise in the rate of inflation; it is not a persistent one. The persistent ones are the ones we have to respond to. If the price of oil goes up today, say, and petrol goes up next week, but that is just a temporary rise in the rate of inflation, we would not normally respond to that. We would look through that.

Mr CRAIG KELLY: But if, say, the price on carbon or the carbon tax escalated over time, that would have a continuing upward—

Mr Stevens : Well, if it is escalating a lot over time, that does complicate the task of looking through it, admittedly, but I think—from my recollection of the pricing structure that was brought in—actually, it was going to go down, wasn't it, Chris, to the European price. And then we do not know where that price was going to go after that.

Mr CRAIG KELLY: I think the Treasury projections were that it would increase to, I think, $38 or about a 50 per cent increase to 2018-19.

Mr Stevens : That is over quite a long period. I do not think we would be jerking around the interest rate aggressively in response to that—unless you thought it was triggering a widespread inflation in the economy. That is a different story; that is something where we have to respond. But these policy-induced changes that flow through and then do not persist in the rate of inflation—we would look through that.

Mr CRAIG KELLY: The second area was the 10 year bond rate that the Australian government is currently selling our bonds at, which seems to be significantly higher than even what we used to refer to as the PIIGs—Portugal, Ireland, Italy, Greece and Spain. In fact, four of those five economies actually have a lower 10-year bond rate currently than Australia. Can you give an explanation for that?

Mr Stevens : This is something I referred to earlier. 'Peripheral countries' is probably the polite description. They are part of the eurozone. Yields on German bonds were actually below one, I think, the last time I looked, which is a record low for Germany. These so-called peripheral countries trade in the market at a spread to Germany. So the base is very low and the spread has come in because, basically, when Mario Draghi said, 'We're going to do whatever it takes to keep the euro intact,' it worked. Since that time, over those couple of years, those spreads, which had blown out massively, have come way back in. We can debate how rational it is for them to be this low, but that is basically the mechanism at work. Some of these governments, as you say, are borrowing more cheaply than we do and borrowing more cheaply than the United States, in some cases.

Mr CRAIG KELLY: But does that not become a significant increase to the Australian taxpayer on the debt the government then holds?

Mr Stevens : Our governments are borrowing at the lowest rates, more or less, since Federation. You can quibble that we are not borrowing quite as cheaply as someone else, but it is an extraordinarily unusual world here. The fact is: governments in this country right now, when they need to borrow, can do so very, very cheaply, in historical comparison.

Mr CRAIG KELLY: But that is still substantially more expensive than many other countries elsewhere in the world.

Mr Stevens : They are borrowing at—what is the CGS rate?—maybe three per cent. It is not two like it is in the US or one like it is in Germany. We have always paid more to borrow than the US or Germany. Whether we should, I think one could debate but that has always been the fact. In fact the spread of the Commonwealth's borrowing rate to the US right now is unusually low, so we pay more but we pay more by a smaller margin than is normally the case. These are cheap rates to borrow at.

Mr CRAIG KELLY: A recent statement is on banking competition. A recent statement in the UK by the head of their Competition and Markets Authority said that:

… despite some positive developments, significant competition concern remain which means that customers may not be getting consistently good service and value from their banks.

Do you think that potentially applies here to Australia, especially with respect to small business?

Mr Stevens : I haven't really got any more things I can offer on small business than what I said before. I think competition to lend in the business space has been increasing. I think it is fairly clear that that emerges from our liaison with banks. Competition to lend in mortgages has also been increasing, and the concern is that we do not want that process to get to the point where standards of loans deteriorate. I think competition to lend has actually increased materially over the past year.

You will remember that there was a period post the financial crisis internationally where we went from having competition to lend to competition to raise money for the banks. The competition to lend abated for some time—that was a cyclical thing. I think that competition is increasing again now. We see banks trying harder in the business sector. We see the securitisation market more amenable to offerings from non-bank lenders enabling to compete. We have seen that interest rates offered on loans as the main test have gone down by maybe 15 basis points on average across the system since the cash rate last changed. So you have had more than half a monetary policy easing there, and I think competition is increasing.

The broader question of whether people get a good deal from their bank or not is across a much broader gamut of the relationship. There is more than one bank you can go to.

Mr CRAIG KELLY: Under the Reserve Bank Act, it talks about the functions and obligations of the Reserve Bank. It refers to the stability of the currency. Do you interpret that as stability of prices or do you also give concern to the stability of the Australian dollar against our major trading partners?

Mr Stevens : When those words were originally penned, which would have been in 1945, this was a world in which the foreign exchange market was rather different. You could not really transact internationally with freedom at all then. My interpretation—and, obviously, I wasn't there and I don't know anyone who was—of those words is that they meant stability both internationally and locally, but mainly the stability in the purchasing power of money, because the historical backdrop here was severe monetary instability in the Great Depression and so on. The purchasing power of money went up a lot, because the price level fell and they were trying to combat that kind of instability, which is also why we have got full employment in those words. I think the main import of those words is a stable purchasing power which finds reflection in the inflation target.

Mr CRAIG KELLY: You write about whether the Australian dollar is too high or too low and, in your deliberations, you also consider what effect monetary policy may have on the stability of the Australian dollar.

Mr Stevens : Yes, but we have to keep in mind that the exchange rate is an adjustment mechanism to the economy. In certain circumstances, for example, if we get a one-in-a-century terms of trade boom and the mining boom and so on that went with it, the exchange rate being able to change helps the economy adapt to that. What we have been arguing about here today and on other occasions is whether the exchange rate is adapting down enough prospectively to help us negotiate the next phase.

So a variable exchange rate, when you are thinking about adjusting to shocks, is a good thing; you do not want to try and keep it stable in the face of such a big event. The thing we are thinking about when we are deciding the cash rate is partly its effect on the exchange rate, but it is really about the track for inflation out into the future and the track for the real economy: is this as good as we can do, or is there a way that we can get it a bit better? Often we feel that we cannot do much better, but that is the kind of question we are asking.

Mr TONY SMITH: I want to draw together a couple of issues that have been raised in questions and in your opening statement. Among other things, you referred to the dynamic of our proximity to a rising Asia, with all its opportunities, and the response coming not just from the established players but from smaller and newer players operating beneath the radar. Dr Lowe commented earlier, in relation to some questions, about trying to foster a greater culture of entrepreneurship and enterprise. In line with what you have said about smaller business financing, I want to get your views on some of that dynamic start-up sector, where there is high risk and higher reward but lower cash flow. I would like to get your view on employee share ownership and enhancing some of the policy settings around that to better provide equity in that important sector.

Mr Stevens : I do not know very much about the settings there; it is to do with tax, and I am not a tax guy. The one observation I can offer is that, in many instances of small start up type enterprises, it is equity funding—your mum and dad lend you some money; you take a loan against the house; friends; crowdfunding; or whatever. To the extent that one could foster the efficient provision of equity financed through some kind of employee ownership structure and still keep the integrity of the tax system, that obviously sounds like a good thing. I am not an expert enough in the area to say a great deal more than that.

Mr TONY SMITH: Would you also agree with the proposition that the dynamism of the economy is going to be determined by the established players but also significant numbers of newer players? What we are seeing—and I think it should be seen optimistically—is that we are going to have fewer mass employers but masses of smaller and medium sized operations?

Mr Stevens : It is a fact that small enterprises employ the bulk of the workforce; that has long been true. How many companies, in any country, that were prominent in the stock market 100 years ago are still here? Plenty of them are, but plenty have fallen by the wayside and plenty will in the future. That is the nature of life. In our national debate it is easy for us to become focused on where the jobs are going and where the industries are shrinking. Without in any way denying that that is very painful for those people, there is another side to that, which is that there are new things happening. We do not read about these because they are often small, they are often busy getting on with things, and they are not cultivating the media to tell their story in the same way. But they are there. In that sense, I would share your optimism that provided there is an environment, as Philip said before, where the risk-takers and the entrepreneurs have the opportunity, the incentives and the flexibility, this is all good, and you could be confident in ways that we cannot imagine. Employment and economic activity will grow into the future. I cannot sit here today and tell you what sector exactly—that is the inherent frustration of this.

Mr TONY SMITH: In terms of your submission to the financial systems inquiry, we have already heard about small business loans, and I will not go over that again, but you also suggested an examination on superannuation in a number of areas. But one I just wanted to get your comments was particularly on fees and the cost structure of managing Australia's retirement savings.

Mr Stevens : I suppose the background to the reason that we flagged that in the submission was that if you think about how things have changed since the Wallis inquiry, the super system is much bigger and it was always known that would happen—it was intended—but it is a very large system. There is a lot of focus on bank fees and the costs of running the banking system and that is fair enough—it is fair enough for there to be that scrutiny—but we felt, qualitatively, the same sort of scrutiny should apply to how much does it cost us to run a system that is managing what is a trillion and a half dollars of the community's savings and is set to grow. Is that all being done as efficiently and cost effectively as it could be? We are not asserting an answer. We are simply saying this probably is a question worth asking. The inquiry is right to put some focus there.

Mr TONY SMITH: Thank you. I am not going to re-ask all the questions that have been asked.

Mr HUSIC: I want to touch on some matters we discussed earlier. What is the plan B? There has been a lot of focus obviously in trying to see investment pick-up in the nonmining sector and to pick up the slack from the mining sector as investment tapers off significantly there, and obviously you want that investment to step into the breach. But the theme that has been picked up from the RBA through your bank liaison references is that business will not invest until they see sustained demand.

When I was listening to your opening statement, particularly the tail end of it, it almost seemed like a call to invest was being issued, where you were listing the reasons as to why business has every opportunity to invest now and make those decisions compared to just waiting for sustained demand. What happens? Where is the plan B? You have already highlighted that monetary policy has its challenges. Low interest rates are being countered by the strength of the dollar. You would expect public investment in infrastructure or education potentially to fill the void, but we have already discussed the determination by this government to proceed with fairly significant fiscal consolidation.

Finally, if you are hoping that there might be some move to spend more in the economy, there is the subdued wages growth and on top of that you have actually people suggesting we should put further downward pressure on wages through, say, cuts in penalty rates. Given those factors, where is plan B if we do not see that investment pick-up in the nonmining sector, which is what everyone seems to be hoping for?

Mr Stevens : I have a couple of points. There are many conditions that are in place for a stronger rate of expansion in those parts of the economy that are not in resources. It has actually been speeding up, but it would be good if it sped up some more, though. I listed a whole bunch of factors and there are probably other things that could be added as to why conditions are there, but you cannot make people be confident;

I certainly cannot make them. It is not that I am unwilling to consider lower rates, even than these, if that really would be helpful. That is the question we would have to ask: how much help would it give versus what risks it would bring? And that is the question we would ask each month. So it is not an unwillingness there, but it is just a sense that, you know, I do not really think interest rates are the answer, really, just at the moment. That could change if something else happens. But I do not think, to the extent that the economy has some ailments, that it is because interest rates are punishingly high. I think we need this environment where there is more confidence to move ahead. I cannot make that happen. I have allowed the horse to come to the water of cheap funding. I cannot make it drink. I think it is a question for legislatures, governments and political leadership on all sides to think about what conduct, what measures and what ways of doing things help to create that confidence, though I am not pretending that you have a magic wand, either.

We face moments like this in every business cycle. I have been through a few, and this always happens. Sometimes it fires nicely; sometimes it takes longer; sometimes it is sooner. I do not have a way of finetuning that. What is my plan B? Well, only to keep trying to articulate these things and hope that enough other people see the message and can bring themselves to do whatever they can to support confidence and take a few risks themselves. That is all I can do.

Mr HUSIC: I want to pick up on that point you said on throwing it over to the legislature, which I certainly understand. The thing is that if you have here the drumbeat about fiscal consolidation and cutting out spending—we have seen billions cut out of what might happen in terms of urban public transport, which you have reflected on, Dr Lowe, previously, and then going to something else that you raised today about innovation and building an innovation culture—and if you have got cuts to education as well, where does that come in? When does it kick in if you are saying it goes over to the legislature and if you are trying to compete between making those investments, seeing that benefit to the economy in a number of ways versus—as I said before—the pressure on fiscal consolidation?

Mr Stevens : I will give Phil the chance to respond, if he wishes. I do not think there is any doubt that we have to have some fiscal consolidation over time. I do not want to get into particular measures. From where I sat, I did not think, really, that the budget was that draconian, frankly, in a macro-economic sense. I am not talking about this measure or that measure; I am talking about the pace of intended consolidation over a run of years. That is actually not that tough, frankly. I do not think that there is any doubt that over a horizon of five, six, eight, 10 years, we have to have a material amount of consolidation. Whichever government is in power today and/or in the future, they are going to face that imperative. How you do it is a judgement call at the political level. I thought the plan on infrastructure was actually to do more of it by selling assets and using those funds to build new ones. That is basically a financing mechanism, and I do not have a problem with that. I do not think that we were savagely cutting back, but then you may be closer to the details than I.

Dr Lowe : This whole discussion is taking place not just here in Australia but around the world as well. At the G20 meetings that I go to, it is all about that too much weight is being put on monetary policy to lift growth and there needs to be structural reform. The whole idea of this two per cent extra objective on the level of global GDP in five years time was really about getting those structural reforms done so that the weight can come off monetary policy. I really see that as the plan B not just here but globally to get those types of structural reforms. Now, it is really up to the political leaders to decide which structural reforms they want to do and how they fit it within the overall budget envelope. Referring back to my main point before, monetary policy cannot drive sustainable, stronger growth in our economies. It comes through structural reform and entrepreneurship. And it is really the task of political leaders and business leaders to put in place the preconditions for that.

Mr CONROY: We have below-trend economic growth driving historically very low interest rates. You have picked up in your minutes and statements that that is driving savers to move from safe investments to riskier investments to seek decent returns. We have what many—including me—would consider weakening of consumer protections around financial advice, which I will not ask you to comment on. How concerned should we be about savers pursuing risky investments? Is this something that could come back to bite them and, quite frankly, impact on the stability of our financial investment industry?

Mr Stevens : Very good question. When I say that monetary policy has to be set with an eye to our mandate for full employment and price stability but also has to take into account financial stability considerations, these are the sorts of things I mean. It is how monetary policy works, when we are expansionary, that we are prompting people to substitute out the yield curve and out the risk curve. That is part of how it works. There is a lot of discussion globally about how terrible this is. Actually, it was—up to a certain level, anyway—the whole point of the very accommodative policies being run in so many jurisdictions. The point was to get people to take more risk, because they went from taking too much to taking none, and we want to go back part of the way. But when I am thinking about how low rates should be it is in my mind, 'How many pensioners do I want to push into slightly higher risk assets? Do they realise what these risks are?'

We have housing prices rising pretty smartly. I hope you know my nuanced position on that. I have explained that before. But do I really want to speed this up a whole lot more? Could that turn out quite badly? These are things that one thinks about. In the end we have to find a balance, and this is the one we have struck. I think it is right but I realise that other people will have different opinions. Those are the considerations that we have to take on board.

CHAIR: I will ask a follow-up question on that before throwing to Mr Coleman to ask his question. In your early-July economic update speech you did discuss house prices. I know that it is of strong interest to committee members and also to people out there in the broader community. In that speech you downplayed concerns about recent price increases and borrowing but you did explicitly state that investors should take care in the Sydney market, which is the main area where a large increase in borrowing has been occurring. Are there any particular parts of Sydney which the RBA is especially concerned about in the same way that, in an earlier episode, the bank became particularly concerned about property market developments in certain parts of western Sydney and in the Gold Coast? The second part of that question is: if there are areas of particular concern, what action, if any, does the bank think the policy makers should be taking?

Mr Stevens : I do not think I would single out particular parts of Sydney or, for that matter, other cities for special mention. What I was trying to convey with those earlier remarks was that, when you look at the data, that is the thing that really stands out—the extent of increase in investor loan approvals in New South Wales, which I take to be mainly Sydney. Some of this is happening in Melbourne as well now. It is starting to pick up there. We may have to nuance the warning to cover the southern city as well at some point, on the simple theory that for the things that are growing really fast and that are significant, you might be concerned that something could go wrong. That is why I gave those messages.

As for what one does about that, apart from just warning—and the warning is probably ignored—I think the next step is to then press through the supervisory mechanism for the lenders to know who they are lending to, take care, keep giving the message about leverage and take a close look at standards of lending. APRA already has been communicating with banks about those types of issues, and I imagine we can probably step up that scrutiny and make it a little bit more targeted if it is appropriate to do so over time. The strongest step would be the dreaded macro prudential tools—they are the latest fad, internationally. And I have said that I do not rule out the use of those or asking if APRA will use them, if needed. That would remain on the table as a possibility as well.

CHAIR: In what circumstances do you think you would use those macro prudential tools?

Mr Stevens : I guess where you felt that impressing on managements the need for strict standards was not effective enough—if there was a sense that there was a significant financial and economic risk building here. They are the sorts of circumstances in which you would use them. Also, at some point interest rates might not be as low as they are today, which will have a bearing too. That seems unlikely on any near-term horizon, as I have already said, but those things that are also on the far-distant horizon have to remain on the table too.

Mr COLEMAN: I just want to change tack a bit and talk about the Eurozone. This week the Eurozone number came out, and for the last quarter GDP growth was zero. And for a long time now they have obviously had very low growth and very high unemployment, consistently. As policy makers, what can we learn from the Eurozone about what not to do?

Mr Stevens : That is a big question. One is tempted, I suppose, to say, 'Don't become part of a monetary union where the countries are fundamentally quite different and are not well aligned and don't actually constitute an optimal currency area.' I think part of the problem here is that not enough integration of various things had occurred in order to build the single currency on top of that. I think maybe they felt that if they did the single currency then that would help the integration happen, and in some sense it probably did, but not quickly enough. So, I think that is a factor. One might also look at some European countries, particularly some of the so-called peripheral ones, whose public finances have proven to be a vulnerability. The lesson there for us is not that that is going to happen to us; the lesson for us is: 'Don't ever let yourself get into that position. Do a good job supervising your banks. Have a flexible economy. Think about the effects of ageing. Think about what societal expectations are in terms of what the state can give them—whether they are realistic—and have a conversation about that.' With the Europeans—and I do not want to be gratuitous—I think it would have been good if all these things had received more attention in the past.

Mr HOGAN: I have a follow-up to that. There were a lot of people saying when the euro was established that it would fail, simply because it did not have a unified debt market—sort of like what you were alluding to, that each of the countries had their own bonds, their own debt, and therefore it was always going to be plagued with problems because they did not have a unified debt market, which most currencies do. Do you think that was an important part of it?

Mr Stevens : In a way, one of the things that got them into trouble, you could argue, was that the debt markets started to treat all the bonds as the same: a Greek bond, a Portuguese bond, a Spanish bond was like a German bond, and they traded with very compressed spreads. Well, they were not really the same as a German bond. That was a bomb waiting to go off when there was shock. As they themselves I think would say, the things that were not built on an integrated European basis were things like bank supervision, how you resolve a failing bank. They made an attempt to have a fiscal compact, to have fiscal discipline, but it did not really bind very well. They had the right idea but the execution really fell short. I think it is in some of those areas, at least in the financial space, where the foundations for the edifice had not really been put in place. That is what I think.

CHAIR: Mr Husic has another question before we proceed to student questions.

Mr HUSIC: I want to refer you to Sarv Girn's speech to CEDA back in June which I thought was important in trying to get business to think more about the impact of digital disruption. I want to refer to it because of Dr Lowe's comments earlier about embracing more risk in terms of seeing a way forward for newer businesses in particular to emerge within the economy and the economic benefit that would bring. This is also a challenge for government in how it deals with that disruptive impact and the tendency to try and regulate against some of that change, one of the notable examples being Uber and the challenges that it presents within the transport sector. Do you feel that business is ready for this disruptive challenge of technology? What do you think they can do to prepare? Also, what are the challenges for government in terms of embracing more of this risk, not necessarily wanting to shut it down with regulation, and allowing some of that economic benefit to flow?

Dr Lowe : Are businesses ready? Probably not. But I think it is going to happen. If you talk to people involved in the technology industries they are full of stories about how we are on the cusp of large breakthroughs in many business models that are going to threaten the existing set of arrangements. I think a strong case could be made that that actually is true. It offers tremendous possibilities, so I am fundamentally optimistic about our prospects here because we have some great scientists and we have the general environment to encourage innovation.

My concern is that the regulatory environment in some specific areas is stifling the ability of these firms to come forward with their great ideas. I do not know how you solve that. The regulations come from a whole bunch of different areas and there is not one specific magic bullet here. I think the message is that when the legislature is putting forward new laws and new regulations we need to be very mindful of the effect it has on the ability of people with new ideas, which ultimately are going to be the source of our growth and our income, to come forward and to test these ideas in the marketplace, to create the environment where that is really what they want to do. They have got the ideas—there is no shortage of ideas out there. We have to create the environment in which they do that. It is really up to our parliaments to do that.

Mr HUSIC: You mentioned some of the regulatory challenges. Are you be able to nominate any areas in particular that you think—

Dr Lowe : I do not really want to do that. I talk to a lot of business people and they have specific things; whether they are legitimate or not it is always very hard to tell. The general point is the one that I want to make, that we really have to be mindful of the environment that we create. It is incredibly important for us as a society that people with new ideas can bring those to the market and test them against the market and disrupt the existing guys, because that is how we will become wealthier as a society over time.

CHAIR: I am delighted to introduce Rachel Bentley and Melonie Gabrielle from St Francis College, Crestmead. I invite them to ask their questions of the Reserve Bank Governor.

Rachel Bentley : Good afternoon, everyone. We would like to thank Dr Jim Chalmers for inviting us, as well as the Governor and all participants here today. My question is: in our area of Logan, we have very few people in the mining industry. Do you think we talk too much about the mining industry and not enough about other sectors?

Mr Stevens : That is an interesting question. I do not know the location personally. What happens in the resources sector has spillovers to other parts of the economy. We cannot always see them easily, but they are certainly there. Many locations in the country do not actually have any mining, but they may well have people who fly from there to work in the mine and come home and bring the income. They may have people who are employed being various consultants, geologists, chemists or whatever for the mining companies. They may be locations that see further spillovers down the track. I once sat on a chairlift with a young guy at the ski fields who drove a truck in the Pilbara. He was just on vacation. He would fly in and fly out. So the money he was earning was going all around the country—I do not know whether to Logan or not, but the spillovers do happen. That is why we have talked so much about it, because everything is connected.

Melonie Gabrielle : I am a year 12 student at St Francis College. There are high levels of youth unemployment in some areas, including ours, which is Logan, where it is currently above 20 per cent. What can we do to channel investments to these areas to improve employment prospects for young people?

Mr Stevens : That is a good question. We could ask what we could do to channel investment into the area or we could ask, more broadly: what can we do to make it easier for young people to get a job? A growing economy; the ability for those people to work in the adjoining area if there are jobs there—the flexibility to do that; and we can think about making sure that we have made it as easy as we can, subject to considerations of fairness, for employers to employ young people and, for that matter, old people. All those things are important.

CHAIR: Well done, ladies. I thank all who participated.

Resolved that these proceedings be published.

Committee adjourned at 12:28