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Standing Committee on Economics
Reserve Bank of Australia annual report 2014

KENT, Dr Christopher John, Assistant Governor, Economic, Reserve Bank of Australia

LOWE, Dr Phillip William, Deputy Governor, Reserve Bank of Australia

STEVENS, Mr Glenn Robert, Governor, Reserve Bank of Australia

Committee met at 09:30

CHAIR ( Mr Alexander ): I declare open this hearing of the House of Representatives Standing Committee on Economics, and welcome representatives from the Reserve Bank, members of the public, school students and the media here today. This is our first hearing with the RBA this year. It is also my first as chair of this committee. I look forward to continuing the important dialogue that we have with the governor and his colleagues this morning.

In its statement on monetary policy released last week the RBA noted that growth in 2014 has remained around the long-term average among Australia's key trading partners. The US economy has continued to strengthen, and although growth in China eased a little in 2014 it is still close to the target. Economic activity in Japan has been weaker than expected since the increase in consumption tax but has improved in the latter part of 2014. The eurozone remains subdued. It is of interest that several central banks, including the European Central Bank, have decided to ease monetary policy further to prevent a prolonged period of below-target inflation. These actions and concerns about global growth have caused a significant decline in sovereign bond yields in the major markets.

Domestically recent economic indicators from the RBA and others show that Australian financial conditions remain accommodative. Our export volumes continued to grow strongly over the second half of 2014 driven by resource exports. However, the Australian economy was growing at a below-trend pace during the latter part of 2014 and non-mining investment and public demand remain subdued. It is notable, also, that mining investment has fallen further recently, and very few new projects have commenced. It is of course significant from an Australian perspective that commodity prices have declined in the past three months particularly for iron ore and, to a lesser extent, base metals, although by less than oil prices. LNG is also anticipated to fall in the period ahead as it is generally linked to the price of oil. Australia's terms of trade are therefore expected to lower.

Household consumption has picked up since 2013 but remains below average. Consumption is supported by low interest rates and lower fuel prices but this has been offset to an extent by weaker growth in labour income. There are positive labour market data but they point to only modest employment growth with a slight rise in the unemployment rate likely in the short term. The housing market remains buoyant due in part to continuing low interest rates and strong population growth. Housing price inflation has eased somewhat since 2013 but is still high particularly in Sydney and Melbourne. CPI inflation had declined to 1.7 per cent over the year to December 2014 quarter in part reflecting the large drop in oil prices and the repeal of the carbon tax. The various measures of underlying inflation declined in year-ended terms to around 2¼ per cent. The RBA notes in its recent statement that the forecast for GDP growth has been revised to a little lower in the near term as consumption growth and non-mining investment are not likely to pick up as quickly as previously thought.

It is significant, of course, that the RBA decided last week to lower the cash rate by 25 basis points to 2¼ per cent after 18 months of stability at 2½ per cent. It is pleasing to see financial institutions passing this rate cut in full to their customer bases. The RBA has noted in relation to this decision that there are now fewer indications of near-term strengthening in growth than in previous forecasts and that, although the Australian dollar has depreciated, it remains stronger than most estimates of its fundamental value. The lower dollar is therefore providing less assistance in delivering balanced growth than it could be. The RBA has stated that this reduction in the cash rate is expected to provide some additional support to demand. The committee looks forward to further discussing the implications of the rate cut and other issues in monetary and economic policy this morning.

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 hearing is a legal proceeding of the parliament and warrants 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 like to make an opening statement before we proceed to questions?

Mr Stevens : Thank you, Mr Chairman, and congratulations on your appointment as chair. Members of the committee, since we met in August last year the economy has continued to grow at a moderate but below-trend pace. Inflation as measured by the CPI has been affected by movements in energy prices and government policy changes, but, even aside from those effects, inflation is low and it appears likely to remain so. The international context is one in which the global economy likewise is growing, but according to most observers at a pace a little below its medium-term trend.

There are some notable differences in performance among regions. The US economy has picked up momentum. It is growing above trend. Its unemployment rate has fallen. China's economy met its growth target in 2014. A slightly lower target seems likely to be set for 2015, maybe something around seven per cent, but that would still be very solid growth for an economy of China's size. On the other hand, the Euro area and Japan have of late recorded lower growth than was expected a year ago.

Commodity prices have fallen, in some cases quite sharply. These trends appear to reflect primarily major increases in supply, with some moderation in demand also playing a role. That would appear to be the case for iron ore prices and oil prices and, prospectively, natural gas prices, which typically are tied to oil prices. Base metal prices, where fewer significant supply changes have occurred, have fallen by much less.

So there has been what economists refer to as a positive supply shock—that is to say, more of these products are available at a lower price. The effect of that on individual countries will vary, depending on whether they are a producer or a consumer of such products. On the whole though, for the global economy, this, it seems to me, is a positive development.

Inflation is quite low in a range of countries, very low in some countries. The decline in energy prices is temporarily pushing headline CPI inflation rates even lower. The very low interest rates that we talked about last time have, remarkably, fallen even further around the world since that meeting. This has been most pronounced in Europe, where yields on long-term German sovereign debt have fallen to be about the same as yields in Japan. German sovereign debt in fact has recently traded at negative yields for terms out as far as five years. Official deposit rates are negative in the euro area, and the European Central Bank has announced a large-scale asset program, colloquially known as 'quantitative easing'. The euro has depreciated.

Some surrounding countries, to which funds tend to flow in anticipation of further depreciation of the euro, like Switzerland, have reduced interest rates to significantly below zero. Indeed, 10-year Swiss government debt has on occasion traded at a negative yield over recent times. The Swiss National Bank took the decision to remove the cap on the Swiss franc, as it assessed that the size of the intervention likely to be required to hold it was becoming just too large. That move occasioned considerable turbulence in foreign exchange markets.

Meanwhile, the US Federal Reserve, faced with a strengthening US economy and having ended its asset purchase program last year, is expected to begin a gradual process of lifting its policy rate in just a few months time. So the monetary policies of the major jurisdictions look like they will be heading in different directions. That means there is ample potential for further turbulence in financial markets this year.

The falls in prices for key export commodities are lowering Australia's terms of trade and hence the purchasing power of our national income. This is well understood, and it has been the subject of much discussion. It will continue to constrain income growth for households and mining companies and revenues for both state governments and the Commonwealth government over the period ahead.

Resource export shipments by volume are increasing strongly as the capacity that has been put in place by the very high levels of investment is put to use. But at the same time those very high levels of capital spending by the resources sector, which had been a strong driver of domestic demand for several years, peaked during 2012 and turned down. All indications are that this downswing will accelerate this year. That has always been our forecast. The recent declines in commodity prices do not change that, though they do emphasise, I think, that this downturn, this trend, is now well and truly underway.

The various areas of domestic demand outside of mining investment are mixed. Dwelling construction is rising strongly—you can see that, actually, around Hurstville—and commencements of new dwellings will reach a new high over the coming 12 months. Consumer spending is responding both to income trends and to financial incentives, and these are pulling in different directions. Growth in wages is by historical standards quite low, and that and the fall in the terms of trade are working to restrain growth in disposable incomes. Working in the other direction, the fall in petrol prices—assuming it is sustained—is adding noticeably to the real incomes of consumers. Increased asset values, which push up measures of wealth, and low interest rates are working to push up consumption relative to income. The net effect of those opposing forces is producing moderate, though not strong, growth in consumption.

Meanwhile, at this point, non-mining business investment spending is still very subdued. While several key fundamentals are in place for stronger performance here, signs of a near-term strengthening remain less than convincing, one would have to say at this stage. That is a weaker outcome than we had expected or hoped for six months ago. Public sector final spending, which is about one-fifth of aggregate spending in the economy, is fairly subdued, and, as you know, the intent of governments is to exercise restraint over their own spending over the period ahead. The lower exchange rate is helping export volumes outside of resources, and we have seen of late some better trends in some categories like tourism and education. Overall, then, growth in non-mining economic activity has picked up over the past year, but it is still running a bit below average pace.

Our expectation had been that a further pick-up would occur in 2015. When we reviewed our forecasts in late January, we did not feel that growth thus far had been weaker than we had expected three or six months ago, but, when we looked forward, as hard as that is to do, we felt that there were fewer signs of a further pick-up in non-mining activity than we had hoped to see by now. As a result, the revised forecasts we took to the February board meeting embodied a longer period of below trend growth and a higher peak in the rate of unemployment than earlier forecasts. They also suggested that inflation was likely to remain pretty low over the forecast horizon, and, indeed, the inflation outlook was revised very slightly lower—in part, that is the effect of declining oil prices and also, at the margin, the weaker outlook for economic activity.

At its meeting in February, the board considered that this revised assessment—that is, sub-trend growth for a bit longer, a higher peak in the unemployment rate and slightly lower inflation—warranted consideration of some further adjustment to monetary policy after a fairly long period in which the cash rate had remained steady. These forecast adjustments were incremental, but they were all in a consistent direction so far as monetary policy is concerned.

Another factor in our consideration, of course, has been dwelling prices, which have continued to increase. Price rises in Sydney remain very strong and they are pretty solid in Melbourne. On the other hand, they are more mixed elsewhere around the country. Excluding Sydney, the rise for the rest of Australia over the past year was about five per cent—that is a healthy pace—and some cities actually have seen declines in prices over some recent months. That is a healthy pace overall, but it is not alarming. While developments in the Sydney market remain, in my view, of concern, in the end we did not see those trends as overwhelming a case for further easing in monetary policy that was made on more general grounds.

On housing, I note in passing that, on the regulatory front, APRA has announced its supervisory approach to managing the potential risks posed by the rise in lending to investors in housing. In brief, they involve more intense scrutiny of investor loan portfolios that are growing above 10 per cent a year, with the possibility ultimately of additional capital requirements if APRA were to deem that necessary. APRA has also reiterated its expectations for other elements of lending standards such as interest-rate buffers, interest-rate floors and so on. ASIC has begun a review of interest-only lending in the context of consumer protection legislation. The bank welcomes those steps and will keep working with the other regulators as necessary in these areas.

The board is also very conscious that, at this point, monetary policy's power simply to summon up more demand with lower interest rates could be less than it used to be. A decade ago, when there was, it seems, an underlying latent demand continually among households to borrow and spend, it was perhaps easier to generate additional demand in the economy by lowering interest rates. Today, that channel may not be quite as effective as it was then. Nonetheless, we do not think at this point that monetary policy has reached the stage where it has no ability at all to give additional support to demand in the economy. Our judgement is that it still has some ability to do that and to assist the transition the economy is making, and we regarded it as appropriate to provide that support.

The forecasts we published last week in the statement on monetary policy assume a lower path for interest rates and a lower exchange rate than earlier forecasts did and, for that matter, than did the forecasts that we presented to the board and to which they reacted. Those are assumptions, of course; they are not a commitment to a particular course of action and they are not a forecast, in particular for the exchange rate.

On the exchange rate, it is worth noting, I think, that, despite concerns that have been voiced at various times about whether the exchange rate would adjust appropriately to our changing circumstances, it has been doing so since the time that we last met with you. Over that period, against the US dollar it has fallen by about 17 per cent. The US dollar itself is rising against virtually all currencies, so some of that move is actually a US story, not an Australian one, but against the basket of relevant currencies the Australian dollar has fallen by less but still by about 11 per cent since the hearing we had in August. Further adjustment—I would say probably—is going to occur.

One other development since our last meeting, of course, has been the final report of the financial system inquiry. This was a very wide-ranging report and there is now a period of further consultation underway. I just note in passing that the inquiry did not find major problems in the financial system. It did make some recommendations about strengthening the resilience of the banking system with capital and about thinking about loss absorbency more broadly in the context of resolution. Those matters mostly will be in the province of APRA to consider. More relevant to the Reserve Bank, the inquiry also made some observations about payments matters, generally supportive of the steps the Payments System Board has taken since its inception in 1998 and pointing to some areas where further steps might be considered. The Payments System Board will be considering those matters at its forthcoming meeting. Thank you, and my colleagues and I await your questions.

CHAIR: Thank you for your statement. I noted in your statement that you anticipated a higher peak in unemployment. There has been significant commentary on yesterday's unemployment figure. Would you please outline the extent to which this level of unemployment was previously forecast and also the underlying causes of this level of unemployment.

Mr Stevens : We did say in the statement, as you note, that the peak that we built into our forecasts is now a bit higher. I think with regard to yesterday's figure that it is always unwise to react too strongly to one monthly number. There is a lot of commentary today about how weak it was; a month ago there was a lot of commentary about how strong the preceding month's number was. I think we need to take the two together and, indeed, we need to step back from monthly ups and downs, because there are always going to be those, and try to distil what the trend is.

That trend, in our view, is that the unemployment rate has been incrementally edging up by about one-tenth of a percentage point per quarter. I think that is still happening and our forecast is that that will keep happening for a little while yet. The most obvious reason that is happening is that the economy is growing and is creating growth in jobs, but it is not growing at its trend pace or above; it is growing a little under. While that is the case, most likely, while we will grow the number of jobs, we will not grow quite enough jobs to keep up with labour force growth and the unemployment rate will tend to rise rather than fall. As to these levels of unemployment, to be honest, still today—just over six on a kind of quarterly average basis—by the historical standards of my professional career that remains low. But it is going up, not down. We can sustain lower rates of unemployment than this, in my opinion, and we should be seeking to do so.

So I caution against overreaction to one monthly number, but the appropriate thing is to contemplate those trends. That is the analysis that we have set out in the SMP and our other published material. Really, the economy needs a bit more growth than we presently have. That is what we are trying to encourage within the limits of our powers, and other policies need to do that too.

CHAIR: In regard to the global economy, could the governor please outline his views about how the events in Greece could impact on the global economy, how the strength of the US economy is being offset by the weaknesses of Europe and what the Reserve Bank's views are on the Chinese economy?

Mr Stevens : There are quite a few questions in there, so one at a time.

CHAIR: I can go back.

Mr Stevens : Perhaps I can take a few minutes to outline a few things. Let me begin with the US, which, as I said earlier, clearly is growing above trend now. My take on what our counterparts in the Fed have been saying recently is that they are much more confident now that they are in a sustained upswing. They are in that period of the cycle where there is enough growth that it starts to reinforce itself through the various feedback mechanisms the economy has. I have been an optimist on the US for quite a while now, and I think I would still be optimistic. The Americans themselves would say—and I think Jack Lew, Secretary of the Treasury in the US, has said recently—that the rest of the world cannot just rely on the US to pull them out of their troubles: as big, as strong and as important as the US is, we need more engines firing in the world economy—and I think that is right.

That then brings us to Europe. The euro area, I think, probably is now in a recovery from a downturn but it remains rather tentative and fragile, and really the world could very much do with Europe being able to generate some growth at home in Europe rather than relying on being pulled along by the rest of the world. So far as Greece is concerned, they are back in the news. There has been a political change, there is a desire to revisit the terms of the various programs that they have had and the assistance they have had from the international community and from Europe. That, to my knowledge, remains at a very delicate state of negotiation. So far as I am aware on the last news that I heard, they have not actually been able to agree on a way forward with their European counterparts yet. It is important that they be able to do that soon, because things could unravel quite badly for Greece if they cannot find an accommodation.

Most of the people of Greece want to stay in the euro area—they do not want to leave it—but some of the other things they want are hard to square with the obligations of staying in the single currency area. So this remains a very difficult situation, and I think we will be reading a lot about Greece, the efforts of Europe and the international community generally to find a way forward with Greece over the next weeks and months. I think I have said before at previous hearings that it will be years before we will be able to say: 'The European problems are now all solved; they are behind us. We can forget about them.' I have felt for ages that, if we ever reach that point, it is some years away. It still is, and this is another manifestation of that.

In regard to China, as I said in the opening remarks, they hit their target in 2014—the target was 7.5; they hit 7.4. I have actually read a fair bit of commentary about how they fell short, but if we can hit a target within a tenth of a per cent, I will be happy. That is a hit, not a miss. They have not announced their target for 2015, but most people expect it will be about seven. That is a little lower, though I think the context for that is that China was growing at 10 per cent a year for quite a few years. Nobody grows that fast indefinitely, and particularly not when you get as big as they are. They are now a very large economy; they are the second or third largest in the world. They are by now, I think, the largest trading economy in the world. An economy of that size growing at seven per cent is still quite an impressive performance if they can do that.

There will now be debate, as there always is, over whether they will or will not hit that. We cannot know the answer, but they have done a pretty good job of managing things thus far. I would say there are few countries that could better their track record of growth—I cannot think of any. But I think the issues in China remain: can they manage the financial excesses that built up in the earlier period of very strong growth? Can they manage those without there being a slump? So far, so good, but that will inevitably remain an open question for a while yet.

For Australia, if you had to pick just one metric—and I would not pick just one metric—the most important is the price of iron ore. And we know what has happened: it has gone down. It has gone down partly because Chinese growth has slowed, and Chinese steel production has slowed notably. It has also gone down because supply of the product—and a lot of it is supply from this country—has gone up. That is an important metric for Australia, and that is the thing that people will be watching into the future. Our forecast, which is in the published document, is that the price of iron ore is probably going to remain low for a while. The largest miners are still profitable at these prices and will continue, I think, to grow their output. So there are a few remarks on China and the others. Do you wish to add anything, Chris?

Dr Kent : I would just add that I think a lot of the time people's focus with regard to China and its impact on us is very much on the demand side of things. How fast is their industrial production growing? What is happening in their property market? What is investment going to be doing? I think that is very important, but the other consideration is the supply of iron ore. China actually produces a lot of its own iron ore. It produces it at a very high cost, so I think that will have an important bearing on the price of iron ore. People have been looking for Chinese production to come down. It looks like it has started to come down a bit, but it might fall further. So it is important to realise that they are a big producer of some commodities as well.

CHAIR: What is the Reserve Bank's view of the level of the Australian dollar, and is the lower Australian dollar helping exporters and Australian manufacturers?

Mr Stevens : I think the decline in the exchange rate will be helpful to the traded sector and I think we will see the evidence of that get clearer over the period ahead. As to whether it is the right level, here is where I have to be careful, of course. We have said over time that we thought the exchange rate would decline, and needed to decline, in order to assist balanced growth in the economy. The backdrop to that simply is that, when our terms of trade are at the highest level for 100 years, you expect the exchange rate to be high. That is part of the economy's adjustment mechanism. It has been a very well documented historical empirical relationship. When the terms of trade fall, as they have been doing, you would expect the currency to respond to that as well. Now it has done and is doing, and I think that will continue.

At various points in time it might have looked like it was not quite doing that as much as you might have expected, and we had some things to say for that reason. But, as I said in my opening remarks, it seems to me that the exchange rate is more or less doing what you would expect it to do. Where it will go from here, well, nobody knows. These things are inherently unpredictable, but I can certainly think of reasons why it might go down some more. But I do not want to offer too much more precise commentary than that today.

Mr HUSIC: Governor and officials of the Reserve Bank, thank you for your attendance today. A fall in oil prices and a falling dollar would normally be celebrated as a major shot in the arm for the economy, yet we have a situation where the bank, similar to the Canadian central bank, has suddenly moved to change rates. I am just interested to know, after flagging for some time that we would be ready for a period of stability in rates, what the economic indicators are that have caused such concern to the bank to prompt it to move away from this period of stability and cut rates in the way that it did?

Mr Stevens : I would go back to the articulation of a revision to the outlook. A year ago, we had been sitting still for a little while and saying, 'Our best guess is we will be sitting still for a while longer.' I think at that stage we had a number of indications that confidence was improving. It was a reasonable forecast at that stage that non-mining activity, which at that point was still on the subdued side, was going to firm and I think the evidence was panning out that way.

In the second half of the year, I think that faded a little bit—not disastrously, but there was follow-through that one might have hoped was not quite there. As I said earlier, it is not so much that growth thus far has been seriously weaker than expected; it is more that by now I would have hoped to have seen a few more signs than we do see of further pick-up in intentions to invest and employ. We have seen some pick-up in those things, but I think by now it would have been good to have seen some more.

Yes, we have been saying we are hoping for a period of stability, expecting that. But we are faced with the question: if the economy could do with a bit more support, can we provide that? And, if we can, should we or will we create some other problem by doing it? The obvious point to make there would be the housing market. So they are the things you have to weigh, but over the summer break there was a couple of months of time to reflect—new data, various events and a fresh look at the outlook. Having done that, we came to the conclusion that really it could do with a bit more help, we could give it some and we should. So we took that decision and eased last week. That is really the rationale.

Mr HUSIC: But let's take into consideration something you expressed in a speech you gave in Hobart. We have reflected on the commentary around stability in rates. Generally the market does value the fact that there are long lead times in any changes that the reserve may be contemplating. Are we entering into a period where those long lead times may be a thing of the past, just because economic factors are altering in a way that you are not necessarily anticipating? That is not meant as a negative reflection; it is more a reflection of the times we are in. Do you see those long lead times as being a thing of the past? I know in particular last year there were changes on positions regarding macroprudential tools through to what we are talking about now. The bank does seem to be moving a lot more rapidly on these things.

Mr Stevens : You do have to change with the times if the times call for change. In my opinion, if you feel the case has emerged and it is clear enough, it is usually best to get going on it. On long lead times, it is actually unusual for central banks to provide very long lead times. There has been a lot more of this so-called forward guidance around the world in recent times. Actually, if you look carefully at what all the central banks who have given that guidance have said, it is always very conditional on things unfolding as they expect. If things do not unfold as they expect, they will do something other than what was in the guidance and markets will have to come to grips with that if and when that occurs.

I have talked about the language of stability before, and I think the committee is aware of why we use that language. The reason is that we came to a point where we thought that we should sit still and allow what we had already done—which I think was eight or nine moves in the cash rate—time to work. We were not thinking of tightening; we were just thinking of letting that work. But the problem in this country is that, the moment we say, 'We are sitting still, having gone this way,' the speculation starts that day about the other way. That would have been very unhelpful, in my opinion. So the stability language was basically aimed at saying, 'Keep calm. Don't rush to the other side of the boat. Just chill out for a while.' It had some success. It did not stop some people speculating about early rate rises, and they have continued to do so until quite recently. But enough people got the message that I think it was helpful for us to say that.

The Hobart speech was really looking forward to a time when any language was going to get you into trouble sooner or later. I could foresee a time when we were going to have one of two problems. One of two things was going to happen. One was that we were going to feel like saying, 'Let's get off this language not because we want to make a change in rates but because we don't want the language to box us in.' To be honest with you, I was looking for that opportunity for months in the latter part of last year. But it always seemed a bit too risky to tweak the language. The fear was that people would think that tightening was now here. It was not here. It was not coming any time soon. But even just getting off the language carried certain risks. I debated with colleagues about this. In the end we said,' We'll just leave it alone.' So we were either going to have a problem changing the language or we were going to get to a point where, not having changed the language, we were actually going to make a change in rates. One of those two things was going to happen. The second one has happened.

That said, it is not actually our job to make sure nobody is ever surprised. There are going to be surprises from time to time. We do not go out of our way to create them, but if there have to be few people surprised for us to do the right thing then—I am sorry—that happens sometimes. I think communication of nuance is basically impossible. It just is not possible. We came to a moment where, notwithstanding the language, we felt, 'Actually we should make a change here.' So we have made it. I know that some people feel wrong-footed. I did not set out to create that situation. Certainly we have been as smooth and as clear as we could be, but there are limitations to how much of this we can realistically achieve.

Mr HUSIC: I am just grateful that you have given us the experience of a Reserve Bank Governor using the term 'chill out'! I did not expect to hear that in my lifetime. In the chair's opening statement he reflected on the work of the RBA that the lower dollar was providing less assistance in delivering balanced growth. Given that, as you indicated in your opening statement, the dollar has dropped in value between 11 per cent and 17 per cent and is at roughly 78c against the US dollar now—and that is a fairly substantive drop—where does the bank believe it will deliver balanced growth?

Mr Stevens : I think the chair was quoting language that we ourselves have used at various times. It is coming down, but it is not supplying as much assistance as it might. That is a fair quote. We have said it various times when we have been giving it a bit of gentle encouragement, if you like, to behave in its normal fashion. I think it is behaving roughly in its normal fashion now. Where it goes from here really hinges on how far the terms of trade fall. I think it also hinges a bit on what other countries do. The US is going to be raising rates in three or four months time if they proceed according to their articulated intentions. I think that will change the environment. Some of that should pretty well be priced already. But I think once that begins to happen, if it does, that is probably going to change the tone of financial markets, including exchange markets.

Mr HUSIC: On that issue that you just reflected on with respect to the US—having just come back from the US myself—there seems to be a debate emerging. The expectation was that the Fed would move to higher rates somewhere around the third quarter. But now with inflation being as subdued as it is—and it is not moving—debate is emerging on what their rationale is in their case for moving rates up. Do you see it as a case of them building up their armoury for being able to have scope to move if events change? And if they do proceed in that environment, raising rates while inflation is still flat, what do you see as the implications for us?

Mr Stevens : The way to think about the beginning of what I think will still be quite a slow return to more normal rates and the way I think the Fed would describe this is that right at the moment they still have their foot right hard on the interest rate accelerator and the car is speeding up. It is not so much that it is time to slam on the brakes but, as the speed increases, you need to back off the throttle a bit because you do not need as much throttle. That is really what they will be doing. Not necessarily in quite those words, but that is how they would think about it.

I think we should welcome the implications, frankly. I have said this before. It is a very strange world we live in. I am not criticising the other central banks for doing what they have done, but it is a very unusual world. If the Fed get to the point, as it seems they will, where they feel that the US economy now warrants incremental rises in the Fed funds rate from zero to positive but still pretty low rates, we should welcome that. It is a good sign if they think that the US economy is in that position. Typically—and we have said this before as well—when the Fed is in a tightening phase, disruption happens around the world. You certainly would not assume that will not happen this time, as well flagged as their moves will be. But, on the whole, personally I think it will be a welcome set of developments.

Mr HUSIC: Again your comments prompt me to another question I had been considering, which was: with more countries turning to QE—I think Sweden now, from what I understand, has interest rates at zero and it has announced it is going to start printing money to stimulate activity and presumably to put downward pressure on currencies—what is the potential end point for the process? Does it put us at a disadvantage, and is it possible to conceivably foresee a situation where we end up at a zero rate?

Mr Stevens : I would have to admit it is not reassuring, in some broad sense, that more countries feel they are in this position. They have to do what they have to do, of course, but it is a mark of the difficulties that the advanced countries, in particular, have faced in the aftermath of the financial crisis. I do not think that we will end up in that position. Nobody can be 100 per cent sure of these things, obviously. I would very much hope we do not. This is not a thing we should wish to see. That is not the thrust of your question, I know. But for things to be so weak that the central bank is buying government debt as a last resort mechanism to try to impart stimulus to the economy is not a pretty picture. I do not think we will reach that point and I certainly would very much hope not to.

Mr HUSIC: On another front, some estimates I have seen calculate that household consumption, business investment and construction activity will contribute roughly 1.5 per cent of GDP growth in 2015. Some would argue there is scope for these three factors to do a bit more work in driving faster growth. Taking into account where we are at at the moment, where does the bank see future growth being driven? What circumstances or factors would help see household consumption, business investment and construction activity do more of the heavy lifting?

Mr Stevens : Maybe I will get Chris to talk a little bit about the forecasts that we have.

Dr Kent : I think we have been saying for a while that many of the key elements are in place for a pick-up in business investment outside the mining sector. Rates are certainly not an impediment. Finance is available very readily to most companies at a very low rate. Population growth is pretty strong. We have seen some improvement in some measures in the business sector, in the various business surveys. They have picked up from conditions that were well below average to something around average. These surveys and our own liaison tell us capacity utilisation has lifted a bit. But, even though the survey measures say capacity utilisation is around average, they still have adequate spare capacity, if needed, if demand picks up noticeably. So they are not feeling a pressing need right now to do a lot of investment but they are in a better place than they had been.

So all of those sorts of features are in place, but I think the animal spirits are lacking. But it has been very low for a long time and I think a cyclical recovery is in order. It is just a question of the timing, and what we have done is just delay that recovery. We do not see business investment outside the mining sector picking up in the next few quarters; it is some time a bit further out from that. Construction, of course, is a very important part of that. One of the soft bits of data of late has been non-residential building approvals, which have come off a little bit. In any case, I think there are reasonable grounds to expect that non-mining business investment will pick up. We just do not think that will happen in the near term.

In the household sector, again there is a similar story. We have seen a bit of an improvement in conditions, we have seen consumption pick up over the course of the last year or more, but it is still a bit below average. So it is welcome that retail sales have picked up and consumption growth in services has picked up. But the indications are that it is not going to pick up noticeably in the near term from here. Even though I think, down the line, the underlying features of the economy suggest the prospects in the longer term are very good and a cyclical recovery is in order, it just does not seem that it is on the near-term horizon. So that is really the sort of theme that underpinned our revision to the forecast. It is not that things are getting worse, but our much earlier forecasts had assumed that they were going to be lifting and getting better from here and we have just pushed that point back a bit.

Mr HUSIC: I want to return to something that we have previously discussed. I want to test it again given that the circumstances have changed. I am talking about the relationship between very subdued wages growth, which you have reflected on in your statement, and household consumption and broader domestic growth. We have talked about this previously. In other parts of the world there are concerns about the fact that wages are not growing as fast as they could or should be. Yesterday's figures, along with the RBA signalling today that unemployment is going to remain above six per cent into the near term, would not help address those low rates of growth. What is the bank's forecast for wages growth and is your thinking evolving on the impact of low wage growth on domestic demand and household consumption?

Dr Kent : Our forecast for wages growth is a little bit softer than when we put our forecast together in November. That just reflects that, with the prospect that growth will remain at current levels for a little bit longer than we had hoped, the unemployment rate will rise a bit from here. With labour market conditions being quite subdued, that will continue to weigh on the growth of wages. We have not pushed them down from here. There aren't indications either in the business surveys or, indeed, in our liaison which suggest that wages growth is going to change much from here in a downwards direction; but we just do not see much of a pick-up in the near term either—so not much change on that front.

Of course, the fact that wages growth is low by itself weighs on household disposable income. I think we have to recognise that employment is growing; it is just not growing fast enough, given the strong growth in the labour force—so that is positive. Employment has to be stronger, one imagines, than it otherwise would be if wages growth had not slowed as much as it has. That is an important adjustment that the economy is going through.

Mr HUSIC: The bank has reflected on that previously. The last time we met in August the governor made the point as well that it was having a beneficial impact. My concern is that you are waiting for business to invest and they are wanting to see a change in confidence, but wages remain low. We are in a low inflation environment, so you would think the cost of living would not have that type of impact, but I suspect it is wages growth that is weighing on consumers' minds.

Dr Kent : At the margin, I think that is hard to deny. If you look back at a long history of business cycles, it is very rare for the lead to come from wages; it comes from other things. Lower interest rates certainly push asset prices up, they increase wealth, they help encourage people to drop their savings rate a little bit and to run consumption stronger than income. That is what has happened in the past couple of years. That is what our forecasts have. It is not dramatic what we have seen so far and neither is it dramatic in our forecasts, but it is not normal for wages to lead the recovery, to then go to consumption and to then go to business investment. Wages usually come last.

CHAIR: We will go to David—our host.

Mr COLEMAN: Thank you, Chair. I take this opportunity to welcome everyone to Hurstville—our committee members, Governor, and all the local residents who are here today. It is good to see you. Governor, I want to ask you a question about public sector debt. We saw this morning's forecasts from PwC about the level of public sector debt that we are likely to get to in the absence of action to correct that trajectory of a trillion dollars within a few decades. We see in western European nations like Portugal, Greece, Italy and Spain very high levels of both public sector debt and unemployment. I was interested in your view on, broadly, the issue of public sector debt and its impact as it rises on economic growth and employment.

Mr Stevens : I saw that article, too. It is talking about debt being 50 per cent of GDP in 2037. To be honest, I think if we are going to have a problem with public debt it is going to be before 2037. We are not having a problem right now because our debt burden in the public sector by global standards is still low. But the other thing, of course. is that it is a very benign environment right now for borrowing. The Commonwealth of Australia can borrow today more cheaply than at any time since Federation, and that is a reflection of the fact that long-term interest rates in the global economy are probably, to the best that I can tell, the lowest in recorded human history. Sooner or later that will not be true anymore—and I do not know when or quite why. The point is that, right now, the environment is extremely benign but it will not always be benign. That is one factor.

There are perhaps other things I could go into. What we have said about public debt is that it is not going to kill us today, but this is the thing that has a trend that we want to change in the medium term, and I think it is important for public policy to get the debt trajectory onto a different trajectory from the one it is going to be on. I am not saying that there is imminent disaster waiting for us, but I think the path we are on is not the right path and it will prove to be a significant problem for us long before we get to 2037.

Mr COLEMAN: Thank you. Perhaps you could just articulate in a bit more detail: if we do not change that path, what the consequences are for the economy.

Mr Stevens : There is some empirical evidence. This is in dispute in the economics community, but there are some people who claim that the empirical evidence is that beyond a certain point public debt burdens are highly detrimental to growth—very high debt, that is: like 80 or 90 per cent of GDP. So, we are not talking about that. But here is the way I think about it. I suppose, as we have said before, the community has, through the political process, said, 'We'd like certain nice things, please', and governments of both persuasions have said yes. We have not yet had the conversation about how they are paid for. That still has to be had. It is proving difficult to do things that close the gap, as we have seen over the past year. So, reform here is not easy. But the reason we should keep trying while times are still good is that times will not always be so good. Frankly, the forward estimates that we all look at—and I have no other information than those—have the budget deficit getting gradually smaller, and it gets to balance out there in five years time or something. That all assumes, of course, that nothing goes wrong in that time. Now, we might be lucky enough to get higher than expected growth—I would hope so—at some point in that period. But, equally, economies have downturns, and if you are thinking over a five- or seven-year horizon and you are assuming that there will not be one, then I would argue that you might be being a little hopeful.

Now, suppose we did have a significant downturn in the economy. The budget deficit would go from two per cent of GDP to five or six, in a heartbeat. That would happen very quickly if we had a serious downturn. I am not forecasting that; I am actually trying to prevent that. But economies have downturns, and if we had one at some point, that is what would occur. At that point, we would then be adding to the debt much more quickly than we are at present. And whichever government finds itself in office when that has occurred—some of you will be there—will find much less discretion afforded to you by financial markets that day than you will be comfortable with if your budget deficit has already gone on to be a fairly big number. The amount of discretion we have right now is a lot. Conditions are very benign, and the debt is not large and is not accumulating rapidly. It is not quite clear what trajectory the deficit is on now, because it is difficult to pass things in the parliament. But in the scenario I am sketching out—which I am not predicting, and which I hope we could avoid but which you cannot just assume blithely can never happen—things would be a lot less comfortable. It would be better not to ever be in that position.

Mr COLEMAN: Just to be clear, then: what is the specific concern of the RBA about rising levels of public sector debt? And perhaps you could just articulate why you see that as a bad thing for the economy.

Mr Stevens : With the scenario I have given I will be accused perhaps of being too gloomy, and I do not want to do that. But why do you want a surplus? Why do you want low debt? Well, one of the big reasons you want it is that on a rainy day, when something big goes wrong and the government wants to expand fiscal policy to help the economy, like we did in 2009, you want the scope to do that. We had scope then, and we probably would have scope now if something really bad happened. But you do not want to be in a position where that scope has become limited because the financial markets accord you less discretion than they would today.

So, when people talk about reloading the fiscal cannon, this is really what they mean: they mean that yes, you use scope to use discretionary fiscal policy in the condition of a serious threat, but then you reload for another day. You do not know when that day will come, or even if it will. But if and when it does you want to be in a position where you could move in a strong way with the budget if need be, because you do not want to just rely on monetary policy in a really big episode like that. That is at least one reason, I think, that it would be wise to be on a better trajectory than we are on right now.

Mr COLEMAN: I want to ask you about productivity as well. Obviously productivity has a big impact on wages growth, which we were talking about a little earlier. And you did mention I think in one of your responses to an earlier question other things that could occur in the economy to encourage growth. So, I was just interested specifically around productivity and your views on what can or should be done in that area.

Mr Stevens : This is a question we have come to many times before, so I will give two bits of the answer. And this will sound like a broken record, but I think productivity growth has begun to improve. I think that is actually in the data now; we can say that. There has been enough of it for a few years to be able to say that yes, from a rather poor previous position, productivity growth has stepped up. One manifestation there is that if you take the economy-wide measure of unit labour costs—that is, nominal wages growth minus productivity growth, which is the cost to business—it is zero for two years, roughly. I think that is right. That is the combination of rather low wage growth. And wages are still growing at 2½, but productivity growth has improved. So, that is very good. There are a bunch of reasons for that. It needs to continue.

In the broader sweep of things, what do we do about productivity? Well, I say again, as I have said so many times: there is a body called the Productivity Commission, and they have PhDs working on this all the time. They have put out a lot of stuff. If we are serious, we go and look at that and we try to do what they have said. It is hard. I guess if it was easy it would have been done. But I cannot do any better than that.

Dr Lowe : The things on the list are about making markets competitive, increasing the skill level of the workforce, improving infrastructure and reform of competition policy. There are a lot of things that can be done; they have been listed for us. I think that is where the answers are, and it is a matter of just getting on and doing them.

Mr COLEMAN: I am going to change tack a bit, to interest rates, and I think this is an issue that we have touched on before, but perhaps not in detail. To what extent to you think there is sufficient competition, not only in the mortgage markets but in credit card markets and other markets that are affected by the interest rate in Australia? And are there any policies or regulatory provisions that could be improved to have a downward impact on interest rates as charged to consumers?

Mr Stevens : Yes—assuming lower interest rates are always better. That is an assumption that is typically made and not one I would necessarily share. I think there is a lot of competition in the mortgage market again. It is very clear that margins have come down. A little-remarked-on fact was that the margin between the mortgage rates and the cash rates shrank. That is, mortgage rates fell, without the cash rate moving—by nearly a whole monetary policy easing's worth—in the period from August 2013, when we started to sit still, and this month. I have not read any commentary about that, but that is a fact. Competition has done that. Non-bank lenders now again have quite good access to the securitisation market. Competition has increased there. I do not think there is any problem of no competition in the mortgage market.

In the lending for business, it is quite competitive to big business, and margins there have also come down. Small business—that is a harder area. I think they are trying harder. The banks do want to lend more to small business. They will not do it at the sort of terms they did in 2006. The risk spreads are wider now. But I think that is the reality of the world that we live in. Nonetheless, the overall costs of loans to small business are as low as they have been in a very, very long time, and the banks do want to lend. So I think competition has increased there. But, of all the areas you might choose to look at, if you are worried about competition in lending, I do not think it is worth spending any more time, frankly, on mortgages—there is plenty of competition there. Large business have other sources of debt anyway. Small business—that is probably where you can most easily make the argument that you would like more competition. How you do it, how you create it, I do not have a silver bullet.

With respect to credit cards, those loans typically do not vary much at all in either direction with the cash rate. But what happens there is that you get a cheap offer to take your credit card to another bank. That is really where the competition shows up, it seems to me. I do not think we should be encouraging people to borrow on credit cards. It is an extremely expensive way of borrowing. By and large, credit card debt is not a major phenomenon in Australia. It is a very small share of household debt.

Mr CONROY: Thank you again for appearing. I think at our March hearing last year, you had unemployment peaking at 6.25 per cent. Could you tell me what you have unemployment peaking at now?

Dr Kent : Our latest forecasts would have it close to about 6.4 per cent, which of course is the number that is just printed. But, as the governor said, we cannot focus too much on the latest monthly number all by itself. The trends in unemployment are still consistent with that. We see the unemployment rate trend continuing to go up gradually for a few more quarters to about 6.4 per cent or something of that order of magnitude. We published, for the first time, a chart on that in the statement with some range of uncertainty around that based on our forecasting history. You look at that very wide range around the central tendency and see that it shows that many things are possible and forecasting is very hard.

Mr CONROY: I am going to be very careful here, because a range is always dangerous and it is very responsible to have a range, but if the animal spirits that we have talked about for the last six months do not kick in, what is the top end of that range of that uncertainty?

Dr Kent : It is pretty wide.

Mr Stevens : It is a very wide range, because the forecast error history that you use to compute the range takes into account not just the period where unemployment has been relatively stable, which is the last 10 years, but bigger, so it is a very wide range, of probably several percentage points on either side.

Dr Kent : Yes, several percentage points. The numbers are here on the table about the range. The range around the central estimate is 2½ percentage points, two percentage points.

Mr Stevens : The point of putting the ranges in the forecasts—some people will do what you might be contemplating and think, 'Gee, it could go to seven or eight per cent.' Other people, who want to make another case, will say that it could fall as low as some other number. The point of putting the ranges in is just to emphasise this game we play in the forecasting community of, 'The central forecast has moved by this much.' Frankly, forecasts are not very good. We have to use them and we have to respond to changes in them, but we have to keep in mind that these forecasts have a very wide margin of uncertainty around them. When we discuss forecast changes, it is very important—and that is the point of the fan charts, as they are called. I think you appreciate that, but I want to emphasise—

Mr CONROY: Yes. I am not seeking to generate a debate about four per cent versus 8.9 per cent unemployment. I am just trying to get an idea of the degree of uncertainty, because last year we were talking about a peak lower than where we are now, and we have the animal spirits that we discussed in August not kicking in yet—hopefully they will kick in, but they are not kicking in yet so we have not seen the replacement for the mining investment other than perhaps residential construction. I want to get an idea of the range. In your earlier comments, you were optimistic that while unemployment was edging up, employment was increasing just slower than the population. Are you at all concerned about the fact that average hours are declining and in fact total hours worked in the economy are now lower than the trend figure for the middle of last year, and that the underutilisation rate of labour has increased from 12 per cent in 2010 to nearly 15 per cent now? The headline unemployment rates might not be too bad, but there is less work in the economy in terms of hours, both average and absolute, and the underutilisation rate is increasing.

Mr Stevens : Yes, I think that is a concern. The picture that that paints is that there is spare capacity in the economy. We could debate how much, but it is clear there is a tangible enough amount of it that we ought to be able to grow above trend for a couple of years to take that back, and we have said that. The whole picture when you put all these bits of labour market things together I think says vacancies are rising, but I would like to see them rising quicker and jobs creation is occurring but really we want that to be more. As you say, average hours have gone down so there is certainly more capacity for labour input to grow if the demand for it is there. We actually need more growth in the economy to use that. That is the fact.

Mr CONROY: I appreciate that. On your forecasts, it is fair to say the Reserve Bank works quite closely with Treasury on forecasts and you would expect them to move relatively uniformly. You are working off the same data; it is people trained in the same universities, you use the same models.

Mr Stevens : You are not suggesting group think, I am sure.

Mr CONROY: No. You have a lower GDP growth rate for this year ending June this year than MYEFO now has. I am not asking you to speak on behalf of the Treasury, but one would expect their GDP growth rate to be revised downwards.

Mr Stevens : Do you want to comment on the differences?

Dr Kent : The discussion we just had about the range of uncertainty is perhaps the most pertinent one because there is a wide range of uncertainty on GDP growth as well. You are right, there is a very slight difference but it is slight between us and Treasury—a quarter of a percentage point. We also have to see what the world delivers us in economic developments and data between now and when the Treasury next publish a set of forecasts in May, and much can happen. I would not emphasise the difference; they are very similar and they are very similar to the sorts of forecasts out in the private sector—the consensus forecasts.

Mr CONROY: I was interested in the debt discussion earlier. I remember when Joseph Stiglitz was here late last year and he made the point that, in his view, economies that used austerity measures during a global financial crisis ended up with higher debt levels than those that had successful stimulus packages because the contractionary nature of their austerity measures obviously reduced the government bottom line. I am not claiming anyone in this country has adopted full-blown austerity measures. Is it a legitimate argument that, within reason, it is better to grow the economy to pay down debt than to cut too deeply, if that is contractionary?

Mr Stevens : There are points you can reach where you cannot cut your way—but you want to grow the economy anyway, because all of these dynamics will get easier, or less difficult, under conditions of growth. There are two points to make about so-called austerity. The first is that some of the countries that found themselves having to undertake austerity really actually did not have a choice. They were not going to get the market access to keep running larger deficits, certainly not at an interest rate that was viable. So the thing feeds on itself. If the markets do not trust you, the price they want to charge you to lend to you is such that that itself makes your budget unsustainable. So, some of those countries had, I would argue, not a lot of choice in the markets. We are not in that position. I am not claiming that we are, but you do not ever want to be. That is the first point.

I guess the second point is to take the example, say, of the UK, which I think had pretty tough budgetary measures, but is actually now growing quite well. It was very painful. I am not suggesting we necessarily should be doing what they felt they had to do. I am not sure that the evidence is unambiguous that taking the fiscal medicine in a sensible way, even if was a bit tough, did not get them on the right path.

Mr CONROY: Finally, regarding the Reserve Bank reserve fund and the $8.8 billion injection from Treasurer Hockey, what dividend has been paid back to the government since that injection?

Mr Stevens : I do not have the annual report in front of me, but there was a dividend declared for the 2013-14 year, of which the Treasurer decided to take half and retain half—so he will get that other half. I do not have the number in my head, but I can look it up in the break, though, as it is not hard to find.

Mr CONROY: Would you mind. I would be interested—

Mr Stevens : It is in the annual report. It is all public. I just do not have it in my head.

Mr CONROY: If you could come back with that after the break.

Mr Stevens : Certainly.

CHAIR: We will now have some questions from some local school students.

Tabitha Cartledge, Innaburra School, Bangor : With interest rates at record lows, is there a danger of first-home buyers being caught in a debt trap where they are being forced to borrow excessive sums of money simply to get into the property market, only to then be trapped further when interest rates change and they are forced to pay more money, but they do not have it because the rates have changed?

Mr Stevens : That is a good question. It is a very relevant consideration, in my opinion, not just for us but for public policy generally, how easy it is for first-home buyers to get into the housing market. To be honest with you the thing I would worry about less is that they take on too much debt, and then if rates rise at some point they cannot afford it, because the banks will test that. The banks typically will test that you can withstand at least a two percentage points rise in interest—maybe even a bit more at these very low levels. That is one of the lending standard metrics that APRA is checking up on right now. The biggest enemy for first-home buyers is rising house values, as the other 97 per cent of the population bids up those prices. That is a very relevant question. In my opinion this is a social issue of considerable importance: how your generation will afford to house itself if you want to live in a city where the supply side of the market is unduly constrained and where prices continue to escalate. That is a serious problem. the answer does not really lie with us, though. We cannot change that much at all. The answer to those problems, in my view, lies in more innovative and more flexible use of the land that we have so that the marginal cost of adding to the stock of dwellings is lower. That is what we need here. So it is a very good question. We certainly do not want to draw first-home buyers, or, for that matter, any other borrower into borrowing more than they should. We have always said to be careful et cetera. It is a good question.

Ryan Morgan, Marist Catholic College, Penshurst : Firstly, I would like to thank you for the opportunity to ask a question. I represent my school, Marist Catholic College, Penshurst. Housing prices are at an all-time high in Australia. The most recent interest rate cut has clearly boosted the confidence of home buyers in Australia even further. What steps are being taken to protect the next generation of first-home buyers, such as me, who will struggle in the market.

Mr Stevens : It is a good question. This question dovetails with the previous one. The Reserve Bank cannot really take those steps. The steps that need to be taken to house your generation at a manageable price really are more availability of supply of dwellings, which includes developable land, and better transport infrastructure. The deputy governor could probably add here, because I know he has views on this. But it is the supply of well-located, developable land that lets you get to your job on transport. If we are going to have manageable costs for housing, these are the sorts of things we need. I cannot make that happen, obviously. Those are very important questions that go way beyond the short-term considerations we have been looking at here.

Dr Lowe : House prices are high not because it costs a lot to build the actual house. It is the land that it sits on. If we are going to make housing more affordable, then effectively we need to increase the supply of well-located land. It is hard to do that, because the land supply is fixed. But through investment in transportation you can make much of the existing urban footprint have better effective location by making it more accessible through transport. So, I think as a society one of the things we could do is invest more effectively in transportation to increase the supply of well-located land and put downward pressure on land prices and make housing more affordable. So it is quite an indirect route. But, ultimately, if we are going to address this problem, as the governor said it is not through interest rate policy; it is through the structural policies that affect land prices.

Anirudh Banargee, Georges River College, Oatley : I would like to thank you for giving me the opportunity to ask a question. Several economists have called for a more diversified export base, as Australia has a very narrow export base. Given the recent fall in commodity prices, which area should our economic leaders focus on in order to broaden our export base?

Mr Stevens : That is an interesting question. It raises a couple of important points. It is true that Australia has a few major commodities that are very important in our export base. It once used to be agricultural commodities—wool and wheat. These days it is iron ore, coal and prospectively gas. They are really large ones. It is not actually true that Australia's economy is not diversified. Actually, the domestic economy, which is most of it, is reasonably diverse compared to many others, but it is the export basket that is particularly commodity heavy.

Now, it is an interesting question whether it should be a goal of policy to diversify that. One argument in favour would be the one you raised: that, because commodity prices are highly variable, maybe we want some diversification away from that. Of course, manufactured prices can also vary. It has been to our advantage as a country in the past decade to have this particular export mix, because the prices for these things have been absolutely sky-high, and, from a historical perspective, they still are pretty high even today—which is not to say they could not fall some more.

You could argue, I think, that we have had an incredible stroke of luck to have the particular endowment of commodities in the ground that we have had in these past 10 years. Economics would say, I think—and I have got two MIT PhDs here so, if I get this wrong, they can cut me off—if you have an endowment, a set of things you have a comparative advantage in, use them to the maximum extent possible—that is the way to be richer. If that imparts variability to growth because commodity prices fluctuate, there are ways you can manage that. A floating exchange rate is one, but not the only one.

CHAIR: Thank you students.

Mr Stevens : May I come back on the dividend, Mr Chairman? I am sorry. I just did not have the figure in my head. $1,235 million was payable from 2013-14, and half of that—$618 million—was paid in August. The remainder will be paid in August this year, so it will affect the budget for 2015-16. Let me just stress that the calculation of what the dividend is is set out in the Reserve Bank Act. It is not a discretionary thing. It is in the act, and the amount was computed precisely in accordance with the act: 1, 2, 3, 5.

CHAIR: Thank you.

Proceedings suspended from 11:02 to 11 : 18

CHAIR: We will resume the hearing. Mr Smith.

Mr TONY SMITH: Thank you, Chair. I join with others and congratulate you on your position. I have a range of questions. I might start with the governor. In your opening statement today, towards the end when you were speaking about the effect of monetary policy, you stated:

A decade ago, when there was, it seems, an underlying latent demand continually among households to borrow and spend, it was perhaps easier—

for a reduction in interest rates—

to generate additional demand in the economy … Today, that channel may not be quite as effective … Nonetheless, we do not think … that monetary policy has reached the stage where it has no ability at all to give additional support to demand …

I think that is an important point. Is it fair to say the flipside of what you are saying, Governor, is that with interest rates at the levels they are, you are highlighting the limit and that the structural changes needed to the economy cannot be avoided in the medium and longer turn?

Mr Stevens : I think it is fair to say that monetary policy is no silver bullet for everything that is wrong, and that surely is amply demonstrated around the world. We will do what we can do within the limits of our mandate and our powers, but long-run sustainable growth is not going to come from manipulating interest rates or, in other countries, printing money. It is going to come from some of the other things that we talked about earlier: innovation, productivity and risk-taking, in the best sense of that word, by which I mean the really entrepreneurial people in the economy who say, 'I think I'll start a business or take on a worker or try a new product or a new market, and I'll use some of this cheaper money to help me do it.' This is kind of hand-wavy stuff, but I see several of you nodding. That is ultimately the source of the sustained growth here. Monetary policy is about demand management within the cycle. It is not a perfect instrument, but we use it as best we can. But those other things, which do go to structural matters, among others, are the source of long-run prosperity.

Mr TONY SMITH: You mentioned innovation, and we had a discussion at the last hearing about the importance of innovation. I would like to take you to the small business sector—which is obviously a critical part of the economy in terms of numbers employed and capacity for future growth—and particularly to some of the positive stories that we see in the papers on successful start-ups and businesses growing very quickly, with some exporting within a short period of time. I know Dr Lowe focuses a lot on that. In the bank's thinking, what other barriers can be removed or what other policies could be pursued to assist that in the transition in the economy?

Mr Stevens : Do you want to answer that, Philip?

Dr Lowe : Yes. This is not our core area of expertise, but you cannot help but have the very strong impression, when you talk to businesses around the country, of just how much things are changing and that changes in technology are really opening up tremendous possibilities. The issue that we are all struggling with is how we as a society grasp those opportunities. I think you touched on this, and the governor has touched on this before: how do you build a culture where innovation is really pre-eminent in the national business culture? I think it is about the incentives offered through the taxation system, and the employee share ownership changes there are a step in the right direction. It is about how you create funding mechanisms, particularly for start-up businesses, because, if you talk to any of these entrepreneurs, venture capital is a real issue. How do you create the ecosystems where business and universities work together? A lot of the people who review this area say that is something that we are not doing particularly well. How do you make sure our markets are competitive? Because, at the end of the day, it is competition that drives people to find better ways of doing things. How, also, do we as a society invest in the STEM skills of science, technology, engineering and maths? There are fewer students studying those subjects in our schools; and, while our international scores are fairly high, they have tended to drift down a bit. Much of this innovation ultimately comes through technology, so our ability to keep producing the students that can drive the technological improvements is a really critical issue. As I said, these are not issues the central bank has any actual expertise in, but it seems to me pretty clear what the areas that we should be thinking of are. Ultimately, it is up to the society and to the parliament to work on these areas; to try to create the culture of innovation that will drive the next increase in our living standards.

Back to one of the questions we were discussing before about the diversity of our exports: I see a possibility for us of being able to build on the natural advantages that we have to become innovative in a whole range of services in particular and in some specialised parts of manufacturing. But I think it needs a concerted effort to build a culture right across these various elements that I just mentioned. But how you actually do that, a central bank is not the expert in that.

Mr TONY SMITH: No, but that is nonetheless still very useful and it dovetails into my next question about the future possibilities within our region. We have spoken about some of the traditional exports and you have just highlighted some of the potential areas into the future. If we look at the recent US growth, what are some of the major drivers of that? And does the bank make an assessment of some of the future drivers of GDP growth for Australia?

Dr Lowe : Ultimately, GDP growth comes from growth in the size of the workforce, growth in the size of the capital stock and the efficiency with which we use the capital and labour that we have. It is really back to the issue that David Coleman was asking: how do we drive that productivity growth to make sure that we increase the efficiency with which we use labour and capital, where there is a long list of things that we could do, potentially?

You asked about the US, but I think developments in Asia here are probably ultimately more important for us. Because there are huge markets there; huge growth in per capita incomes; huge demand for services, and we are very good at producing a whole range of services; and huge demand for clean food, and we are very good at that. So it is the growth in Asia and, particularly, our links with Asia. One of the things that I have spoken about before is the people-to-people links. Eight per cent of Australians were born in Asia. And we have hundreds of thousands of students from Asia studying in our country, often going back to their own country and helping build business relationships. That gives us a tremendous base upon which to build, and it is how we best take advantage of that base that we have. There are the questions but, ultimately, they are not for the central bank; they are for the parliament.

Mr TONY SMITH: But we are interested in your observations, nonetheless!

Dr CHALMERS: I add my thanks to those of my other colleagues for you coming along today. I want to spend a little bit of time on unemployment—given the recent commentary and the focus on unemployment. Would you agree that Australia stands out when you compare us to countries like the US, Germany, Canada, Russia, Brazil, Japan and others, in that our unemployment rate is a bit higher now than it was during the worst part of the global financial crisis?

Mr Stevens : That might be true, I do not have the figures of the other countries in my head. Of course the unemployment rate here in the global financial crisis was not that high, but it sure was in a few of those others—and that is a good thing.

Dr CHALMERS: In your Statement on Monetary Policy, you talked about how unemployment will rise further and peak later than earlier statements from the bank. Can I get your comments on how concerned you are specifically with youth unemployment as part of that analysis?

Mr Stevens : Chris, can you perhaps comment on the youth dimension.

Dr Lowe : It is certainly a significant concern. The youth unemployment rate among 15- to 19-year-olds is pretty high. The latest number is somewhere around 20 per cent. You want to be careful not to assume that that means one in five people of that age group are unemployed. It means that one in five people who are actively looking for work in one way or another are unemployed. I certainly do not want to in any way diminish the fact that it is very high and rising, but I think we also need to think about some of the reasons why it has risen. It always moves up when the aggregate unemployment rate rises. This time round maybe it has moved a bit higher still. I think one of the possible reasons for that is that quite a lot of the extra youth who are unemployed are actually looking for part-time work and they are in education. So there have been various changes making it easier to get into higher education and also requirements on young people nationally to be in education more so than in the past. So quite a number of those extra unemployed youth are engaged in some study or training but they are also looking for some part-time work. It is not to diminish the fact that it is a significant concern.

Dr CHALMERS: Notwithstanding the pick-up in the last figure, generally over the last 12 to 18 months confidence has been quite low in the economy. How does that lower confidence flow through to the real economy in relation to unemployment and particularly youth unemployment.

Dr Kent : I do not know that it is specifically tied to the youth labour market. Again, going back to my earlier comment about where the economy has been tracking relative to our earlier forecasts, the measures of things like consumer confidence and business confidence are around average. There has been an improvement, particularly on the business front, compared to where they had been in middle to late 2013; that is on the business side. Consumer confidence moves around a bit and it is around average now, and that is lower than it had been. I think those are the sorts of conditions where we say that growth is not necessarily going to be weakening in terms of household expenditure or the business side of things but just that it is not going to necessarily be picking up any time soon, not from the current growth rate.

Dr CHALMERS: With respect, Chris, consumer confidence is down 16 per cent since September 2013. That is not a small change.

Dr Kent : Right. But I think the longer consumer confidence and consumption growth had been pretty weak up to 2012, if I am remembering rightly, and then consumption growth lifted, confidence lifted and it has pulled back over the course of the past year or so, but it is around average. I think the main point I am trying to make is that, whileever business conditions, business confidence and consumer confidence are around average, it is harder to see a near-term lift in the current growth rate.

Dr CHALMERS: In relation to the statement on Friday that referred to a weaker outlook for GDP growth, how much worse would that be were it not for the support that is being provided by the substantially lower oil price?

Dr Kent : That is very hard to judge. We said in the statement that it is having a significant effect on the outlook. We can already measure in things like the CPI the direct effect of the lower fuel prices. It has contributed to the CPI, making it lower by about a quarter of a percentage point than it otherwise would have been. That is boosting household disposable income. We think about another half a percentage point is coming down the line in the March quarter, if fuel prices hold at their current rates. Of course, the question is how much of that extra boost to disposable income coming from that source alone do consumers choose to spend. One imagines that they will spend at least some of that. So it is helpful; how much? Time will tell. We have assumed some of that three-quarters of a percentage point boost to their disposable income will be seen in the form of stronger consumption than we otherwise would have had.

Dr CHALMERS: Do you agree with the analysis that was published in the last week or two—in terms of the sort of magnitude decrease in the oil price, and how that flows through to the petrol price and into the pockets of consumers, as you have just mentioned—that said that the magnitude that we are seeing is, according to Deloitte or Fitch Ratings, greater than the impact of the quarter point interest rate cut that you announced in the last week? Is the petrol price benefit bigger than an interest rate cut benefit to consumers?

Dr Kent : It is of a similar sort of order of magnitude. It might be a little bit more than 25 basis points, but I think that you have to be very careful about that analysis, because often what they are doing is just calculating the effect of the lower interest rates on households cash flows given their net debt position, and interest rates work through so many other channels. They work through movements in asset prices, and we have already seen a response over a long period of time, not just in Australia but elsewhere, to very low interest rates. They have some effect on exchange rates, no doubt. They work by encouraging people to save a little bit less and spend a little bit more. So those other analyses making those comparisons usually just do a very simple comparison on the cash flow effect.

Dr CHALMERS: I have two more questions, both for the governor. The first picks up on a question that Pat Conroy asked you in Brisbane. Are you worried, with interest rates so low, that older investors might be chasing any kind of yields in the system and therefore getting into riskier investments that might not be properly understood?

Mr Stevens : I think there is always that risk when you have declining rates, particularly this low. Part of how monetary policy works is it prompts risk-taking. The risk-taking that we ultimately want at the end of the chain is the real entrepreneur type that we talked about in response to Mr Smith's question, but along the way there is the kind that you are talking about. That is part of how it works. To a point, I think that we have to accept that some of that will occur. In my mind, it is one of the things that we have to try to kind of balance. I still think that lower rates are expansionary for the economy, but most of the mail that I get now, particularly in the last week, is from the retired folks who are saying, 'Look at my income. What are you doing here?' and I feel for them. We are acutely sensitive to the fact that some of these people will be prompted, possibly, to go looking for yield and not realise that with high yield comes more risk. So, in some sense, that is how monetary policy works, but it is a kind of countervailing argument for those who say, 'Well, just keep slashing the rates.' There are potential downsides that you can have. We have to keep that in mind. I am not sure that we can stop it; it is part of the mechanism.

Dr CHALMERS: From memory, you have articulated a few times over your tenure that, ideally, fiscal and monetary policy would work hand in hand rather than at cross-purposes. Is that still your view, in an ideal world?

Mr Stevens : Well, who would argue for fiscal policy and monetary policy to work at cross-purposes? No, I would not argue for that. I do not, at the moment, feel any particular conflicts, I must say.

Mr CRAIG KELLY: Welcome to Hurstville, Governor Stevens, Dr Kent and Dr Lowe. I would like to pick up on the comment that you made, Governor Stevens, that forecasts have a wide range of uncertainty. About 25 years ago I was sitting in the building next door having a beer. It was the old St George rugby club. If I had forecast forward to say that we would be sitting here today at a hearing before the Reserve Bank Board—I think that is an uncertainty no-one could have predicted. We have seen it in oil prices—a fall which I think no-one predicted. Given that, where do you see the bond rate in decades to come?

Mr CONROY: Just let me get my life savings!

Mr Stevens : Firstly, I actually spent quite a bit of my childhood around Hurstville, because my grandparents lived not far from here. But I would not have made the forecast either that we would be sitting here—so there you go.

The price of oil has fallen 50-odd dollars in a short time. Someone will claim that they forecast it, somewhere, but I am not aware of anybody who picked that. We could probably debate at some length the factors behind that and whether it will persist, and so on. But your point, I think, is things are inherently very hard to predict. That is absolutely true. This is why, as I said earlier, we have tried to put more emphasis in our forecasts that we publish on ranges—even those ranges, truthfully, are a bit ambitious in terms of how narrow they are.

Where will the bond rate be in the future? One has to observe regarding long-term rates, as I said earlier, that the government of Japan, which has a debt to GDP ratio in excess of 200 per cent, borrows for about 50, 60, 70 basis points for 10 years. That is an amazing combination. Somehow, at some point, I cannot help but feel that these very long rates that are literally as low as they have ever been recorded, ever, must someday be higher. But we would have said that a year ago, two years ago, and they are in fact lower than they were then. So it is hazardous to predict. Someday they have to be higher, especially given the amount of public debt which is on issue in so many countries around the world. But I cannot predict for you quite how that will come to pass, or when. My five-year horizon: surely they have to be higher.

Mr CRAIG KELLY: Given those levels of uncertainty about what our bond rates will be that the government can borrow in 10, 15 or 20 years time, if you look at that PricewaterhouseCoopers report today, they are talking about $1 trillion worth of government debt in 2037, $2 trillion by 2042 and they are also talking about state government debt increasing above Commonwealth government debt in just 15 years time. Aren't we taking an enormous risk, in fact playing a game of Russian roulette, by loading this debt up that future generations may have to pay a much, much higher bond rate on?

Mr Stevens : It is a complex answer to that question. My position on the public debt is as I outlined earlier: this is not a crisis immediately, it is a trajectory that we should be looking to change for the medium term. Since it is hard to do, I would be starting ASAP with measures that start small but build up over time. We have said that consistently.

In truth though, if the capital markets want to lend to you incredibly cheaply, some people would argue, 'Well, you should take that money and do something useful with it.' The key question is: can you use it usefully? Is there a set of projects that have a higher return than the rate at which you can borrow? If the capital market will lend to you at 20 years, well, in principle, if there is a 20-year use for the money that helps service the debt and you have it locked in—and that is what a fixed interest rate is, it is locked in—that case can be made.

So there are subtleties here. But, for the recurrent part of the budget, where we are paying for pensions, public servants' salaries, defence and all these things that are recurrent every year—which we do need to balance over time—we need to get that headed, over time, towards a better trajectory than it is presently on. We have time to do that; we should use that time. That is my position. I do not want to weigh into the politics of this any further than that, really.

Mr CRAIG KELLY: You say there is time but that we cannot put these decisions off forever. But there must be some urgency about starting to change the trajectory we are on.

Mr Stevens : We are not in a position right now where the capital markets are saying the borrowing rate for Australia is 10 or 15 per cent, like they are for Greece. It is 2.3 or four per cent or something; it is very low. So we are not being given, by capital markets, the immediate signal, 'You guys've got to have massive austerity right now,' but capital markets change, conditions will not be this benign forever, and they can change quickly. So, while we have the time and the flexibility, now is the moment to think about and talk about and enact measures that will gradually get us onto a better trajectory than the one we are otherwise going to be on. That is what I am saying. The going is good now; use that good going to have a course change that will in due course get us onto the better track. Do not wait until the bad signals from the markets come. I have no idea whether that will happen anytime soon—probably not, but you do not want to be in that place.

Mr CRAIG KELLY: On the international comparison of bond rates, even though in Australia we are down to historic lows of, I think, about 2½ per cent, the bond rates that are paid in Japan and many European countries are substantially lower than what we pay in Australia. Doesn't that make the servicing costs of our government debt much higher than elsewhere in the world? Therefore, when we are making comparisons of debt-to-GDP ratios without looking at the borrowing costs, we are not making very accurate comparisons.

Mr Stevens : If you want to compare debt-servicing costs, you can multiply the debt by the interest rate across countries and get the number. Japan are borrowing at a third of our rate, but they have a lot more than three times the amount of debt we have. So I think they still have a much more difficult position than us, and it is amazing that the capital market will lend to them at that rate. Actually, the reason that is happening, in part at least, is that their central bank is the one buying the debt—not something we are proposing to do here. So I think it is correct to say that you have to think about the cost of debt service. This is not an unmanageable problem for our country at this point in time. My message is simply: we are not on the right track, we are not headed towards imminent disaster, but we want to be on a different trajectory than the one we are on, in time; and we should use the time we have, while there is flexibility, to have the adult conversation—which has to be done in the parliament—about that.

Mr CRAIG KELLY: You mentioned the monetary policy becoming less and less effective over time and perhaps the importance of small business, as well as your concerns that small-business lending does not seem to be as competitive as big-business lending or mortgage rates. Could you expand on that just a little bit? I am concerned that small business has to compete against large business in this country. Even though there are low interest rates historically, if small businesses are competing against larger businesses and paying much higher interest rates, is that a concern?

Mr Stevens : Well, I think it is a fact that many small businesses are riskier than some of those larger businesses; and, I am sorry, but that means you have to pay more for finance. That is because risk and return have to go together. I do not see a way around that, not while it is left to market pricing.

On monetary policy being less effective, the point I was making is a simple one. I think there was a time between the early 90s and about 2006 when the household sector was basically in this long period of gearing up its balance sheet. I think in that world people were very keen to spend—save less; spend more—and, if we lowered the price of borrowing, I think the economy was quite responsive to that. It may still be as responsive as it was. I personally rather suspect that dynamic is not as powerful as it used to be. It does not mean monetary policy has no effect. There are other channels that it has effect through, so I am not saying there is nothing we can do. I just make the point that in certain ways it might not be as powerful as it once was, and more generally—and there is ample testimony to this globally—monetary policy cannot just dial up the growth we want just like that. We can help, and we will do what we should and what we can. But we are not the whole answer. That is really the point there.

For small business there is, in many respects, inherently more risk—and that has to be priced. If we do not like that, the only solution I could see would be for the government to take the decision that it was going to offer a subsidy. Now, I am not proposing you do that, but I do not see that there will be a time when small business does not pay a bit more than the average big business for funding, because inherently the risk is different—and risk has to be priced.

Mr BUCHHOLZ: I will need to follow up later.

CHAIR: Thank you, Craig.

Mr HOGAN: Thank you, Chair, and congratulations on your appointment. I would like to thank Mr Coleman for his very warm welcome to Banks, as well. I do not know if you are aware, but there is potential for the next public meeting to be in the seat of Page, and I promise you all a very worthwhile experience there.

Mr Stevens : We have already booked our travel.

Mr HOGAN: Fantastic! That is great news. It is going to be good for the local economy.

CHAIR: I have self-transport too.

Mr HOGAN: Thank you again for appearing. I would like to touch on the previous questions about bond yields and the bond markets. Do you think potentially in some markets—obviously not all markets—some bond markets have very high prices—there is what may be termed a 'bond bubble'? Do you think there is a potential bond bubble happening?

Mr Stevens : Well, what is the definition of a bubble? It is typically where a price moves above a fundamental. People get drawn in because it is a speculative thing. Often this is debt-financed—though not necessarily. Then one day people wake up and realise the actual value of this thing is nothing like what is being paid, and they are out of there—and crash. Is this a bubble like that?

The most sophisticated investors in the world have been piling into bonds, but that is not a guarantee that it is fundamentally driven. I think, at heart, we have two phenomena. Firstly, central banks have been buying bonds of their respective governments as a way of trying to impart stimulus to economies. The main way that works is it lowers longer-term interest rates, which then lowers longer-term interest rates to the private sector—and hopefully that prompts investment and so on. So central banks have been doing it. The Fed has now stopped. Even since they stopped, US bond yields have gone down. I think they are now lower than when the Fed stopped buying.

The other thing that is happening is that many people in the investment markets are genuinely very worried about the prospects for growth in various advanced economies. The real interest rate on safe assets has been bid down as a response to that. Whether those fears are valid or not, I do not know. But those sorts of factors are at work. At some point one would expect that this will reverse. But, as I said earlier, I cannot tell you when. It is a very strange world in which we live. Do you guys want to add anything? I probably have not explained that very well.

Dr Lowe : It is a very strange world. If you think about German government securities at the moment, a 10-year security is offering 30 or 40 basis points and the ECB says its inflation target is two per cent. So, if the ECB delivers on that inflation target over the next 10 years, people who are currently purchasing German government securities will in real terms lose almost 20 per cent of their money. The same is true in Japan and in most Western countries—including ours now, actually, I think. The bond yields are less than the central bank's inflation targets, which says, 'If you buy these securities, over 10 years you will lose money in real terms.'

That should not be sustainable. If that is what actually happens, then I think it is a very depressing world because it says the underlying return on new capital investment in these countries is such that you cannot, on risk-free assets, earn positive rates of return. I am more optimistic about the prospects of the world than that, so I think at some point these bond yields will increase. Let's hope they do, because it would signal that the world economy was doing a bit better and that the underlying return on capital investment was more positive.

Mr HOGAN: I suppose there is also another reason that yields may rise and we are seeing that in some other countries. We touched on Greece earlier. Obviously financial markets are jittery at the moment in Europe, especially on bond yields. That is not so much about the positive ramifications of increasing bond yields because of growth but increasing bond yields because of the market's suspicion, if you like, about their ability to pay back. What concerns do you have or potential ramifications do you see for us with the Greek situation at the moment?

Mr Stevens : It is exceedingly difficult to answer that question. It is a highly fluid situation over in Europe. If Greece were to leave the euro—I cannot believe that is actually in their interests, but if they did—then I think that would potentially be very disruptive for global markets because it would potentially raise again the whole question of the euro. I cannot believe the Europeans will allow that, but these things are not necessarily completely under their control.

The most likely outcome, I suspect, is that the Greeks and the European partners will find some way of keeping the show on the road for another year or two. The euro will carry on. They will have very low rates in Europe for a very long time. They will be doing so-called quantitative easing for some years. There will be spillovers of that around the world, which we may feel to a greater or lesser extent, just like there are spillovers when other countries do it. That is probably the good scenario, really.

Mr HOGAN: I have two more questions, if I could. You have touched on them both before, but perhaps you could elaborate a bit. We have spoken a lot about interest rates and monetary policy. As we know, in the past it was almost the main game at some stages, about a stimulatory or a contractionary instrument. You are saying now that its impact has lessened. How would you rate it? I think we have had a 35 per cent fall in the dollar. We have spoken about falling oil prices, but we now have a currency that has fallen 35 per cent over the last year or so. How would you rate that as a stimulatory thing relative to monetary policy?

Mr Stevens : It is clearly expansionary compared to the alternative of it not having happened. I think we will see the effects of it. The thing to remember, of course, is that the 30 per cent fall in the exchange rate would be on the US dollar from its absolute peak of nearly 110c to where we are today. We have not fallen as much against other currencies, but still we have had a material change. So, other things being equal, that is expansionary for the economy. Of course, other things were not equal, though.

The world economy has delivered us a decline in terms of trade et cetera. That is the force to which the exchange rate has been responding, as it should. It is doing roughly what it should be doing. It is imparting the expansionary impetus that helps to offset the contractionary influences of these other things on us. The question then is: what is the net effect? That is the one that is hard to answer. In the end, the way we answer the question is by asking, 'What does the forecast say?' The forecast says we will grow in time or pick up to above trend—but not yet.

Mr HOGAN: Obviously the role that you three gentlemen have is an interesting one in our economy and our society. At the moment we have falling commodity prices, increasing debt levels, lower interest rates and lower currency rates. When you wake up in the morning and go to work, what at the moment would be the one area that you would flag as your major concern with what is going on in our economy and the world economy? What is your No. 1 red flag at the moment?

Mr Stevens : I will invite my colleagues to give you their fears. Mine—and this is another broken record—is that we have a capacity here to talk ourselves into gloom and doom that we do not really need. We have a significant lack of confidence—I think more in the business community than among households—to expand, invest, hire and innovate. With our instrument, we do not have something directly connected that will change that. Interest rates maybe help, but we do not suddenly spark animal spirits with lower rates and, for that matter, we do not kill them with higher rates either. To my mind, that pervasive sense of caution and feeling you do not want to take a risk is the thing I worry about most when it comes to getting growth.

Dr Lowe : Mine is not that different. It is to do with this lack of appetite for risk taking. When talking about Australia's future, I see tremendous possibilities. We have so many natural resources and an intelligent, well-educated workforce. We have great agricultural land. We have a rapidly growing population. Our demographics are favourable and we have been able to draw people from right around the world to make a very diverse, prosperous society that works well together. We have some tremendous fundamentals, but it is this lack of risk appetite and willingness to take a risk and take advantage of risks that I worry about.

It is not a peculiarly Australian phenomenon. I have just been to the G20 meetings in Istanbul. It is a common response. Many countries are saying that their private sectors are just not prepared to take enough risks. In response to that, there has been very heavy reliance on monetary policy globally—perhaps an overreliance. That is creating other risks. The question is: how do we get the private sector to start moving forward and increasing investment? What can the public sectors and governments around the world do to make a more conducive environment for private sector investment to get that going? As the governor has said a number of times, the effectiveness of monetary policy, while it is still there, is diminished because, to a large extent at a global level, loose monetary policy works by getting people to bring forward future consumption spending to today. But there are too many people who do not want to do that. They say that the level of debt is too high and they are not confident about the future and so loose monetary policy is not encouraging them to spend today. In summary, how do you re-energise the private sector in Australia to take advantage of the fundamental positives that we have? But how do you do that globally as well? Those are the issues I grapple with.

Mr Stevens : That is very well put. Do you have any other views you wish to confess to?

Dr Kent : I think I will sound a little bit like a broken record. What we have said in a number of different forums is that the fundamental forces are in place to support stronger growth in this economy. The economy is adjusting and sometimes that is very challenging and painful, but at least it is adjusting. We have picked up on this already in the labour market. The fact that wages growth is very low is, on the one hand, a sort of negative thing; but, on the other hand, it is better than if it were not, because it is leading to higher employment than otherwise would be the case.

We have pretty competitive and flexible product markets and labour markets. I am sure we could make further inroads, and you have talked about how the Productivity Commission could do more on that front. Again, we just seem to lack confidence. I wonder if, too often, we are waiting for a lead, particularly from offshore. We talk and worry about developments in much of the world, with a very advanced economy focus. That is important to do but we should remember the perspective that we are in the Asian region, which has very good growth prospects. We are well placed to continue to take advantage of that. I think the US story is a positive one.

I think the other thing is that we find it easy to look at things that can go wrong, because often when they go wrong they go wrong quickly and they are obvious to everyone, and that is how we often get things wrong in terms of our forecasts. But things that get better unexpectedly often happen incrementally, in small ways that we did not expect. Growth and better times come from sources we have not seen before, and they creep up on us. That we can remain lacking in confidence is, I think, the biggest risk—but I am generally optimistic about the future.

Mr BUCHHOLZ: Can I associate myself with the comments of those earlier in congratulating you on your new appointment as chair. I know the transition that you will make from chairing the tax and revenue committee to the economics committee will be seamless. Mr Coleman, thank you for the opportunity to be here. Your advocacy for bringing this group to your backyard makes it my maiden voyage to Hurstville.

Mr COLEMAN: You're welcome.

Mr BUCHHOLZ: I compliment also—

Mr HUSIC: Don't mind us for a moment if we just talk amongst ourselves.

Mr BUCHHOLZ: this is for the public record, of course—the executive and management for the way that you have looked after us here at Club Central. Reserve Bank Governor, my mum asked me to ask you a question, and you have touched on it during the morning—the lowering of interest rates around credit cards. Mum simply wants to know why she is not seeing the softening effects of this in her credit card. She sees the headlines of record profits for banks. She sees the headlines of softening prices or the cost of money. She said, 'Why aren't I seeing it in my credit card?'

Mr HUSIC: Stop using your card so much.

Mr BUCHHOLZ: Ed said that, Mum, not me.

Mr Stevens : Credit card rates typically do not move that much—not as much as most other rates—with the cycle. I think there are probably a few different reasons for that. The only advice that I think I could give is that there will be another bank who will give you an introductory offer at a very low rate temporarily. As someone has just said, there are much less expensive ways to borrow money than a credit card, if you need to borrow. So I guess go for those competitors.

Mr BUCHHOLZ: There you go, Mum. Now for my line of questioning. The Basel III committee reports that are coming out are making noises about the higher liquidity rates for banks, particularly with the higher loan value products. Does the Reserve Bank have a position on future barriers to entry to the housing market as a result of those stiffening liquidity issues?

Mr Stevens : I think it is more likely to be capital than liquidity requirements that change the cost of mortgage funds, if that occurs. I think the way that will play out if it happens is that there will be incrementally more cost to the major banks funding their mortgage book, which will change the competitive position of non-bank players and probably some of the smaller banks. If the financial system inquiry's recommendations were followed up, the capital weights, the risk weights on mortgages in the majors are going to rise a bit, but that is what would happen. That will change their competitive position relative to other players. In a competitive sense that will tweak the playing field a bit in favour of some of the other players. I think the likely effects of all that on actual interest rates on mortgages is going to be pretty small—very small. I do not think that those things will seriously affect the availability of mortgage finance in any material way.

Mr BUCHHOLZ: You think there should be no effect in that first homeowner market sector?

Mr Stevens : I do not see why there would be. Just to be clear about what question we are answering, if the idea is about risk weights on mortgage products in the banks that use the very low risk weights at the moment because they have the internal ratings set up, the Murray inquiry said that perhaps those weights should be raised closer to the weights used by smaller banks, who do not have the fancy internal models. If that happens—it will be APRA's decision, not mine—then the major banks would have to have a bit more capital against those particular mortgages. That would raise the rate at the margin they need to charge the customer in order to get the rate of return on capital. But it will not affect the position of the other players, so it would make the majors slightly less competitive in that space, all other things being equal. But we are talking about very small changes in the overall level of mortgage rates here. I do not think that disadvantages first home buyers or other homebuyers, for that matter, by any material amount. And whatever increment there might be to mortgage rates is probably much less than one monetary policy change. We debate 25 points endlessly and agonise over it. These other things are fractions of that, most likely.

Mr BUCHHOLZ: Back in 2012 you guys forecast the unemployment trajectory correctly, that there would be a softening of the economy as the capex left the resources sector, and you were pretty well on the money. So my question goes to forecasting in commodity prices. We are seeing a softening in ore and coal prices. Ray Robertson gave us a brief the other day on it and picked up the RBA's graphing on that. Given that you forecast unemployment rates today back in 2012, have you done any forecasting on where you see the softening figures, the bottoming out of the softening in ore and coal?

Mr Stevens : I think we are fairly transparent, are we not, Chris, on what we are assuming about those things? The extent to which they are assumptions as opposed to forecasts is a nice point, but perhaps you could give a general flavour of the way we have approached the outlook for the bulk commodity prices.

Dr Kent : I think the easiest one to discuss, perhaps, is iron ore. It is certainly front and centre of late. I think most analysts have been surprised at how much it has come off. There is a temptation to say that that relates to weakness in demand, particularly in the steel market in China. I think of late there has been an element of that, but by and large this is about more supply coming onstream, including from Australia. So, in terms of our current forecasts, we do not see prices lifting much from here. Those are very uncertain. I think that is somewhat lower. That is about where many of the market analysts are in the near term, and we do not see it picking up much from here.

The very difficult thing, as I suggested in earlier comments, is understanding what is going to happen to some of the high-cost supply. In China, many of the producers are producing iron ore, it seems, at a cost that is above the current price. They are losing money, as best as most people can tell. They are doing everything they can, like other producers where prices have fallen a lot, to reduce their costs; and, presumably, they are making some progress there. That is the thing: we sit down and try and work out what the cost of production is, and the price cannot go below that for too long—otherwise, the production stops and then the price corrects back up. I think the surprising thing is how long some of the high-cost producers are holding on and losing money, and it is not clear how long they will continue to hold on for. It is hard to know for sure, but we just have the price sitting around these levels.

Mr Stevens : For what it is worth, there are a range of market price assumptions out there, and we are sitting in that range, maybe—

Dr Kent : Yes, in that range or maybe a touch lower. One of the things is that the oil price fall is actually beneficial for costs in industries like this because oil is a non-trivial cost in extraction and transport. So, that is not a bad news story, but it means the price might be a bit lower than you would otherwise have thought.

Mr BUCHHOLZ: With the rate cut the other day, do you guys measure the inflationary impact or do you forecast what you think the inflationary impact of the cut will be? And do you think that that will push you back into a range where you would prefer to be, from an inflationary impact—

Mr Stevens : With the forecasts that were published, the sequence was that we presented to the board a set of forecasts based on whatever the exchange rate was then, which was a bit higher than it is now, with the cash rate staying where it was at 2.50 per cent. They responded to that and the exchange rate move. A few days later, when we were updating the forecasts with a now lower cash rate and a slightly lower exchange rate, we built in—Chris's people built in—our estimated effects of the rate move and whatever else has happened in between the dates of the two forecasts. So the answer is yes, the published forecasts embody the effect of that rate change.

Mr HUSIC: Governor, turning to China, I want to ask three quick things. Firstly, you talked about a growth forecast of about seven per cent, but do you think the suggestions—and these are public suggestions—that growth will be around 6.6 or 6.7 per cent are too pessimistic? I will ask all three questions and then you can answer them. Secondly, how concerned are you by emerging reports that deflation could start plaguing the Chinese economy? Finally, I am still picking up concerns about the growth of the shadow banking system in China. Have there been any measures taken by the People's Bank of China that you have noted which are starting to better guide the growth of that sector?

Mr Stevens : With regard to 6.6 versus 6.7 per cent: I guess, if it was 6½ per cent—that is half a percentage point lower than forecast—that is probably worth talking about, but not if it is only ¼ per cent, frankly. Coming back to ranges, if I was putting out the forecast for China, I would write 6½ to 7½ per cent, and if it was in that range at the outcome I would think: yes, not a bad forecast.

With regard to deflation, they have had price deflation in producer prices for several years already. The CPI inflation rate has come down a bit lately. I do not have a good sense of whether deflationary forces will take root in China, but it does not seem to me all that likely that the kind of deflation that is really, really dangerous will take place in China. The kind of deflation that is dangerous is where an economy with a very low potential growth rate—say, Japan—also encounters deflation in the general price level and you cannot get the interest rate low enough to get the real rate down below the natural rate of return on capital. I would have thought that the natural rate of return on capital in China is clearly a long way north of one or two per cent. So, even if they got a bit of price deflation, it does not strike me as likely that that would get to be the intractable, ongoing, persistent deflation that has been so difficult for Japan to escape from. I do not think that that is that likely.

There is the dynamic of overcapacity in some Chinese industries—and they talk about this—and they will have to allow that overcapacity to be worked off. But in an economy growing, even if it is only at 6½, that should not be that big a problem. If your potential growth rate is one per cent or no per cent, like Japan, these problems are much more difficult.

On shadow banking: I am not really aware of major initiatives just lately. They have been, in a targeted way, easing up on some of the restrictions they put on housing as housing prices have stopped rising and fallen. Those housing prices look like they are still falling but at a slower pace. Perhaps that will lead to a stabilisation. And they have been trying to tighten up on the sort of backdoor channels for financing some of this shadow banking. That is all sensible.

As far as I can see, they are across the issues and are managing them fairly well.

Mr HUSIC: I want to ask a lateral question, partly prompted by something I told parliament, which is: quizzing the Reserve Bank is sort of like quizzing the Sphinx; it is kind of hard to get—

Mr Stevens : Oh, good.

Mr HUSIC: No offence! He doesn't mind that; he wears it as a badge of honour!

Mr Stevens : You have no idea how boring I can be.

Mr HUSIC: In terms of the holding of gold reserves by the bank, I am just interested as to the size. It does not earn much interest. There is huge volatility in the price, and it costs us to hold. Why are you still holding on to the levels that you are? What is the reasoning there?

Mr Stevens : We have 80 tonnes, which is not much, actually, by global standards. It is securely stored, mostly offshore. It is a small portion of the reserves. We have had other things to worry about than whether we might shift the rest of that. And, actually, what are we going to put it in that earns more? At the moment, you get a negative yield in Europe on short-run euros, which is what we hold—all our holdings are of fairly short duration. It is, if anything, a negative yield in Europe. In Japan it is zero. In America it is pretty close to zero. So, from that point of view, the opportunity costs of holding the gold are not that high right now.

Mr HUSIC: Was there any thought given to liquidating those holdings? The government argued that they needed to provide you with the injection, the $8.8 billion, to the reserve fund. Was there any consideration given to liquidating that store in preference to receiving that amount of money from the government?

Mr Stevens : No, and, even if you did, the value is nothing like $8.8 billion. And the look of, 'We've got to sell the gold'—I do not like the look, so, no, I did not consider that.

Mr HUSIC: The RBA rightly values the position of its independence, and I note that the bank studiously avoided any direct comment on the fine detail of fiscal policy, but I note that in papers recently there have been some references to cabinet meetings that had been held in the last two weeks where someone apparently briefed media outlets suggesting that the bank was urging the passing of the first Abbott budget. I want to understand: was that correct, and were those media outlets correctly briefed on what the bank told cabinet?

Mr Stevens : Well, I did not brief any media outlets myself. Perhaps I should just set out the facts of what happened. I was asked to go to speak to the cabinet about the economy, not about the budget—global and local economies. I did that. It was on the same day as the board meeting, late in the afternoon. I did that. That is what happened. It was not my job to talk to them about fiscal matters. There were people in the room much better equipped than I to do so. Regarding my remarks to them—without wanting to talk about what happened in the cabinet room, because it is not my place—let us just say that I spoke about the global and local economic situation and outlook.

Mr HUSIC: Well, what was reported was:

The governor of the Reserve Bank and the new head of Treasury have delivered a dire warning to Cabinet that if the government's spending cuts, being blocked by Labor and the Senate, fail to get passed, then the budget is at risk …

Mr Stevens : Well, it would be the Treasury secretary's job, and he was present to talk about budget matters. I am not commenting on things he said, but it was not my brief to talk about the budget.

Mr HUSIC: Finally—I am conscious of the time we have—I want to come back to something that Dr Lowe discussed. You made reference to venture capital, and I was surprised by a recent comment made to me in the US that predicted that local VCs may not be in operation within the next five years, which has been hotly contested by local venture capital funds. But I would be interested in knowing whether the bank has any thoughts about what factors or conditions could help the growth of VC here in Australia, given its relatively low level compared with other markets—if you are in a position to answer.

Dr Lowe : I do not want to draw attention to any specific issues. The returns on venture capital in Australia have not been that good, and this is one of the things that the industry faces—that the investors who have put money into some of the funds have not enjoyed very attractive returns. When you talk to people in the industry one of the things they draw attention to is that it is just not a critical mass. So, the investor class has not been able to scrutinise potential projects very well, because there just are not enough projects. They seek more projects coming through so that we can develop a critical mass. How you do that I do not know. But it is this lack of critical mass and lack of a great deal of transparency from the businesses who are seeking the funds and developing the investor class around venture capital. How you do that I do not know.

CHAIR: I would go back to Tabitha's concern about the debt trap, in that home ownership is probably the best demonstration of common wealth, and your comment earlier that monetary policy and fiscal policy should go hand in hand. While you urge caution to young people buying homes as rates get lower and lower and bring that home within grasp, on the other side, when interest rates inevitably go up, there could be a great concern. And this personal concern must be the hardest thing to deal with, when it is your obligation, or you choose to have to put up interest rates, and young people are going to lose their homes. Given that the interest component of mortgages is after tax, if they are in a 50 per cent tax bracket it actually has an effect of doubling that increase. Would you consider that the government should look at some consideration to mitigate such a situation, with the possibility that first homebuyers have the interest component of their mortgage be tax deductible, which would then halve the actual impact of a raise and ease that burden of your decision?

Mr Stevens : The answer to that is that I would be very wary of doing that, for the following reason. Firstly, there are some people who argue that the tax deductibility of interest for investors prompts more demand by those investors, who push up the prices. If that is true, that is actually detrimental to the interests of the first homebuyers. But I am not sure that the right answer to that problem, if it is a problem, is to extend the tax deductibility.

The other thing to say is that there is already non-trivial public assistance for first homebuyers in the form of grants. But the way that ends up working out is that that money basically ends up in the hands of the vendors of the properties. The young people who are buying get that extra $14,000 or whatever it is, and that ends up going into higher prices. So, the people who most benefit from that actually are the people selling the houses, not those who are buying. I think most people who look at this accept that that is ultimately where that goes. And I rather fear that if we extend mortgage deductibility we may well end up with a rather similar phenomenon whereby it just results in higher prices—and, by the way, higher mortgages to pay those higher prices. So, while I am sympathetic to the problem that you raise, I do not think that is the best solution. The best solution, surely, for first homebuyers is to borrow within your means. And the banks, if they are doing their jobs, should test that. And we ought to be able to have confidence that that is being done, and to the best of my knowledge it is.

Secondly, if we are concerned about the cost of getting a roof over people's heads, the answer to that problem is the one Phil described: more supply of well-located land on which dwellings can be built. And 'well-located' does not mean harbour-side; it means with transport, with proper infrastructure so you can commute to your job quickly and so on. In Sydney in particular, this is probably the most serious constraint. I think the state governments are aware of this and are trying to deal with it. But those are the things we have to do if we want to go back to the world we once had. In a country with this much land, it ought to be cheap to get a roof over your head. It ought to be inexpensive to get basic accommodation in this country. We are not short of land in general, but we are short of developable, well-located land connected with transport. That is surely what we have to address.

CHAIR: High-speed rail would probably deliver that.

Mr HUSIC: I meant to ask earlier: something I questioned you about last March was in relation to tactile features on banknotes. Have there been any further developments on that?

Mr Stevens : Thank you for the question. There have been some developments. As you know, at that time we said that this was still an open question, that the designs were being worked on and that we would investigate tactile features as part of that. We have done quite a lot of work. There are a few ways you can do these features, and several of them have been tested in terms of durability, which is very important. We have also done a lot of consultation with the vision impaired community and some focus group type work to see what kinds of features they felt worked best for them. We have taken the decision that there will be a tactile feature on the new note series when that comes out. At this stage I expect that we will see the first of the denominations next year some time. We will say more about the details of a design before then. But there will be tactile feature on those notes. It adds a bit to the cost, but we have found a way of doing it that we think will be effective and durable, which is the main consideration.

Resolved that these proceedings be published.

Committee adjourned at 12 : 35