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Standing Committee on Economics
Reserve Bank of Australia annual report 2019

BULLOCK, Ms Michele, Assistant Governor (Financial System), Reserve Bank of Australia

DEBELLE, Dr Guy, Deputy Governor, Reserve Bank of Australia

ELLIS, Dr Luci, Assistant Governor (Economic), Reserve Bank of Australia

LOWE, Dr Philip, Governor, Reserve Bank of Australia

Committee met at 9:32

CHAIR ( Mr Tim Wilson ): I declare open this hearing of the House of Representatives Standing Committee on Economics and welcome representatives of the Reserve Bank of Australia, members of the public and the media present—and I suspect some people and media are listening over the internet and through closed circuit.

Since the RBA appeared before the committee in August 2019, the RBA has eased monetary policy by 25 basis points to 0.75 per cent, following the RBA's decision to cut the cash rate in October. At its meeting on Tuesday, the RBA decided to leave the cash rate unchanged at 0.75 per cent. I'll congratulate the latter. Commenting on the decision to keep rates on hold, the RBA governor said:

The outlook for the global economy remains reasonable. There have been signs that the slowdown in global growth that started in 2018 is coming to an end. Global growth is expected to be a little stronger this year and next than it was last year and inflation remains low almost everywhere.

The governor noted:

The central scenario is for the Australian economy to grow by around 2¾ per cent this year and 3 per cent next year, which would be a step up from the growth rates over the past two years. In the short term, the bushfires and the coronavirus outbreak will temporarily weigh on domestic growth.

In relation to the coronavirus, the governor concluded:

It is too early to determine how long-lasting the impact will be.

The governor stated:

Interest rates are very low around the world and a number of central banks eased monetary policy over the second half of last year. There is an expectation of a little further monetary easing in some economies.

He further noted:

The unemployment rate declined in December—

that's December 2019—

to 5.1 per cent. It is expected to remain around this level for some time.

The governor stated:

Wages growth is subdued and is expected to remain at around its current rate for some time yet.

In relation to the inflation outlook, the governor said:

Inflation remains low and stable. Over 2019, CPI inflation was 1.8 per cent and underlying inflation was a little lower than this. The central scenario is for CPI inflation to be around 2 per cent in the near term and to fluctuate around that rate over the next couple of years. In underlying terms, inflation is expected to increase gradually to 2 per cent over the next couple of years.

The governor further remarked:

Due to both global and domestic factors, it is reasonable to expect that an extended period of low interest rates will be required in Australia to reach full employment and achieve the inflation target.

This is not a new statement.

These and other issues will be scrutinised by the committee. The committee will examine the decisions of the RBA in the context of Australia's broader macroeconomic conditions and assess the RBA's confidence in current monetary policy settings which aim to encourage growth and keep inflation consistent with the target over the coming years. Of course, we are against the backdrop of various factors locally and internationally. It will be an interesting discussion to see and get clarity about how the RBA sees those circumstances and the impact on the Australian economy and over the long run as well.

I remind witnesses that, although the committee does not require you to give evidence under oath, this 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.

Dr Lowe, would you like to make an opening statement before we proceed to questions?

Dr Lowe : Thank you very much. Good morning to you and to members of the committee. My colleagues and I view these hearings as a really central part of the accountability process for the Reserve Bank of Australia. As usual, we will do our best to answer your questions and to explain how we're discharging our important public policy responsibilities on behalf of the Australian community. Later this morning we will be releasing a full set of updated forecasts in our quarterly Statement on monetary policy. Ahead of that I'd like to highlight for you the main numbers and some other factors that are influencing our outlook. I'll then turn to monetary policy and finish with some remarks about RBA's payment policy responsibilities.

When we met six months ago I said there were signs that the Australian economy may have reached a gentle turning point. The data we have received since we last met is consistent with this. Our central forecast is that economic growth in Australia will pick up from an average rate of two per cent over the past couple of years to 2¾ per cent this year and three per cent next year. This expected pickup in growth is supported by accommodated monetary policy, a new expansion phase in the resources sector, stronger consumer spending and a recovery in dwelling investment later this year. High levels of spending on infrastructure and strong growth in public demand are also helping the economy.

The outlook is also supported by an expected modest lift in global growth. The global economy clearly suffered over the past couple of years from the uncertainty and interruption to international trade caused by the disputes between the US and China over trade and technology. More recently, though, there have been signs of stabilisation, especially in the manufacturing sector. Consistent with this, in its latest public forecast the International Monetary Fund predicted that global growth would be stronger this year and next year than it was last year; so we are expecting a gradual pickup in growth. Notwithstanding this assessment, there are still some significant areas of uncertainty. One of these is the possibility of a re-escalation of the US-China trade disputes. The phase 1 deal has clearly alleviated some of the earlier uncertainties but it has not eliminated them, and it is possible that they will flare again. There are also a number of other trade disputes simmering elsewhere around the world.

More recently, as you mentioned, Chair, the outbreak of the coronavirus represents a new source of uncertainty. It is still too early to tell what the impact is going to be. The SARS outbreak in 2003 may provide a guide. On that occasion there was quite a sharp slowing in outlook growth in China for a few months before a sharp bounce back as the outbreak was controlled and the Chinese introduced economic stimulus measures. Today, though, China is a larger part of the global economy and more closely integrated with other economies, including Australia. I think it is quite likely that the international spillovers will be larger than they were back in 2003 with SARS. Much will depend on the success of the various efforts to control the virus. Like everyone around the world, we are watching developments very carefully.

In terms of domestic issues, perhaps the most significant one at the moment is that household consumption spending has been very soft. For some time now, households have been gradually adjusting their spending to slower growth in income. It appears that this adjustment accelerated last year in response to falling housing prices. Faced with the reality of slow growth in wages and falling housing prices, many households scaled back their spending and adjusted their finances last year.

Looking forward, we expect that this adjustment in household finances will continue for a while yet, but we also expect consumption growth to pick up gradually. As households become more comfortable with their finances they should have the confidence to spend more. Continued growth in employment, stronger growth in disposable income than in recent years and the recent increase in housing prices will also help, as will an upswing in the residential construction sector. So we are expecting stronger growth in consumption over the course of this year, although there is some uncertainty about how long this period of balance sheet adjustment we've been going through will last.

The other significant domestic issues are the bushfires and the drought. The fires have had a devastating personal and economic impact on the areas affected, and the whole country has been affected by these fires. In addition to the tragic loss of life, many people have lost their homes, and there has been extensive damage to farms, businesses and public infrastructure. Our current estimate is that over the December and March quarters, the fires will have reduced Australian GDP growth by around 0.2 of one per cent. For 2020 as a whole, though, there's going to be a rebuilding effort, and, once we take this rebuilding effort into account, it's expected to broadly offset the contraction from the fires that we saw in the first couple of quarters. So, for the year as a whole, we don't expect any effect from the fires. The drought, though, is continuing to act as a drag on the economy and is expected to reduce GDP growth this year by a quarter of a percentage point, as it has done for the past couple of years. So, the drought is a continuing drag on our economy.

Turning now to the labour market, we 're expecting the unemployment rate to hold steady for a while at around its current rate of just over five per cent before declining to a little below five per cent as economic growth picks up. Employment growth did slow towards the end of last year, but most of the forward-looking indicators, including job vacancies and hiring intentions, suggest there is going to reasonable growth over the months ahead. In terms of wages, we're expecting a continuation of the current pace of increase. Wage increases of two point something have become common across much of the country, and we don't expect to see this changing any time soon.

The recent inflation data were in line with our expectations, with CPI inflation running at 1.8 per cent. Within the overall CPI there are contrasting trends, though. The prices of many food items are rising more quickly than they have for some time, and that's largely because of the drought. In contrast, housing-related costs remain subdued, with rents increasing at the slowest rate on record and electricity prices falling in most places after many years of increases. Looking forward, we're expecting inflation to pick up to two per cent over the next couple of years.

I would now like to turn to monetary policy. Since the previous hearing, the Reserve Bank Board has cut the cash rate by a further quarter of a percentage point, bringing the total reduction last year to three-quarters of a per cent. Since last October, including at our meeting earlier this week, the board has maintained the cash rate steady at 0.75 per cent.

I understand that some people in our community have concerns about interest rates being at very low levels and that low interest rates have made it more difficult for people relying on interest income. I would like to assure these people that we did not take these decisions lightly. Rather, we've been responding to two very major developments: the first is the low interest rates globally, and the second is the period of balance-sheet adjustment by Australian households.

As we've discussed at previous hearings, world interest rates have moved lower over the past decade. This is mainly because of structural factors related to ageing of the population, slower productivity growth, slower population growth and high rates of saving in Asia. Since we live in an interconnected world, we can't ignore the shift in world interest rates. If we did seek to ignore it, I think our economy would suffer.

On the domestic front, as I discussed earlier, households have been responding to a period of low wages growth and a decline in housing prices. This has resulted in a period of low consumption growth and below-average economic growth. If interest rates had not been reduced last year, this adjustment in household finances would have been more difficult and our economy would have suffered. The lower interest rates have made it easier for people to manage their debts, and, on the other side of the balance sheet, they've boosted asset values.

In doing so, they're bringing forward the day when households feel sufficiently comfortable to increase their spending again. The easing of monetary policy is also supporting a turnaround in housing investment and it has also had an effect on the exchange rate, which at the moment is the lowest it has been in a decade, and the lower exchange rate boosts demand for exports and jobs. So the easing of monetary policy last year is working.

Looking forward, we're expecting progress to be made towards the inflation target and full employment, but that progress is expected to be only gradual and there are uncertainties. Given the only gradual nature of this progress, the board has been continuing to discuss the case for a further easing of monetary policy in an effort to speed the pace of progress towards the inflation target and full employment and to make that progress more assured.

In considering the case for further easing, we've taken account of the fact that interest rates have already been reduced to very low levels and that there are long and variable lags in the transmission of monetary policy. The board also recognises that a balance needs to be struck between the benefits of lower interest rates and the risks associated with having interest rates at very low levels. Internationally there are increasing concerns about the effect of very low interest rates on resource allocation in the economy and their effect on the spending confidence of some people. Lower interest rates could also encourage more borrowing by households eager to buy residential property at a time when housing debt is already quite high and there's already a strong upswing in housing prices in place. If so, this could increase the risk of problems down the track. So there is a balance to be struck here.

After considering this balance at its recent meetings, the board has decided to maintain the cash rate steady at 0.75 per cent. We recognise though that the nature of the balance between the benefits of lower interest rates and the risks can change over time and that balance is very much dependent upon the state of the economy. If the unemployment rate were to be moving materially in the wrong direction and there was no further progress being made towards the inflation target, the balance of the arguments would tilt towards a further easing of monetary policy. So we're continuing to watch the labour market carefully, as we seek to strike the right balance in the interests of the community as a whole.

While on the topic of interest rates, I'd like to draw your attention to some new analysis of lending rates that will be included in today's Statement on monetary policy and which will be updated each month on the RBA website. In particular, the newly published data shows that households that took out their mortgage four or five years ago are paying noticeably higher interest rates than those who took out their mortgage in the past couple of years. This reflects the fact that the discounts offered to lenders' standard variable rates have risen over time and these discounts tend to be fixed for the life of the loan. So people who took out loans four or five years ago might have got a discount that they thought was big, but today what was big before is no longer big. The discounts have increased over time and people have got mortgages with relatively low discounts, so people who took out mortgages four or five years ago are paying more than those who took them out in the past year or so. As I've said a number of times recently, if you took out a loan four or five years ago it is worth shopping around and checking with your lender to see if you can now get a bigger discount. If your lender can't give you a bigger discount, I encourage you to look elsewhere. New data being published by the RBA and ASIC should help with this shopping around over time.

On a different matter, you might recall that at our previous hearing we had extensive discussion about quantitative easing, QE. Shortly after that I gave a public speech on the issue. Given the committee's previous interest in the topic I thought it would be useful to summarise the main points of that speech for you. The first is that negative interest rates in Australia are extraordinary unlikely. This is not a direction we need to go in.

The second point is that Australia's financial markets are currently operating normally, so there is no need for any special liquidity operations. If liquidity pressures did emerge in our markets though, we have the capacity, the ability and the willingness to respond to that. We've done this in the past and we would do so again in support of the smooth operation of Australia's financial markets.

The third point is that the threshold for undertaking QE—that's, the RBA purchasing assets through balance sheet expansion—has not been reached in Australia, and I do not expect it to be reached. So it's not on our agenda at the moment.

The fourth point is that we would only consider QE if there was an accumulation of evidence that, over the medium term, we were unlikely to achieve our objectives of full employment and inflation target. As I have said on other occasions, including before this committee, in the event that the country did find itself in that position, I would hope that policy options other than monetary policy were also on the country's agenda.

The fifth and final point is that QE would only be considered at a cash rate of one-quarter of a per cent. Our focus would be on purchasing government securities to put downward pressure on longer term interest rates. We have no appetite to purchase private sector assets as part of any QE program. Doing so would represent a major intervention by the RBA into resource allocation in our economy and it would come with a whole host of governance issues, so this is not a direction we're inclined to go in.

Finally, I'd like to highlight a few payment matters. Australia's new fast payments system is continuing to grow, with most of the major banks now close to offering the agreed initial functionality. The RBA, as banker to the Australian government, has been using this new system recently to get money immediately into the bank accounts of people affected by the bushfires, so we can get money into people's accounts on the weekend or at night-time, if they really need the assistance. More generally, most people in Australia are now able to move money between bank accounts in just a matter of seconds. The Payments System Board is hoping to see banks, fintechs and others use this new infrastructure to develop innovative payment solutions that help individuals and small businesses. Seeing this innovation take place is a major priority for us.

Another priority for the Payments System Board over the year ahead is to complete its periodic review of payments regulation in Australia. We're currently reviewing the initial submissions to this review, but it's very clear that the world of payments is moving quickly, partly driven by new technologies.

One of the issues that the Council of Financial Regulators has already raised with the government is the regulatory arrangements of so-called stored value facilities, which could include digital payment 'coins'. The Council of Financial Regulators is seeking some changes to current regulatory arrangements which would provide stronger protection for consumers as well as creating a simpler regulatory system that encourages innovation.

Another issue on which the Council of Financial Regulators will provide advice to government this year is the resolution arrangements that apply to Australia's systemically important financial infrastructures, including central counterparties and security settlement facilities. We need to make sure that our arrangements for dealing with problems in these critical parts of Australia's financial infrastructure are strong and that they meet international standards. To do this will likely require some changes in current legislation.

Chair, that concludes my introductory remarks. My colleagues and I are here to answer your questions. Thank you.

CHAIR: Thank you very much, Governor. We've got four members present today, so we're going to have plenty of time to all share the torch around and ask questions. I just want to go to your opening statement. You talked specifically about the need for balance in the approach the RBA is taking, particularly on things like impact on house prices, inflation and the like. At 0.75 per cent, are there really any options for balance?

Dr Lowe : There are always options for balance.

CHAIR: But, really, the options are incredibly constrained in practice in terms of—there's one direction you can go up; there's not much in terms of the other direction, particularly in light of the fact the RBA has pre-flagged that 0.25 per cent would be the beginning or the discussion of quantitative easing.

Dr Lowe : The point which I'm trying to emphasise is I think there would be further benefits or there would be some benefits of a cut in interest rates. The cuts so far have helped households repair their balance sheets, and as their balance sheets get into better positions people will start spending. A further cut in interest rates could add to that process, but it does come with some risks.

Internationally, there's a lot of discussion about the effect of low-interest rates on the economy and people's saving and spending decisions, and domestically people are starting to borrow again for housing. So it's possible that if we lowered interest rates again that would encourage people to borrow even more. That might be desirable, but it does carry a longer term risk. We're trying to balance the benefits that we would see in terms of lower interest rates with these risks, so it's a difficult balance to strike. That's the discussion we're having at our board: what is the benefit from lower interest rates versus the longer term risks from lowering them? That's the notion of trying to balance off benefits versus risks.

CHAIR: To what extent at the moment in weighing those risks up, particularly around the longer term consequences of loan rates—you just outlined that if you lower rates people borrow more. The flexibility then for an increase in interest rates over the medium to longer term actually diminishes quite considerably, not without putting significant pressure on households.

Dr Lowe : That's not the particular concern, that it would be hard to raise interest rates in the future. It's just that if people borrow a lot more now does that reduce flexibility in the future? For macro stabilisation does it introduce new risks to the economy—

CHAIR: Would you say that if people borrowed more now that it would be harder in the medium to longer term to raise rates?

Dr Lowe : It could well be, but the deeper concern would be people have a lot of debt now. That could introduce a vulnerability later on that could come back to hurt us.

CHAIR: The RBA has basically acknowledged that inflation isn't going to move dramatically, including even in your opening statement. If households are borrowing more it constrains their disposable income and increases their financing obligations, which means that, really, the only direction the RBA can move is to stabilise or decrease, unless there is a dramatic turnaround where suddenly people are experiencing significantly higher wage growth and significantly higher inflation.

Dr Lowe : It's true the likelihood of interest rates going up anytime soon is very low. We'd have to have a marked change in the current outlook to see higher interest rates. So the discussion is whether we hold where we are now or whether we reduce interest rates further. This is really saying the same thing, and I said this to the National Press Club on Wednesday: it is possible to have too much of a good thing. The issue we're grappling with is where is that point where it is removed from a situation where the lower interest rates have helped, which I think they have over the past year, to a situation where they're building up vulnerabilities for the future. Where is that crossover point? The truth is no-one really knows, and that's the issue we're grappling with. The lower interest rates so far have helped people pay down their existing debt. It's very clear that people are paying their debts off more quickly and loan arrears are falling, which is interesting. Loan arrears in Australia are low, but they're actually falling at the moment and people are paying off their debts more quickly. So the lower interest rates have clearly helped.

CHAIR: Isn't that partly a perception around anxiety about the economy?

Dr Lowe : It's low wages growth and falling housing prices. The government gave people some tax refunds and that's helping people pay back their debts. People are paying back their debt more quickly than they have in the past, and lower interest rates are helping them do that. It's an important part of—

CHAIR: Let's go onto that point. In terms of disaggregating out why people are increasing their repayments and paying down their debt, what analysis has the RBA done that's actually highlighted the contribution of interest rates in comparison to other contributions like tax cuts?

Dr Lowe : We've got data on interest payments as a share of both income and credit. They were included in the speech I gave on Wednesday. As interest rates have come down, total interest payments as a share of income credit have come down a lot, so people are paying less in interest. That frees up income. What are they doing with that extra income? It would appear that most of it's being used to pay off their mortgages more quickly. It would also appear that most of the tax cuts have been used for people with debt to pay off their debt more quickly. Partly that occurs through people leaving the tax refunds in their mortgage offset accounts, which effectively counts as a mortgage repayment. We have looked at the rise in mortgage repayments—partly it's lower interest rates, partly it's the tax refunds and partly it's been weak consumption growth. All three things have been working.

CHAIR: Sure, but the question I asked was: has the RBA done any research specifically looking at the contributions of each section? You've given me an outline of how everything would contribute; I'm not arguing with the point you're making. Has the RBA actually done specific research? I see Dr Debelle nodding his head, so you may have done.

Dr Lowe : We've done some analysis. This is hard, because money is fungible, but we looked at the total amount of tax refunds as part of the low- and middle-income tax offset refunds. That could explain maybe a third of the increase in mortgage repayments and extra balances in offset accounts. You've got to make a whole set of assumptions but it wouldn't be surprising if that comes up to a third, and perhaps the same amount again from lower interest payments. People are actually saving more of their income. We've seen the saving rate go up, people saving more of their income. They've got a bit more income because of your tax refunds and interest payments have come down.

Dr Ellis : I've got the graph there. The national accounts show that interest paid by households came down quite a way, even just in the September quarter, and, of course, since then there was one more rate cut, so when we get the December quarter we would expect that number will be lower still. The net payments have come down. So across the whole household sector the effect of interest rates is to free up more disposable income. The analysis the team has done on how much the low and middle income tax offset might've contributed—as Phil mentioned you do have to work out how many of these people are likely to have a mortgage and so forth. We think maybe up to a half of the increase in total mortgage repayments could be potentially attributed to people who received that lump sum tax offset then put it in their offset account while they thought about what to do. But it can't explain all of it.

The important point is normally most mortgages are designed so that you keep your repayment constant. And as long as interest rates stay the same then you're paying off an increasing fraction because the interest payment on a smaller balance goes down. When rates fall the required repayment does go down, but many people will just maintain their total repayment at the same level, so that's one part of the mechanism. But what we've actually seen in the September and December quarter, as shown in the graph in Phil's speech, was that total repayments have increased. So it's not just this passive thing of keeping your repayment at the same level; it's also that some people must've decided to make more, or they had some spare cash that they put into their offset accounts, which counts towards that figure and saves them interest along the way. So you do end up amortising the actual balance quicker that way.

Dr Lowe : It's all these things. It's the tax refunds. It's lower interest payments and the saving rate is going up. They're all contributing.

CHAIR: I'm not disputing that. I'm asking about the research base on which the RBA is doing their claims. You mentioned the medium term in your opening statement in relation to the use of QE. The inflation target is also a medium term objective. What's the medium term interpreted as—five years, seven years or three years?

Dr Lowe : In terms of the inflation target?


Dr Lowe : The underlying concept here is we want to deliver price stability for the Australian economy. When people are thinking about the rate of inflation over time we want them to think two point something. I don't like to necessarily pin down, 'It's three years or five years.' What I want people to think about inflation in Australia is it being two point something.

CHAIR: So you don't have a specific time frame. But two point something consistently—not over a three to five year period, five to seven?

Dr Lowe : We don't think of it in such specific terms. The more important thing is you want people in Australia, when they're thinking about what the price level might do and what inflation might be, to think two point something. It'd be better if inflation were back to two point something now and it's a concern that it's been below two point something for a while. That's the underlying concept: to get it back to two point something so that people think of inflation in those terms.

CHAIR: But you don't have a time frame in which you wish to achieve it?

Dr Lowe : We'd like to see it sooner rather than later obviously. The forecast that we're publishing today shows that inflation, in headline terms, will probably be back to two per cent next quarter. It's only 1.8 now and I expect it to pick up next quarter and then to bounce around two per cent for a while yet. We would like to be making faster progress, but there are some significant structural issues that are meaning it's hard to make progress and that progress is slow. Australia is not the only country in this situation. You see that many countries around the world have inflation slightly below their inflation target—even countries with very low rates of unemployment. So, if something is going on in the inflation process that means it's harder to get back to two or two-point-something per cent, it's a slow, gradual process. This is why I don't like to put a specific number of years on it. It's not that I'm trying to avoid accountability; it's just being realistic about the process that is taking place in both the Australian and global economies that means that progress towards inflation targets is slow.

CHAIR: I know, but there's been a consistent concern around the inflation target and that not being met for a considerable period of time, so putting some clarity around it would at least give some guidance around thinking about how the RBA is going to approach it. I know that in our private meeting late last year we had a discussion, but it obviously wasn't for the record, about the inflation target and where the RBA sees it in terms of whether it was the right approach to keep it where it was or not. It might be helpful, just for the public record, to outline why you don't think there shouldn't have been a movement or reduction in the inflation target to ease the pressure to cut rates. Could you expand on that for us?

Dr Lowe : The discussion that's taking place internationally at the moment in many policy circles is actually that inflation targets should be raised, not lowered. And the logic here is that if you have a low inflation target you then have a low average level of interest rates, and if interest rates are low on average there's a greater probability that you'll hit the zero or effective lower bound. If you have a higher inflation target, you have higher average interest rates and therefore a lower probability that you'll hit the zero or lower bound. I think that's the discussion that's taking place, and I think that's a reasonable perspective. I'm not advocating for lifting our inflation target, but not many people are thinking of lowering inflation targets. I think it would be inappropriate to lower our target just so that we could say we met it. We don't really shift the goalposts!

CHAIR: That's not the point that people have been making—an argument about lowering inflation targets so they can meet them; it's around the flexibility and the obligations it puts on the RBA around its interest rate decisions.

Dr Lowe : Remember: if we had a lower inflation target, we would have lower interest rates on average. So it might reduce the arguments to lower interest rates immediately, but on average we would have lower interest rates with a lower inflation target. Largely for the reasons I was just talking about, I don't think increasing the probability of hitting the lower bound makes sense. I think the inflation target is really providing a north star—it's where we're going to, it provides direction for the setting of monetary policy and it helps guide what we're doing, and we will not be raising interest rates until we're very confident that inflation is sustainably within the two to three per cent range.

CHAIR: There's no time frame on that?

Dr Lowe : I wish I could give you the answer to that, but, given the structural factors that are changing the world economy and some of the domestic issues, I don't have a crystal ball. All I can tell you is that we will not be raising interest rates until we are confident that inflation will be back within the two to three per cent range. I would like that to be sooner rather than later. It's the North Star, and it's providing the direction, but the journey is difficult. There's rough terrain and we have to slow down. We're doing our best, given the structural factors that are at work. I think we'll eventually get there, and it's guiding our policy in the sense that we'll keep interest rates low until we get there.

CHAIR: But how much confidence can people take at the moment out of RBA forecasts in light of missed targets? It just seems to me that we're obviously in a situation where the RBA has made a series of decision forecasts over a reasonable time frame and some have not been met, and it's raising questions amongst many people about whether or not they can be relied upon. How would you respond?

Dr Lowe : We don't have a crystal ball and we forecast like everybody else. We've looked at our forecasting record, and, over recent times, broadly it's no worse or no better than it has been in previous decades. The one thing was that late last year our forecast on GDP growth was optimistic and the forecast miss was larger than it normally is, and, when we've looked at why that's the case, it's largely because of this household balance sheet adjustment. We did not pick in advance how fast anyone would want to adjust their balance sheets and that a decline in housing prices was bigger and quicker than we thought and that had a bigger effect on household spending, particularly in an environment where people already had high debt and their wages weren't growing that quickly. So households adjusted their spending and we saw per capita consumption growth decline last year, which was a big surprise. That was a big surprise last year and, as I said, in my opening remarks, I think that's starting to turn around but it's going to take time.

The other big surprise last year was labour force participation rose a lot, which is good for the economy but it does mean that it's been quite hard to create a tight labour market in Australia. We've had employment growth of two to 2½ per cent for quite a few years and, in the normal course of events, you would've expected that to drive the unemployment rate lower and lift wages but that has not happened in Australia. The main reason that it hasn't happened is that participation has risen a lot, which is kind of fantastic—a higher share of the population have a job than ever before. We did not pick this rise in participation and we did not pick the extent of the household balance sheet adjustment. So they're the big forecast misses last year but, by and large, our forecasts recently have been no better or worse than average. We've got to be realistic: we don't have a crystal ball.

CHAIR: In your opening statement, you spoke specifically about the challenges around the coronavirus. You acknowledged that and, obviously, there's an historical precedent around SARS. This may be different, but you can't draw any clarity. Let's use a crystal ball—you don't have a crystal ball; I don't have a crystal ball. Although the indicators to me would suggest that it's somewhat different to SARS and that its infection rate is higher but mortality might be lower, but we will watch that. To what extent is the RBA maintaining a vigorous watch on the impact economically the coronavirus is having? How is it regularly updating itself around how it can assess the potential impacts to inform your forecasts?

Dr Lowe : The SARS experience does provide a kind of baseline, but China's much larger. It's a bigger part of the global economy. Links with China are much more extensive than they were. The Chinese population is much more mobile than it was in 2003, and the Chinese economy in 2003 was going very strongly and it took a hit of two per cent in one quarter but it bounced back quickly. Growth now is slower and the capacity to bounce back and have stimulus measures isn't as great. More people are being affected now than with SARS. It's more contagious, but it's not as deadly. So there are more people being affected, and the response by the Chinese authorities in terms of stopping people moving around and quarantining is much more extensive than it was with SARS so the interruption to normal life in China is much bigger than it was.

CHAIR: So would you say that the risks in terms of the impact on the Australian economy are likely to be greater than SARS?

Dr Lowe : Given what we know at the moment, I think that's true. The rate at which new cases are increasing is still around 20 per cent a day, so over five days you've got double the number of people infected. The rate of growth was 30 per cent last week so it has slowed to 20 per cent, but a 20 per cent increase in the number of cases per day is still extraordinarily fast. Everyone is hoping to see that number come down quite quickly. If it does and the number of cases stabilises, I think we could see a bounce back. The Chinese central bank has announced stimulatory measures to support companies that are having to slow operations and the Chinese President last weekend said that they're considering infrastructure and stimulus measures.

I've got no idea whether the rate of infection's going to slow quickly now. If it does, I think there are reasonable prospects of a quick bounce back. But it's possible the rate of infection does not slow very quickly and the number of cases escalates and the interruption to Chinese economic activity is more pronounced.

CHAIR: The point, if I compile all of those assessments together, is that, particularly as a result of the greater integration with the Australian economy and exposure, the risk profile from the coronavirus for Australia is potentially significantly higher than the SARS virus.

Dr Lowe : Yes. That would be my assessment. The first order of effect is on international students coming to Australia. The universities—

CHAIR: There's obviously been movement around agriculture—and aquaculture in fact in the past 24 hours.

Dr Lowe : There is. It's affecting tourism, obviously, but as well, of course, there were fewer people leaving Australia to go to China. They're staying here and spending money. So there is a small offset. We are hearing some reports of interruptions to supply chains. Many Chinese or Australian companies had inventories so they could deal with factory shutdowns for a while, but they can't do that indefinitely. We have heard some reports of interruptions to supply chains and firms having to scale back. There are some reports of Chinese companies claiming force majeure—that something has happened and they can't deliver on their agreements. That hasn't been happening on a widespread scale yet, but, if this goes on for much longer, I think we will hear more cases of that. The potential risk to the Australian economy is bigger than SARS, and the truth is that none of us know how this is going to play out. If the infection rate comes down quickly, I think it will stabilise and we'll bounce back, but, if the infection rate does not come down quickly, and the number of cases are doubling every four days, the Chinese authorities presumably will have to tighten further on the movement of people, the movement of goods and the movement of services. Because we're so integrated with China, we're going to feel the effects here.

Dr Debelle : I'll add one thing, Chair, to answer your question. Our liaison program talks to businesses in these sectors regularly—at any time, but particularly in the current circumstances—to find out what they are seeing across the sectors that I mentioned: tourism, agriculture, the resource sector and the education sector. We have obviously ramped up our focus on that over the last week or so—hearing from them as to what they're seeing and hearing.

CHAIR: Thank you, Dr Debelle. Before I hand to the deputy chair, I have a final line of questioning which covers one of the lines that he and I asked about at the last hearing. At the last hearing we presented the RBA's own research. I think the fellow was Peter Tulip. It was a paper outlining that RBA interest rate cuts were fuelling the price of housing and housing price inflation. There was a disagreement that that was the case. Based on the statements that were provided this morning, you are now saying that interest rate cuts last year were contributing to house price inflation. How do we account for the inconsistency?

Dr Lowe : I don't see an inconsistency, but it is a complex story. At the last hearings, we discussed a whole bunch of structural factors that were affecting housing prices as well: population dynamics, the rate of new construction and, at some point, Chinese investors buying Australian properties. It's a kind of rich story, but interest rates are part of the story. I've never stepped away from that. But, six months ago, I did not see interest rates as the main thing that were driving housing prices. Six months on, the cuts in interest rates that we have had have had a noticeable effect on housing prices. At some points, interest rates are the main drivers. At other points, population dynamics are the main drivers.

CHAIR: Just for clarity, your own research acknowledged there is a diversity of opinion within the RBA, but the research base suggested that it was. My personal view is that the research was right. There was a disagreement, and I accept that there are sometimes underlying factors. What in your opinion has changed within that time frame? Suddenly we're arguing that maybe it isn't the case that house price inflation has been driven by interest rates and now, all of a sudden, six months later, it is because of the most recent cuts.

Dr Lowe : Interest rates have changed—

CHAIR: But not spectacularly, you have to acknowledge.

Dr Lowe : For nearly three years, interest rates—

CHAIR: Stabilised.

Dr Lowe : were stable, so it was hard to say that interest rates were driving the housing market for those three years. I think the underlying structural supply and demand factors were really driving housing prices. They're still obviously important, but, as we've cut interest rates three times and the mortgage rates have come down a lot, housing prices have gone up, and I think that is linked to interest rates.

CHAIR: I'm sure they would say that they don't think there was any, but, having relatively low interest rates over a longer period of time, including that three-year time frame, increased the potential for people to be able to take on more debt and therefore there were increased house prices. We've had modest cuts in a relatively short time frame, but that hasn't dramatically shifted the amount and the extent to which people can borrow.

Dr Lowe : Lower interest rates do boost asset prices, including housing prices. I'd take that as a given. I've never stepped away from that. I think it's a fundamental here. My recollection of the discussion last time is that, in different markets, housing prices were doing quite different things. In Perth they were declining. In Darwin they were declining. In Hobart they were rising very quickly. Yet we've got the same interest rate across the economy. So the point I was trying to emphasise last time is that these structural factors are important as well. At the moment, though, the structural factors are particularly important. The dominant factor at the moment is lower interest rates.

CHAIR: The reduction in interest rates, or lower interest rates?

Dr Lowe : Both. Low interest rates and the reduction in interest rates have allowed more people to go to the bank and borrow, and that is being effected in housing prices now. It's a complex story and it's changing through time. At certain points in the housing market these structural factors about population and supply and migration are the dominant factors and, at other times, changing interest rates are important. But, right through this period, I accept the point that low interest rates have meant a higher level of house prices than would be the case if we had higher interest rates.

CHAIR: Do you think that's a positive development?

Dr Lowe : From a cyclical perspective, I think the lower interest rates pushing up housing prices over the past six months is actually. It has helped household balance sheets get into a more comfortable position and eventually people will spend. From a longer-term perspective, do we benefit as a society from having very high housing prices relative to incomes? Different people have perspectives on that. My own personal perspective is no—that there are things that we could do on the structural side, even with low interest rates, to have a lower level of housing prices relative to income. You see that in the United States. Housing prices relative to people's income, across the country as a whole, are much lower. Yet their interest rates, by and large, over the past decade have been lower than ours. They've got lower average interest rates and lower average housing prices relative to income. Why is that? Structural factors relating to the supply of and demand for housing.

My own view is that society would be better off having lower housing prices relative to people's incomes. It's because it's the result of structural factors—monetary policy and everything. We can't do anything about that. It's a complex picture. But in the last six months the increase in housing prices has been a positive development for household balance sheets. And because it is positive for household balance sheets it is positive for spending and positive for the economy and jobs. But we can have too much of a good thing.

Dr LEIGH: Given that Canberra's tourism sector has been knocked around by the bushfires, we are looking to attract more tourists now that the smoke has cleared. So thank you very much for making not one but two trips to Canberra this week, boosting our economy!

Dr Lowe : Thank you. It's a pleasure.

Dr LEIGH: I want to ask you about the overall state of the Australian macro-economy. We have seen declines in labour productivity for the first time on record, the slowest wage growth on record, declining household spending per capita, record household debt, record government debt, below average consumer confidence, retail suffering it's worst downturn since 1990 and construction shrinking at its fastest rate since 1999. The economy is in a pretty bad way at the moment, isn't it?

Dr Lowe : That wouldn't be my characterisation. One thing you left out of that list is that a higher share of Australians have jobs today than ever before in our history. I know the unemployment rate has been lower, but the employment-to-population ratio has never been higher than it is now. Ultimately what matters is that people have jobs and employment and security, and a higher share of the population have jobs then ever before. So that is a positive. Growth over the past two years—2018 and 2019—averaged two per cent. Many countries would love to have growth of two per cent. Partly, it is that our population is growing more quickly; per capita growth is not strong. So two per cent, I'd say, is satisfactory—it's not disastrous. And I think there are reasonable bases to believe that growth will pick up to average—close to three per cent—over the next couple of years. So my characterisation would be more positive than yours.

That's not to deny that we have very significant issues, and the one that worries me most is weak productivity growth. Ultimately, productivity growth is the source of increasing living standards, of increasing real wages, of real asset prices, of strong government revenues. We've had four or five years now where productivity growth has been very weak. I think it's a significant issue. I spoke about this at the National Press Club, and in my own view it's linked to very low levels of investment relative to GDP.

I fear that our economy is becoming less dynamic. We're seeing lower rates of investment, lower rates of business formation, lower rates of people switching jobs, and in some areas lower rates of R&D expenditure. So right across those metrics it feels like we're becoming a bit less dynamic. I worry about that for the longer term. For the moment, it would be good if things were better, but they're not as disastrous as your summary would suggest.

Dr LEIGH: One of your predecessors, Ian Macfarlane, said on Joe Walker's Jolly Swagman Podcastrecently that the Australian economy was 'lacklustre'. Does that seem a fair assessment?

Dr Lowe : Lacklustre—that wouldn't be an adjective that I would use. I would say it's okay and it could be a lot better. As I said to the National Press Club, our fundamentals are fantastic. We enjoy a standard of living in Australia that very few countries in the world enjoy. More of us have jobs than ever before. We live in a fantastic, prosperous, wealthy country, and I think we should remember that. We're growing at a subpar rate, but two per cent in the broader scheme of things is not that bad. The unemployment rate is five per cent. It would be good if it were lower, but it's not that bad. Inflation is close to two. I think we need to keep some perspective. The challenges are lifting productivity growth and real income growth and making our economy more dynamic than it has been.

Dr LEIGH: Let's go to a couple of those issues. As you pointed out in your Press Club speech, over the last six years, we've seen a collapse in private-sector investment as a share of GDP and we've got public-sector investment as a share of GDP below historical norms. Given that interest rates are at record lows, it's difficult to see why Australia wouldn't benefit from greater public and private investment, isn't it?

Dr Lowe : I agree that Australia would benefit from higher levels of investment, yes. That could be either public or private—I'll leave others to determine the balance there—but I think it's difficult to escape the conclusion that we're suffering at the moment because of low levels of investment. Public investment is not particularly low at the moment. What is low is private investment. Firms don't seem to be investing at the same rate that they used to, and I think this is adding to this sense that I have that the economy is just less dynamic. You're seeing it not just in investment but in innovation, in business formation, in the rate at which people change jobs. There's something deeper going on, and it's not just in Australia; it's everywhere. At the meetings I go to with the other central bank governors, this is the kind of thing we talk about. Something's going on in our economies that means the same dynamism that used to be there isn't there.

And it isn't as if there's a lack of opportunities. There's fantastic progress in technology being made which is opening up new opportunities, but for some reason businesses are not taking advantage of those at the rate that we would hope. I don't have a full explanation for why that is.

Dr LEIGH: I would put competition policy squarely in the mix there. An increase in mergers and decline in start-ups probably points to competition policy settings which have allowed the oak trees to crowd out the smaller saplings. But I put that aside. You spoke about the high participation rate, but what really matters if we're thinking about wage growth is the unemployment rate. In your Press Club speech this week you noted that America has its lowest unemployment rate since 1969 and Britain its lowest unemployment rate since 1974. You then went on to talk about the Australian unemployment pattern, but you didn't explicitly link that back to the other countries. I would have done so, pointing out that Australia had unemployment in 2007 that was a full percentage point lower than it is now and that those other two countries have unemployment a full percentage point lower than ours now. Shouldn't Australia's unemployment rate be a first-order issue and there be an aim of getting it to something more like four per cent, which, as your colleague Luci Ellis has pointed out, is now more like what the bank defines as 'full employment'?

Dr Lowe : Well, I agree. We should be seeking to have a lower unemployment rate than where we are now. From a historical perspective, an unemployment rate of 5.1 per cent is quite reasonable, but I think it is quite possible and it is desirable to have a lower rate. If you had told me three years ago we would have employment growth averaging close to 2½ per cent, I would have thought the unemployment rate would be close to four now. But the big shock, the big surprise, has been the rise in labour force participation. There has been no shortage of jobs growth in Australia. In fact, it's been very strong. But it's been met with a lot of extra labour supply. That's not the case, I think, in the United States.

Dr Ellis : That's one important point. The US is the outlier here. A lot of other countries have also seen an increase in participation, particularly of women and of older people. If you want to see a big increase in participation, look somewhere like Japan. Some of that is obviously structural, in terms of removing impediments to female participation as well as the participation of older workers, but in many respects the increase in participation of women and older workers is part and parcel of the ageing of the population. The population is ageing. Women are having fewer children on average and people are living longer, healthier lives. Both of those factors would tend to increase participation of those groups.

But the US is the outlier. You've not seen the increase in participation that you've seen in other countries. There are a number of things that people speculate about for what is driving that. Participation, particularly of men in their middle years, has been very low. People have suggested that some of this is the climate of despair. Longevity has come down. The suicide rate has come up. There is an opiate crisis. The US is an outlier. What's happening is that actually the employment to population ratio in the US has not come back to its pre-crisis highs. The employment to population ratio still has quite a way to go in the US. It's not similar to all the other countries, of which Australia is one, that have actually seen quite significant increases in employment to population ratio.

You mentioned productivity. One of the difficult things is that that is not directly measured in the national accounts. We had weak GDP growth. We had very strong employment growth. So the net of those two things is weak productivity growth, but it's not independently measured; it's just a calculation from those two things. If someone had told me, 'Yes, we missed our GDP forecasts'—if I'd known in advance what the GDP forecasts were, I would never have forecast 2½ per cent employment growth, but, if I'd known 2½ per cent employment growth, I would never have predicted that actually the unemployment rate has been more or less static, where it's been. There's usually a pick-up in participation growth when employment growth is strong, but, over the last couple of years, that's actually been a much bigger pick-up on average, and that's absorbed more than all of the excess of employment growth over working-age population growth.

Dr Lowe : That's all correct, but it doesn't invalidate your basic point, that we should be achieving a lower unemployment rate in Australia. I agree with that. An even higher share of the population should have jobs than they do now, which is a record high. We think we're on a path to get the unemployment rate down, but it is slow and it's gradual.

Dr LEIGH: As you pointed out in your speech this week, per capita household spending fell over 2019. You called this a 'highly unusual' outcome. Am I to think that slow wage growth is at the heart of that problem and that, going one further back, excessively high unemployment is one of the reasons we haven't seen faster wage growth?

Dr Lowe : Slow wage growth is part of the issue. But we've had slow wage growth now for six or seven years, and consumption growth slowed quite a lot last year. What was different last year was that housing prices declined quite a lot, and that came as a shock to many people. I think, when you've got low wage growth, and the value of your house is falling in value, you are more careful. Many people probably thought, 'I've got too much debt. I'd better pay some of that back because the value of my biggest asset is actually declining in value.'

I think the particular combination we had last year is one reason I'm moderately optimistic about the year ahead, because housing prices are no longer falling; they're actually rising quite strongly. The loan arrears rate is coming down. The number of people who have problems with their personal debt is coming down. So it looks like, across a range of dimensions, balance sheets are in a better position. Once the balance sheets are in a better position, people will start spending again.

I think last year we had this particular combination. Again, that doesn't take away from your basic point that slow wage growth is a brake on consumption. At these hearings in the past I've said that I thought the country would be better off having aggregate wage growth starting with a three rather than a two. We are not there and I don't see us getting there any time soon.

Dr LEIGH: Let's go to the effect of monetary policy. I think there is general consensus that the marginal effect of a 100-basis-point rate cut diminishes as rates go towards zero. But some critics have gone further and said in fact there's a sign flip and at a certain point rate cuts can have an adverse impact on growth. You said before you thought a further cut in interest rates would have benefit to the economy. So I take it you do not share the view that a rate cut from, say, 0.75 to 0.25 would have an adverse impact on the economy?

Dr Lowe : No, I certainly don't, but I accept that there are risks in doing that. If we just reflect back on the past year, we've cut interest rates by three-quarters of a per cent. That has had an effect on the exchange rate. It's no accident the exchange rate is the lowest in a decade. It's really helped with household balance sheet repair. If you accept my idea that households wanted to fix up their balance sheets last year because of low wage growth and falling housing prices, do you think that balance sheet adjustment would have been easier or harder if interest rates had been higher? The proposition I am putting to you is that, if we had not cut interest rates, that balance sheet adjustment that households wanted to do would have been much harder last year. Therefore, consumption would have been even weaker and the economy would have been softer. I say it's helped that adjustment because it has allowed people to pay off their debts more quickly—we had this discussion at the beginning—and it's pushed up housing prices. So it's helped with the liability side and the asset side. So the balance sheets are in a better position today because we cut interest rates last year and the exchange rate is at a lower level because we cut interest rates last year. Both of those things are helping the economy.

Would we get more help from a further cut in interest rates? I think, on both those levels, it would help with balance sheet repair and probably would have an effect on the exchange rate, so we would get more of a good thing. Back to the discussion we were having before, is it possible to have too much of a good thing and are the risks acceptable if we cut interest rates further? It would help in the short run, but would it help in the long run? That's the question.

Dr LEIGH: One of the arguments that's made is that a cut in interest rates could adversely affect confidence. Indeed, the claim that the November 2019 minutes seemed to make was that there could be an adverse impact on confidence through a rate cut. That seems to me to be based on muddy theoretical analysis and poor empirical analysis. From a theoretical standpoint, the chief channel through which I would imagine that working is if a rate cut somehow revealed private information that the central bank carried, which would only occur if you had a very opaque central bank. In some sense, you don't want to claim that because you've improved your transparency markedly over the last decade. Perhaps you could go further still. But also your own research, US research and some new research by Stephen Kirchner shows empirically that there is no evidence that rate cuts are associated with a fall in confidence. Do you really think the minutes were right to suggest that a cut in interest rates could adversely affect confidence?

Dr Lowe : I don't think they suggested that, but the minutes did record that we had a discussion on this. Many people you speak to at the moment raise this issue. You only have to open a newspaper to see—

Dr LEIGH: Let me give you the exact quote and then you can respond to that. The minutes said board members 'recognised the negative effect of lower interest rates on savers and confidence'.

Dr Lowe : We had a discussion on their effect on confidence, but I pretty much agree with your summary. We have seen over the past year household confidence come down a bit and interest rates have come down a bit, so there are many people out there who are saying that it is the cut in interest rates that damaged confidence. I'm pushing back against that because household confidence is weak because income growth is weak and housing prices have fallen, and we're responding to that. So these two things—interest rates and confidence—are measured at the same time, and they move together, and people say, 'It's the cut in interest rates that has damaged confidence,' but I don't think that's the case. It's low wage growth and falling housing prices that have damaged confidence, and we've responded to that. So I don't accept the idea that this is what is driving weak confidence, but it is the case that there are many, particularly older, Australians who, when we cut interest rates, have a reasonable reduction in their interest income, and their confidence is damaged and they feel bad and they don't spend as much. So that's really that reference which, as you read it out, was linked to savers—or, I think, was it, as well, confidence and—

Dr LEIGH: To savers and confidence, not confidence of savers!

Dr Lowe : The discussion was really in the context of: there is a group of people; when we cut interest rates, it does hurt them and their confidence is diminished. But the broader point, which you didn't articulate there, was that confidence is really responding to weak wage growth and falling housing prices. So I don't think what we are doing is damaging confidence. I hope in the end it leads to a stronger economy and more confidence.

Dr LEIGH: Let's go to your mandate. Last time we met, inflation had been below the target band for the previous four years, and since then inflation has remained below your mandate. In the latest statement on monetary policy you've got inflation staying below or just touching the target band over the entire forecast horizon until 2022. You keep on talking about getting inflation back to two-point-something, but at what point do you acknowledge that there have been structural policy errors by the Reserve Bank and not just a series of one-off forecasting mistakes?

Dr Lowe : You asked a kind of similar question when we met last time and it was in the context of whether we would've been better off cutting interest rates in 2018 and would've got better results because of that. Your questioning prompted me to think a lot about that question. I look back at late 2018 when the economy was growing above three per cent; the unemployment rate was coming down quickly; employment growth was 2½ per cent; the vacancy rate was very high; as to the consumption data, we had one weak quarter and one strong quarter. So it basically looked like, at the end of 2018, things were going okay, and, at the time, we thought the right thing to do was to hold interest rates at 1½ per cent. Since then, what have we learned? We had this big rise in participation, which meant strong employment growth didn't translate into stronger wage growth and declining unemployment. We've learned the household balance sheet adjustment was taking place in response to falling housing prices. And the global effects of the trade disputes on investment were bigger than we'd thought. So they were the three big things that happened last year which meant that we didn't achieve our forecasts. I've thought about the question: if we'd known those things in advance, would we have been better off with lower interest rates earlier? I think the answer to that is yes. I'll leave it to you and others to judge whether we should've known those things—whether we should've understood the balance sheet adjustment, the sobering effect on investment from the trade disputes and the rising participation. We didn't pick those three things. Back in 2018, we thought it was appropriate to be holding interest rates at that higher level. When those three things occurred, we responded and we responded pretty quickly and decisively. I think that's the best we can do. We analyse what's going on. When things change, we respond.

Dr LEIGH: I appreciate the candour with which you've discussed that past decision, but, given what you know now and given that your current forecasts have you not achieving your welfare mandate or your inflation mandate, what is the case for not bringing rates down to 0.25 per cent?

Dr Lowe : The case, as I outlined before, is: there's a balance to be struck here. Lower interest rates, as we talked about, I think would help with the balance sheet adjustment and lead to a lower exchange rate, and, at the margin, that would mean a bit more employment growth and probably inflation picking up a fraction more quickly. So that would be the case for lower interest rates, and, as you'll see in the minutes when we release them, we discussed that case at our board meeting extensively.

On the other side are the risks. People can make different judgements about how valid these risks are, but, at the moment, with borrowing picking up quite strongly, there is a risk that further cuts in interest rates could encourage further borrowing. If people borrow more, then perhaps down the track we have problems. We're also conscious of the fact that we've lowered interest rates quite a lot quite quickly, and there are variable lags and long lags. It's quite possible that, as household balance sheets repair and the residential cycle picks up, things improve more quickly than we thought. So it's really a balance and a judgement about the balance of the risks and the benefits. We're going to keep assessing that. In the view of the board, if the unemployment rate was moving in the wrong direction, this balance clearly tips in the direction of lower interest rates.

Dr LEIGH: So, while you said in the last board meeting that you didn't believe that the RBA had been pursuing a policy of leaning against the wind, you do seem to be saying now that a focus on financial stability concerns is what is pushing you away from the rate cut which would be beneficial for you meeting your inflation and welfare targets.

Dr Lowe : I would say: medium-term macrostability. Would we enhance the medium-term outcomes for the Australian economy by lowering interest rates today? I'm not sure. I think in the short term, we'd be probably a bit better off, but, over the next five to 10 years, will we be better off with lower interest rates today if the main effect of lower interest rates is to encourage people to borrow more? And I accept people are going to make different calls on that judgement. If the unemployment rate is rising and it's clear we're not moving towards our goals, I think everything is different. But, while it's plausible that we can move towards our goals, at least right at the moment, the risks are slightly tilted to outweigh the benefits. But that could turn, particularly if the unemployment rate deteriorates.

Dr LEIGH: Let me put to you a statement that the man to your left made in 2009:

Nor do I believe there is much to be achieved by 'leaning against the wind'. The wind that is blowing in most episodes of credit booms is generally at least gale force. Setting interest rates a bit higher in such circumstances is likely to be close to futile when such credit dynamics take hold. Again, what would be the point of undershooting the CPI inflation target and enduring a higher than desirable level of unemployment with little to be gained. How would such actions be explained to the public?

Isn't that an accurate statement about the mistake that the RBA is making now?

Dr Lowe : You might think it's a mistake. My view is that we're doing the best we can do to preserve medium-term macrostability in Australia. We've got a medium-term focus. We accept the inflation rate's a bit low. It would be better if it were higher, but lowering interest rates further at the moment—given the progress we expect to make and debt dynamics. We've got very high levels of debt and it's possible they could start rising quickly. So I don't view it as a mistake, but I accept that not everyone in the community would draw the same balance on these arguments. They'd see the risks and the benefits quite differently. Guy might want to expand on that, but he's a member of the board as well and supported the decision, so—

Dr LEIGH: Dr Debelle, do you agree with yourself?

Dr Lowe : he might have a different explanation.

Dr Debelle : When the facts change, I can change my mind. I hope everyone on the committee shares the same view. Personally, I put weight on the fact that we've already done a reasonable amount in a shortish period of time. Rather than emphasise the debt angle, I would say that, last year, the other thing which surprised me personally—which I talked a bit about at some point late last year—was that the spillover of the housing downturn both in prices and construction to the real economy and to inflation was considerably larger than we had expected and, certainly, than I personally had expected. As the governor noted, we clearly see that the house price cycle has turned. I think with great confidence that the construction cycle is going to turn later this year, and both of those two are related to the interest rate decisions that we've taken. Personally, I think that the impact of those two things may well surprise us on the upside, in both output and inflation.

So, I suppose from my point of view, in terms of thinking about the most recent decision, I'd put a lot weight on the fact that they've done a reasonable amount in a shortish period of time, the effects of which we really are only barely beginning to see, but at least a few of the channels that the governor talked about earlier—we clearly see the exchange rate lower; we clearly see that the price cycle on the housing side of things has turned. And I think actually we're getting, by the day, stronger and stronger evidence on the construction side. And I think just as we may have made under-forecasts of growth and inflation because of the downswing in the housing cycle, I personally think there's a reasonable chance that the error will be on the upside. And I suppose in my risk assessment calculus I would put a reasonable weight on that over the period.

Dr LEIGH: Let's suppose, just hypothetically, that you wanted today's statement on monetary policy to forecast that by December 2021 inflation would be in the middle of the target band. What sequence of interest rate cuts or quantitative easing would be required to produce that outcome?

Dr Lowe : If we wanted to produce a forecast—

Dr LEIGH: Well, what policy would be required to get inflation to the middle of the target band by the end of next year?

Dr Lowe : By 2021? I don't think there is a monetary policy that can do that. I think that's the reality we face. The Phillips curve—the relationship between unemployment and inflation—is very flat. When we run it through our models, to get inflation up to 2½ per cent, say, in two years time, we would have to have interest rates—wait for it!—three or four percentage points lower than where we are now, because the relationships between interest rates, output and inflation are quite weak at the moment. So, you'd have to have much lower interest rates to get inflation up. It's just not practical at the moment to get inflation back to 2½ per cent in two years time or 18 months time with monetary policy. Of course, there are other government policies that could do it.

This is why I've got this focus very much on the medium term—getting there gradually over time. We've got to be realistic about what can be achieved with our instrument in a world where the relationship between unemployment and inflation is much weaker than it once was. We're seeing this in every country around the world. There are countries with unemployment at its lowest in 40 or 50 years and inflation is still not picking up. So, something's changed in inflation dynamics around the world, and the same is true in Australia, and we can't really hide from that. It just means that progress towards the inflation target is going to be slow, and I hope steady, and that's the forecast we're producing today—slow and steady progress, and the idea that you would try to accelerate that progress with super-easy monetary policy doesn't make sense and doesn't pass the risk-benefit calculus that we were just talking about.

Proceedings suspended from 10:53 t o 11 : 03

Mr CRAIG KELLY: Governor, you mentioned earlier that more Australians have jobs than at any time before. What is the driver of that? Is it necessarily because of housing? Is it greater opportunity for females in the workplace? Is it more people in retirement working part time? Could you expand a little on why you think we're seeing this high number of people in the workforce.

Dr Lowe : It's a good question. There are multiple things going on. One is opportunity. When I entered the workforce you were faced with the choice of working 40 hours a week or zero. Many women and older people chose zero. They didn't want to do 40, either because of family reasons or health reasons, so they chose zero. Today you can choose five, 10, 25, 30, so the workforce is much more flexible, employers give people the flexibility and job design is more flexible, so people have the opportunity to work. It's not surprising to me that, as a result of that, you're seeing increased female participation and increased participation by older people who get to, say, 65 and can cut down hours and stay in the labour force. I think that's an incredibly positive thing. One-third of the workforce now works part time. Most of those people who work part time actually say they want to work part time and they're broadly happy with the hours they work. Not everyone, but opportunity is important. Over recent times the increasing demand for health care and education has allowed, particularly women and older people, to have part-time employment, so opportunity is an important part of the story.

Another part of the story is the pressure on household budgets. Wage growth has been weak; people have decided, maybe a spouse or an older person, to stay in the workforce longer. It's also the case that people are carrying debt into retirement or into their later life. Once upon a time, by the time you were 55 you'd probably paid off your mortgage, but many people now, at 55 and in their 60s, have still got mortgage debt. We've got higher housing prices, people have borrowed a lot to buy the house, or maybe to help out their kids or their grandkids, and they're staying in the workforce longer. So it's a combination of both opportunity and budget pressures.

Mr CRAIG KELLY: Where we're not seeing the wage growth that I think we'd like to see, how much of that is related to more people in the economy having jobs? So even though an individual's wage may not be growing, you've got more people working and the overall wages paid in the economy are increasing, but it's not actually—on a per capita basis we're not seeing that increase.

Dr Lowe : Yes; that's true. If you think about a world where we had this strong demand for labour that we've seen over the past three years, with very strong demand by firms for workers, and if we hadn't had this response in participation, then the unemployment rate would have come down more and firms would have had to compete more for workers and there would be more job-hopping as people sought out opportunities.

Mr CRAIG KELLY: But that may not necessarily be a good thing for the economy, against the opportunity—

Dr Lowe : I'm just trying—

Mr CRAIG KELLY: You're saying the opportunity that more people have had to enter the workforce surely has to be a very good thing, which is offset by the lack of—

Dr Lowe : I'm trying to explain what's going on; I'm not making a judgement about whether it's good or bad. What is good is that a lot more people have jobs. For getting inflation back to target, it's not so good that wages haven't increased, but it's good that a lot of people have jobs.

But I think there's something deeper going on with wages, other than just this rising participation. It's this sense of uncertainty and competition that people have, and this is kind of global. Most businesses are worried about competition from globalisation and from technology, and many workers feel that same pressure. There are many white-collar jobs in Sydney and Melbourne and Canberra that can be done somewhere else in the world at a lower rate of pay, and many people understand that.

So the bargaining dynamics, because of globalisation and competition for workers, is less than it used to be. And firms are less inclined to bid up wages to attract workers because they're worried about their cost base and competition. So globalisation and changes in technology mean that everyone feels more competition. What I learnt in my first year of economics at university, maybe even in high school, is that where there is more competition, you have less pricing power. I think this is going on. It's one reason, following up on Andrew's earlier question, why it's just hard to get inflation back up quickly, because the pricing dynamics, both in the labour market and firms' pricing decisions, have changed because of globalisation and technology. So that's a deeper thing going on, and overlaid on that is this rising participation.

Mr CRAIG KELLY: On that, we still are seeing wage growth ahead of the rate of inflation—that's correct?

Dr Lowe : Inflation over the last year was 1.8 and the wage price index was 2.3 or something, and the broader measure of income is a bit stronger than that. Real incomes are still rising, but not at the rate they did in the past.

Mr CRAIG KELLY: So isn't that ratio, if you want to call it that, where wages are growing greater than inflation, a more important economic indicator than just inflation itself? Where you say you'd like to see inflation at a higher rate, with a two in front of it, doesn't that also necessarily mean you'd want to have wage growth creeping up incrementally with inflation?

Dr Lowe : Yes, exactly right. What I would like to see, and this is kind of the central bank nirvana for us at the moment, is inflation being 2½, unemployment probably being four or 4½ and wages increasing perhaps 3½. So 2½ per cent for inflation and one per cent real—and if we get our act together, I think, we can do better than that. So 3½ per cent wage growth and 2½ per cent inflation at full employment is where we'd like to be.

Your point is right: if we have higher inflation, we'll have higher wage growth. In the end what's important is the differential between the two, and this is why the discussion about productivity's so important. The differential between wage growth and inflation comes from productivity. One of the longer-term concerns that I have is that productivity growth is weak and so the ratio between those two numbers, or the difference, is not going to be that large.

Mr CRAIG KELLY: So rather than concentrate on inflation numbers or anything else, the ultimate goal should be the gap between inflation and wages growth.

Dr Lowe : We've got to keep inflation low and stable. That's the role of the central bank. The central bank can't in the end do very much at all, if anything, about the gap between nominal wage growth and prices. That's something the parliament and businesses can do something about. It comes down to how we organise ourselves, the dynamism in the economy, the amount of investment, and the skills and the opportunities we have. So my board can't really effect that; all we can do is effect the nominal part, but parliament and business can.

Mr CRAIG KELLY: You mentioned that, as a long-term structural issue, the economy is less dynamic—I think those were the words that you used. Doesn't that indicate that there's an imbalance in the risk-reward ratio in the economy and that someone can get a very well-paid job in the government services without a lot of risk? Why therefore would you take the risk of going to some entrepreneurial activity, if the reward is not quite there? What's causing less dynamism?

Dr Lowe : I wish I knew the answer to that, and I'm getting close to being out of my lane here. My sense is, as an Australian and looking at what's going on in our economy, that we're becoming very risk-averse. We don't—

Mr CRAIG KELLY: Is that an indication of what—

Dr Lowe : It's a global thing that happens—I think it probably happens partly when you're a wealthy country. The standard of living here is fantastic. It's hardly matched anywhere in the world, so we've got something important to protect. But I think in that environment you become more risk-averse. Probably with the ageing of the population, we become more risk-averse. When people have a lot of debt, they're probably more risk-averse, and we're seeing that risk aversion in my own view play out in less dynamism in a whole range of dimensions in our economy. It's not something the central bank can do anything about. It's a kind of challenge for government, society and business: how risk tolerant are we going to be; and how tolerant are we doing to be of mistakes? If we're not going to be tolerant of mistakes, then we won't have many mistakes. But if we don't have many mistakes, we don't have any. So we've got this distribution of outcomes all the time. The world's uncertain, as we know, and society's become very good at looking at the left part of the distribution as the downside. My sense is that, as we do that, we spend less time looking at the other side of the distribution: the upside. We're seeing the effects in investment, labour turnover, dynamism, slower growth. It's okay, but it's slightly frustrating from where I sit.

Mr CRAIG KELLY: So you seem to be agreeing that long term there's a bit of an imbalance in the economy between the risk-reward ratios.

Dr Lowe : Whether there's an imbalance—I'm really describing what's going on. It's really up to you, the parliament, and the broader society to determine what type of society and economy we want to have. You look at countries like Israel where they focus very much on opportunity, innovation and dynamism. Their risk appetite is quite different to the one we have here in Australia. I'm not saying one's better or worse; I'm describing the situation. My sense is that if we had a stronger risk appetite we'd see more investment, a better labour market and, in the end, stronger growth and a bigger gap between wages and prices. That's a reflection of what's going on in our society. How do we get back dynamism and appropriate risk-taking?

Mr CRAIG KELLY: When you look at what you see as the role of the RBA, you've got your monetary policy tools. How much do you think the tone of what you say affects sentiment? You could be out there saying—I'm not saying that you are; it's not a criticism, but there is the potential—'Things are down and terrible and we've got to cut interest rates because things are really bad.' When you're making your decisions at a board level, how much does the tone of what you say get taken into consideration as an effect on sentiment?

Dr Lowe : I'll let others judge how our tone is affecting sentiment.

Mr CRAIG KELLY: I'm not saying it is. I'm saying: is that a consideration that you give at the board level, about—'jawboning' could sometimes be a word, up or down? How much emphasis do you give to the tone of what you're saying as opposed to the policy levers that you have?

Dr Lowe : We spend a lot of time on words, but my main objective is to seem to be credible, trustworthy and reliable and, where I can be, as optimistic as I can be—but, similarly, to be credible. Being credible, trustworthy and realistically optimistic—that's the narrative I want to have, and we discuss that at the board. I think that's appropriate. We live in a fantastic country. We have fantastic opportunities. Things are okay. We want them to be better, but they're okay and they can be better. In the end, I don't think it really matters that much what I say. I'm just one person. But I do want to be credible.

Mr CRAIG KELLY: Maybe you understate the power of your words sometimes.

Dr Lowe : I want to be credible and realistically optimistic—not fancifully optimistic but realistically optimistic—because my board and my institution are incredibly confident about the future of our country. We've got some challenges but we can meet them. We've met them over decades. By doing that, we've built the best country in the world, and it's growing okay. Inflation is a bit low, but the country's growing okay. We have opportunities in the future and we can take account of those. I'm conscious of drawing attention to those opportunities and subtly challenging people to take advantage of them.

Mr CRAIG KELLY: The Sydney Morning Herald earlier this week ran a headline that said 'RBA governor warns of 'profound' impact from climate change'. Did that overstate your position?

Dr Lowe : No, I don't think it did. We have no particular role in the discussion about how the economy should react to climate change. What we are doing, though, is trying to understand the impacts on the economy, on our financial markets and the financial system. The Bureau of Meteorology tell us that last year was the hottest on record and that temperatures are more variable. We've seen a terrible drought which is affecting the economy. The bushfires are obviously having significant effects. So right at the moment the weather is having a material effect on our economy. When we look forward, climate change is changing patterns of production and investment in the economy. It's changing the cost of insurance, which is affecting where people want to invest and the availability of insurance. It's affecting the value of assets. I don't know how this is going to play out, but there is the possibility of some assets being stranded and a collapse in asset values. And there are new opportunities in new industries that are coming because of climate related issues. The effects are pervasive. Our job is to try and understand them. There are also effects in the financial system—the value of assets change because of climate related issues, so, for the insurers and for banks lending to companies whose assets move up and down. We're working with the other regulators to make sure that financial institutions disclose those risks so that people can understand the investment risks. I think the effects are significant, and we're trying to understand them, just as we're trying to understand the effects of many other things on the economy—investment, dynamism. It's just one of the things in the mix.

Mr CRAIG KELLY: But hasn't that been true throughout the history of our nation? I think today is the anniversary of the 1967 fires in Hobart, which I think had losses that today would be something like a $1 billion hit on the economy. Go back to Cyclone Tracy, with Darwin wiped out, or to cyclones wreaking havoc across the Queensland coast. Is it always droughts we've had come and go? Hasn't it always been the case that we've had these significant climatic disasters through our history and we've overcome them every single time?

Dr Lowe : We have. We've had droughts for many years. In the early part of the bank we focused very much on non-farm GDP because the droughts were pushing around the GDP numbers so much. Perhaps we need to have a look at that. So it's been a long-term issue. The judgement of most people is that, with the temperatures being higher and more variable, we're going to see more volatility, and with volatility comes changes in production, investment, insurance and asset values. How quickly that will play out, we don't know, but, with higher temperatures and more variable conditions, the patterns we've always seen are probably going to be amplified. We need to prepare for that, and institutions need to disclose their risks. So I'm not disputing that it's always been there, but it's quite plausible that it's become bigger.

Mr CRAIG KELLY: We talked about the effect of drought on the economy and the hit to GDP. I think you mentioned a zero.—

Dr Lowe : A quarter per cent this year.

Mr CRAIG KELLY: And that is droughts and fires combined.

Dr Lowe : If I take 2020 as a whole, the drought is a quarter per cent off, and basically it's been a quarter per cent off on average for the past two years as well. It's almost reduced the level of GDP by one per cent now over the last three years. That's a significant hit to GDP.

Mr CRAIG KELLY: You did mention that, from your study of the early days, you deducted the content of the drought. What was the effect of the drought on the economy in years gone by?

Dr Lowe : We've seen bigger effects in particular years. What's noticeable about this one is how it's going on and on and on, so the cumulative effect this time is bigger. Luci, do you have figures at hand? The millennial drought was more concentrated, and there was a bigger subtraction from GDP over one year, but this one is going on and on.

Mr CRAIG KELLY: So what about the droughts we have in the forties, fifties and sixties?

Dr Lowe : We probably don't have that.

Dr Ellis : No, we don't have those going back. The millennial drought had two phases. There was an interim recovery, and then it came back. Those two together were also very debilitating, but in terms of consecutive years it wasn't as big. One of the other things that happens is that, in the first year and a bit of a drought, meat production actually goes up as farmers reduce their herds. It's mainly on the grains side and it depends a lot on where the drought is. So, for the first year of the drought that we're currently in, Western Australia was relatively less affected and it was concentrated on the east coast. That's spread since then. But this one is now about three years.

Mr CRAIG KELLY: Without wanting to downplay the significance of this drought whatsoever and acknowledging that a lot of people have suffered, a lot of people have lost and it's caused a lot of harm, as a percentage of GDP loss, I think what you were saying is that it's similar to what we've experienced in decades past.

Dr Lowe : There have been episodes over the past few decades where the annual subtraction has been bigger. Without having looked at the data, I suspect that back in the forties and fifties the effects on GDP would have been bigger because the farm sector was more important as a share of the economy. The farm sector now is important, but it accounts for like two per cent of employment. It's a smaller share of the economy, so the drought isn't as noticeable in the GDP figures, because the farm sector is not as big and the economy is more diversified.

Mr CRAIG KELLY: You mentioned insurance losses related to climate events. There was a paper published last year entitled 'Normalised insurance losses from Australian natural disasters: 1966-2017'. Their conclusion was:

When aggregated by season, there is no trend in normalised losses from weather-related perils; in other words, after we normalise for changes we know to have taken place, no residual signal remains to be explained by changes in the occurrence of extreme weather events, regardless of cause. In sum, the rising cost of natural disasters is being driven by where and how we chose to live and with more people living in vulnerable locations with more to lose …

Doesn't that indicate that some of the claims by the insurance industry in wanting to jack up their insurance costs might be a bit overblown?

Dr Lowe : I haven't followed that debate carefully enough to know. But I've looked at the insurance losses for the fires—and they're still coming in. Maybe it is about $2 billion, which is a very significant number, but in inflation adjusted terms there were much bigger losses—

Mr CRAIG KELLY: Rather than comparing these in inflation adjusted terms, shouldn't you also look at the size of the economy and the greater population? The normalised losses are be a far more accurate measure than just inflation adjusted terms.

Dr Lowe : Yes, we can normalise by the size of the economy or inflation. The point I was going to make was that the insurance losses for the Sydney hailstorm—was that in the 1990s?—were much bigger. I know you had a hailstorm here recently, and you can still see the effects of it. The insurance losses do tend to be bigger when the weather events occur where a lot of people are living and their cars and houses are affected. Guy, you are part of the various regulatory efforts in Australia and overseas. Has this issue come up?

Dr Debelle : Yes. You can make the point you make, and that's true. Sorry, that's a view, I would say. Take the Houston floods as an example. There have been two 'once in a hundred-year floods' in Houston in recent history. That's unusual. It's the frequency and intensity of the events, I would argue—and I appreciate that others have different views—which is also changing. As well, the point you make is right: there are more people in some of the affected areas. So I think all of those elements are at play. It's not just the frequency and the intensity; it's also the scope and more people being in those vulnerable areas.

Mr CRAIG KELLY: If I look at data for Australian cyclones, I see the frequency and intensity going down by all measures. The number of cyclones, the number of severe cyclones, the normalised insurance losses—I see all those declining.

Dr Debelle : I can look at some data and draw a different conclusion. I look at the frequency of high-temperature events. Luckily, I have managed to experience most of them over the last couple of months as I have been driving around the country. I have stopped in any number of towns across Australia. Luckily, on the day I was there, it was the hottest day they had ever had. So I have nailed that one pretty frequently over the last couple of months. I appreciate that different people come to different views, but I suppose I would draw a different conclusion from the data I look at.

Dr MULINO: I want to pick up on the bushfires again. As you indicated in your opening statement, the bushfires had a devastating impact on those communities that were directly affected and a very significant effect on many other communities. I am interested in you unpacking some of the numbers in the speech you gave. From my reading, there is likely to be a negative impact in the December quarter and the March quarter, and possibly a slowly offsetting impact in the following quarter, as a result of rebuilding. I think the net impact was likely to be minus 0.2 per cent. I'm interested in your comments on the modelling.

Dr Lowe : That is in the December and March quarters. By the time we get to the end of the year—the December quarter this year on the December quarter last year—it is going to be unaffected; we're just going to have a period of weaker growth and then it picks up. Luci, you are probably across more of the detail of this estimate of 0.2 and where the rebuilding comes from.

Dr Ellis : There are a couple of different things going on. The forecast that we published this morning has a reduction of about 0.2 per cent in the December and March quarters cumulatively and that comes back with some rebuilding efforts in the second half of the year. Just to compare, we also put in a minus 0.2 per cent in the March quarter for the effect of the coronavirus outbreak on tourism service exports in that quarter. Things are very fluid and we don't quite know, but that's what we've done. The forecasts we've published have both of those things in there.

In terms of what we have on the bushfires, we are expecting a little bit of a reduction in consumption. We've revised down our rural exports and we've revised down domestic tourism spending in the quarters. But, to the extent that people either defer their trips or go somewhere else, that kind of nets out. They're the main things that we've factored in to our forecast. Our forecast for specifically the effect of the bushfires is within the range of both the official sector and the private sector estimates of the impact of the bushfires. Because it is geographically very concentrated on the areas affected, you've got to scale that up to the rest of the economy and know what else is happening. We also need to think about the insurance losses. One of the things that we've put into the forecasts for later in the year is the insurance payouts as they come in. That is actually measured as household income. We've added that to our household income forecasts. One of the things about growth is: the house burning down doesn't reduce GDP, but building a new house where it once stood is part of GDP. In some sense, your welfare may not be better off, unless you got to build a nicer house. When you have such an extent of devastation in a localised area, a lot of the things that burnt down would not meet code if they were built today, so, when you rebuild, you have to build to code and that means you have a different thing. That will also spread things out because you have to get permission and so forth.

One context is in terms of the scale of the effect. Our current estimate is that around 3,000 homes have been damaged. That is the highest number by a long way of any past bushfire event. I'm looking at data going back to the fifties. It's not uncommon for bushfire season to take several hundred homes. There are a couple of other cases where bushfires have taken more than a thousand homes. The team plotted this on a log scale because the current data point is so much more. That is more than you'd really be able to attribute to population growth, so, in that sense, there has been a big increase. We've done a pretty careful adding up of where we think the effects might be.

As to some of the uncertainties we have—things that are really hard to get a handle on—include things like an awful lot of smoke around areas that were quite far away from where the bushfires actually were. We don't know what the effect of that has been on health outcomes. We know that hospital admissions for people with respiratory issues have gone up, but how do you factor that into your forecasts? Did that do something to productivity? On the other hand, if there's been less rain, that means that there are fewer rain interrupted days in construction work. There are a number of factors you have to consider. Where we've landed is roughly 0.2 per cent across the December and March quarters, with the rebuild after that.

Dr MULINO: Then they're offset essentially?

Dr Ellis : Yes. So, by the time you get to the end of the year, the level is back to where it otherwise would have been.

Dr MULINO: I would expect the Reserve Bank to do nothing other than plot the impacts on a log scale. Thank you for your mathematical rigour! That's useful. Again, in terms of what's happened in the broader economy, is it fair to say the economy is being supported by fairly high resources prices? For example, if you look at iron ore, over the last six months I think it's averaged around $90 plus. Obviously, it's come down a little bit and who knows where it's going to be in a month's time after the coronavirus. I imagine gold has fluctuated a bit based on uncertainty. What are your observations about the economy's level of growth and resources prices?

Dr Lowe : Australia's terms of trade—that is, our export prices divided by our import prices—were off the peaks a few years ago, but, in a historical context, they're still very high. That's helping to support corporate profits and ultimately government revenue. That's still a significant effect on the economy. What we're seeing, though, now is the resources sector moving to an expansion phase from an investment perspective. We had investment firm, but over the last seven years investment in the resources sector has been lower every year compared to the year before.

We don't expect that process to continue. In fact, this year we're expecting resource sector investment to actually lift and a bigger lift the following year, so this is one of the things that is actually supporting the economy. There's some expansion of capacity going on, but the big miners have to invest to replace the depreciating capital. They're having to do that, so we've seen the corner finally being turned after a long time in Western Australia. So this is one thing that's helping the economy—high terms of trade and the mining sector going into expansion mode again, and I don't think that's going to be derailed by the current problems in China. The big miners have to invest to replace the capital stock, and they want to expand capacity. That's going to help.

Dr MULINO: As would always be the case, there are some things which are putting downward pressure on growth and some things which are supporting growth, but it's fair to say that your overall growth forecasts are that the economy will grow faster next year than in the last two years, and a major part of that would be these two major changes or, in the case of terms of trade, a continuation of high terms of trade—

Dr Lowe : Yes, we expect—

Dr MULINO: They're going to more than offset the negative things going on along the lines of the bushfires and coronavirus?

Dr Lowe : In the short term, the bushfires and the virus are going to cause a hit to GDP growth, as Luci said. In the March quarter, there's probably going to be a 0.1 per cent hit from the fires and a 0.2 per cent hit, at least where we stand today, from the virus. That's a substantial hit, and we're getting a negative effect from the drought as well. So in the short term there is a hit to GDP growth from these things. Over the year as a whole, though, with the resource sector in expansion mode again; continuing high commodity prices; the turnaround in residential construction that's been declining for a year but we think, by the middle of the year or maybe late in the year, will be in expansion mode again; households already having done some adjustment of their balance sheets; and housing prices rising, we expect consumption to rise. And if the world economy does a bit better, that will help as well.

So we've got a number of things moving gradually in the right direction—consumption, residential construction and mining investment—and that's enough to lift growth from two per cent over the past couple of years to closer to three over the next couple. That's not guaranteed. There are some uncertainties. The adjustment of household balance sheets—how much longer does that have to run? We can't be confident. I think it's going to come to an end, but we can't be confident. And it's certainly possible that the effect of the virus will be larger than what we factored in. So there are some uncertainties, but the baseline we're working with is growth picking up.

Dr MULINO: So you can give us a number or an estimate of the impact on GDP from coronavirus and the drought? Are you able to give us a number for the net impact on GDP growth of terms of trade being above the long-term average and of the mining sector going into expansionary made? Is it possible to—

Dr Lowe : The terms of trade are actually expected to come down a little bit. I don't think that with where we're at at the moment the high terms of trade are adding to growth—it just means that we've got a lot of revenue and a lot of national income. So it's boosting the level of national income, but certainly, if we look back over the last decade and a half, the higher terms of trade have made us incredibly wealthy. One of the reasons we've done so well is that commodity prices have been so high, but it's not helping growth at the moment. But what is going to help growth is the pick-up in resource sector investment. That's partly linked to the high commodity prices, but I think there are other things going on—having to replace the depreciating capital stock and some modest capacity expansion. So the high terms of trade are fundamental to high living standards—it's true.

Dr MULINO: Would you be able to give us an estimate of how much that's contributing?

Dr Lowe : Not off the top of my head, because you'd have to look back at how the high terms of trade have generated a lot of investment. We've got a higher capital stock because of that. There's more government revenue and there's more business profits, so I can't do that in my head and I haven't seen data. We could come back to you, if you'd like.

Dr MULINO: That would be great. So the higher terms of trade, relative to the long term, though, are not, as you say, feeding into GDP growth per se, but they're definitely feeding into the government's revenue—

Dr Lowe : And the level of GDP.

Dr MULINO: and the level of income?

Dr Lowe : Growth is the change in income. The high terms of trade are giving us a high level of income. At the moment, the terms of trade are probably going to come down a bit, which will detract from income growth, but off a very high level because of the high terms of trade.

Dr MULINO: They'll be maintaining that flow of healthy income into the government's bottom line.

Dr Lowe : Yes. In the short term, in terms of growth—the change in GDP—it's the pickup in mining investment after seven years of contraction. When mining investment picks up there is a lot of spin-off from that. We're starting to see the effects of that in Perth. After housing prices declined in Perth for a long time they've started to rise, the unemployment rate in Western Australia has just started to tick down and there are some signs that things are improving. This is largely linked to the pickup in activity in the resources sector.

Dr MULINO: I have a couple of questions around fiscal and monetary policy. You're setting the interest rate at a level that is balancing a few different considerations, as you've outlined already a couple of times. There are likely to be some fiscal policy initiatives—for example, spending from governments to help with the recovery—that will in a sense be working to support what you're doing, with interest rates being lower than they were a year ago. You've spoken on a number of occasions about quality infrastructure investment also working to support current interest rate settings. In fact, spending of that nature would probably make your job and that balancing act easier. Would it be fair to say that?

Dr Lowe : A pickup in investment generally would help. Some of that could come from the public sector. Ideally a fair chunk of it would come from the private sector as well. It would make our job easier. I know the federal government already has a very substantial infrastructure spend—$100 billion over 10 years—and the state governments have very substantial infrastructure spends as well. I think it's important that once we get to this very high level of infrastructure—we're almost there—that we keep it there, that we don't tail off. The economy, while it has some capacity constraints and infrastructure, needs a continuing high level of infrastructure spending. We'd like to see that high level maintained. In some areas there is capacity to do a bit more, but the more important one is that we need to keep the high level going for quite a while. The population is rising quickly and the existing infrastructure is often crowded and not working very effectively, so there are plenty of opportunities. It will help both medium-term productivity growth and the short-run growth dynamic. I'd like to see that continue.

Dr MULINO: In addition to investing in physical assets, which is what some people will often think of at first instance when they talk about investment, when you think about governments supporting an expansionary monetary policy, governments can support it by a range of measures—tax cuts are one way and increased government spending on well-designed programs is another. Isn't the flip side true, that what we've seen in a number of areas over the last year or two is significant underspends in some areas like the NDIS? Would it be fair to characterise that—we can not get into the weeds today as to why it's happening and all the administrative reasons and whatnot—if you've got a forecast of spending a certain amount and then it comes in at $4.6 billion lower, and that's money that's not going into services and the jobs they would have created and the social benefits they would have created, that's got to be acting against expansionary monetary policy to a degree I would have thought.

Dr Lowe : It's swings and roundabouts, isn't it? There are some things where they're underspending and other things where the government have actually increased spending. The best measure of the fiscal stimulus or impulse is the change in the budget deficit. For a number of years the budget deficit has been on a steady improvement track, so there have been small fiscal contractions as the government has got the budget into a sounder shape. That's had an effect on the economy. You've got to weigh the benefits of that against the longer term benefits of having a budget in a sounder position that gives you more flexibility in the future. In the policy circles, not just in Australia but elsewhere, there's a broader discussion going on at the moment about the role of monetary and fiscal policy in macrostabilisation, because, with many central banks at zero or very close to zero, the scope for lowering interest rates further, if we get hit by a downward shock—a bad shock—is very limited, so the scope for monetary policy to play that stabilisation role over the next little while is limited in most countries. We have some scope, but it's limited. The discussion going on in the meetings that I go to, particularly with central banks, is: is there a shift? Should there be a shift towards fiscal policy playing a greater role in stabilisation? And, if there should be, how does that work and what are the problems with it?

So there's a broader analytical discussion going on globally about the relative roles of fiscal and monetary policy as tools of macrostabilisation, apart from the current debates in Australia about what should happen right now. But I think it's quite an important public policy issue over the next decades. If we're going to have low interest rate and they're going to be between zero and two per cent much of the time, there's not much scope to cut interest rates if we have downshocks. How is the economy going to respond to that? I don't know the answer to it, but some people argue that fiscal policy could play a greater role and I say, 'We've tried that in the past, and it didn't really work out that well.'

Dr MULINO: I agree with all of that. There are swings and roundabouts, but 4.6 billion is a big swing.

Dr Lowe : Yes, it is.

Dr MULINO: It will be interesting to look at the figures and see how many roundabouts there are. Just one final topic, and that's going back to the labour force. It's interesting to look at graphs 7 and 9 from your speech a couple of days ago. Just looking at the next 12 to 24 months, it almost looks as though the wage price index and trimmed mean inflation are almost converging—not quite. But it's really looking like, on current policy settings, you're seeing real wages declining slightly from a pretty low level to an even lower level. Is that fair?

Dr Lowe : I wouldn't say real wages are declining but real wage growth is not really picking up. Inflation is going to pick up. At the moment it's 1.8 and it's going to pick up, let's say, to two over the next couple of years and in the wage price index, there's not much of a pick-up—a little one and then we've got the—

Dr Ellis : There hasn't been one, so it doesn't go anywhere.

Dr Lowe : There's the increase in—

Dr MULINO: And you've got it going up—

Dr Ellis : Just to clarify, in terms of what people really experience, in terms of their incomes, it's the average earnings profile rather than the WPI. In our forecast for the WPI at the very end—and this is actually spurred on a little bit by a question last time—the effect of the superannuation guarantee is now in our forecast horizon, so we've done some work to think about what we should do there. We've assumed a partial passthrough that affects the WPI but doesn't affect average earnings. So average earnings growth will pick up a little bit from here. But in a WPI sense, we've shaved off what would otherwise have been a gentle lift in WPI, as the labour market tightens up, and held it close to constant. There are bumps around because you've got base effects from the history, but I would describe the WPI index growth forecast as being essentially flat. But it would have had a little bit of a pick-up from where we are had the superannuation guarantee not come in.

Dr Lowe : There is some pick-up in average earnings, even though the wage price index is pretty much flat, because the super is going to increase by half a per cent. And there are some compositional changes going on which means that average earnings are growing a bit faster than average wages, so there's a very modest pick-up in earnings, but there is a pick-up and it's pretty much matched by the pick-up in inflation, which means the gap between, as I was saying to Mr Kelly, doesn't really change very much.

Dr MULINO: So wage growth will be flat for the next two years.

Dr Lowe : Yes. To repeat the point: to make a difference there, we've got to see productivity growth pick up. That requires more investment and a more dynamic economy.

Dr MULINO: One of the factors that you've alluded to that has been difficult to forecast over the last couple of years has been the participation rate on older workers and women. Another dimension of choice is the number of hours worked. The underemployment rate has been tracking up over the last 40 years. It's at a pretty high level now at over eight per cent. What are your thoughts on that? There are a group of workers who, depending on the options they have and if they have flexibility in their workplace, would choose to work more hours. We know from the HILDA survey, for example, that some people are taking on second and third jobs. What are your thoughts about that as a potential other source for downward pressure on wages?

Dr Lowe : It means that, if labour demand picks up, even if the participation rate doesn't rise further, we mightn't see the labour market tighten up that much because people can work additional hours.

Dr MULINO: Yes, but it's not easy to model.

Dr Lowe : About one-third of the workforce work part-time. Of that third, roughly three-quarters are happy with the hours they work, but of that third roughly a quarter are unhappy with the hours they work and they would like to work more hours. If there were a pick-up in labour demand, many of those people could work more and that wouldn't put any upward pressure on inflation. This is another reason why I think we could sustain quite strong labour demand without putting upward pressure on wages and inflation. Many people who are in these flexible jobs can actually work more if there's demand for their labour.

Dr MULINO: There was some recent work done by the Parliamentary Library that accessed ABS data which hadn't been publicly released before at a regional level. It suggested that in a lot of regional areas the underutilisation rate is at high levels—sometimes near 20 per cent—and had actually worsened more than metro areas over the last six years. Again that's just suggesting that, if we try to boil down to local labour markets, there are some real risks there about what the prospects might be for real wages growth.

Dr Lowe : Yes, there are. The broader macro point is that the unemployment rate isn't a sufficient statistic for the state of the labour market. We spend a lot of time on underemployment. We look at the people working part-time, how many want to work extra hours and how many extra hours they want to work. It clearly is different across the country. There are a significant number of Australians working part-time who want more hours, and a stronger labour market will help them.

Dr MULINO: My final question on this is: is this something that you are looking at or intending to look at more as a driver of what's going on?

Dr Lowe : Yes.

Dr Debelle : We have someone who has been, for want of a better term, embedded in the ABS accessing a lot of the microdata in the labour force survey. I talked about some of the findings he got in the speech I gave in Canberra late last year. As the ABS is providing access to some of this microlevel data we are looking at that, including to answer some of the exact questions you're asking.

Dr MULINO: Thanks.

Dr Lowe : The ABS and the RBA are working very carefully on this microlevel data and we can use it to understand what's going on with wages and labour supply choices. There's a tremendous reservoir of data there and, as improvements in data technology have occurred, there's opportunity for more research.

CHAIR: Thank you, Dr Mulino. I want to pick up in part on one of the questions he asked that related to interactions. In answer to a question earlier in the week, Governor, you said:

Longer-term there is an issue about the intersection of monetary and fiscal policy. The standard way of thinking for the last 20 years has been that monetary policy really is the stabiliser, deals with the economic cycle, and fiscal policy just deals with structural issues. But with interest rates as low as they are there is limited scope in the future, probably, for monetary policy to play exactly the same role that it used to play.

This is an open-ended question, but can you flesh out exactly what it is you mean and where you see the discussion around the interaction between fiscal and monetary policy heading in light of a question about its role in the future?

Dr Lowe : I want to make clear that I'm not talking about the current situation in Australia. There's debate in the international circles about how we should proceed in general. If the economy slows down, in the past the normal response would be to cut interest rates to stimulate things and get inflation back and the labour market strong again. If interest rates are already very low, the scope to do that is very limited. If you're not going to do quantitative easing and interest rates are as low as they are, you can't do anything there. If that were to be the situation, what does the country do? Do you sit there and say: 'There is nothing we can do. Bad luck. We have to have slow growth for a while and the self-stabilising properties will take place and fix things up'? Or is there a role for fiscal policy to respond to stabilise the economy in a way that it hasn't had to do in the past?

There's a school of economic thought that says, 'Fiscal policy should do that and it actually should be automatic.' There are people who argue, 'You should set up automatic mechanisms'—again, I'll make it clear: I'm not advocating for this—

CHAIR: I know, I know—

Dr Lowe : I'm just explaining what—

CHAIR: I'm just reflecting my caution as to that sentiment.

Dr Lowe : Exactly. But there are people who argue that, and there are other people who say, 'This should be purely discretionary.' Another perspective on that is—with the greatest respect—that politicians haven't been very good at doing discretionary fiscal policy, so we shouldn't even try. So these are the different perspectives that are out there. The economics profession really hasn't had to deal with these for the past 20 years because monetary policy has been a great stabiliser. But in the next 20 years, is that going to be the case? We don't know. If the answer is that it isn't, what role is there for fiscal policy or structural policies to play a greater role in macro stabilisation in response to shocks? Again, I'm not advocating any position; I'm just outlining what the debate is and what the issues are at the moment.

CHAIR: In my foreword to the report into the RBA's annual report, I made the observation that, obviously, between monetary policy, fiscal policy and structural reform, there was too much emphasis by the media on your commentary about fiscal policy and perhaps not enough of an understanding or reflection of your commentary around the need for structural reform to help the Australian economy. Do you agree or share that sentiment?

Dr Lowe : I agree the focus should be on structural policy. I didn't use these words today, but last year I was saying repeatedly, 'I want to see Australia to be a great place to invest, innovate, expand and hire people,' and—

CHAIR: And you believe that's best achieved through—

Dr Lowe : I don't think that's too structural, and it's coming back to the discussion we had before about dynamism and investment. That's the best solution to the problems we face. From a cyclical perspective, it'd be great if we were growing a bit stronger, but two per cent growth—in the broad scheme of things, it's not that bad, and we expect it to pick up. The real challenge we have is to make real wages grow at a faster rate than they have over the past five years, and that really is from structural policy. That doesn't come from short-term fiscal stimulus. It comes from making Australia a great place to invest, expand, innovate and hire people. To bring the sense of dynamism that we've had in previous decades and generations back to Australian business and government—that's the challenge you have. The central bank can't do—I can describe the situation; that's all I can do. The challenge is really for businesses to take advantage of those fantastic opportunities out there and for government to do its bit and to help create the environment where businesses want to take those opportunities. That's the path to stronger living standards in the country, not short-term fiscal stimulus. If the economy hit a very rough spot and things were moving in the wrong direction, monetary easing would be an option, as I said in my remarks. I hope other options would be on the table as well. But we're not in that situation at the moment. We don't think we need more stimulus. What we do need is: structural reform to make Australia—I'll say it again—a great place to invest, expand, innovate and hire people.

CHAIR: The smile that has been on my face is because the clarity with which you have said that is a very welcome interpretation. For the media present, it would be encouraged that perhaps they take mind of that, rather than just always falling for the alternative option of saying that the recommendations of the RBA governor are simply to spend more money. What research is the RBA doing at the moment, if any, in the context of the cost of—sorry, of increasing the superannuation guarantee to 12 per cent?

Dr Lowe : We had to confront that issue as we prepared our forecasts, and perhaps Luci can talk about how we've incorporated that into the forecasts?

CHAIR: Please.

Dr Ellis : As I mentioned earlier, we were asked that question last time and we hadn't looked at it at that point because it just wasn't germane to the forecast horizon we had at the time, and it was like, 'We'll deal with that when we come to it,' which was, of course, over the course of this summer, in preparing the current set of forecasts. So the team has done a fair bit of work thinking about what that appropriate pass-through should be, and, as I mentioned earlier, we have looked at a range of studies focused on examples of things that are benefits to the worker—so, not payroll taxes. Payroll taxes are not really something that the worker benefits from, so they're unlikely to engage in any trade-off between higher payroll taxes and lower wages so that's not a comparable thing. The question is: to what extent would wages growth be lower than it otherwise would be because you've got this other benefit that's not cash wages? As I mentioned earlier, something like an increase in superannuation contributions is something that, if there is a trade-off, affects the WPI measure, but you actually see the boost in average earnings measures.

CHAIR: Can I just clarify, because it goes to the heart of the discussion in part: does the RBA operate on the same basis that Treasury does—that is, superannuation is essentially deferred wages, rather than being paid for by employers?

Dr Ellis : The way we've looked at it, for the purposes of our forecasts, is we've looked at both Australian and overseas examples where there's been some non-cash increase in benefits that the worker prefers, and it's not quite a full pass through. Historically, about 80 per cent of the increase in the non-cash benefit tends to show up as somewhat slower wages growth than you would otherwise have seen in—

CHAIR: So that 80 per cent is how the RBA looks at it?

Dr Ellis : That's what we've come up with in our current forecast.

CHAIR: So overwhelmingly, but not exclusively.

Dr Ellis : Yes; so it is not a full trade-off, but it's most of it. The difference is, of course, the superannuation guarantee, so half a percentage point, comes in in one lump while the trade-off sort of comes through—we think that trickles through over several years because of wage bargains. We're embedding an assumption that the Fair Work Commission does engage in some trade-off of the fact that the superannuation guarantee has been increased when they think about what the increase in the minimum wage and award wages should be. So there is an embedded assumption there, and then we're allowing for enterprise agreements to follow suit over time as they're renewed.

It's important to point out that this is mainly a private sector story. In building up our forecasts and allowing for this, we've made the assumption that most public sector workers are unaffected by the increase in the superannuation guarantee. This is because they're already getting more super than that to begin with, because many public sector workers already get 12 per cent. Additionally, we're assuming that where there are binding wage caps, basically governments won't seek to then lower those to trade off that difference. You do have to make some assumptions about how this will play out. We've assumed that it's largely, but not completely, offset in WPI-base cash wages growing a bit slower than they otherwise would, and I feel more confident about making that presumption when the net result of that is to shave off an increase in wages growth that would otherwise have occurred as the labour market tightens. I think I would have felt a little bit more nervous about assuming that if it implied an actual decline in wages growth because of the superannuation guarantee.

Given that wages growth is already very low relative to historical experience, I think that would have—again, Phil was talking earlier about people's risk aversion. One thing we know is that people are loss averse. Workers are much more likely to resist a reduction in wages growth than they are to forgo what otherwise might have been faster wages growth.

CHAIR: Just for clarity: so if there's a dollar increase in somebody's superannuation, you are saying that 80 per cent—

Dr Ellis : One percentage point, yes.

CHAIR: You're saying that 80 per cent—

Dr Ellis : Roughly.

CHAIR: of it is coming at the cost of increases in wages.

Dr Ellis : Over time, so the timing of that in the private sector.

Dr Lowe : To think about the effect of that on the economy, you've also got to take into account that when compulsory savings go up, there's some offset in voluntary savings. So if you have to save more through super, you might save less voluntarily and therefore your consumption doesn't move.

CHAIR: Is that a hypothesis, or does the RBA work on the basis of research?

Dr Ellis : There's a lot of data.

Dr Lowe : No; there's been a lot of data over time. The last time I looked at this, the offset was almost 40 per cent. You force people to save and then they decide to save less voluntarily. But there's a lot of—

Dr Debelle : That's our effort. That's the work we did, Andrew. Different people did get different estimates, but that is the estimated—

Dr Lowe : But the point is there is some offset in terms of voluntary saving. There's a debate about how big that offset is, so we've got to take that into account in thinking about spending as well.

CHAIR: To what extent does the RBA look at how low interest rates at the moment are leading to people investing more in the stockmarket in pursuit of returns because they're not able to get it from products like term deposits?

Dr Lowe : I think it's very hard to see portfolio switches going on, but we do know—

CHAIR: Not necessarily portfolio switches, but they may be choosing to invest there in the first place.

Dr Lowe : It's hard to get the data on that. Equity prices are up quite a long way. Why would that be? There's more demand. Part of that demand is households and others are deciding to buy more equity.

CHAIR: But is it a search for growth as well?

Dr Lowe : It's a search for return, isn't it? When people are getting very low interest rates on their term deposits, some people look for other assets to buy. Some of them go into equities and some of them go into more structured products which they need to be very careful about.

CHAIR: But doesn't that raise serious issues around risk and the consequences of low interest rates, if that's what's happening in terms of investment?

Dr Debelle : One thing you can look at is price-earnings ratios and to some extent that gets to your question. PE ratios have gone up in Australia. They're on the high end, but they've been certainly considerably higher in the past. That gets to your point about risk, if you use that as a shorthand assessment of risk. They've been considerably higher at various points in the past than they are now. The other thing to point out is that if you—and this is an if—believe that interest rates are going to be lower for a longer period of time, you would expect PE ratios to be on the high end. If I take that into account and I look at PE ratios, I think they're not particular high. They've certainly been a lot higher at episodes in the past where there is clearly a large risk element to them. So they've gone up, and if I use that as a shorthand assessment of the degree to which people are stretching for yield I don't think I would characterise them as being at a particularly elevated level to cause a large amount of concern. As I said, they've certainly been a lot higher in the past.

CHAIR: I get the point that you're making about risk. I guess my question is really about to what extent the RBA thinks behaviour is being affected by interest rates which is leading people to invest in the stockmarket. As you've outlined, they're up considerably and it's because people are looking for some sense of return which they can't secure anywhere else.

Dr Lowe : I'm sure that's going on and that's how monetary policy works: you reduce the interest rate on the risk-free asset and people take a bit more risk. Coming back to the point I raised in the beginning: it's possible to have too much of a good thing. To date I think it's been a healthy adjustment in asset values. We are seeing some evidence that households have increased appetite to buy more complicated structured products in an effort to get more return. Some of that's appropriate, but people need to go into those structured products with their eyes wide open. More return normally comes with more risk—we shouldn't forget that.

CHAIR: No, I haven't forgotten that.

Dr Lowe : Most of the time you don't get more return unless you're prepared to take more risk, but in the current environment there's a possibility that some people forget that and just focus on the return. I'm reminding people to focus on the risk as well. At the moment we don't see this going too far but, if interest rates are low or lower for a long period of time, which they are likely to be, this will be an area of focus for us—including through the Council of Financial Regulators—to see where people are putting their money in the hope of avoiding the lower interest rates. So it's something on our radar screen.

CHAIR: It is on your radar screen?

Dr Lowe : It is certainly.

CHAIR: What would be the trigger which would lead the RBA to question the trend, shall we say?

Dr Lowe : If we saw people investing in complicated mortgage products, structured products—big inflows into those—we'd want to make sure, together with ASIC, that people understood what they were doing. More broadly, the focus is on debt rather than asset prices. I'd be concerned if I saw a rapid escalation in borrowing because of low interest rates.

CHAIR: Which we already acknowledge has at least partly occurred as a consequence of the lower interest—

Dr Lowe : There has been a pick-up in borrowing. It's perfectly understandable and to date it's reasonable. Many first home owners, particularly, are finally getting into the market after having been squeezed out for a long period of time, so I see this as a helpful adjustment. What I've seen so far I'm not particularly concerned about, but it's possible that the lower interest rates encourage more borrowing.

CHAIR: It's not just low interest rates; it's also shifts around macroprudential policy by APRA. To what extent do you believe that, in light of house price inflation, there may be a justification, or not, around APRA tightening lending standards again?

Dr Lowe : The movements in house prices have never been the rationale for the macroprudential measures. It's all about borrowing and credit standards. House prices move around for lots of reasons. I think we agree interest rates are a factor, and these structural things. That's what's going to determine house prices. Whatever house prices are doing, we want to make sure that borrowing is not excessive and, when banks and others are lending, they are applying good lending standards. The macroprudential standards came in when we saw 40 per cent of the loans being made in the country not requiring $1 of principal to ever be repaid. I thought that was kind of not good. So we fixed that up, and the investors were dominating the market and borrowing a lot on the back of expected capital gains. I thought that wasn't healthy. It's really the borrowing, and the macroprudential issue would come back on the agenda if we saw trends in borrowing and lending standards that were unhelpful for the longer term health of the economy.

CHAIR: But you don't believe that's the situation—

Dr Lowe : We haven't seen that yet, but, to return to the earlier theme, there is a risk that it could happen, and we're aware of that risk. We're watching it. I haven't seen that risk manifest itself, but it could.

Dr LEIGH: To pick up where I was earlier, Governor, inflation expectations as surveyed by the Reserve Bank are now below the target band for trade unions, market economists and the bond market. Are you concerned that, if that persists, the Reserve Bank is going to lose credibility with the Australian public?

Dr Lowe : You're right: inflation expectations have come down a little bit. For many of the measures, they're around two per cent plus or minus a little bit. My current judgement is that most people in Australia don't think inflation is going to be down at one per cent. Most people think inflation is already two or two and a bit.

Dr LEIGH: On what do you base that? Your own surveys say the opposite.

Dr Lowe : Most of the inflation expectation series are around two. If you ask people what inflation is likely to be over the next year, they say one point something. But, if you think about the medium term—I haven't got the data in front of me—I don't think many people in Australia think that inflation is going to be one point something over long, long periods of time. If they did come to think that, I think it would be an issue. I don't think we're there yet. Remember, inflation is 1.8. One point eight, frankly, is not that far from two. Most people can't tell the difference between 1.8 and two.

Dr LEIGH: Governor, you're meant to be targeting a band between two and three.

Dr Lowe : And we are.

Dr LEIGH: You shouldn't be taking credit for almost getting to the bottom of the band.

Dr Lowe : I'm not taking credit for it; I'm just—

Dr LEIGH: This isn't a ceiling; it's a target.

Dr Lowe : I agree 100 per cent with you. The point I was making is that 1.8 is not that far from two, and I don't think that most people, at least at this point in Australia, think we're going to get trapped with low inflation. If we do, then it will be an issue, and we're trying to send the message that we'll get back there. It remains the North Star. We're not going to be raising interest rates until we're confident that inflation is back to two point something.

Dr LEIGH: But my concern goes deeper than the fact that you've missed the target band for almost the entire period of your governorship; it's also that credibility is essential for a central bank. We've fought monetary policy wars in order to get to a point of credibility. Aren't you at risk of eroding that credibility by failing to get within the target band for a persistent period of years?

Dr Lowe : There is a risk of that. I accept that. My strategy in response to that is to try and explain as best I can to the Australian people why we're in that situation. It's not a lack of commitment to the target. We remain highly committed to it. I think it's the right framework. As I said, it remains the North Star. But there is some bumpy territory to traverse, and that bumpy territory is coming from changes in globalisation and technology and some things going on in the Australian economy. That bumpy territory means we have to traverse carefully. It slows us down, but we will get there. I hope the Australian community accept that explanation. If they don't, and inflation gets stuck below two per cent, then we've got a problem. But I haven't given up hope that people understand what's going on in terms of the global context—that we are gradually moving in the right direction and will get there, but it will take time and we need to be realistic.

Dr LEIGH: There's a social welfare cost in the meantime, isn't there? Lower inflation expectations mean lower wages. And presumably if you were in the target band there would be more jobs created. Have you modelled how many jobs would be created in the Australian economy if you were within the target band?

Dr Lowe : I agree 100 per cent with you that it would be better to have lower unemployment and inflation in the target band. Welfare would be improved. So I agree 100 per cent with you. The issue we are grappling with is: how do we get there? Given the rough terrain we're travelling over, given the global factors, given some of the domestic adjustments, what is the best way of getting there and staying there and delivering medium-term macro-stability for the Australian economy? That's the discussion we are having in our boardroom and that's the discussion we are having here today and trying to have in public to explain to the Australian people that the landscape we face has some bumps and we have to go carefully over those but, rest assured, we are heading in this direction. It's two per cent inflation. The best I can do, given the rough landscape, is to explain to people and hopefully be seen to be credible, honest and transparent about the challenges we face. I accept 100 per cent that it would be fantastic to have lower unemployment and inflation at 2.5 per cent. But I'm trying to navigate my way through rough landscape and I'm guided by the North Star!

Dr LEIGH: You have a tool to get there, which is rate cuts. You made the case earlier as to why you don't believe that is appropriate—and we differ on that. Let's go to other tools. The chair mentioned macroprudential standards. When APRA repealed their macroprudential regulations in December 2018 we certainly saw an effect in the housing market. If they hadn't repealed those regulations wouldn't that now give you more scope to cut rates? I feel we are sort of in a Tinbergen Rule area, where you don't want to have more targets than instruments, and to have macroprudential regulations taking care of some aspect of your concerns over housing price stability would allow you to focus more squarely on inflation and unemployment.

Dr Lowe : I don't quite see it like that. Those requirements were both targeted and temporary, and by the time they were lifted they were not binding.

Dr LEIGH: So why did lifting them have an impact on the market?

Dr Lowe : I don't think that was the main thing. It helped at the margin in some cases. I think that really helped the psychology. Remember, there was a cap on interest-only loans and investor credit. All institutions were way below those caps; and the caps were not binding at the point they were lifted, and lending standards have been improved within financial institutions. So if they had been maintained it probably wouldn't have had that much effect. But it was the right thing to do because the mindset was that these were targeted and temporary and when they were no longer needed they should be lifted.

The discussion we'll be having over the course of the year if credit growth picks up and lending standards deteriorate is: should we re-implement some of those things? At the moment, the credit trends are fine and lending standards are strong. The issue I keep coming back to is: is that going to remain the case? If people in Australia understand that interest rates are going to be at this level or lower for years—which I think the situation is—what is going to be the response in borrowing? We get information about that every month. If borrowing remains contained and there is no deterioration in credit standards, and the unemployment rate is not moving down, then we'll have an opportunity to perhaps look at interest rates again. That's the balance we're facing. The best I can do is explain to people that that is the situation we're in and leave it to others to judge whether we're losing credibility.

Dr LEIGH: Clearly the best way to regain credibility on the inflation target would be to meet the inflation target, would it not?

Dr Lowe : I agree. We're working out how best to do that. In a way, that is not just achieving it over the next year but giving the country the best chance to have macro stability over the next decade. People are going to view those trade-offs quite differently; I accept that. What I can do is explain how we think about it and the judgements we're making, and you and others can make your views on whether you think that's appropriate.

Dr LEIGH: The other channel through which we could see expansion is a depreciation in the dollar. You had an analysis in the November Statement on monetary policy on what would happen if the Australian dollar depreciated five per cent. You found there that the unemployment rate would fall significantly faster, reaching 4.5 per cent by the end of 2021, and that core inflation would be back in the target band within the next two years. It sounds like a win-win to me, with more jobs and inflation closer to the target. The question is how you might achieve it. Have you considered jawboning the currency lower to achieve that result?

Dr Lowe : I agree with you that a lower currency would be helpful. It would mean more jobs and higher inflation. Have I considered jawboning? Not really, because I don't think it works very effectively most of the time. People listen to me for a day or two but then the fundamentals start reasserting themselves, as they should. Lower interest rates would have an effect on the currency, but cutting interest rates 25 or 50 basis points isn't going to deliver five per cent depreciation.

We're swimming in a big ocean here. There are lots of things that are influencing the exchange rate, including our interest rates. As I said in response to Dr Mulino's question, the resources sector is going into expansion mode again and the terms of trade are still high. Trying to manipulate the exchange rate for short-term macro benefits is not a successful strategy most of the time. There are circumstances where that might be appropriate, but we're not in those circumstances.

Dr LEIGH: So, if you've ruled out open-mouth operations with respect to the FX markets, I take it you've also ruled out direct intervention in the FX markets?

Dr Lowe : I would never rule that out. Our intervention strategy is, I think, pretty well understood. We only intervene in the market when it's clear that there's market dysfunction and that liquidity has evaporated or is a problem, or when the exchange rate is a long way from fundamentals and is hurting the economy. Our markets at the moment are working very well. Liquidity is fine—there's no problem—and I can't tell you that the exchange rate is a long way from fundamentals. From those perspectives, we can rule out direct foreign exchange intervention. I'm not saying we will always rule it out, but I think we're a long way from considering that. I don't think me talking to get the currency down is going to have any lasting impacts. It'll be newsworthy on the day and the currency will probably come down, and then, two days later, the fundamentals reassert themselves.

Dr LEIGH: Turning to Reserve Bank operations, the chair noted earlier that most of our forecasting models perform poorly. My reading of the evidence is that that's particularly true when you most need them to do well—that is, in predicting turning points. Wouldn't it be better if the Reserve Bank was to invest a little bit less in forecasting and a little bit more in nowcasting, in getting accurate data about the current performance of the economy and, perhaps, more direct surveys of measuring expectations? We've got the Westpac-Melbourne Institute survey on house price expectations. Would it be better to invest in getting better data on long-term house price expectations, for example, as Shiller has done in the United States?

Dr Lowe : Would it be better spending more resources on that? I'm not sure. If we've got concrete ideas and we can do that cost-effectively, we'd be happy to explore those. In Australia we've got quite a lot of data on expectations. We've got the Westpac-Melbourne Institute survey of consumer expectations—there's a new house price one in there—and so many business surveys that tell us about firms' hiring expectations, investment expectations and price expectations. I feel that, compared to other countries, we do pretty well on surveys of people's expectations. What's the incremental benefit? This is the question I'd be asking. What's the incremental benefit from spending more, ultimately, taxpayers' money on getting more surveys? Maybe it would be useful to have a think about that. Luci's team could look at that.

Dr Debelle : We devote resources to our liaison program, which I think gets to some of the points you're talking about, and actually is very informative of our nowcast. We do feed a lot of information from that exercise into our nowcast. Maybe it's the case that there would be a case to devote even more resources to that, but we do actually devote a reasonable amount to that. The biggest influence on your forecast most of the time is having some idea about where you are now, because that's something you can know rather than improving the fogginess of your crystal ball—

CHAIR: The crystal ball is getting a good run today.

Dr Debelle : I'll just keep that meme going. So we do devote I would say a reasonable amount of resources to that. We certainly devote more resources to that and, I would say, use that information more effectively now than we did 10 or 20 years ago—certainly 20 years ago. Maybe it's the case that we could put more resources that way, but I would say we devote a reasonable amount. Whether it is sufficient is certainly an open question we could think about.

Dr LEIGH: I was thinking in particular, given your concern over financial stability and house prices, that to have better surveys on expectations of house prices would seem useful.

Dr Lowe : It's worth looking at, yes.

Dr LEIGH: Staying on data, we're currently one of only two OECD countries without a monthly consumer price index. I know you've had periodic conversations with the Australian Bureau of Statistics about moving to a monthly CPI. Where are they at?

Dr Lowe : I don't know where they're at.

Dr LEIGH: Are you agitating strongly for a monthly CPI?

Dr Lowe : They understand our position.

Dr Ellis : They understand our position. We would regard the outcome as being better if we had a monthly CPI, but that does have to be traded off against the really quite serious budget cuts that the ABS are facing. They face some quite material and difficult trade-off decisions about what surveys to drop. They have thought about it recently, because the cost of doing it has come down a long way in the last 10 years. One area where technology has really improved the situation is that it would now be a lot cheaper to do a monthly CPI than when they first thought of it. It is something that they have contemplated. You'll have to talk to the new Statistician about where they're at now.

Dr LEIGH: He used to occupy your job, so presumably you're fairly simpatico. Have you considered a cost-sharing arrangement?

Dr Ellis : I'm not sure I'd be comfortable with us paying for something that we're meant to be achieving. It would look a bit weird for us to be subsidising the production of something against which we are measured. I think I would much prefer that to be independently funded. I think it would cause accusations of a conflict of interest. We do support the idea of having a monthly CPI, but we also want a high-quality labour force survey, because there are no—at least we're still getting it quarterly. To be honest, I don't know that we would have done a better job—you mentioned the trade-off between forecasting and nowcasting. If anything, our inflation forecasting and certainly our inflation nowcasting is pretty good. We have access to so many more datasets than we used to. Our headline CPI forecasts for the next quarter are informed by weekly data on petrol prices. We at least get fruit and veg directionally correct. These are hard things to do. Mostly your near-term CPI forecast is based on what you can get for volatiles, which is always going to have a lot of noise in it, and then that's overlaid on top of your underlying inflation forecast. You said 'attention to forecasting versus nowcasting'. It's not so much nowcasting where we are that I think there would be the most bang for buck. Where you seemed to then go on was more about expectations.

But coming back to the monthly CPI, I think it has to be understood that there are policy trade-offs here, and I certainly wouldn't want to trade-off a worse-quality labour force survey. One of the things people don't realise is that, around the world, Australia has one of the highest response rates to its labour force survey. It's still in the low 90s, whereas in the UK it's in the 40s. I think we have a lot more faith in our labour force survey that a lot of other countries have in theirs. Would I want to trade that off for a monthly CPI we've survived without for 30 years? I'm not sure I would make that trade-off.

Dr LEIGH: I have a range of other questions about RBA operations, but I look forward to returning to them at our next hearing.

CHAIR: You can of course always put them on notice, Deputy Chair. Just quickly—I let you have one extra, so I get one too. Before we conclude, Governor, today's front page of the AFR seems to suggest that retail sales are strong, but The Australian is saying they're weak. We've had major retailers close recently or go into administration. Do you have any insights into which one it is?

Dr Lowe : Like most things in life, the truth is in the middle. The volume of retail sales in the December quarter was half a per cent up, which is better than it has been for the past year, so there are signs of life there. It's not as difficult as it has been for a while. The monthly value number for December was a decline because of the big increase in November, as everyone's doing this Black Friday shopping now.

CHAIR: Yes. It's a bizarre concept.

Dr Lowe : So there's a change in the seasonal pattern, and the ABS is having trouble adjusting for that. But the important point from my perspective, and the good news there, is that the volume of retail sales was up half a per cent in the quarter, which is better than it has been for the past four or five quarters. Having said that, it's still clear that retailing is very difficult. The industry is going through a lot of structural change. You've got households doing this balance-sheet adjustment. There are foreign firms coming in. So the industry is going through a lot of churn, and households are adjusting. But I was encouraged by the December quarter number for retail spending, and it's suggestive of this gentle turning point in spending, which we think is in prospect.

CHAIR: The only reluctance I have now, at the end of this hearing, is not just that we don't have more time but also that we don't have the opportunity to see you more than twice a year. Perhaps we should investigate avenues to do that, depending on what happens with interest rates. There you go: the decision is yours! We look forward to seeing you soon, then!

Thank you very much for your appearance here today. We greatly appreciate, as always, the participation of the RBA. Our enthusiasm is very clear-focused. These hearings—apart from the fact that they probably do have some effect on the markets, according to what I'm reading in the press—are a good insight into where the RBA's thinking is heading. As I outlined in my foreword in the most recent report on the RBA annual report, I think our role, particularly in times like these, is particularly important in holding the RBA to account. That's not a reflection on the RBA; it's about making sure all the institutions are doing their job and building a sense of public confidence, and the opposition and government members play a critical part in that as well. Thank you very much for your appearance.

Resolved that these proceedings be published.

Committee adjourned at 12:33