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Standing Committee on Economics
Reserve Bank of Australia annual report 2011

DEBELLE, Dr Guy, Assistant Governor, Financial Markets, Reserve Bank of Australia

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

STEVENS, Mr Glenn, Governor, Reserve Bank of Australia

Committee met at 09:30

CHAIR ( Ms Owens ): I declare open this hearing of the House of Representatives Standing Committee on Economics and welcome representatives of the Reserve Bank, members of the public and the media. Since the last hearing in August 2011, the Reserve Bank has cut the cash rate by 50 basis points. However, the major banks have increased their market rates independently of the RBA. In view of these competing pressures, the committee will examine the RBA about whether it is confident that the current monetary policy settings are achieving their policy objectives. The hearing will also provide an opportunity for the governor to update the committee on the sovereign debt problems in Europe and the potential impact that this has for the global economy. It should be noted that, despite the current international uncertainty, the fundamentals of the Australian economy are strong. Public debt and unemployment are low, underlying inflation is at the midpoint of the inflation target range and we have a significant pipeline of business investment, particularly in the resources sector.

Once again, on behalf of the committee I welcome the governor and other senior officials of the Reserve Bank of Australia to this hearing. I remind you that, although the committee does not require you to give evidence under oath, the hearings are legal proceedings of the parliament and warrant the same respect as proceedings of the House. The giving of false or misleading evidence is a serious matter and may be regarded as contempt of parliament. Mr Stevens, would you now make your opening statement before we proceed to questions.

Mr Stevens : Thank you, Madam Chair, and good morning to all of you. When we last met, in August, we had entered a period of heightened uncertainty about the global economy and financial system. The investment community was focusing increasingly on the high levels of public debt in major countries and especially on the situation in the euro area, where budgetary pressures, banking pressures and competitiveness issues within the single currency area make for a very difficult set of problems. There was considerable instability in markets. But our view at that time, tentatively, was that we were not witnessing a repeat of the events of late 2008. Admittedly the second half of 2011 saw some very anxious moments. There was a flight from risk that pushed up borrowing costs for major countries in Europe like Spain and Italy, but pushed them down for countries like Germany and the United States—in fact, to the lowest levels for 50 years, in spite of the fiscal challenges that the US itself faces. Funding markets for European banks in particular were effectively closed for a few months and for other banks became much more difficult and certainly more expensive.

The palpable fear that I think one could sense before Christmas that Europe was on the brink of some sort of very bad financial event has lessened over our summer. The anxiety has not gone away altogether—and nor will it, I think, for some time—but the worst has not happened. Financial markets, while hardly brimming with confidence, have recovered somewhat over the past couple of months. Banks are able to access term funding again, albeit at higher cost. High-frequency gauges of business conditions and confidence have stabilised over the past few months in Asia, in North America and in fact even in Europe. We have not seen the very steep fall in all these indicators that we saw late in 2008.

The actions of the European Central Bank have contributed greatly to the stabilisation of financing conditions, essentially by removing, at least for a time, doubts about the funding position of European banks. The efforts of European leaders to craft a stronger framework for euro-wide governance on fiscal matters have also continued. It is true to say, I think, that a great deal more needs to be done yet to place European banks and sovereigns onto a stable footing and even, just as importantly, to boost potential growth in Europe. But progress is being made.

Forecasts for the global economy this year have been marked lower, mainly due to these problems in Europe. Revisions to the IMF's forecasts in particular were given great prominence in the press a few weeks ago. Our own forecasts have also come down, although they were already a little bit weaker than the IMF's were. On these sorts of forecasts, global GDP will grow by about 3¼ per cent in 2012. If that happens, it will be down from about 3¾ per cent in 2011. That outcome was around the average pace of growth for the global economy in the past 15 years. On its face, if that is what happens, that performance will be no disaster. After all, growth is going to be below average some of the time.

If we look for things to worry about, we will certainly find them. That global figure has a very uneven composition and there are some countries, particularly in Europe, which will record very weak outcomes this year. Moreover, it is unlikely, I think, that any time soon we will get to a moment at which it can be said that these problems in Europe are now behind us. Most likely progress will be slow and there will be periodic setbacks and bouts of heightened anxiety. I think that is just the nature of these things.

But, equally, we should recognise that things have not been uniformly bad recently. The US economy has not experienced the double dip that some people feared six months ago. Instead, it has continued growing. The US corporate sector is in very strong shape. It is cashed up and it will at some point be able to start moving ahead more quickly and, indeed, it would appear that over recent months American corporations have begun to step up the pace of hiring, which is very good news.

In China, the slowing of growth we have seen seems to have been roughly what the policy makers there were looking for. They appear to be getting on top of the housing boom and inflation problems. Around the rest of Asia, activity has slowed—that in part reflects their trade links with Europe—but it has not slumped. As inflation falls, it seems to be that policy makers have increased room to respond.

The pressure on European banks to shed assets has had some impact on trade credit in Asia. The French banks in particular were quite big providers of trade credit, and they have had to pull back somewhat. But, at this stage, the system seems to be adjusting to that without major drama. We have not seen to date the collapse of trade credit and trade flows that we saw three years earlier.

Commodity prices, which had declined noticeably from their peaks in the first half of last year, have, if anything, been moving sideways or, in a couple of cases, picked up a bit over the past couple of months. They remain high by historical standards. That seems broadly consistent with the expectation that the group of countries that make up our trading partners will expand at a reasonable pace, expected by the IMF to be four per cent or more this year, which is not very different to last year. Again, we do not see, at this point, the signs of a rapid collapse in global demand that we did see at the end of 2008 after the financial turbulence in that year.

At home, most of the information coming in suggests the economy has grown at close to an average pace over the past year. That outcome is a bit weaker than we expected a year ago. That is partly due to the effects of flooding in the Queensland mining area, but it is not all due to that. It is also partly due to outcomes in the non-resource side of the economy being a bit softer. CPI inflation has come down more or less as we expected as the effect of the floods last summer on food prices has reversed. In underlying terms, inflation was 2½ per cent through 2011. That also is a slightly lower outcome than we at one stage had thought might occur. The labour market was generally softer last year after unusual strength in 2010, although the unemployment rate at its latest reading is virtually unchanged from a year ago.

These changes to the macroeconomic picture against the backdrop of a period of intensified international turmoil saw the board lower the cash rate by 50 basis points in the closing couple of months of 2011. Perhaps a little surprisingly in the face of developments in wholesale funding costs at that time, that was initially fully reflected in a reduction in most lending rates, though, of course, there has been some partial reversal of that lately. We have repeatedly made clear that the shifting relationship between the cash rate and other interest rates in the economy is a factor that the board takes into consideration in setting the cash rate, and that will, of course, remain the case. Recent developments do not, in our view, materially affect the capacity of monetary policy to achieve its goals.

Looking ahead the bank's central expectation is for growth to be close to trend and inflation close to the target over the coming one to two years. Naturally there are risks surrounding that central view and some of them are spelled out in the latest statement on monetary policy.

Perhaps what is most noteworthy about the Australian economy is the way in which the drivers of growth have changed recently. We have spoken at length in the past about the terms of trade, the resulting investment boom, which is still building and has somewhat further to go yet and which will take the share of business investment in GDP to its highest level in at least 50 years. We have also spoken on the other side about how household behaviour has changed. People are saving more and borrowing less. Spending is growing and it is growing in line with income, but people are spending their money differently than the way they were in the past. The retail sector is finding it has to adapt to that changed environment. Some industries are struggling with the high exchange rate, meanwhile, certain other sectors, not just in resources but some services sectors, are growing quite smartly. Hence, while the economy overall has recorded average growth there are probably very few sectors who themselves are experiencing average performance. Some are quite clearly weak relative to the historical average while others are much stronger.

The bank is quite aware of those differences and the pressures that they bring to businesses and individuals. We also know that monetary policy cannot remove the forces that generate different paces of growth across industries or regions in the economy. We have to keep our eye on the overall performance of demand and prices. We are also acutely conscious that history may offer limited guidance in assessing the net impact of the very disparate and very powerful forces which are at work to an extent which has seen few historical parallels. Nonetheless, that is the assessment we have to try to make as best we can.

The most recent assessment was that, with growth near trend, inflation consistent with the target, interest rates at about average and an outlook which suggests, as best we can tell, more of the same, the setting of monetary policy was about right for the moment. Of course, we continue to reassess things every month.

With that, Madam Chair, we are at your disposal to respond to questions.

CHAIR: Thank you. I will start with a question about interest rates, because I know that a lot of people have noticed the banks acting independently and their intention to continue to do so. I note you have already said that you do not believe it makes a material difference. I want people to look at it and see how the banks act after the Reserve Bank makes a decision on monetary policy, and the banks act afterwards to change the setting somewhat. How do you reconcile that with your statement that the settings are where you would want them to be?

Mr Stevens : I think it is the general structure of loan rates within the economy, and we should not forget the other side, the deposit side. I think our assessment would be that, even after the lending institutions made their own adjustments in recent weeks, these rates are roughly where we think is appropriate for the circumstances that we face. As I said in my opening remarks, I was probably just a little surprised that the interest rate reduction in December that we did in particular was quite as fully passed on as it was. We cannot make a precise forecast of these things, but I had anticipated that that might not be completely passed through. As it turned out, it was, but a little bit of that has been taken out subsequently. Overall, I think where we are sitting at present is about where we should be. As I said, every month we re-evaluate whether that is still true and, if it turns out not to be, we will respond accordingly.

CHAIR: There is a lot of criticism of banks about whether or not they are overprofitable at the moment, whether there are genuine costs that they are covering or even whether they are behaving cautiously for possible headwinds. What is the Reserve Bank's view on that?

Mr Stevens : What is our view on whether they are too profitable?


Mr Stevens : My first comment would be, as I have said at this committee on numerous occasions, if I had to choose between unprofitable ones and profitable ones, I would chose the latter. You only have to look at the dimension of the banking problems in Europe to see that we do not want banks that cannot earn a good return. Are they too profitable? You have to think about too profitable relative to a benchmark. Our assessment is that, if you look at the rates of return on equity in our banks over a lengthy period of time, say 20 years, they are good but they are actually broadly in line with the listed company sector in general in Australia. I do not think it is obvious from that comparison that they are in some sense excessively profitable. That is at least one benchmark one could look at. It is not necessarily the only one, but that is probably where I would turn first to try to assess that particular question.

CHAIR: If they were excessively profitable, one would assume that foreign banks would start to move in. Is there any evidence that the profits are such that people are starting to do that?

Mr Stevens : We had large-scale entry of foreign banks in the mid-eighties, as you know. It was a very competitive environment. Some of those players came to grief actually. I think, in terms of foreign competition, what we see is that it tends to wax and wane with the credit cycle and the cycle of confidence. When globally credit conditions seem pretty easy and money is easy to get and fairly cheap and everybody is confident, you get foreign banks increasing their presence in Australia, typically chasing corporate business. When that cycle turns, as it did three or four years ago now, those institutions come under some pressure to wind back, as indeed they have done. That is a cycle that waxes and wanes. It is a reasonable assertion that, if it is really, really profitable here, other players will want to find some way of getting their hands on some of that profit for sure.

CHAIR: You said in your opening statement that if we were looking for things to be worried about they are out there.

Mr Stevens : They always are. There are probably one or two more than normal just now.

CHAIR: It does seem from reading your statements over time, and we all know it, that various sections are behaving with caution. Consumers are saving more. Employers are putting off the employment of new people just to see how things go. One could argue that the Reserve Bank and the government both have a cautious approach to possible headwinds. Are we being overcautious and are we prepared for the headwinds that may come?

Mr Stevens : I think there is potentially a tendency for us to focus only on the things that could go wrong. There is a list of them, as you say, that could be put forth. Perhaps as a society we tend not to give sufficient weight to the fact that we are in a long upswing. Our rate of unemployment has a 'five' at the front and the next digit is a small number. Inflation is about where we want it and our banks are strong. Our government finances, despite some pickup in debt in recent years, show that basically we are a AAA-rated country and rightly so—there are not that many of those. We are attractive to foreign investment. The government did not end up having to own any banks as a result of the crisis. There is a lot that is good about that picture. I do not wish in any way to be a Pollyanna and say, 'Look, it's the best of all possible worlds,'—it is not. We have issues, but it is actually a pretty reasonable performance compared both with our historical experience and also with the vast bulk of other countries you might choose with which to draw a comparison.

I think we should not lose sight of that, and occasionally it is my job to try to remind people of a few positives, as well as keeping an eye on what could go wrong.

CHAIR: There are undoubtedly a lot of changes in the economy, and some of them are structural. You have covered some of them in your opening statement but, again, I am interested in your views on some of the others. Does the Reserve Bank, to some extent, look through the changing savings patterns because you think they might be an adjustment? Or do you think they are permanent? Do you think the change in retail is permanent, or—

Mr Stevens : There is no particular science to saying, 'What is the correct rate of saving?' by, say, households. But the current number—which is 10 per cent or more—to the extent that there is a norm from history, it is much more likely to be near that than zero, which is where it got to five years ago. I know we have covered this at previous hearings, but we had that long period of household behaviour in which the rate of saving from current income went down progressively to nothing, basically, as measured by the ABS. Asset prices were rising, leverage in the household sector was rising and confidence was high, and that is not going to continue indefinitely. At some point that phase will come to an end, and it has. I think that the kind of saving performance that we see now is much more likely to be normal in the future than what we were seeing five years ago.

I do not think that the so-called 'caution' has got to the point where the saving rate is continually going up and up and up. I do not really think that is happening. I think the evidence over the past year is that consumption in aggregate and income have roughly gone up together, so the saving rate has not changed much. Most likely, the period of the large rise in the saving rate is behind us now—I think. But I think that a pattern towards a positive saving rate like what we see now probably is normal, and we should expect that that will continue into the future.

Retailing: I think there are a number of adjustment issues that that sector faces. I am no expert in it, but we can talk about that if you wish. I think that is partly occasioned by different saving behaviour but partly also occasioned by the higher exchange rate and changed shopping habits in general that were always going to come, and they have probably been accelerated by some of the events we have seen—particularly on the currency. Those things were coming independently of changed saving behaviour is my guess.

CHAIR: I have asked you this before, but things seem to change so quickly between our meetings these days that I will ask it again! If there is a significant downturn—if the headwinds that people seem to be preparing for are stronger than we expect—are we in good shape as a country, relative to where we were in 2008?

Mr Stevens : I think so. I think that in the banking sector we are probably in better shape than then because of the extent of usage of offshore wholesale funding. There is still a considerable amount of it, but it is smaller than it was then. Asset quality is good and capital is strong. So, from that point of view, I think we would be in good shape. From the point of view of macroeconomic policy and capability to respond, we have some and, in extremis, there would be fiscal space to do so as well, I think, really.

So in thinking, 'What if the worst occurs?' we will be affected. There will not be any escaping some effects should that occur, but I think we have as much capability as any country and more than most to respond to it. But, as I said earlier, the worst has not occurred, actually. The US did not go into double-dip. Europe has not keeled over completely; it is making progress. There is a whole lot more to come and one wishes it could be faster, but Europe is making some progress. I think we will probably need to kind of manage our way through these potential problems for several years.

CHAIR: You referred in your opening statement to the different elements of the economy and the different demands and condition of them, I guess. In the early days when I sat on this panel, not in this position, you seemed to not give a great deal of consideration to the different responses to interest rates in the different sectors of the economy and your language has changed quite a bit in the last few years. I heard what you said in your opening statement that you cannot really take them into account, but, given the concern across the country about the different impacts of the high dollar and the boom et cetera on different elements of the economy, how do you deal with that?

Mr Stevens : I say that we are conscious of these differences. I might say that it is still the case on a number of important metrics that the degree of dispersion in performance is not as large as we have seen at some other times in history. That could change, but to date that has been the case, which I suspect is at least partly attributable to an economy that is more responsive and more flexible now than it was in the previous times we have had a big run-up in resource prices. So the first point would be: yes, there are differences, though I think we should take care not to overstate them. The second point, and this is a message that does not really gladden too many people's hearts: monetary policy is a national policy. We have one instrument—one currency. We are a currency area and we cannot make the differences go away because they are really driven by fundamental forces in the global economy.

What has happened is that there has been a major shift in relative prices, so the prices for natural resources and energy are way up; the prices for manufactured products and some services are down. There is nothing anyone in Australia has done to make that occur; it is a global phenomenon and there is actually nothing we can do to make it go away. It is a feature of the global economy that has occurred. In aggregate, for our country it is an enriching thing because we have such a large natural endowment of natural resources and energy, but also, because it is a relative price shift, that will occasion pressure to change the structure of the economy. There are no two ways about that. Monetary policy cannot make it go away. I do not actually think any policy can make it go away. If we are talking about policies to help the economy adjust, they would be in the realm of other policy areas. Monetary policy cannot do anything about that because we cannot change relative prices. That is the fundamental thing. It is a major, relative price shift that the global economy, because of what is happening with Asia and so on, has handed down, so to speak. Every country in the world has to adjust to that, including us. For us the adjustment is not necessarily easy but, overall, it is actually a positive opportunity because of our resources endowment. So, in that sense, you would have to think we are better placed than most others. But it is an adjustment; there is no way around that.

CHAIR: There is talk from time to time that one country or another is thinking about or is intervening to move its currency one way or another or hold its currency stable. I understand that Switzerland did something recently. What is the Reserve Bank's answer to people who think that that is a good idea?

Mr Stevens : Switzerland actually did a lot of intervention a couple of years ago, which I think you would have to conclude was not all that effective at that time. Recently they have announced that they will defend a cap on the Swiss franc relative to the euro, at a level which, by historical standards, is very, very high. So they have let it move a huge distance. Switzerland is a country experiencing deflation in consumer prices. So the exchange rate forces acting there are more powerful than what we have faced. So far, that cap has held credibly. I am not attracted to attempting to do that at the moment because I am not sure it would be effective. We have not done any intervention to try to hold down the Australian dollar. I am not saying we never would. We have been known to intervene on both sides, but we certainly do not foreshadow it. I am not saying we would never do it, but we have not done so to date. We do continue to ask ourselves whether what is happening in the currency makes sense. I would observe that the most recent bout of strength is happening at a time when the terms of trade have actually peaked and have started to come down. That is a bit odd, but we will see what happens.

Mr CIOBO: Governor, I would like to touch on a number of topics this morning. If I can start with your opening comments and reference both today and previously with respect to the business investment pipeline and the growth that we have seen. Could you outline for the committee the key factors that impact on that business investment and, in particular, the issue of business certainty?

Mr Stevens : I think the biggest single factor driving that pipeline is the relative price shifts that I have just been talking about. There is a very large rise in investment in the resource sector going on. I might get Phil to help me with the exact numbers, but I think historically over a long period investment in that sector was running at about two per cent of GDP. We are seeing it rise to five or six.

Dr Lowe : Possibly seven—maybe higher than that so that is an extraordinary rise.

Mr Stevens : If you plot out the share of investment to GDP for 50 years—we have quarterly figures going back to 1960—I think it is already pretty much as high as it has been in that period. We think it will go up one to two percentage points of GDP over the next couple of years. The reason for that is we have a lot of natural resources—iron ore, coal and gas—and the prices of those things are very high. It would appear that the industry is fairly confident that prices, not necessarily this high but pretty high, will persist for a long time. So that is underway.

With respect to the rest of the economy, the share of business investment is not remarkably high, although it is not incredibly low, either. In some of those sectors they are seeing the other side of this structural adjustment phenomenon where their part of the economy relative to the total is tending to get smaller. Some of those sectors will probably increase investment in order to raise their productivity, quality and so on in a response to the pressure; others will probably contract. So there are a range of forces at work, but the really big story of the large investment pipeline is the high relative prices of natural resources and energy.

Mr CIOBO: I accept what you are saying with respect to terms of trade, but no doubt impacting upon that is the issue of risk and uncertainty. There are many examples around the world of equally attractive, on the face of them, opportunities to invest but which are otherwise precluded because of sovereign risk and various issues like that. Can you outline for the committee the impact that, for example, certainty has on business investment?

Mr Stevens : Uncertainty is obviously an impediment to investment plans. Most measures that we have of business confidence from surveys are about average or perhaps a little below, but not very much. Then again, by industry they are quite different, depending on which industry you are in. Because that reflects the various pressures of relative price shifts that the sectors are under, it is probably a little hard to detect out of that information separately an impact of any kind of sovereign risk. To be honest, I am not convinced that foreign investors generally have taken a negative sense of Australia's sovereign risk lately. I do not think that is so—and we do not want them to, of course, so we need to be careful with all our policies. I am not sure I conclude that perceptions of sovereign risk have gone up seriously lately.

Mr CIOBO: Don Argus is on the front page of today's Australian talking about the need for business certainty. I note there have been a number of comments by business leaders and industry captains over the past several years about the need for greater certainty. Do you think that you are missing a broad view out there by some of the key people driving investment that says that there is in fact a certain degree of uncertainty which is inhibiting the flow of business investment?

Mr Stevens : I cannot comment on what business people say. Mr Argus and others have their own views and it is a free country so they can put them. What I am saying is that if it were true that there was a serious perception of elevated sovereign risk for Australia, I do not think we would be seeing the appetite for Australian dollar denominated Australian government debt that we have seen, which has been quite strong lately. At least that factor leads me to be wary of drawing strong conclusions about sovereign risk. There are other elements where there can be uncertainty, over regulation and so on, and that maybe what business people are referring to. I am not really convinced that sovereign risk is a major issue at least at present.

Mr CIOBO: The discussion seems to have become focused on sovereign risk—I was talking about uncertainty more broadly. I take it from what you are saying that you concede industry concern has been expressed both recently and historically that the level of uncertainty with respect to government policy has increased?

Mr Stevens : If people say this in the newspaper, one cannot deny that that is their view.

Mr CIOBO: Could I turn to the issue of productivity more broadly. I know, for example, that recently the Business Council of Australia made the comment that they thought Australia was becoming a high-cost, low-productivity nation. I would be interested in your views in response to that. I ask you, as you have done for the committee previously, to outline areas where you think there may be possible reforms that could be undertaken by government which might help to address this issue.

Mr Stevens : I think the facts on productivity are that, pretty much whichever way you cut it, we had a period of quite good growth in productivity in the decade up to sometime in the early 2000s—maybe around 2002 or 2003—and since then, at least as I eyeball the figures, the trend rate of growth of productivity has slowed materially. I am sure we could have a lengthy debate about why that is or was, but I think that is what the facts are. There is no question that rising productivity is really fundamentally the only source of higher living standards available to a community, particularly one that starts with reasonably full employment overall, as we do. From here, rising output from our capital stock and our workforce is really the only source of higher standards of living. So, wherever we can, we want to do things which will assist that and not impede it.

As for what can be done to raise productivity, I can only give you the answers that I think I have given a couple of times before. There is a body called the Productivity Commission whose job it is to tell us as a community the sorts of things that can impede productivity and the sorts of things that can help it. That is their job. They spend all their time on it, they are experts in it and I would refer the committee to the things that they have said. I think that one time at one of these hearings I rattled off a whole bunch of things that they had said. I cannot actually find that list here at the moment, but I cannot do any better than that.

Mr CIOBO: Given the significant amount of business commentary about the productivity impact in a negative way of the Fair Work Act, for example, do you think that, as I take it from your answer, the Productivity Commission should be looking at that as addressing a business community concern in a way that boosts productivity?

Mr Stevens : I do not have any particular comments about the Fair Work Act per se. There is a review of that, I understand, being undertaken. I do not know what it will conclude.

Mr CIOBO: Not by the Productivity Commission.

Mr Stevens : Whether the Productivity Commission should be asked to do it or not I do not know; that is not my call. But my general point in answer to your question, 'What can we do to lift productivity?' is that there is a body who give you those answers and I could not possibly give you a better set of answers than theirs. They are the experts in this.

Mr CIOBO: The connection I am drawing, though, is that there is clearly widespread business community commentary about the impact on productivity of the Fair Work Act. You are saying that the Productivity Commission is best placed to make a determination about how to boost Australia's productivity, so, as night follows day, should it not therefore be the case that, to address some of the business community's concerns, the Productivity Commission look at this?

Mr Stevens : I think it is open to you to make that argument. It is not my call whether the Productivity Commission gets a reference on a particular topic or not.

Mr CIOBO: Can I ask about discussions that take place within the Reserve Bank about whether you are hearing concern, as part of taking a snapshot of the business attitude towards investment in the economy, on the level of industrial disputation and unrest and whether that is flowing through to decisions that the Reserve Bank is taking with respect to monetary policy.

Mr Stevens : Is your question whether industrial disputes per se are a factor in our decisions?

Mr CIOBO: Not exclusively but, yes, as a factor, and in particular the impact that has, obviously, on wage rises et cetera.

Mr Stevens : I would not say so to date. I do not think I could recall serious discussion at the board meeting of industrial disputation being a factor in our setting of the cash rate. I do not think we have referred to those things in any of our reasoning for the decisions that we have made over recent years.

Mr CIOBO: Even, for example, where in Victoria we see a push now for a nearly 20 per cent wage increase? We have many examples across the economy of very large and aggressive pushes for increased pay. That is not something that the Reserve Bank is looking at?

Mr Stevens : The effect of higher overall wages on costs, and therefore on prices, is obviously a thing that we would keep a very close eye on. We monitor the settlements that we see occurring; we monitor the aggregate data. Clearly, if there are very large settlements that are anything other than confined to a fairly small group of people, that raises the potential for overall labour costs to start pushing up the whole cost structure, therefore making it harder for us to achieve the inflation objective. Our assessment on overall wages up till now has been that they are okay. I do not really want to see them accelerate materially from here, but what we have seen in the official aggregate data so far is probably broadly consistent with where we need to be. That is on the proviso that we think we will get a little bit of a lift in productivity growth over the next few years. The reason I think that is that I think all the structural change in the economy is going to force that. On that assumption, which I think is reasonable, the pace of labour cost growth in aggregate that we have seen up to now is probably okay from a medium-term inflation performance point of view. I am going to be bit uncomfortable, though, if it materially accelerates from where it has been just lately. That is obviously a reason to watch particular settlements if they have some prospect of spreading widely. Obviously you have to watch that.

Mr CIOBO: In your opening comments, you said few sectors are experiencing average performance and some are clearly quite weak relative to the average while some others are much stronger. Could you outline some of the sectors where you are noticing significant weakness. I am guessing, for example, the tourism industry with the high Australian dollar.

Mr Stevens : Some parts of tourism are suffering quite a bit from that, particularly in Queensland. I think visitor nights in Sydney hotels are quite strong at the moment, so it is varying a bit. But it is certainly very evident that the kind of tourism that goes to Queensland resorts is quite weak and a lot of those people who might otherwise go there are travelling abroad. So some sectors of tourism are very weak. Trade-exposed manufacturing is obviously having a difficult time with the high currency. Some other bits of manufacturing that feed into resources are doing better. Engineering-type construction is exceptionally strong because of the mining story, but building construction—some types of non-residential building and also residential in many of the states—is relatively soft. Those are the weak ones. The strong ones are, as I said before, the resources and the parts of the economy including service areas that feed into that, and some other personal household services are growing strongly.

Mr CIOBO: To what extent does policy that provides support to industries in those sectors that are weak have an impact on your settings on monetary policy? Clearly there is an impact on those sectors as a consequence of the policy settings you make. Is government support—or a lack of government support—a factor? Do you have a view on whether there should or should not be government support when this kind of structural change is taking place across the economy?

Mr Stevens : I am not going to bite on the question of whether the government should support the car industry or this or that other industry. That is for others to decide. In terms of how this effects the way we think about things, there is a kind of indirect effect, I suppose, in the following sense. Presumably it is possible that policies that have a bearing on how weak sectors turn out to be could have some bearing on how the price level of the output of those sectors evolves over time. It is hard to know for sure what that effect might be, but in principle there could be some effect. Presumably that would show up eventually in prices for goods and services. We are of course trying to keep the inflation rate at a 2½-type number. That is a fairly lengthy chain of causation to our decision process. I do not think I would say, 'Oh yes, we have observed policy X being done in sector X and we know that the effect of that on its prices is going to be this much.' We cannot analyse it with that much precision.

Mr STEPHEN JONES: I want to go to the paragraph in your statement this morning regarding what you describe as the 'shifting relationship' between the cash rate and the retail rates. I think the chair went to this issue as well. I ask you to make no subjective observation about bank profitability. I just want your views about the extent to which this disconnect is driven by cost increases for banks in relation to accessing capital on global markets and the extent to which it is about profit maintenance.

Mr Stevens : What is the difference between those two things? The same level of profit means that if your costs increase then you want to recover that in the price of your product—any business does. I do not think there is any question that, relative to the cash rate, the costs of some term funding in wholesale markets has risen. It has come down in absolute terms since the middle of last year, but not as much as the cash rate. In other words, relative to the cash rate it has gone up a bit. There is no doubt about that. It is not possible to be exactly precise about how many basis points that is, but certainly there is an effect there. So I think when people say those costs have risen that is true. I am not here to defend the banks; they can defend themselves. But most businesses seek to reflect their costs in the prices of their products, if they can, and that industry is no different in that respect.

Mr STEPHEN JONES: My second question goes to the same area. Do you think that Australian banks are paying a fair price for access to credit in the global credit market, taking into account the relative risk profile of Australian banks compared with other institutions accessing credit in those same markets?

Mr Stevens : Maybe I could get Guy to comment on the pricing relative to what we know about that from banks of comparable countries.

Dr Debelle : The Australian banks, given their credit standing, pay about the right price relative to banks around the rest of the world. So in terms of comparing them with other banks, the answer is yes. Their pricing is appropriately differentiated from those that are weaker—and there actually are not that many that are stronger or even that many in their peer group anymore. There does not seem to be anything particularly odd there. Relative to other corporates, as I said last month and as we put out in our statement, BHP can borrow cheaper than, to give an example, the four largest banks here even though, according to the rating agencies, they are a riskier credit. That gives an assessment as to what the market's assessment is of the rating agencies' relative assessment of those two groups. There are corporates who are, at least at face value, riskier credit propositions, at least according to the rating agencies, who can borrow cheaper than the banking system. But in terms of our bank's ability to borrow and as global markets have moved, it has been in line with that of other banks around the world.

Ms O'DWYER: I want to go to the statement of monetary policy first and just ask you a little bit about the price impact of the carbon tax. I notice from the most recent statement of monetary policy the usual forecast table in chapter 6 is missing one of the items that often includes—namely, the non-farm GDP growth. What are the bank's near-term forecasts for non-farm GDP growth and how do they compare with the trend?

Mr Stevens : I am not sure why that is not there, but I can give you those numbers, I think. No, I cannot, because I have not got them here. But they are probably similar to the overall GDP ones because, in the absence of a large climatic event that would drive the farm sector very differently, if the farm sector is growing at something like average then non-farm in total will not be very different. Although I do not actually have the precise numbers right here, I am quite sure that they are quite close to the figures that are in the table for total GDP. So it is around trend.

Ms O'DWYER: The discussion at the end of the statement of monetary policy sometimes also includes information on where the bank is expecting the unemployment rate to hit in the near term. In light of the extraordinary weakness of employment growth of 2011, with no net jobs created for the first time since the depths of the early 1990 recession, what is the bank's latest thinking on what might happen to unemployment over the coming year?

Mr Stevens : I will get Dr Lowe to go into the details. I believe that we think it will probably go up a little bit from here. Although, in contrast to that, the latest reading actually went down. But that is just one month. It is going to rise a bit, we think, and then starts to decline.

Dr Lowe : In our central forecast we have the unemployment rate drifting up probably to around 5½ per cent some time over the course of the next year and then gradually coming down a little bit. What we detect at the moment when we talk to business is some reticence about hiring. In 2010 businesses were prepared to hire on the prospect of stronger demand. Now they want to actually see the stronger demand before they commit to taking on extra workers. That is attributing to the softness in the labour market. Over time, if our view about the demand strength in the economy turns out to be true, I think businesses will feel that they have the confidence to actually go and hire workers a bit more aggressively again than they have over the past year and so the unemployment rate will then drift down a bit. But most of the time over the next two years, I think we will be sitting with the unemployment rate between five per cent and 5½ per cent.

Ms O'DWYER: You said that business will want to see the higher demand and that that is different to the past. What do you think has impacted on business wanting to actually see that higher demand before making decisions on employment?

Dr Lowe : I think this is really coming from global events, because you see this everywhere around the world. The movements in business confidence have been very highly correlated over the past three years. We saw in August, when the European problems really blew up again, business confidence fell everywhere, including Australia. I think that constant reporting of what is going on in Europe and the possibility of a very bad outcome there has weighed collectively on the business sector and made people just a bit more reluctant to hire. If things work out reasonably well, which is our central scenario, I think that gradually will dissipate and people will feel again, given the underlying strength of private demand in the economy, that businesses will hire.

Ms O'DWYER: So you do not share the concerns that have been expressed by the business community that flexibility of the labour market is also impacting on their decision to hire new workers?

Dr Lowe : I do not think that is the major issue here. I think it is global uncertainty. It was not that long ago that we had the IMF talking about the possibility of another 1930s moment. That is typically not an environment in which businesses feel emboldened to go and hire workers on the prospect of stronger demand. There are obviously a whole range of other factors at play here, but I think the first order one is really the global environment. If that can settle down and private demand in Australia grows like we think it will, I think we will see the employment growth come back again.

Ms O'DWYER: You have just mentioned the volatile global environment. Obviously the G20 plays an incredibly important role in that. Does it concern you that the Treasurer of this country will not be attending the G20?

Dr Lowe : The G20 has got a lot of issues on its plate.

Mr Stevens : I will be going to the G20 this afternoon, so actually one of the two principals from Australia will be there. It is not at all uncommon for ministers to miss an occasional meeting due to some political event at home. I think we will be okay.

Ms O'DWYER: You have got big shoulders, Governor. I am sure you will be able to carry the weight. I wanted to talk a little bit about inflation. In the statement on monetary policy the bank noted:

While non-tradables inflation has recently been lower than the peak rates seen in 2008, it has been running at a higher rate than would appear to be consistent with inflation being around the centre of the medium-term target range if tradables inflation was no longer being held down by an appreciation of the exchange rate. Accordingly, some modest easing in domestic cost pressures, including from stronger productivity growth in the domestically oriented services sectors, is likely to be required in the medium term.

Could you give us some comments on why non-tradeables inflation has been running so strongly when domestic growth since 2008 has been noticeably below average and households have actually been moving to save a larger fraction of their income?

Mr Stevens : Fundamentally we have had a number of steep rises in utility prices, which I do not think will get even steeper on a percentage change basis on the whole over time. That has been happening. More generally I think the truth is that unit costs in aggregate in the non-traded part of the economy have been running at a pretty solid clip and the very eloquent words that you read out are saying that we actually think that needs to slow down a bit over time. The forecast is that it will. This comes back to my comment earlier that we are making an assumption that there is some improvement in productivity growth over the period ahead. I think that is a reasonable assumption to make. If it were wrong then for the inflation target to be achieved we would need something else to adjust—namely, the rate of growth of costs, including labour costs, to moderate a bit. So that is the forecast we have made and the passage you have read out is seeking to articulate what we think the dynamics are and what they need to be. That will be I think an important thing for us to be watching over the period ahead.

Ms O'DWYER: You said you have confidence that there will be increased productivity growth. Could you perhaps explain to us why you have that confidence?

Mr Stevens : I think it is a reasonable forecast to make, that there will be some improvement. I do not have in my head the extent of the pick-up that we are contemplating. But the reason I think that that is likely is that we are, as we have been saying earlier, in a period of structural change. I think it has probably accelerated in recent times. It would normally be expected that that results in an acceleration in productivity improvement. It is not an easy process for the firms doing it. Sometimes when we talk about productivity I think there is a tendency in community discussions to think of this as a very nice, soft, wonderful concept and that we can just dial it up, but it actually does not work that way; it works by firms, managements and workforces grinding out difficult changes to the way they do things every day. That is where the productivity comes from and from implementing new technology, new equipment and new ways of doing things. All of us have a much quieter life if we are actually not under any pressure to do that, but I think people are under pressure to do that and that is why I suspect that we probably will see some pick-up in measured productivity growth. Whether we will actually be able to see that clearly in the data is another question because in assessing productivity usually you look back from a long time in the future and see that, yes, something happened, like we can now look back and say that things clearly slowed in the early 2000s. For a few years it was not really clear whether that was so or not. But that is what I think and I am aware that not everybody would agree with that, but that is the assessment that we have made, and for that reason.

Ms O'DWYER: So you believe that there will be some productivity growth. In your view, will it be enough? A lot of business has been making commentary recently that we need to be very focused on increasing productivity, as has the Productivity Commissioner. Will it be enough?

Mr Stevens : The question for us is about the combination of productivity growth that can be achieved, also the rate of growth of wages and other costs—and we should not forget capital productivity here as it is not just labour productivity. So will all of those things combine in a way that gives us 2½ per cent inflation? That is my question. Will it be enough? Well, that is the forecast with, as I admit, the risk that that could be wrong. The forecast could be wrong for other reasons too. Whether it is enough in some broader sense, that is a bigger question. The really big reason we want as much productivity improvement as we can have is because that is what makes our living standards go up. In some sense you could almost say, 'We've never got enough. Wouldn't we like to be even wealthier than we are? Yes.' The only way to do that is to grow the productivity even faster, but that is a much broader and arguably more important question than the narrow one of 'will things work out' from our narrow remit. On that score we are saying we think they will, but we are cognisant that that could be wrong.

Ms O'DWYER: I am also very interested in your perspective on Europe. I note that you made a statement earlier this morning where you talked about the fact that the problems of Europe are still not behind us. Could you perhaps also give us your perspective, if the elections go as we think they might and there is a change of government in a number of the countries in Europe, whether this will have a broader impact? Obviously, it will on Europe but also there is the flow-on impact here in Australia. What is your perspective on that?

Mr Stevens : I am not sure what countries you mean. Greece, France or whatever?

Ms O'DWYER: Greece, France.

Mr Stevens : In the Greek case, where there is a very large assistance package coming, what the countries of Europe who are rendering the assistance have insisted on, as I understand it, is that all the major parties commit to implementing the reform package regardless of the election outcome. Of course, I do not know for certain whether such commitments will ultimately be met, but that is what the other countries of Europe have insisted on. I do not know what is going to happen in other countries or what effect electoral changes might have. I think, though, that at one level the sorts of things that are needed are reasonably clear. It is also reasonably clear that they are exceptionally difficult to do, because there are fiscal problems and you have to address those. But too heavy-handed an attempt to address them in the very short term can kill growth, which then means your fiscal problem does not actually improve, because the economy is weaker, revenues are down and so on. But you do have to have some credible story for the long run. That is one thing.

There is still a need for European banks to have stronger capital positions, and it is necessary that that be done not by deleveraging the balance sheet but by getting capital, and that is actually one of the issues at the moment, because there is a fair amount of deleveraging happening. Then, probably most fundamentally of all for a number of key countries, really all of this stuff works only if you can get growth in the economy, and in a number of key countries they need supply-side growth and positive reforms. These things do not produce the growth straightaway, of course, as you know. From our own experience they take years to come through, but then they are quite powerful. If you look at Italy, that is the plan Mr Monti is trying to bring in. He is trying to do supply-side things that will help the economy have a faster potential growth so that you get a virtuous capacity for more growth and better budget. The thing is a virtuous circle as opposed to the vicious circle of continually trying to cut the budget, which weakens the economy, which weakens the budget and so on. So that is what they have to try to orchestrate.

On top of all that, you have 27 countries in the EU all trying to do this in some kind of reasonably coordinated fashion. This is no easy project, but that is what they are attempting and we all have an interest in them managing to pull it off. As I said earlier, I think some credit should be given for some progress having been achieved recently. There is a long way to go, and during that time we will periodically at these hearings still be talking about what happens in Europe. I think we will be talking about that for a few years, really.

Ms O'DWYER: Thanks.

CHAIR: Thank you very much.

Proceedings suspended from 10:43 to 11:02

CHAIR: We will resume.

Dr LEIGH: Governor, I want to raise with you the issue of the dual mandate. Obviously, the bank wants to target both output and inflation, but there are differences in the weight of that one should place on those two. There was an interesting paper by Glenn Otto and Graham Voss in the Economic Record last year that tried to back out the weight that the Reserve Bank places on those two. Their best estimate was that you place a weight of about one-third on output deviations and about two-thirds on inflation deviations. Does that feel about right to you?

Mr Stevens : I do not know that I want to endorse particular weights out of an estimated objective function. I think what I would say is that the sort of inflation target, medium-term average type specification that we have does a pretty good job of allowing us to take due account of cyclical fluctuations in the real economy and anchor inflation over time. Somebody can back out from the way the cash rate has responded. I have not actually read that paper, but I assume they ran some regressions of cash rate changes against deviations of output from trend and inflation from target or something. But I do not really have in my mind particular quantitative weights of that when we are making the policy decision, I must say. It sounds like an interesting result, but I think we are conscious of both elements of the mandate and I think the inflation target setup we have does a pretty good job of allowing us to hit both.

Dr LEIGH: I should say that I passed a copy of the paper to Dr Debelle before, if he wants to add anything to that.

Dr Debelle : I've had plenty of time to read it thanks, Andrew, while I've been sitting here!

Mr Stevens : I would have thought you would have some regressions to add by now.

Dr Debelle : I have actually been hanging on Glenn's every word, so I haven't had time to read it.

Mr Stevens : That's because he thinks I might make a mistake!

Dr Debelle : The only thing I would say, Dr Leigh—and I agree with what Glenn has said—is that I am not sure how meaningful that sort of analysis is because you cannot map inflation variability and output variability into the welfare of the Australian people—which actually is the third part of our mandate—all that precisely. I do not know how a given quantum of inflation variability or a given quantum of output or unemployment variability would map into what we are actually here to do. So that means if you throw a couple of weights at me and ask if that works or gels, it is a difficult question to assess.

Mr Stevens : One thing you could say is: neither of the weights are zero and neither of them are one, and nor should they be.

Dr LEIGH: But this is about as helpful as saying that we would rather have banks than no banks, with respect. We are not in the world of corner solutions.

Mr Stevens : It is a bit more than that, because it is saying we are not what Mervyn King used to call 'inflation nutters' to the extent that we give no regard to the real economy at all, but nor are we so intent on trying to finetune real economic activity that we let the medium-term path of inflation drift seriously off course. So we should not be in either of those extreme positions, and we are not. I do not know whether one-third, two-thirds is the correct assessment of what we are doing. I think there is some substance to saying we are not in either of the corner solutions, and I think it is appropriate that we not be.

Dr LEIGH: Have you formally evaluated the inflation targeting regime? Have you given any consideration to nominal GDP targeting?

Mr Stevens : I have given a couple of speeches over the years looking back over our history, at how we have gone, and maybe I will do that again one day. There have been a couple of those. I am not aware of a formal piece of research on nominal GDP targeting versus inflation targeting. We may have done one but I am not aware of one.

Dr LEIGH: That makes it sound as though you are agnostic on the question.

Mr Stevens : I think I can claim that I did more than most people to build the current framework. I think it works very well and I would be very loath to move off it. There are plenty of respectable people who would say a nominal GDP target has certain attractions, and it does—though I suspect that in a case where we have, say, very large terms of trade swings that make nominal GDP rise 10 per cent one year and go down 10 the next year we would have to have a way of figuring out how to handle that if we were targeting nominal GDP. We do not have that problem with a recurrent inflation target. So I think that is a potential issue.

I suppose my story, Dr Leigh, is that we have had the current framework for nearly 20 years, I personally had a lot to do with helping to articulate it and I have been very committed to it. I would not say this is the end of history, that there will never be a better framework, but of all the things that have been tried this is the best one we have tried. I still think it is working pretty well. Here we are, on the latest data, combining 5.1 per cent unemployment and about 2½ per cent core inflation. For most of my working career as an economist—in the time since I started studying economics in the early 1970s—that would have been regarded as a remarkably good combination on both elements of the mandate.

Dr LEIGH: Thinking about levels of unemployment, we are now in mining boom mark 2, with an unemployment rate around five per cent. In mining boom mark 1 the unemployment rate was closer to four per cent, but with inflation outside the target band. Is it reasonable to say now that the minimum sustainable level of unemployment is closer to five per cent?

Mr Stevens : I am not doctrinaire on unemployment rates, because there are various reasons they can shift. It is certainly observable, as you say, that we actually got down a fraction under four per cent—3.9 was I think the lowest for a brief period there. I think it is pretty clear that the economy was overheated at that time. Core inflation went to about 4½ per cent. In 2009, when growth slowed markedly and unemployment went to about 5¾ per cent, we did have quite a material slowing in wage and price growth. It sounds like the right place to be is somewhere between those two numbers—assuming we can draw any empirical meaning from that experience, and that of course is quite a big assumption. I do not quite feel comfortable with the notion that there is a hard barrier for unemployment—that it is a particular number and you must not go below or above that. I think we should be a little bit reluctant to be too doctrinaire about numbers.

Dr LEIGH: All of us are uncomfortable, I think, with the notion of full employment, but it is still important to think about.

Mr Stevens : It is indeed. We think about spare capacity and what potential we have to grow faster than trend. We think about that a lot. I just do not want to be drawn on a number that I think is the minimum or the maximum. I think that is probably unwise, and I think you would agree.

Dr LEIGH: I respect that. We spoke last year about the vacancy rate. I noticed in the November statement last year that you had a chart showing that the vacancy rate was at what looked like historic highs—around 1½ per cent. That seems to suggest some degree of either spatial or skills mismatch. Do you have views on ways in which policymakers like us might bring down that vacancy rate?

Mr Stevens : We probably interpreted the high vacancy rate as evidence of a tightish labour market, though not as tight as it was in 2007 and 2008. The question you raise is whether it indicates mismatching. That is an important question. I guess that mismatching can be spatial. It could be industry skills. I suppose one would think of policies to do with labour markets, education and training and so on in an effort to lessen that mismatch.

Dr Lowe : It is most noticeable in Western Australia, where the unemployment rate is very low—just around four per cent—and there are a lot of vacancies. So in Western Australia the ratio of vacancies to the unemployment rate is very high—unusually high. If you look across the rest of the country that is not the case; it is around average. We see that in business surveys as well. The businesses are asked how hard it is to find labour, and they are not saying that it is particularly hard at the moment, with the exception of people trying to hire workers in the resources sector. I think for the economy as a whole it is broadly working out okay. Firms have got vacancies. They are not finding it incredibly difficult to hire people. They are not having to advertise extremely aggressively to get people. That is a general statement. In Western Australia I think there are pockets where there is a mismatch between the demand for labour and the supply of labour. That is something that only education and human capital policies can ultimately address.

Dr LEIGH: Mobility policies too, surely. If you look at the internal migration data, it seems as though the maxim 'Go west, young man' does not apply at all here. All of the increase in the Western Australian labour market comes from external migration rather than internal. Should that worry us?

Mr Stevens : There may be scope for more there. Actually there is a lot of fly-in fly-out. They are commuting west quite regularly, even from New Zealand or Indonesia, to some of these sites. In that sense, there is a kind of mobility to some sectors of a kind that we have not seen in history. That is not to say there are not impediments there to the more old-fashioned sort of mobility of actually upping and going and moving your family and so on. I do not know. There may be. I am not saying you should not look at that, but I think we should not understate the degree of mobility that is actually already there.

Dr LEIGH: Moving from jobs to banks, there was a Societe Generale report out earlier this week that suggested that rising Australian bank costs were impossible. I am trying to reconcile that with Dr Debelle's speech on changes in bank funding costs. I was wondering about your reaction to the report in general but also the extent to which we should be looking at the spread for the bank bill swap rate or the level of the bank bill swap rate. The spread has gone up but the level has gone down.

Mr Stevens : Since you have referred to Guy's speech, I will pass it over to him.

Dr Debelle : I think there is a confusion here between levels and spreads. As Glenn said earlier and as I said in my speech, the spreads have gone up. That is unambiguously the case. But the levels in some cases have come down. They just have not fallen as much as the cash rate has fallen. So that is a confusion that is out there by a number of participants in this debate who sometimes talk in spreads, sometimes talk in levels and sometimes do not make it clear which of those two they are talking in. As Glenn said in his opening statement and as we put out in our statement on monetary policya couple of weeks ago, if you take the case of deposits, the deposit rates have fallen but they have not fallen as much as the cash rate, so the spread of deposits, which is more than half of banks' funding, has gone up relative to the cash rate. The same is true particularly of longer term borrowing costs, where the spread has certainly gone up and the level might have come down but is around the same.

Dr LEIGH: Should there be greater transparency in banks' net interest margins, either by a requirement on the banks themselves or through you?

Mr Stevens : They publish their net interest margin in their published results I think. We will publish in a few weeks time, in the bulletin in March, our update of funding costs. So there is information. I think the difficulty is that it is a complex subject. The information has to be pulled together from disparate sources. When we talk about this, particularly in the piece we will put out in a few weeks, we are trying to give a framework, but in a lot of the public discussion that goes on I think people talk different languages. Some people talk in absolutes, some talk about spreads to swap, spreads to cash and spreads to CGS. It gets snippets from here and there and it is not surprising that the general public could easily end up wondering what on earth is going on because many of the people who discuss this are actually speaking different languages really.

What we try to do is set this as clearly as we can. As I said, this will come out in a few weeks time. Now that we have a full round of published results for banks—and that is one of the sources of data that we use to put this together—that will come out and then all the various protagonists will interpret it as they wish. That will be our best attempt at shedding light on this. But in the end I think the simple answer is that the cash rate has come down 50 and the costs of funding the books have come down less than 50. One cannot be entirely precise about exactly what the gap is, but there is a gap and that has been reflected in the recent set of discussions and decisions that the various lenders have made.

Dr LEIGH: You are right, but there is certainly a great degree of complexity in this debate. Thinking about just one simple example, would Australia have cheaper access to credit if the market share of the big four were taken by, say, 10 banks? To what extent are they exercising a monopoly power?

Mr Stevens : My colleagues can chip in if they wish. I do not really see why that would be. With 10 banks or four banks, there is an amount of credit to be funded. Banks actually, it seems to me, would like to grow their balance sheets. They want to lend to you. They have to do it safely. If the cost of lending to you comes down, they are going to make it cheaper for you because they like to do more of it—provided it is done safely, of course. It is not obvious to me that the market share of those four particularly raises the cost of funding for the overall system. Actually, in most banking systems in most countries there are a small number of pretty big banks that are dominant. That is not true in America so much, but America is unusual. Many countries would have a handful of largish institutions that do a lot of the business.

Dr LEIGH: One of the strengths of the US system that people talk about is this access to venture capital. Do you think that one of the impediments to productivity growth in Australia could be the difficulty of accessing credit for risky enterprises?

Mr Stevens : I am not sure. I am not sure what the size of the venture capital sector here is. There are other forms. There are active private equity businesses in Australia. So I do not really think I can offer a conclusion that there is some kind of market failure there. That is not obvious to me. There might be, but I am not really in a position to give you a strong opinion about that. Do you guys want to add anything?

Dr Debelle : The venture capital market has been small. There have been various attempts to make it bigger over 20 or 30 years, which have not been ultimately successful. I think no-one has ever really been able to come up with a coherent explanation as to why that is the case.

Dr LEIGH: Do you have suggestions for policy reforms that would increase the depth of that lending market? It does seem important at the really innovative, very risky end of the business sector.

Dr Debelle : I am not sure it is related to the banking question you were asking—and maybe you did not intend it to be—because the venture capital which is provided in, say, the US does not have much to do with the traditional banking sector at all. As I said, quite a few people, including a number of venture capitalists, have put their minds to why this is the case, and in terms of being able to identify a policy prescription no-one has really been able to come up with what exactly is the problem here beyond, 'It's not happening.'

Mr Stevens : America in many respects is quite unusual. There are probably not many countries that have that big a venture capital sector; I am not sure. We often say we need a corporate debt market like America's, but few countries actually have a corporate debt market to the extent it does. So we sometimes berate ourselves, but actually a lot of countries do not meet those standards.

Dr LEIGH: How does the exchange rate enter into your models of output? Is the net effect of an appreciation in the exchange rate positive or negative? Do you think about nonlinearities, in which a higher exchange drives rapid structural adjustment, potentially having negative impacts on growth?

Mr Stevens : There are multiple models the staff have. Generally speaking, I think the sign on the exchange rate as it goes up is contractionary for output and it lowers prices, the caveat being that it always matters why it rose. An exchange rate rise in response to, say, a big boom in the terms of trade is a different story to an exchange rate rise because, all other things equal, we tighten monetary policy. I think those are important considerations. Is it true to say that they are the signs?

Dr Lowe : You got that right. The issue of nonlinearity, though, is an interesting one, because in history—let us take the last 30 years—the exchange rate has moved in cycles. Our general sense is that those cycles have had some effect on economic activity, but many businesses expected the cycle to be reversed at some point in time, and so the exchange rate might be high but there was not that much adjustment going on in the economy. My sense is, from talking to businesses, that that perception that this is a cyclical fluctuation has receded a bit and more people at least countenance the probability that this is going to be highly persistent.

I think what we struggle with and are likely continue to struggle with is just what effect that is going to have on the economy. Is the perception that this is going to be highly persistent starting to lead to the types of changes that would not have occurred with this high an exchange rate previously because people thought it was going to come back down? Unfortunately, history does not provide us with that much of a guide to deal with that, because this is a very unusual event historically. But it is certainly an issue that we are cognisant of. We think about it all the time. It is just that history does not provide us with a very good guide about what the answer to that question is.

Dr LEIGH: Thank you.

Mr TONY SMITH: Thank you, Governor, for your update today and for your insights in answers to the questions over the last couple of hours. I would like to refer to a matter that has not been raised today but was raised in the hearings in August and February of last year, and that is the serious issues surrounding Securency and Note Printing Australia. I should start by giving you the opportunity—there have been some developments since August; I was not at the August hearings—to say if there is anything you would like to update the committee on with respect to those matters.

Mr Stevens : As you know, there were a number of criminal charges laid against individuals and against the companies. The companies have continued to offer their cooperation to the authorities. These matters remain before the courts. I cannot really therefore offer public commentary on how those cases are proceeding, because I am obligated to respect the processes of the courts. So I cannot really say any more than that.

The other development, I suppose, was a series of claims, published in the newspapers, that people in the Reserve Bank sought to cover this stuff up. If that is what you are referring to, let me be crystal clear that I unequivocally reject that. That is not true. There is no basis for those claims at all. That is probably what I would start with. I am happy to try to respond to any questions you have.

Mr TONY SMITH: Can we start just where you finished. At the February hearings, which I was not at, you said:

The time at which we became aware of the allegations that were made by the newspapers was when they were made. No-one in the Reserve Bank or on our board had ever had those allegations put to us before that time.

That was May 2009. Since you last met this committee, your letter to the Treasurer of 2 June 2010 has been released under freedom of information—and I think it was released on 24 or 25 November—and what you say in that letter is obviously consistent with that. My first question is whether you could confirm that that chronology also applied to Note Printing Australia, because I know different approaches were taken as a result of how this unfolded? Your letter refers to both. I just wanted to get you to confirm that.

Mr Stevens : The chronology at NPA was different. No allegations of corruption were made by the media about NPA before the 2009 stories about Securency. The events of NPA in 2007, I think, we have covered in these hearings before. There was a sequence of events that arose stemming from the Reserve Bank board asking to see the policies of the two companies surrounding the use of agents, which were shown.

Mr TONY SMITH: This is in the wake of the AWB?

Mr Stevens : That is right. That was in 2006. There were requests by the Reserve Bank senior management for an update on how NPA was travelling with respect to stronger policies they were putting in and how that was going. Some concerns arose as a part of that work, which then led to the audit, which made recommendations for further inquiries, which were undertaken by the NPA board. All that resulted in NPA suspending the use of agents pretty much immediately. All of that happened in 2006 and 2007.

Mr TONY SMITH: You have described that before at hearings. I will just take you to that point because, at the last hearing in August, I believe, when Mr Battelino was still with us. I should say, congratulations, Dr Lowe. Mr Battelino retired about 10 days ago?

Mr Stevens : I think on the 13th.

Mr TONY SMITH: I was hoping you can clarify this. These questions do not go to the matters before the courts; I respect that. They really go to the internal and management processes within the bank. At that hearing the then deputy governor went through a sequence of events amongst other things. I just want some clarification on this because I was not there. There were some questions asked by three members, including two of my colleagues who are here. He said this with respect to Note Printing Australia, 'Allegations have been made by one of the staff members that agents had said certain things. The agents denied those.' That was on 26 August 2011. What I wanted to clarify, firstly, was that the allegations were made by one of the staff members, presumably from Note Printing Australia. Was that within Note Printing Australia? Do you know?

Mr Stevens : A person raised some concerns as part of the work on strengthening agent policies. A couple of people had said something to him, I understand, which could be interpreted.

Mr TONY SMITH: Orally.

Mr Stevens : Yes, that is my understanding. That was followed up. That was an important part of why the audit and the NPA board subcommittee inquiry was done.

Mr TONY SMITH: So, just in answer to my question, those concerns were raised by an NPA staff member with NPA?

Mr Stevens : Yes.

Mr TONY SMITH: And with the bank?

Mr Stevens : I think the bank's senior management became aware of it because one of the assistant governors was a board member of NPA, so he was involved in the process of the NPA board strengthening these things. I think he would have become aware of it there. If you are asking whether the person in question wrote a letter or something to the bank, I do not think that he did, no.

Mr TONY SMITH: Or discussed it with the bank?

Mr Stevens : Not to my knowledge. But, as I said, the bank became aware of the gist of his concerns because there was an assistant governor who was on the board and it found its way into that process. So the bank was aware of it, but the person concerned—

Mr TONY SMITH: I suppose I am interested in whether there was a separate process.

Mr Stevens : Not that I recall. Not that I am aware of.

Mr TONY SMITH: When Mr Battellino made that statement before this committee last August, you were obviously well aware of it at that time, were you?

Mr Stevens : Of his statement last August?

Mr TONY SMITH: Sorry, the statement I just quoted—that one of the staff members—

Mr Stevens : I was briefed on what was going on because the Reserve Bank board had initiated a process of asking about policies, and then we had initiated a follow-up, asking, 'How is the implementation of the stronger policies going?' I would be briefed from time to time on the results of that. If concerns arose, I would have generally been briefed about it, yes.

Mr TONY SMITH: Would you have known the staff member or not?

Mr Stevens : I do know who the individual was. Yes, I know who that person was.

Mr TONY SMITH: Do you know him yourself?

Mr Stevens : I have met him. He is not a person I see since he is no longer with the company, but I have met him once or twice. I have not had a discussion with him about that matter though.

Mr TONY SMITH: I just want to go further on the management inside the bank. As you said in May 2009, those stories were the first you knew of alleged criminality.

Mr Stevens : At Securency?

Mr TONY SMITH: Yes. At that point within the bank did you call Mr Battellino or other senior people together to say, 'We better recheck everything'? That must have been quite a surprise.

Mr Stevens : It was. I think I have said before that I struggled to believe it could be true. But we very quickly reached the conclusion that the proper thing for the company to do was refer it to the police because the allegations seemed so wide ranging and so contrary to what we had seen as a result of the audits of that company. So the decision was made that the chairman of Securency would call the police and I concurred with the decision, as did Ric. It was the right thing to do.

Mr TONY SMITH: I do not think anyone disputes that. Going back to that staff member, as Mr Battellino said in August, the staff member had a point to make—that agents had said certain things orally to him, as you said earlier—and the agents denied that at that point.

Mr Stevens : That is my understanding.

Mr TONY SMITH: Without going to any of the matters before the courts or the police investigation, and you have just outlined your actions in May 2009, on reflection, given some of the charges and the like and the developments, do you think that there is anything you would change within the management processes within the bank with hindsight? I know hindsight is a wonderful thing.

Mr Stevens : That is a question I ask myself. With these things still all unfolding, it is possibly not the right moment today in a public forum to give a considered and final answer to that. All I can say is that I think, of the people who were seeking to uncover whatever there was that they ultimately could not uncover, that in 2007 they sought to do what was right. They made sure serious inquiries were made. They got advice, and I think they reasonably relied on the advice that they received at that time, and followed it to its conclusion. I think that since the allegations about Securency emerged in 2009 the way the bank has responded to that has been correct and the way the company has responded has been correct. Obviously, I would rather not be in a position to have to ever answer questions about this stuff. It is quite easily the most unpleasant and difficult set of issues I have had to deal with in this job. But the alleged events took place a long time ago—if they took place as alleged—and we have to sort out the upshot of that now properly and that is what we are seeking to do.

Mr TONY SMITH: Could I take you back to that June 2010 letter. How am I going for time, Madam Chair?

CHAIR: You are getting very close actually, so maybe one more.

Mr TONY SMITH: That is fine.

Mr Stevens : This is the letter to the Treasurer?

Mr TONY SMITH: Yes, that is right. I have got a copy of it in front of me, from 2 June 2010. For the benefit of the members of the committee, it is an extensive—as we would both agree, wouldn't we, Governor—letter and it is of five pages.

Mr Stevens : Yes. I think it is an attempt to set out for the minister the position as we knew it at that time. That was about a year or so after the investigation had begun.

Mr TONY SMITH: You finished where I was about to ask my question. It is a little over a year, I think; it is from May. Is that the first time you had corresponded with the Treasurer on these matters?

Mr Stevens : I think it is probably the first time I had put matters in writing. If your question is if I briefed the government about it, yes, I briefed, as you would expect, the Treasurer and the then Prime Minister about what the allegations were, who the companies were, what the basis of the allegations was when they first emerged. I did that orally in May or June.

Mr TONY SMITH: Yes, within days, I imagine.

Mr Stevens : I do not recall the exact date—

Mr TONY SMITH: That is fair enough.

Mr Stevens : but quite quickly. It was all over the papers and I gave them my understanding of what it was all about and said what we were doing, which was referring to the police. So that briefing was given orally. With this letter, some water had gone under the bridge and it seemed to be an appropriate time to give a reasonably fulsome account of what we knew at that stage.

Mr TONY SMITH: So within a short period of time—and I agree it is unreasonable for you to have at your recall the time and the day after the allegations surfaced in May 2009—you briefed both the then Prime Minister and the Treasurer.

Mr Stevens : Certainly the Treasurer's office. I do not recall whether I spoke to the Treasurer personally.

Mr TONY SMITH: You don't recall.

Mr Stevens : I do not know that I spoke to him personally right then on that very first occasion, but I have had other conversations with him on certain occasions in the now nearly 3 years since this all first emerged.

Mr TONY SMITH: Specifically on this or was it in the course of your discussions with him at various board bank meetings?

Mr Stevens : Sometimes it would be in the course of another conversation. Once or twice it was specifically. But I do not recall what the balance between those sorts of conversations was.

Mr TONY SMITH: Just on this letter: was it your initiative to write to the Treasurer?

Mr Stevens : It was. I felt that it was a proper piece of accountability, as chairman of the board of the bank, to the shareholder. A number of things had occurred. It seemed appropriate at that point in time to set out some facts and what our responses had been up to that time.

Mr TONY SMITH: And you did not think—

Mr Stevens : I did not seek a response to it.

Mr TONY SMITH: No, because I was about to say that at the end it says—

Mr Stevens : No response was necessary, in my view.

Mr TONY SMITH: You say, 'No reply is expected or necessary' at the end of the letter.

Mr Stevens : Indeed.

Mr TONY SMITH: On reflection, you do not think that you should have written earlier?

Mr Stevens : I do not know. I think it was important to set out some key things in writing at a point in time. Exactly when that would be done I think one could discuss. But I do not feel terribly sheepish about the timing of the letter, no.

Mr TONY SMITH: I am pressing the patience of the chair. I have many more questions, but they will have to wait for another day.

Mr BUCHHOLZ: Firstly, congratulations, Phil, on your new appointment. I know that you will carry that charge with dignity. Could you all pass on my sincere thanks for the work done by Ric. I trust he will enjoy his retirement.

My questions go basically to where the chair started at the beginning of the day, with the preference of profitability. We have spoken during the course of proceedings today about spreads, levels, increased funding costs and various degrees of complexity, but I just want to talk about record profits. What is your opinion of the banks' movements when you sat down and made a decision on the cash rate and the banks moved in a different trajectory, on the principle of increased funding costs, and then within 24 hours, virtually, of those decisions we saw some of the banks announce record half-year profits?

Mr Stevens : On the profits, they are large institutions, so they make large profits. There is nearly $200 billion of shareholders' equity invested in the banking system, and $160-odd billion of that I think is in the four large banks. So you would expect them to earn a profit which in absolute dollar terms is large, because they are big companies. I suppose the real question is: what is the rate of return being earned by those shareholders on that $160 billion? The evidence over 20 years or so is that the kinds of returns they are earning are on average quite similar to the sorts of returns being earned by the share market as a whole.

Mr BUCHHOLZ: Sure, I get that. There is enough evidence to support the trend lines that the banks follow the cash rate. Why would this period of reporting be any different?

Mr Stevens : Actually, the period in which they followed the cash rate exactly was a rather unusual one historically. If you go way back, there was not such a lock-step pattern at all. There was a relationship, because the cash rate and the near-term yield curve which the cash rate very powerfully affects have a big impact on the whole structure of market interest rates and therefore the cost of funds to the banks, but the period that we had—admittedly for some years—where the rates moved in lock-step was historically unusual. It was a period where the credit spreads between benchmark rates and what banks can actually borrow at did not really move very much. That was very unusual, though. In the longer sweep of history, it is not that unusual for those credit spreads occasionally to shift. They have been shifting a lot, of course, since the crisis in Europe and the US erupted in about 2007. I think there is still actually a fairly good relationship between the rate we set and the rates the banks ultimately will borrow at and charge, but it is not exact; it is not one for one. The cash rate is still powerful, but it is not the only factor at work. On occasion we are going to see banks move their rates a little bit differently to what we did, or maybe move a little bit when we did not move. I do not find that terribly surprising given the sort of funding environment that the whole banking system of the world has faced in this time.

Mr BUCHHOLZ: Maybe it is not surprising, but for some of the punters in my electorate it is somewhat disappointing.

Mr Stevens : Sometimes people are led to believe that the banks have to do everything the Reserve Bank says, and actually that is not quite how the system works.

Mr BUCHHOLZ: Sure. On the return on equity for the banks and their yield rates, they have marvellous yield rates—19 or 20 per cent. I think Canada, a four-pillar society, offers similar yield returns. There seems to be a considerable advantage to our banks with those yield rates given that, when you look across the global sector, the average yield rates vary between 10 and 13 per cent. Would you like to make some comment?

Mr Stevens : All those other banks would like to be making returns more like ours, and if they had better balance sheets then they could, but many major global banks are still digesting the problems of the last several years. Some of them are more advanced than others in getting through that, but it is actually a sign of the health of our system that our banks are probably earning a better rate of return than many of those others. Compared to other sectors, where on figures I am looking at the return on equity for banks as a group is something like 15 per cent on average over quite a run of years, there are some industries with less than that and some with more. So I am not sure you can pick the banking sector particularly out and say that it is more profitable than everybody. I do not really think that follows. They are in the pack and they are certainly doing well.

Mr BUCHHOLZ: My point was that they had stronger returns on equity rates than other banks outside Australia.

Mr Stevens : Yes, but many of those other banks outside Australia have been struggling. Occasionally our banks struggle. They have had good returns for quite some years now, but there was one year when their return went south incredibly quickly when we had an economic recession, back in the early nineties. That is the nature of banking: that sometimes conditions can come along and you really get hammered as a bank. That is what has happened to some of these other banks in Europe, North America, the UK and so on.

Mr BUCHHOLZ: I am fine with profitability, but it is hard to argue that it is okay for us to be about profitability and at the other end of the spectrum try to create the argument of, 'Boo hoo, we're doing it tough; we have to move on a different trajectory of monetary policy.' How does the government bank guarantee work? I probably did not even say that correctly, but how does that guarantee work?

Mr Stevens : There is a guarantee for deposits in effect. Nobody remarked on the fact that the cap was wound back from $1 million to $250,000 only a couple of weeks ago. That passed without comment or drama, which is good.

Mr BUCHHOLZ: There were probably other things on some of the political leaders' minds.

Mr Stevens : There appears to be other news around, yes. As to how it works, it is technically called a financial claims scheme. Should a bank fail, you would get your money very quickly up to that capped amount. The $250,000 covers almost all people, at an individual level. In effect it functions a bit like a guarantee. At a technical level, without going into too much detail, if some institution is put into administration by APRA then the financial claims scheme would come into operation. The bank's assets would be recovered in the wind-up to pay out the creditors, but in the interim the scheme would step between the depositors and the wind-up process and say to the depositors, up to the $250,000 cap, 'Here is your money, so you can go and buy your groceries.' You would almost certainly always get your money, but it might take quite a long time. People need it quickly, and the whole point of this was early access up to that cap. That is how it would work. Then the scheme would recover those funds from the wind-up of the institution. It is extremely unlikely that the scheme would fail to be repaid in that process.

Mr BUCHHOLZ: Has the RBA put a value on that for the banks? Do they pay for it?

Mr Stevens : No financial institution that has the financial claims scheme applicable—which is all deposit takers, not just large banks but all ADIs—pays for it. They do not pay a fee for it.

Mr BUCHHOLZ: Has the RBA put a price on it—on the value of that security or insurance?

Mr Stevens : Have we worked out what the fee should be? We have not done a formal calculation of that. I suspect that if you did do a calculation you would end up with a small number of basis points.

Mr BUCHHOLZ: Does that guarantee provide the four banks with a competitive advantage over second-tier operators?

Mr Stevens : I doubt it. I suspect that if anything it probably advantages the smaller institutions.


Mr Stevens : I think large institutions naturally have an advantage. My guess is that an explicit arrangement that says that your money is safe up to a quarter of a million dollars in any deposit taker, no matter how small—which is what it is saying—gives a greater relative advantage for the small institutions, not the larger ones. Larger ones just have a natural advantage because they are large.

CHAIR: I just want to go back to an answer that Dr Lowe gave much earlier on, when Ms O'Dwyer was asking some questions. You talked about businesses during the boom time being prepared to put people on even if there was no evidence that the market would continue to grow, and now they are tending to want to see the evidence first. We talked about the normalising, if you like, of household savings from boom-time behaviour to more normal behaviour. Do you see this as a normalising thing or is this some sort of negative indicator?

Dr Lowe : Normalising of the employment intention?


Dr Lowe : I think it is just a natural response of businesses to global uncertainty. As I said in my response before, I think that will pass because as long as the European situation does not get materially worse the strong investment boom in Australia will generate sufficient demand in our economy that even businesses who are cautious will find that, at least in aggregate, they will want to hire again. I do not see this as something that is going to derail growth in the economy; it is changing the timing of when businesses respond to the underlying demand growth in the economy. Provided that the global environment gradually gets a bit better I think we will see this pass.

CHAIR: We sometimes hear from community and commentators that businesses not being as willing to hire as quickly is actually a negative thing. Do you see it as a negative thing?

Dr Lowe : It is one of the things that have meant the labour market is soft at the moment—employment growth over the past year has been very slow. From that perspective it is a negative thing, but it is not is something that I think is going to last indefinitely. The economy, at least in our central view, has very strong growth in private demand—I think probably business investment will be up another 10 per cent this year—it is extraordinary—and 10 per cent the following year. That is generating underlying demand growth in the economy. To meet that demand firms are going to have to employ workers. Just at the moment they have been saying, 'Well, I want to see that demand before I commit,' but I think that will pass.

CHAIR: It is a fairly normal response to circumstances as they have been.

Dr Lowe : I do not think anything here is incredibly out of the ordinary. We go through periods where people are very confident. They are worried about getting workers and move quickly to hire. Then we go through the periods when people are just a bit more reticent. I think we have been in one of those periods. It has meant the labour market has been a bit softer than it would otherwise have been, but I think that, by the time we go out later this year, that will pass.

CHAIR: I think we are now tending to talk about the change in savings behaviour as a more permanent one and, certainly, the exchange rate as being a more permanent change. Do you see other areas where the changes are moving away from being just a cyclical response to something that is a more permanent change in behaviour?

Dr Lowe : We are certainly seeing changes at the industry level that I think are likely to be permanent or at least highly persistent. We have talked a bit about retail: I think there is a structural change going on there as people compare the prices that you can buy, particularly clothing and household goods, overseas. The retail industry has to make a structural response to that. As Glenn talked about with tourism, some of those things are structural and the economy is going to have to change for that, and for the banking system as well. The banks have got used to double-digit credit growth year after year. I think that in the environment we are living now is very unlikely to happen. Low single-digit credit growth is probably likely to be the norm for the next while, and the banking system has to get used to that as well. In the real estate industry, the rate at which houses are turning over is really half of what it was in the boom in the early 2000s. So the real estate industry is also having to adjust to that, and that adjustment is likely to be highly persistent.

On many dimensions these structural adjustments are occurring. I think that is why, when people look at what is going on in the economy, depending on what lens you look through, you can come up with very different perceptions. As Glenn has said, our job is to put that all together to try to make sure that aggregate demand and output in the economy are growing around trend and that inflation stays around 2½ per cent. That is what has really happened over the past year, despite these very different and disparate stories in individual sectors.

CHAIR: The fiscal stimulus has probably washed through now. I think every time we have spoken in the past there has been stimulus winding back or growing, and you have spoken a number of times about how that related—whether it was working in the same direction as monetary policy. What is your position now? Are we both in neutral? Where are we?

Mr Stevens : If you want to describe the stance of monetary policy as broadly neutral, it is probably a reasonable description. The fiscal side, as far as I know is unfolding more or less as it was planned. In fact, I am surprised we have got this far without the word fiscal coming up.

CHAIR: I just thought I would raise it. It was a risk of being an own goal.

Mr CIOBO: I want to touch upon a couple of separate issues in government. I might get you to earn your money on the issue that most people are speculating about. Of course, there is no clarity, but could you crystal ball gaze for a moment with respect to Europe and, in particular, the inflation/deflation debate. I am interested in your general comments as a set of road guides about where you see this progressing over the next six to 12 months.

Mr Stevens : I think the European economy is presently in a downturn. It is too early to know whether it is going to be a deep one or not, though I do not think we should assume that, at an aggregate European level, it will be deep. In Germany, notwithstanding that they had a contraction in the GDP in the fourth quarter if I recall correctly, on a number of indicators things are very good. Things in Spain and Italy are very bad. Other countries are between those two extremes. But they certainly have a period of economic activity weakness at a euro area level.

As I said earlier, I think we will continue to see an approach to managing Greece and the other peripheral countries. There will be flare-ups every few months. There will be anxiety over whether the program is going to be met, will the next disbursal of money be made and so on. That has been happening for a couple of years and it will keep occurring. My guess is that they will, each time, manage to get over the hurdle and we will progress like that for a while.

On inflation versus deflation, I think in Europe in particular inflation has probably come down a little bit just lately. The large long-term question to which I suppose you might be referring is whether all the unusual central bank action would ultimately be inflationary. I think the central banks who have done those unusual policies—including Japan, which has been doing zero interest rates and quantitative easing for 13 years now and I think is still in deflation, the United States, the UK and Europe—all describe it a little bit differently but there are a lot of similarities in what they have done. I think what they would say is: 'This is a large balance sheet expansion by the central bank. That is an effort to ease financial conditions once interest rates have reached effectively zero. It is intended that that would result in a lowering of longer-term yields, of a bit more search for yield and risk by the private sector. That is really what is intended. Once the economy starts to really fire then we just withdraw it.'

In one sense, that is not that different from normal monetary policy in that, at various points, we ease, and we know that, if we have got interest rates unusually low, at some point we probably have to go back to normal once the economy looks like that is the thing to do. Picking the timing and pace of that is always a judgement call. It will be a really complex judgement call in these cases because they have got both the balance sheet thing to decide how to unwind and the interest rate part also to normalise at some point. I would love to see them get to the point where they have to make that decision, frankly, because that would be the world normalising, and I would hope that will come quickly. So that would be the set of calls they have to make. But they would say we will manage to do that without getting into a situation where we will have high inflation. All that said, I think it will be a tricky balance to manage, with very high levels of public debt, unusually low interest rates for a long period and bloated balance sheets. It will be a long, tricky way back to normal from there. In that sense, it is not that surprising that some people worry about the potential for longer run inflation. I think one can understand why the central banks will need to manage this process very carefully. At the moment the only country seriously in deflation would be Japan, and also probably some of the European peripherals are deflating. Ireland would be one. In the rest of Europe inflation is very low. I think that is right, isn't it?

Dr Lowe : Yes. What has been surprising really over the past little while is that the inflation rates have not come down more in the United States and in Europe. The US has had unemployment at 10 per cent and it is a bit above eight per cent at the moment and in Europe it is above 10 per cent and they still have inflation running at between one and two per cent. It has not come down by much as you might have thought, given historic relationships between unemployment and inflation. The developments in commodity prices, which have trended up over recent years, have been an important part of that. So in the short term the risks are probably on the downside of inflation but in the medium term on the upside.

CHAIR: I know you think about these things, Dr Lowe. Do you have any theories why that is the case? It is the same with the Australian dollar: you said it was a bit odd that it that has not come down a little more. Do you have any theories why it is behaving differently? I am talking about the inflation rate initially in the US.

Dr Lowe : There are theories. I do not think we have a really good answer. In the US what has happened is that workers have borne the brunt of the adjustment, so the corporate profitability in the US is quite high and corporate balance sheets are in very good shape. The collapse in demand was largely borne by workers losing their jobs. The fact that inflation has not come down is part of that process, where the prices have stayed up reasonably high and the corporates have earned significant profits and it has been the workers who have actually borne the brunt. Maybe that is starting to turn around now—let us hope so—with the good balance sheets that firms have built up over the past few years and really little debt, making them just a bit more confident to go and hire workers again. But that has not been the case for the bulk of the past three years.

Dr Debelle : The other thing to note is that the whole purpose of what the Fed has done in expanding its balance sheet was exactly to avoid deflation. So, to some extent, if I were them I could claim that the policy has been successful. They are quite concerned—and Andrew mentioned nonlinearities earlier—that what happens when deflation hits can start getting quite nasty. Their stated aim has been to avoid that, which thus far in the US they broadly have.

Mr CIOBO: My final question is with respect to the payment system. I have had a long interest in the bank's decision with respect to three-party and four-party schemes. My understanding is that there has been a substantial pick-up in market share in relative terms of the three-party schemes over the four-party schemes. I am interested in the comments of the bank with respect to where this is going, the review process and whether or not that increase in market share has taken place.

Mr Stevens : I think there was an increase in market share of the three-party schemes taking place up until recently. For a while now, the last time I saw the figures, I do not think there had been any further shift. They are the facts. I think the reason that happened is that there is an incentive for some of the banks to issue some of those cards because of the higher fees associated. I know that your argument has been: why not regulate the four-parties the same way?

The broad facts are that merchant fees have come down since the RBA reforms of some years ago, including those charged by the three-party schemes. I think that is good. We do not actually technically have a power to regulate those fees in the three-party schemes. What we technically have is the ability to regulate, if we see fit, a payment type fee, which is what the interchange fees in the four-party schemes are. There has been some shift in market share, as you say, for that reason of incentive for issuance, although I do not think that has proceeded any further in the past year or so, from my memory of the last time I looked at the database.

Mr CIOBO: I just want to clarify. I am not sure you meant to verbal me, but I am not sure I ever did propose that three-party schemes be regulated as well. I think it would be fair to say in many respects that those merchant fee reductions, where the interchange fee is regulated, are more than offset by surcharging. With respect to three-party schemes the prevailing view, as I understand it, is that there is a strong feeling that there is a lot of cherry-picking going on. Market share increase has reflected both the cherry-picking nature of what is taking place as well as, of course, the underlying profitability of the customer base. I would be interested in your comments on that.

Mr Stevens : As to surcharging, as you know we have put out a proposal for consultation that we consider is acting in a way which would, in effect, limit the surcharge to the genuine costs being experienced by the merchant without being able to be precise about exactly how big that is. The state of play is that that is out for consultation at present. Were we to do that, I think that it will work by allowing the schemes to re-impose a certain degree of limitations over surcharges by merchants.

I think some of the instances of surcharging that are quite prominent really are a manifestation of the market power of merchants. I think some of these cases are like airlines and so on where there are a whole bunch of fees that they are adding to the fare—the taxes, the booking fees surcharge, the fuel levy and all other things. My guess is that, in cases like that, the pretty substantial surcharges say as much about the relative market power of some of the merchants as it does about the payment regime itself. I still think having surcharging is an important signal, but it may be more appropriate to try to limit it to what the actual cost is that the merchant faces. That is why we are consulting on it.

Dr LEIGH: Coming back to banks, if we accept that the big four Australian banks have some market power, and I assume you would not quibble with that, then in some sense we can think of them as price-makers. For a lot of Australian firms, particularly in the manufacturing sector who have been hit by a large appreciation of the exchange rate, we think of them as largely price-takers. In maximising the economic prosperity and welfare of the people of Australia, wouldn't it be better if more of the pain were to be taken by large banks rather than by the manufacturing sector, and isn't there some role in the RBA jawboning to see that happen?

Mr Stevens : Sorry, is your question about interest rates?

Dr LEIGH: It is about banks' profit margins. In a context in which banks are enjoying large profits due in part to their market power, wouldn't it make sense if the RBA were to jawbone them to have slightly slimmer profits at a time when many firms are hurting?

Mr Stevens : I suppose one would have to start with whether the assumption that they are earning good profits due to market power is right. That, of course, goes to one's assessment of the degree of competition in the system. One of the things which are quite a feature of the system at the moment is the intensity of competition on the liability side of their balance sheets; in other words, there is intense competition to get deposits. So I think one would start by questioning what is the extent of market power. I am not sure there is really a role for the Reserve Bank in jawboning bank shareholders to accept lower return on equity, which is what we are talking about here. If it is a social judgment that that should happen, I do not think it is for us to make; I think that would be for the political process to do. I suppose that once you start down that track one would need to be careful that you do not end up thinking that perhaps you will dictate to all industries what their returns and the prices of their products will be. That is not really the kind of economy we have. So I am certainly not keen for the RBA to be jawboning banks to try to impose on their shareholders a submarket rate of return. The kinds of rates of return they are earning, as I said earlier, are very much in line with the average in the listed company sector.

Dr LEIGH: Changing tack somewhat, if we look at the top eight in your leadership team, you have only one woman in that. This is not uncommon in other sectors—I know the senior ranks of the Department of the Treasury are mostly male dominated—but your board has three out of nine members being women. Do you have a strategy to see more women enter and rise up the ranks of the Reserve Bank?

Mr Stevens : My main strategy is that we recruit the very best people we can, we pay them as well as we can within the constraints of being a public organisation, we give them interesting work and we seek to promote them. We do that, generally speaking, without regard to gender. There are two other observations I would make. One is that we certainly have tried to make the institution more family friendly. We have a childcare facility which interestingly, as it turns out, is used more by males than by females, but that seems to be the way it has turned out and that is okay. There is also a—

Mr TONY SMITH: It is used by the kids, you mean!

Mr Stevens : I also understand that there has been quite a gender imbalance in the study of economics. There are many more males doing it than females. I do not really understand why that is, but that of course is the pool from which we are drawing many of our professional staff, and that is quite an interesting phenomenon. We certainly have some very, very capable, quite senior women, and I am sure that we will see more of that over time.

Mr STEPHEN JONES: I think Dr Leigh has taken his share of the blame for the disparity in gender of people studying economics!

CHAIR: Three out of nine is slightly better than we are doing on this committee!

Ms O'DWYER: On Wednesday the ABS released its wage price index data. After a soft quarter in September, we saw in the December quarter that the data was a little bit stronger than the market had probably been expecting, with private sector wage growth picking up by around one per cent in that quarter. Is that something that the RBA had been expecting?

Mr Stevens : I think the numbers were close to what we had assumed in the forecasts. I think that the private was a little higher and the public a little lower and the aggregate quite close to what we had been assuming.

Dr Lowe : Yes.

Mr Stevens : So at this point I do not regard that particular statistic as materially view changing.

Ms O'DWYER: On the public being lower, I am interested in your thoughts on the fact that the ABS noted that the slowing in the public sector wage growth was mainly due to continuing delays in the commencement of new enterprise agreements in many jurisdictions. Given that the bank highlighted in its most recent statement on monetary policy the likelihood of some catch-up in public sector wages in the near term as agreements are finalised, do you see any risk in the bank's inflation forecasts from aggregate wage growth in this data?

Mr Stevens : As I say, I did not regard them on their face as view changing—that is to say, I do not think they will have a material effect on the forecasts. If we had to write down a forecast for inflation again now, compared with a few weeks ago when we put out the statement, I do not think we would change it on the basis of those data. But, as I said earlier, this is certainly an area that we need to watch because we actually need the pace of productivity growth to be a bit better in the years ahead than it has been in the recent past for the current pace of wage growth to be okay. For reasons I said earlier, that is what we think will occur. But there is always the risk there that we might be wrong, so that certainly is a thing to keep watching.

CHAIR: I have a quick question and then we will call it a day. Can I just go back to where we started, with the banks raising or lowering, one assumes, interest rates independently. If monetary policy is where you want it to be, does the Reserve Bank actually care who makes that call—whether it is done by the banks or whether it is done by the Reserve Bank?

Mr Stevens : I would come back to: we take account of what they do. If the movements in the spreads start to take things for the overall economy significantly away from where we think they should be then we would, I would expect, act to kind of offset that. Indeed, as I think I have said before, probably I would say the cash rate is at least 100 points lower now for the kinds of conditions we face than you would have once expected because that has basically offset the total margin widening, at least until quite recently, that had happened as a result of these international forces. So I think really we are still making the calls as to where monetary policy ought to be and there is just a small bit of slippage in part of the transmission mechanism that I do not think is going to really, from our point of view, cause us a huge headache at this stage.

CHAIR: Thank you.

Mr TONY SMITH: Chair, according to Mr Buchholz's highly accurate clock on his iPad, we have a couple of minutes left. Is it possible to ask another question or two?

CHAIR: Just one.

Mr Stevens : Madam chair.

Mr TONY SMITH: Can we go back to a question on the topic I was asking about earlier, just for a clarification. I quoted statements to this committee from Mr Battellino back in August about allegations being made by one of the staff members that agents had said certain things and the agents denied those. Governor, I think your answer was that that was conveyed orally. I just want to confirm that.

Mr Stevens : I need to come back to that. I think I said that the bank was aware of that but that it was not in writing. Actually, that was not quite true. I have been reminded while we have been talking that, in fact, the deputy governor invited that person to put that in writing, which he did, and give it to the deputy governor. That written statement on the matter was available to the Freehills people that did the investigation in 2007. So, whereas I said I thought that we were aware of it but that it was not documentary, in fact it was invited to be put in documentary form, which it was.

Mr TONY SMITH: One final question, Chair?

CHAIR: No, we are done.

Resolved (on motion by Ms O'Dwyer):

That this committee authorises publication, including publication on the parliamentary database, of the proof transcript of the evidence given at public hearing this day.

Committee adjourned at 12:30