FX International Payments
By Frances Coppola
For U.S. businesses trading in Australia, this meant that instead of Australian dollar (AUD) exchange rates remaining stable, they would now vary in response to market conditions. But on the upside, there would be less uncertainty around the cost of doing business in Australia. The history of Australia’s gradual monetary policy shift offers interesting lessons, and insights for companies engaged in Australian trade.
The Reserve Bank Act of 1959 separated the central bank functions of the Commonwealth Bank from its commercial interests and established them in a new, publicly owned central bank, called the Reserve Bank of Australia (RBA).2 The Commonwealth Bank remains today one of Australia’s largest commercial banking corporations.3
According to the Reserve Bank Act, the aim of the RBA’s monetary policy should be “directed to the greatest advantage of the people of Australia.” Specifically, monetary policy is supposed to contribute to:
(a) the stability of the currency;
(b) the maintenance of full employment;
(c) the economic prosperity and welfare of the people.4
The RBA thus has a triple mandate. But what each of these objectives means in practice is changing.
While the AUD’s exchange rate was pegged, “stability of the currency” meant maintaining the peg. But now the exchange rate is floating. So, “stability of the currency” has come to mean price stability, i.e. maintaining the domestic purchasing power of the currency. Controlling domestic inflation thus meets this objective, even when the AUD exchange rate is volatile because of changes in international demand for Australia’s principal exports.
Similarly, the definition of “full employment” has changed since the 1950s. Then, “full employment” was usually taken to mean that everyone who wanted to work had a job, so unemployment would be at or close to zero.5
But during the 1960s, economists became aware that there was a trade-off between employment and inflation. When there are more vacancies than there are people to fill them, wages tend to rise, which can force businesses to raise prices and thus fuel inflation. Conversely, when there are more people looking for work than there are jobs, wages tend to fall, which can cause prices to fall (deflation). The “Phillips curve” documents this relationship.6
The Phillips curve says that to prevent inflation rising, some unemployment is necessary. The definition of “full employment” has therefore come to mean the level of unemployment at which supply and demand for workers exactly balances and wages and prices therefore remain steady. This is known as the “Non-Inflation Accelerating Rate of Unemployment,” or NAIRU.7 Estimates for Australia’s NAIRU vary, but typically it is 5-to-6 percent.8
On the “economic prosperity” side, the RBA monitors Gross Domestic Product (GDP) growth, which is a measure of the income of the country: when it is growing, Australia is becoming more prosperous, and when it is falling, Australia is in recession. Recessions are typically associated with rising unemployment and falling incomes, so demand for goods and services depends on GDP growth staying positive. Therefore, although the RBA does not explicitly manage GDP, but monitors it as a proxy for economic prosperity and reviews monetary policy in light of it. GDP can be an important indicator for businesses interested in Australia’s prospects.
Inflation affects all three parts of the RBA’s mandate. High inflation reduces the purchasing power of the currency and depresses its exchange rate; on the employment side, rising cost of raw materials and intermediate products can force businesses to lay off workers, reduce hiring and cut working hours and wages; and price rises erode the living standards of ordinary Australians whose wages can’t keep up.
During the “stagflation” of the 1970s – a combination of high inflation and poor economic growth which caused misery for many Australians9 – the RBA’s focus gradually shifted from full employment to inflation control. But unlike its neighbor New Zealand,10 Australia was initially unenthusiastic about inflation targeting.11
From 1976 to 1985, the RBA and the Australian Treasury tried to reduce inflation by setting targets for “broad money” (M3) growth, in the belief that restricting money creation by commercial banks would keep inflation under control. As M3 is only measurable after the event, however, targeting it accurately proved impossible in practice.12 Even more importantly, economists showed that because demand for money is not constant, maintaining constant growth in M3 could cause interest rates to fluctuate wildly, making life very difficult for Australian borrowers.13
After it abandoned M3 targeting in 1985, the RBA briefly used a “checklist” of economic indicators to determine the appropriate setting of monetary policy. But faced with stubbornly high inflation, it abandoned the “checklist” in 1988. There ensued an intense debate about the direction that Australian monetary policy should take, which eventually resulted in the adoption of inflation targeting with interest rates as the principal policy tool.14 In 1993, the inflation target was set at an average of between 2-to-3 percent in the medium term, where it remains to this day.15
Some have called for Australia to adopt a “nominal GDP” target.16 Usually, GDP growth figures are adjusted for inflation: we call this “real” GDP. But nominal GDP (NGDP) includes inflation. So, for example, if real GDP growth is 2 percent and there is inflation of 2 percent, NGDP is 4 percent. Conversely, if GDP growth is 1 percent but prices have fallen by 2 percent, NGDP is minus 1 percent. Targeting nominal GDP potentially better balances the need to control inflation with the RBA’s mandate to promote economic prosperity. But it is not without its critics,17 and as yet, there is no agreement to move in this direction.
The RBA’s “triple mandate” means that low inflation, low unemployment and strong economic growth are equally important goals for policymakers. This helps to ensure that unlike many commodity exporters, Australia remains economically stable despite being exposed to the vagaries of international markets, making it an attractive place to do business.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1.“Australian Monetary Policy in the Last Quarter of the Twentieth Century,” Speech of Ian MacFarlane at the University of Western Australia; https://www.rba.gov.au/publications/bulletin/1998/oct/pdf/bu-1098-2.pdf
2.“A Brief History,” Reserve Bank of Australia; http://www.rba.gov.au/about-rba/history/
3.“History,” Commonwealth Bank https://www.commbank.com.au/about-us/our-company/history.html?ei=bc3
4.Reserve Bank Act 1959, Government of Australia (legislation); https://www.legislation.gov.au/Details/C2015C00201
5.“Definition of Full Employment,” Economics Help; http://www.economicshelp.org/blog/453/unemployment/definition-of-full-employment/
6.“The Phillips Curve,” Econlib; http://www.econlib.org/library/Enc/PhillipsCurve.html
8.“Unemployment and Spare Capacity in the Labour Market,” Reserve Bank of Australia; https://www.rba.gov.au/publications/bulletin/2014/sep/pdf/bu-0914-2.pdf
9.“How ‘Stagflation’ Killed Golden Age,” Sydney Morning Herald; http://www.smh.com.au/news/national/how-stagflation-killed-golden-age/2006/11/17/1163266787633.html
10.“Inflation Targeting 14 Years On,” Reserve Bank of New Zealand; http://www.rbnz.govt.nz/research-and-publications/speeches/2002/speech2002-01-05
11.“Two Perspectives on Monetary Policy,” Reserve Bank of Australia; https://www.rba.gov.au/speeches/1992/sp-gov-170892.html
13.“The Debate on Alternatives for Monetary Policy in Australia,” Malcolm Edey, Reserve Bank of Australia; http://www.rba.gov.au/publications/confs/1997/pdf/edey.pdf
14.“Australian Monetary Policy in the Last Quarter of the Twentieth Century,” Speech of Ian MacFarlane at the University of Western Australia; https://www.rba.gov.au/publications/bulletin/1998/oct/pdf/bu-1098-2.pdf
15.“Inflation target,” Reserve Bank of Australia; https://www.rba.gov.au/inflation/inflation-target.html
16.“The New RBA Governor Should Target Growth, Not Inflation,” Sydney Morning Herald; http://www.smh.com.au/business/comment-and-analysis/the-new-rba-governor-should-target-growth-not-inflation-20160821-gqxlcd.html
17.“Nominal GDP Target A Risky Mistake,” Garry Shilson-Josling, News Limited; http://www.news.com.au/finance/business/breaking-news/nominal-gdp-target-a-risky-mistake/news-story/567703e13b2cfc8205d3c873aa0ff6a5