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Ian Macfarlane on central bank policies, inflation and China

Ian Macfarlane, AC, was Governor of Reserve Bank of Australia from 1996 to 2006. He is a Director of ANZ Bank, Woolworths and the Lowy Institute for International Policy. He is a member of the International Advisory Board of Goldman Sachs and the International Advisory Board of the China Banking Regulatory Commission.

This is Part 1 of an edited transcript of a Q&A session at the Morningstar Investment Conference on 15 May 2014.

Q: Let’s talk about three main topics: central bank policy, emerging markets with a focus on China, and then a look at Australia.

Since 2009, central banks’ primary role has been stimulating economies through monetary easing. Can you talk us through how this works.

IM: I hope it doesn’t sound too much like an economics lesson. I think of the effects of monetary easing in two parts. The first part is the effect on the real economy, output and employment. There are four channels there: lower interest rates change the economics of some investment plans and lead to new investments; second, there are other aspects of the economy which are interest-rate sensitive such as residential construction, which picks up quickly after an easing; and third, the effect on people who have mortgages (but note only one-third of households have mortgages). When rates go down disposable income goes up so they spend more on consumption. The fourth is that as interest rates go down, other things being equal, the exchange rate may go down, which increases prospects for export industries, and those parts of the domestic economy competing against imports.

That’s the first part, which I describe as the real economy. It increases spending and income and it’s the one everyone focusses on.

The second is the financial part, which is becoming more important. When interest rates go down, simple interest rate products like bank deposits become less attractive, and we see a search for yield. Funds move into equities, property and riskier forms of lending, and this drives up asset prices.

The issue for the US is that the Fed funds rate is effectively zero. It is having an effect and the economy is recovering, although not particularly quickly. So the first channel is working but not as strongly as hoped. The second channel is definitely working, where US equities are at an all-time high. This is the challenge for central banks, and what they fear is that you could end up with an asset price bubble before the real economy is back to full capacity. That’s a worry. It’s probably not going to happen but there is that risk. Part of the reason is that too much weight has been placed on monetary policy. In a perfect world, you would use more fiscal policy, but a number of countries already had large deficits going into the crisis, more debt than they wanted. This over-reliance on monetary policy has created the added risks.

Q: If you’d asked a group of investment bankers about the major consequence of over-stimulating, they might have said inflation. But there is little evidence of increasing inflation. Is monetarism dead? Where is the economic theory?

IM: Well, monetarism is dead. No doubt about it. You saw what has happened in the US where the money base has quadrupled over the last four to five years, but there’s been virtually no inflation at all. In fact, there’s been more fear of deflation. The relationship between monetary aggregates and inflation has completely broken down. It broke down in the late 1980’s. It was replaced by inflation-targeting, that the best thing a central bank could do was achieve low inflation. It improves your chances of having a long, sustainable expansion.

Let’s get onto forward guidance. Most of the time, during my period, transparency of monetary policy consisted of when you changed the cash rate (which they call the Fed funds rate in America), the central bank would put out a statement explaining why they did it. But you weren’t expected to say what you would do in the future. And I actually think it’s very difficult to do that, because most of the time you don’t know. There’s nothing worse than putting out something that you don’t personally believe in. In the US and UK, having lowered interest rates to zero and done everything they can to stimulate the economy, and it didn’t seem to be working very well, there was a reach out for other things like quantitative easing.

The other thing they did was say we won’t tighten rates until some trigger point is reached. The point they chose was the unemployment rate going down to 6.5% in the US. What happened? The unemployment rate has gone down to 6.5% and they haven’t tightened, so that forward guidance was not very useful. They lost faith in the unemployment rate as a general indicator of the health of the economy. They still have lots of excess capacity.

Q: Let’s turn to China. Can we believe the growth numbers, and what are their chances of avoiding some sort of crash based on credit conditions?

IM: Can we believe the numbers? Well, they’re not as good as ours, but I’ve seen two phases of people criticising China’s numbers. The first phase they used to say China must be growing faster than they claim. If you look at all the sub components – consumption, investments, exports - they are growing faster than GDP. Now we hear the argument the other way. Surely it’s not growing as fast as they claim it is. I think it is. I think they make a genuine effort with the resources they have to estimate GDP growth rate, and if you don’t like that, there are other things to look at such as the amount of steel produced or the rate of export growth which are easier to measure. Usually you’ll get something that’s not too different from GDP. So you can, by and large, accept their figures.

The other question I get is what are we going to do when China collapses. My answer was always that I don’t think it will collapse, and so far that’s been right. We hear a lot about imbalances in the Chinese economy and especially that there’s been excessive credit expansion. There is obviously some proof to that, in that in the financial crisis, those countries like Australia that could expand fiscal policy did so by increasing government expenditure. The Chinese approach is to tap the banks on the shoulder and tell them to lend more. Which they did. They still have a legacy of a lot of loans out there, some of dubious quality.

But for the big four or five state banks, I don’t think they’ll get into trouble. They’ll be able to handle the inevitable bad loans. All banks have bad loans. Plus the central government has the resources. The main issue is shadow banking, which is anything other than banking. These are pools of funds available for lending at much higher interest rates than major banks, and the Chinese government is determined to slow it down. There are a variety of things they can do. You will notice for the first time insolvencies, where small financial institutions are failing. This is very unusual in China, in a communist country, the concept of failure did not exist. This was one of the problems in trying to contain shadow banking – people thought you could earn 12% in you went to one of these shadow banks because there was no concept of failure. The government is selectively letting a very small number of shadow bank securities fail. Not necessarily losing all their capital, but perhaps missing out on the final coupon. Some of the securities were issued though ICBC, a big retail bank. As usual in China, these things can be carefully controlled. In other countries, a couple of failures might be the sign of something very bad, but it’s really part of many policies to get a proper capital market where there are a range of returns for risk. So don’t be alarmed if you read more stories like this.


In Part 2 next week, Ian Macfarlane shares his views on emerging markets, Australian banks being ‘too big to fail’, Fed expansion and residential property prices.


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