What has the Australian government done to reduce inflation? Policies or initiatives?

Question

What has the Australian government done to reduce inflation? Policies or initiatives?

Answer 1

Australian authorities  focused on the policies necessary to reduce inflation, maintain financial stability, and foster strong growth prospects over the medium term.

1. Sound macroeconomic policies and structural reforms have delivered a prolonged expansion, but recently the economy's productive capacity has become increasingly stretched. The commodity driven boom has pushed up against capacity constraints, with unemployment falling to the lowest rate since the mid-1970s and capacity utilization rising to historic highs. As inflation accelerated over the past year, the RBA appropriately tightened monetary policy, and fiscal policy in the latest budget is providing needed support.

2. The global financial turmoil that emerged in mid-2007 and the extraordinary jump in Australia's commodity export prices in recent months present additional challenges. Underlying inflation is the highest it has been since the introduction of inflation targeting in the early 1990s, and monetary and fiscal policy will need to focus on reducing inflation. The global financial turmoil has illustrated the resilience of Australia's financial system and highlighted the role of the sound macroeconomic policy framework, the flexible economy, and the importance of structural reform.

The Outlook and Risks

3. We share the authorities' view that activity is beginning to slow as required to reduce inflation. Growth in real domestic demand has begun to ease with the rise in debt-service costs, higher energy and food prices, and a decline in confidence. However, the jump in commodity prices and cuts in personal income taxes will provide support for economic activity. Our baseline forecast is that real GDP growth will decline below trend for the next two years, easing domestic capacity constraints and returning CPI inflation back within the target band over the next two to three years. Slowing domestic demand and higher terms of trade should narrow the current account deficit.

4. The outlook is more uncertain than usual because of large countervailing forces. In our view, the balance of risk to growth is tilted toward the upside, stemming from the recent jump in commodity prices, sizable immigration flows, and the increase in state infrastructure spending. These factors could offset the impact of weaker consumer and business confidence and support domestic demand. On inflation, the risks are clearly on the upside. Further increases in energy prices are in the pipeline and capacity constraints, especially in the mining and housing sectors, could push wage and CPI inflation higher than envisaged. On the downside, a global slump could weaken export demand, and further international financial turmoil could tighten credit conditions and increase banks' funding costs. In addition, farm output may not rebound from the drought as expected.

Monetary Policy

5. The highest underlying inflation in more than a decade presents a significant challenge. A firm monetary policy stance is essential for keeping medium-term inflation expectations well anchored. The risk that wage inflation will rise further if CPI inflation persists at current levels calls for the RBA to maintain a tight policy stance until it is clear that inflation will abate. Reducing inflation back within the target range will require a significant easing in domestic demand growth. With the risks to inflation on the upside, the RBA should be prepared to tighten quickly if leading indicators suggest that domestic demand will not slow as expected or the outlook for inflation deteriorates.

6. The existing inflation-targeting framework is appropriate. The benefits of the framework are illustrated clearly when there are large shocks to inflation. Despite the pickup in short-term inflation expectations, the absence to date of a notable acceleration in wage inflation demonstrates that the RBA's inflation target has helped to anchor medium-term inflation expectations.

7. We welcome the moves to improve the transparency of monetary policy decision making. The publication of a statement explaining the RBA's interest rate decision at the conclusion of every policy meeting, followed two weeks later by the release of detailed meeting minutes, should enhance public understanding of monetary policy decisions.

Exchange Rate and External Stability

8. The flexible exchange rate has been helpful for monetary policy. The appreciation in recent years, driven by higher terms of trade and interest rate differentials, has contained inflation by reducing import prices and lowering demand for domestic resources. We estimate that the currency is above its long-run equilibrium level, reflecting positive interest rate differentials that have attracted capital inflows. Over time, the currency is expected to fall back toward equilibrium as the RBA reduces the cash rate once inflation moderates. However, with a portion of the improvement in the terms of trade likely to be permanent, the currency is expected to remain above its average for the last ten years.

9. In recent years, the buildup in foreign debt, especially short-term debt, has increased external vulnerability. Mitigating factors include the limited currency risk associated with the foreign debt, low public sector debt, the healthy banking system, and the sound macroeconomic policy and financial supervision frameworks. Australia's current account deficits largely reflect high investment rather than low saving, and should be sustainable as long as investment leads to growth in export capacity.

Fiscal Policy

10. Fiscal policy focused on medium-term sustainability has delivered a sequence of surpluses that has eliminated commonwealth net debt. This leaves Australia with a strong fiscal position, an enviable situation by international standards. We support the strategy in the latest budget to save the revenue windfall from the commodity driven boom and thereby allow automatic stabilizers to support monetary policy. Saving some of the revenue from the commodity price boom in three new funds will take pressure off monetary policy in the near term and enable increased infrastructure investment over the medium term.

11. The reduction in public spending growth in the latest budget illustrates the government's commitment to help reduce inflation. With the upside risks to the outlook for inflation, more public spending restraint could be required and we encourage the authorities to identify areas where additional spending cuts could be implemented. In addition, positive revenue surprises should be saved to assist monetary policy until it is clear that inflation will decline. Given the uncertainty about how much of the increase in commodity prices will be permanent, saving the additional revenue in the near-term may avoid sharp changes in taxes and spending in the future.

12. The states have increased capital spending and their budget balance has shifted to a small deficit in aggregate, thereby adding stimulus to the economy. This highlights the importance of maintaining restraint at the commonwealth level.

13. To the extent that the improvement in the budget balance is structural, associated with permanently higher commodity prices, this should provide scope to reduce taxes or increase spending over the medium term. The governments' intention to achieve a positive balance over the medium term should increase public net worth, further strengthening the fiscal position. Our analysis suggests that a combination of lower labor and capital income taxes, along with increased public investment, will generate the largest economic gains. The gains from other options such as lower consumption taxes or higher public consumption are not as large. Despite the expected structural improvement in the medium term, significant long-term fiscal challenges remain, particularly in the area of healthcare spending, and early adjustments will be key to preserving fiscal sustainability.

Financial Sector

14. The soundness of Australia's banks was demonstrated during the recent global financial turmoil. Since banks had minimal exposure to sub-prime assets, the main impact of the crisis was a sharp increase in funding costs. Although the major banks were able to maintain access to offshore markets, the turmoil highlighted financial institutions' vulnerability to rollover risks arising from short-term wholesale funding. Some of the smaller financial institutions that relied more heavily on capital markets, particularly securitization, for funding were more affected than institutions that had sizable deposit bases. Nevertheless, banks remain profitable and well capitalized, and asset quality is high by international standards, despite a marginal increase in non-performing loans. It is encouraging that banks are drawing lessons from the global turmoil, and are increasing liquidity as well as lengthening the maturity of their funding and diversifying the sources. Our analysis using extreme stress test scenarios applied to the large banks suggests that they would remain resilient if there were a jump in funding costs or a sharp increase in mortgage loan defaults.

15. The supervisory response to the credit market turmoil has been timely and appropriate. The RBA provided the necessary liquidity support through exchange settlement accounts and by increasing the range of securities accepted for repo lending. APRA has intensified its monitoring of asset quality, capital adequacy, and the liability structure of banks. In the context of Basel II, APRA is working with large banks on stress tests, which include extreme scenarios such as the loss of access to offshore credit markets for an extended period.

16. We support the planned introduction of new liquidity guidelines that will focus on improved disclosure and stress testing. These guidelines should further encourage banks to diversify their funding source