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Ian Macfarlane on central bank policies, inflation and China

At the recent Morningstar Investment Conference, Ian Macfarlane shared his thoughts on central bank policy, emerging markets with a focus on China, and Australia. This is Part 1 of the edited transcript. Part 2 next week.


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

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