But in terms of your central outlook, in principal if things remain on that kind of a

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1 1 The Australian: Your central outlook for growth has the economy continuing fairly weak until the middle of next year and then starting to get stronger from the second half of You ve been saying since February that a period of stability is the prudent course for monetary policy at the moment. While lots of things can shift, does your central outlook imply that that period of stability could last until this time next year or until mid-next year? Well we haven t defined what the period of stability is and indeed, as my remarks from last week should make clear, I think before too much significance gets attached to that language we ll probably think about shifting to something not quite so specific. But at this point we haven t defined what the period is, it s already been almost a year, market pricing is for not much to happen for some time yet. I ve got no particular view to report about that sort of expectation at the moment. The Australian: track... But in terms of your central outlook, in principal if things remain on that kind of a The central outlook is for growth which admittedly has been a little higher than expected just in the near past, the period just past to be probably a little below trend for a little while yet, and then to pick up somewhat further out. That forecast is predicated on an assumption of no change in interest rates for that period, but that s not a commitment to deliver that, that s just a working assumption. The Australian: But you would want to see something changed from that central outlook before you... I mean if unemployment starts going down or if inflation starts going up then things change. Well if things change from the central outlook then they change. The Australian: Yes Then we would recompute our policy if needed. But at the moment, I think it s been a little early actually for people to be contemplating early rises in rates. Indeed that was the whole point of having the language on stability to try to lean against that. I can see that I think was obviously there, early in the year. The Australian: And have things.. financial markets seem to be leaning, if anything, in the other direction? Well I say their...their pricing suggests the most likely outcome is nothing happens for a while. Their pricing I think suggest that if something did happen in the near-term it would be down not up, and then if it was in the longer term more likely up than down. The Australian: Housing has been a major point of interest in terms of the bank s perceptions of the economy for the past six months or so, past year I guess. But I note that the latest building approvals are trending down, price rises seem to have levelled-out, auction appearance rates maybe a bit softer and we ve also had APRA commenting that it was minded to tighten controls on individual banks, constrain risks in housing portfolios. So I guess what that leads me to wonder is, is this as good as it gets in terms of monetary stimulus to the economy?

2 2 Well let s go through a few facts there. It s certainly true that in a number of the cities the price rises, the prices have tended to steady out for a few months, I think that s welcome. Even in Sydney the pace of increases has abated somewhat, and auction clearance rates as you say have come down a bit lower in Sydney, although they re still quite high. I think they re welcome trends because I think ongoing large price rises for housing is going to... if that occurred, would present something of a conundrum and make our job a bit more difficult. Personally I would welcome an outcome in which price rises are unremarkable in either direction for some time ahead. On activity: well the latest rise, the latest figure for building approvals was a rise of ten-plus per cent I think. So I m not so worried about that turning down just yet and I suspect that what we ll see is pretty high levels of construction for a while yet and that will be a good thing. That s...it s a good thing for two reasons. One is that it s part of the more balanced growth path that we re looking for, and we actually do want to house people, more people at reasonable costs. That s been the objective of housing policy, so I think on both those fronts, the recent data over the past some months has been quite encouraging actually. The Australian: And so then to the broader question, do you see the stimulus from your interest rate settings as still exercising further work in the economy? I think that the current level of rates will be supporting demand for quite some time yet. I doubt that we ve seen all the effects. We ve certainly seen a goodly portion of them. I think that s clear, but I doubt that the full impact on the level of spending is yet here. The Australian: Right and then resource sector, the coal industry s been looking not-so-good for quite a while. Iron ore also - output levels obviously soaring, but investment falling and prices looking a whole lot weaker. There s always been concern that the hand-over from the fall off in resource investment to the pickup in non-resource investment might not be smooth. So I guess what I m wondering is whether the levels of resource investment and commodity export prices are coming off more rapidly than perhaps you expected. I wouldn t say that there s markedly different outcomes so far. We ve anticipated a very large decline in mining Capex over several years. If anything my sense is that that probably took a little longer to start than we initially thought. But there s not much doubt it s going to decline quite a lot. The exact timing of that s quite uncertain. I think that will remain the case until the episodes are much closer to completion than it is now, but I don't think the big picture story that we ve been telling really warrants serious revision right at the moment. But in any event in a just a few weeks we ll be releasing some updated numbers and I don't know what they re going to say at this point and it wouldn t be sensible to foreshadow that, but whatever revisions need to be taken in, that will be clear when they come out. The Australian: But is there a sense that we might have a bit of a hole in activity over the next twelve to eighteen months? That whilst there s some sign of lift in non-resource investment... Well our forecast as we were earlier saying is for things to on average be probably a little below trend. Not a long way below, but a little below trend over the coming year. So if you want to define that as a hole, I ll leave that to you. The big point to make here I think is, there are very large forces moving in various directions here. We ve got a phase shift

3 3 in a very large episode in the resource sector. Shifting from part two to part three, as the investment spin comes down, the shipments pick up and that s happening very quickly. We ve got very low interest rates, but quite a high exchange rate, so things are pulling in opposite directions, and the truth is, it would be foolish I think to pretend that one can precisely forecast the net effect of all those forces. I don't think we can, and nor do I think that it s within our capacity to guarantee some kind of fine-tuned, very smooth outcome. I think the tuning is roughly right for circumstances, but there isn t much in the way of precision here. There can t be. The Australian: Does that level of uncertainty almost by definition mean that there s a greater level of risk in the Australian economy at the moment, or do you think the countervailing forces are within the realm of manageability? Well, I guess it depends what you mean by risk, but there s inevitably a period in which relative prices have shifted a lot, where we have very unusual policy settings in other countries, some of which are continuing to be adjusted even now, and where we ve got other quite powerful forces at work on our own economy. There s just inevitably, I would say, a wider margin of uncertainty around any central view. There s no way of avoiding that. The Australian: Governor, I wanted to ask you about how your outlook for inflation has evolved since the last (Monetary Policy) statement. So it was a fairly benign outlook and firstly that, and then secondly is there a risk that as the CPI relates to goods and services that are affected by government such as health and education that in the long run the structural inflation rate will be higher because there s less productivity growth in these areas? Well fair question, but the structure of the economy and the various price indexes that measure it have been shifting in that way for quite a long time actually. Services have been growing as well as the economy for as long as I ve been studying the economy, pretty much. To date that doesn t seem to have, you know, materially impaired our ability to control the inflation rate. We ve had pretty good control for about twenty years now, a bit more. So I m not particularly worried by that, and when you re looking at services and inflation, the other thing to say is you re paying a lot of attention to labour costs because that s probably the main driver and at least in the near term, the outlook seems to be for quite subdued pace of growth in costs there. Over the last year, unit labour costs as measured in the national income are pretty close to zero rate of change. It s a legitimate question to ask for the long run. I don't think we re going to have a problem within the policy horizon, over the next two or three years, and I don't think that we should assume that there s necessarily a serious problem longer out, further out. The Australian: And in terms of the data we have on the CPI, I recall the bank prefers...would prefer a monthly measure as opposed to a quarterly measure, is that still the same? Well I would prefer that, on the theory that more information is usually better than less. And I think we re one of the very few countries that does not have a monthly price index. But the fact is, I think, if you were to ask the bureau they will say they haven t got the funding and that s the reality. So we re going to have to make do, it would seem, with just quarterly data for the foreseeable future, certainly in my time.

4 4 The Australian: We saw a welcome increase in consumer confidence in the wake of the federal election last year, but earlier this year and certainly in the wake of the budget it slumped significantly and it seems to have stayed fairly low since then. Do you see this as a sustained fall, firstly, and then secondly what s the relationship between confidence and spending, consumer spending? Well it s too soon to tell whether it s a sustained fall because you re talking about a month or two, and I would recall that last year the budget contained some tough messages, confidence as measured went down but it did recover after a while. Perhaps that will happen again, perhaps not. We have to wait and see. On the relationship between confidence and spending, well actually my recollection of the empirical studies in the past year is that, if you know income and the usual variables that we think of as explaining consumption and then you add the information about confidence, there s very little additional explanatory power there. Where I think confidence indexes of the kind we re talking about, may be of some help is that in the very near term we don't know some of those other fundamental drivers, and the other thing to say I suppose is that the low-frequency moves in the confidence indexes do have some association of the broader business cycle of frequency. So at that frequency, that business cycle frequency, they re at least giving you information that s consistent with other things and therefore perhaps telling you something. Very high-frequency movement, I very much doubt, that there s systematically information and the really high-frequency swings unless they re big, and many of the movements we see month to month in those indexes really aren t statistically significant. The Australian: So is that another way of saying that we re only going to see a pickup in consumption growth if we also see a pickup in income growth which has been fairly lacklustre recently? Well income growth is clearly a key thing for consumption. The other thing that s key is what s happening to people s balance sheets and in some sense that s maybe is where some notion of confidence comes in. Households wealth as measured has been going up quite noticeably over the past year because house prices, we were earlier saying have risen quite significantly and so have share portfolios and when people receive their superannuation fund statements in the near future for the end of June. That s probably going to be a fairly positive story, and that s probably positive for consumer spending on the margin. The Australian And I suppose then if confidence is linked to equity values or household wealth, then it s going to be more susceptible to financial shocks now than in the past say, people have a far greater a share of their assets in the market sense. To the extent that the aggregate balance sheets have got bigger relative to current income. I think that s probably right. The Australian There s been some chatter in the press suggesting that we may have exaggerated - the press, the Reserve Bank, the Treasury - maybe exaggerated the importance of the resource burn to the economy and we shouldn t be so fearful of a sharp decline. I just hoped you might comment on that... You re referring to the John Edwards...?

5 5 The Australian Well I suppose the John Edwards book. Which is actually...i have read that. It s a beautifully written book, and I wouldn t necessarily agree with every single thing in it, but I think...i suppose what I would say is I was very pleased to see there s another optimist out there because I felt lonely in the optimist camp, over quite some years now. And our message I guess is, in terms of the trade boom and all the things associated with, it is a big deal. But the economy has actually coped with it quite well so far. Unlike other occasions where we ve had very large terms of trade gains and associated investment booms, we have not really had serious widespread overheating in the economy as a result of that. That s actually new. Most other times that is what happened in these preceding episodes. That is not a guarantee that we now manage the down phase of the investment boom without anything going wrong, but it s actually a much better starting place than we ve had in other episodes. And so, our message has never been that we re all going to be ruined by the ending of the mining boom. Our message is that it was a considerable challenge to manage. We ve managed significant parts of it already, I think quite well. I think we can manage the next phase as well, quite effectively, but the truth is there s legitimate uncertainty about how smooth that will be at this point in time and really, that s inevitable. The Australian: But surely people can take heart that the Australian economy, at least GDP growth, was fairly rapid before the resource boom in 2004, during the nineties, the early naughties, and all the structural features of the economy were largely the same except for the exchange rate, and so is that the...? Well, I think there are plenty of reasons for confidence about our medium-term future if certain things go right. The key things that help the economy cope with the up part, the terms of trade, I would nominate, obviously, a flexible exchange rate which we never had in the booms of the mid-seventies or the 1950 s or the earlier ones in history. We did not have that stabilising price movement that we ve had here. I think the second thing that should be said is that notwithstanding discussion over whether we need more labour market flexibility, the fact is that by and large the labour market responded pretty well to what was a couple of fairly sector-specific shocks. So, incomes and wages in WA and in the mining sector and associated areas went faster, but other areas by and large didn't. So relative wages shifted,the signal for labour to shift from one sector to another was given. That s actually what s supposed to happen, and that is a mark of an economy adjusting fairly flexibly to the shock that it s had. So provided we can keep that kind of suppleness, flexibility. Provided that the exchange rate more or less does what it is supposed to do and provided that we keep the prudent macro-economic frameworks which I think has also been a factor in helping in this period, you should be able to have some grounds for confidence that we can manage the next phase. It may be difficult, but certainly not impossible. The Australian: There s been a tendency for people to say that the production phase of the resources boom, it s all foreign owned companies and apart from some revenue for the government there won t be that much in it for Australia. I m thinking with the Gregory analysis for example. You have spoken at earlier times of just the extent which we

6 6 underestimate the spillovers from resource activity. It s been a massive build-up in capital stock. You see that...these benefits... Well I think the people who say look there s a high level of foreign ownership here, well that s right. It s probably higher in the gas sector than it would be in iron ore, but it s certainly not trivial. But I suppose the point we ve made is that there are some domestic shareholders, there are locally employed people in the resource extraction sector itself, and then other ancillary areas that service it. There are various layers of government taxes - perhaps not as much as there might have been had there been other taxation arrangements on resources - but nonetheless there are some taxation flows. All these things add up. The estimates our people did, certainly on the investment build-up phase was that maybe half of the value stays in Australia roughly speaking, if you add all that up. They re only approximate numbers and that s all you can do here. It is nonetheless certainly true that there s high levels of foreign ownership in some of these companies. That reflects choices that Australia has made in the past. We ve accessed the savings of foreigners to build up the capital stock of this country, and there s nothing wrong with doing that, but what that means is when those returns to that investment are flowing some of it goes to the foreign investors as it has to. That doesn t mean it wasn't worth doing. The Australian: You mention the exchange rate; you might have hoped that, this year would have seen some lift in global interest rates, weaker commodity prices and easing of the currency back to mid-eighties. Global bond rates have remained pretty low and while current commodity prices have weakened, the net has been that the Australian dollar has not fallen. It fell but now it s risen back and I m just interested to get your sense of what some of the factors that play are. For example, a lot of people talk about Australia as a safe haven, that we re starting to get safe haven flows that we never would have seen before. There s also global QE, or the fact that we ve got foreigners owning quarter of a trillion dollars worth of Australian government bonds... Well all these things are at work. On the safe haven point, I would put that slightly differently. I think there is some portfolio reallocation-type flow. You have a phenomenon that particularly sovereign investors who want AAA quality assets, but the list of countries who s got AAA ratings has gotten smaller, and I think we re quite prominent on that list because of, basically a sound economy by global standards. We have strong banks, government finances - for all our current debates, actually, the government finances overall are in very good shape compared with the case in many other countries. So there s some reallocation of official portfolios. Perhaps you could call that safe haven, though I think what safe haven normally means is that when there s a sudden risk event, people run to the haven. I m not sure whether I d be willing to say that we re going to be the recipient of those kind of flows in a kind of a major risk-off event. I suspect we might well see the Australian dollar go down in such an event, time will tell. So those things are at work. Global interest rates are very low, that remains the case. I think the day is coming when we will see the Federal Reserve begin the process of, at least starting towards some normalisation. That s a while away yet but by all accounts in a year from now, that path is going to be seriously in prospect. And at some point I expect people will start to focus on that and we could expect I think that when that day comes and starts to get closer even, the likelihood of some disruption in markets is probably pretty high because it always is when the Fed eventually changes course. And that will be the case

7 7 even though they will be very careful and measured and signal and so on, as they re doing. It continues to be my view that on most standard metrics that you could devise, it s hard to see how most of those metrics would have the Aussie dollar quite this high. And that s why we ve said that our sense is that some of the investors are maybe underestimating the probability of a material decline at some point, but I can t say when that might be. The Australian: There ve been suggestions that Australia should issue very long term bonds, as a device to mop up foreign interest in our assets and a potentially less disruptive way than them? Well it would depend what you do with the money, wouldn t it? I mean the standard process is that the debt management office issues the debt needed to fund the budget balance, which they re doing. There s a decision for them about what the tenor of duration of those asset should be and I think they have been lengthening the duration somewhat. Over recent times I assume that s probably because long rates are actually pretty cheap. The Commonwealth and the states for that matter are probably, in recent times, borrowing as cheaply as they ever have since we ve been a federation. So to the extent that they re taking some of that at longer term in order to lock better and that s probably quite sensible but that s within a framework where they issue enough to fund whatever the budget deficit or surplus, in some years happens to be. It s a different thing to do more than that in an effort to mop up, then you have to work out what you re going to have to do with that extra funding that you ve raised. The Australian: It could be quarantined and but that s going down a different path... Well it has to go back into the capital market somehow and I m not saying that this is shouldn t even be contemplated, but there are a number of elements to the kind of thing you re talking about that would have to be though through. The Australian: Through last year, you were expressing concern about the level of the exchange rate, perhaps a little more forcefully than you are now and certainly it was higher at various stages. The March quarter was a very strong quarter in the economy, despite falls in commodity prices and despite a pretty elevated exchange rate through that quarter. So I m wondering, has your thinking around the exchange rate been changing... maybe were you wrong to be as concerned about it as you were a year ago? Well I think we ve actually had a fairly consistent story here, which was the terms of trade which is usually regarded as quite an important fundamental for the exchange rate and certainly empirically - in the past that has been quite a close relationship. The terms of trade were falling and the exchange rate for a while didn't, and we pointed that out, then it did come down somewhat. One observes the terms of trade has been falling in the last six months, with not so much response from the exchange rate at least so far. But I think we ve had a fairly consistent line and the things that I ve just said now, and that I said last week, I ve said on a number of previous occasions. Maybe people are listening differently, that can happen, but I think we ve had a fairly consistent story. As far as the March quarter goes, that was a good outcome. That was probably a little higher than we had assumed or forecast. For various reasons that I ve articulated, we think there is some temporary strength there that we won t keep seeing. That said, I d

8 8 much rather be in the position of saying we ve had strong data. It probably isn t quite as strong as it looks, don't get too excited. I d rather be there than try to explain why weak data was not really as weak as it was, so I was pleased to see that outcome. I think at the margin, even though it was heavily driven by an unusual surge in resource exports in the quarter, to get a bit of strength is somewhat confidence-enhancing and I think that s by and large a good thing. The Australian: And again on a more positive note; the latest Capex survey was showing some signs of improvement in outlook for non-resource business investment. Where do you see the greatest areas of promise for non-resource investment? Well it s true as you say that those forward-looking components of that survey I think for the second quarter show a mild upgrading of intentions. This is very early days and that intended spending level comes off quite a low base. So one would be hoping that we see a good deal more of those upgrades ahead, but it is pleasing to see and I think we ve seen in some of the other business surveys similar improvements in intended investment. So to that extent, at least qualitatively, I think we see a number of things occurring that we want to see in order for the so-called handover to take place. It s just that this is an early stage and there s quite a way to go yet and inevitably a degree of uncertainty about how it will all unfold. There is a promise, well we clearly, just to make the point, we clearly can increase the rate of housing construction and we will. I think that s close to sure as you can ever be. Outside of that, one would think that there are some service-oriented sectors of the economy, health education so on, where there will be stronger than average growth for quite a long time in the future. And I would think, even in some of the tourism sector, and some of these other areas, probably reasonable prospects as well. Even in manufacturing I would hazard a guess that it won t be so much growth in some of the areas we know are under acute pressure to downshift but there d no doubt be other areas in manufacturing that are of a more niche nature which we can t pinpoint as well, because they re new. But I would think that there is a pretty reasonable future for that as well. So you know a number of areas where I think you could get some expansion. The thing that s really needed for that to become more solidified is confidence. That the path of demand is okay, that they can sell the products and that the general environment will be conducive to demanding a return on the investment, and animal spirits are... not something... there isn t a lever called confidence you can go and tug you know. It doesn t work quite like that. I think eventually that confidence will improve, but one can t say, how quickly and how strongly that will occur. It just isn t possible to do that. And that s why we have this period of uncertainty that I think we ll be in for a little while. The Australian: Most economists suggest that the federal budget at least does havea structural problem in the medium term, in terms of expenses exceeding revenues and that gap is likely to widen. So my question is, does it disappoint you at all or will it undermine our resilience that many of the savings measures - quite aside of what they actually are in practice, but the actual values of those savings measures, that the current government is proposing - it seems like very few of them will actually get through the Senate and become law and may be there ll be actually no consolidation whatsoever.

9 9 Well what I said about the budget, and I think this is an important point, as a country we have voted for some quite important things that are in the education, disability and some other spaces. These are all good things. We didn't actually vote for the revenue to fund them just yet and so that s the kind of fundamental issue that will emerge more clearly in a few years time. I don't want to comment in any detail about the current negotiations which are ongoing and no doubt in various respects are quite delicate. I think one would have to say though that if we can t find some way of putting together a set of fiscal accounts that at least begin the process of addressing these medium term issues with measures that start small but then build over time. they re the sorts of measures we should have I think. If we fail to manage to do that here, I m not sure that that would fill one with great confidence in our capacity to deal with the genuinely serious problem when one day that emerges, which sooner or later something will happen that will bring this stuff into a sharper focus, especially if we delay action. So I suppose my only comment is it would be good to show that to our own community, the investor community, it would be good for our own self confidence. I think if the political leadership all round can find some set of measures which help address this gap that s going to grow - not right now but over time. We shouldn t leave it until the gaps emerge, and a time when financial markets might not be so forgiving as they are now to start the measures that will deal with that. We should be starting in a measured way now. The Australian: Is it possible that in some circumstances, spending cuts could actually boost economic growth or indeed improve confidence, if households or consumers think that their future tax debt is going to be lower and there ll be a less chance of a crisis, down the road? I think the thing that would most help household confidence is simply - not so much the Ricardian equivalence ideas which is what you re talking about - I think the thing that s most conducive to confidence is a sense among the community that the leadership of the country, by which I mean the political leadership on all sides, has a grasp of the problem, a balanced sensible assessment of the issues we face and can agree on some plans to deal with it. That s confidence-enhancing. Not coming up with some set of plans to deal with it would be confidence dis-enhancing I would suggest. The Australian: You suggested earlier that Australians hadn t yet voted for the revenue to support many of these useful policies that have been at least partly legislated. So as you well know Martin Parkinson s given speeches a few times now suggesting that there is a fundamental disconnect and a more general problem in terms of population voting for policies but not voting for taxes to pay for them, and so you re onboard with that. No I support what Martin says. I think that should be clear from things I ve said in the past. He s closer to the details of the issues than me clearly but I think his point, and Ken Henry said similar things before him, it is easy to present to the public good things on the spending side. I think the art of leadership though is surely to also have the conversation on how we pay for it. And people understand that if you put it to them clearly. The Australian: State and federal government face different economic incentives because of the vertical...the revenue imbalance between the two tiers. Could that have something to do with what s led to this, states do so much expenditure but don't raise the taxes.

10 10 Well no doubt there are some difficulties that emerge here because of the relative configurations of the states and the federal government, I don't want to really go down into the detail of that. It s beyond my brief, but the main point simply is, there is a medium term issue which will grow if it s not addressed and it would be best to be agreeing on measures now that will address it over time rather than let it fester and be faced with more genuinely draconian measures at some later day. The Australian: On a kind of related point, Martin Parkinson has also spoken and I appreciate this is a difficult question to put to an optimist, but Martin Parkinson has also spoken about the fact that our twenty-three and a half years without a recession has little precedent. If we re to stretch that out to thirty-three as the current budget projections suggest, well that would entirely be without precedent. Just interested, it is a very long time since we ve had a down turn, how do you see the risks around a down turn? Is it something that...? Well you see I don't think it s true that it s a long time since we had a down turn. A long time since we had a... The Australian: Recession. And this is a thing I feel rather strongly about. We are creating a narrative here about the twenty-three years of no recession as though this is some miracle and, you know, we ve sort of advanced smoothly without any setback, but that s not really true. I mean we have had a few episodes of mid-cycle slow down, and we ve had a couple of episodes where the economy contracted, but only briefly and they were shallow contractions and brief ones. We had one in the later part of 2000, and we had one as you d well recall at the end of 2008 which could have turned out to be much deeper - and I actually thought it would be deeper at the time but, we got back to growth quickly. So the down turns were shallow. We did see the rate of unemployment go up a percentage point or so,in both those episodes. The only reason they weren t labelled recession is because the contraction happened to be all in one quarter, not spread across two, otherwise you guys would have written very different stories. But the way to think about this isn t that we don't have down turns and we haven t had downs, we have had them. The way to think about it is that we ve managed for twenty some odd years to only have little ones and short ones, and what we should be thinking about is, how was it we managed to do that. It isn t because we re a miracle economy and it s not because we re geniuses in government or the central bank. I do think though that good policy frameworks, careful policy development and implementation does make a difference. That s the difference it can make. It doesn t promise you that we can go another ten years without recession or without down turn. I would fully expect within, over that ten year period at some point, there will be a down turn for some reason of some depth. The question is, can we be in a position to do the things that would make it a shallow and short one, that s really the issue. And having a strong fiscal position by the way, ahead of any such down turn, which stood us in very good stead in 2008, would be one such thing and sound monetary policy framework another obviously. So I want to fight against this narrative that s built up. It s a myth really that this economy doesn t have down turns, we do have them, we will have them. We happen by either good luck or good management, or both, to have had

11 11 pretty shallow ones the last couple of times. Long may that be so, we should be doing what we can to give us the chance for the future down turns are short and shallow. The Australian: Just darting back just briefly on to housing, your submission to the parliamentary inquiry that s underway at the moment on foreign investment in housing. You downplayed the significance that it s having in terms of housing demand and emphasised the role that foreign investment is having on housing supply. Nonetheless asset markets are becoming globalised, and we are seeing more foreign investment in property and in residential housing. Do we have to accept that the global investment will be an additional source of housing demand? I think we probably have to accept to some extent that Sydney in particular and I would say Melbourne as well, these are cities that enough foreign people have been to and like the look of. There s going to be some, we re on the global radar to some extent. It isn t London or Paris or New York, but I think certainly our larger cities are on the radar for international people more than they used to be. And so there s going to be some demand on the part of some of those people for property here. It s very hard to say quantitatively how much that has been or will be I think. But the issue for us is, whether that interest results in our own people not being able to housed at a reasonable price in our cities. I m not sure we should assume that. I think surely it s not beyond us to make sure that the supply capability particularly for new housing - and at least legally, its new housing that the foreigners are supposed to have the access to - can t we do things that ensure that the supply responsiveness is adequate to meet both their demand and the demand of our own children and new families here, without excessive increases in price? If that s the challenge to us, why can t we meet that challenge? It seems to me we should set out to do so. The Australian: Well still on the subject of asset markets, I thought we could shift now to the legacy of central banking since the crises if you like, and more world issues. I wanted to know what you made of the Bank of International Settlements annual report - they criticised global central banks for keeping rates low for too long and for overseeing too loose policy and they suggested that one of the signals that it was too loose was that asset markets in particular, bond and equity markets, had decoupled from economic fundamentals in a fairly grand way and they were quite worried about that. Is that something that worries you? What do you make of that analysis? Well yeah I ve read the report and BIS has I think, had a fairly consistent sort of story for quite some years now about the importance of asset market and credit cycles. I very much agree with the sentiment that the low frequency swings in the financial sector of the economy which are not necessarily all that well aligned to the conventional business cycle swings that people think about. I think these things are important, and there are certain risks with very accommodative policy settings which are in place globally, largely as a result of the policies being undertaken in the major jurisdictions. But the thing is I suppose the notion that there s more risk taking, as a result of very accommodative monetary policy, well actually that s the point, that s the idea. The question really is whether we re getting a right sort of risk taking in the right places, and so in my view, we should be trying to form an assessment of how much is the risk taking of the kind that we want by entrepreneurial business in the so-called real economy, a new product, a new factory, a new process, an innovation, and by extension some employees as well. It s

12 12 that kind of risk taking that is good because that s how society advances, and that s the inherent growth dynamic of a capitalist economy that makes them so productive and wealth creating over time. So the question that is how much of that do we get along with the obvious instances of the search for yield pushing the financial investor community out the risk curve. If we re getting an adequate amount of the real genuine risk taking for accepting some of the financial risk then arguably that s a trade-off worth making. I think the difficulty is that the jury is out really at this point on just how well that s working at this point in time and so I don't think we can form a full evaluation of this issue. I think the BIS, at least qualitatively you know without looking to necessarily endorse every sentiment, I think they re right to kind of pose the general question. My view is that we re not in a position as yet to form a good judgement on whether the risks involved in the policy settings are earning the adequate pay off in terms of the support to the real economy. They may be, they may not quite be, it s a bit early to know yet. The Australian: What sort of data could we look at anyway to know whether we re getting the right sorts of entrepreneurial activity in monetary policy? Well that s a very good question and I m not sure I can point to all the data sets that one would look at and I think it isn t just, is there the data, it is has enough time elapsed for the data to show the effect or lack thereof clearly enough? But presumably to some extent we would want to over time look at where the business capital spending has recovered, whether there s evidence of you know good innovative new ideas getting adequate financial support from whatever source and things like that. And those things will be I think requiring a fair bit of research to try to evaluate it, and time. The Australian: Does the simultaneous strength of both bond and equity prices raise financial stability concern and that shift out the risk curve simply on financial assets Well to some extent these things can go together if the bond rates are sustainably low and they are driving the discount factor that the equity investor is applying to the future stream of earnings then equity prices go up in a valuation sense. it s not really that clear is it, that things like price to earnings ratios are that overdone, not in this country certainly. Even in the US they re pretty fully priced I guess, maybe a bit above average but you wouldn t say wildly so... That having been said there s still a question of whether...when we look at exceptionally low volatility in most financial prices and quite compressed risk spreads. The very low level historically of long rates, I think it is legitimate question to ask whether there could be events that might upset that at some point. And obviously one potential candidate is when the Fed eventually does begin, even a very careful process of normalisation, that could trigger a reassessment of liquidity premia and risk premia. It usually does, historically. That s not necessarily a disaster at all, but it s just a fact that there are any number of geopolitical things one might point to right now, that if they went the wrong way could serve as an upset as well. So you know, that s a legitimate set of questions to ask about the current conjuncture, which I think you can contemplate somewhat independently of these longer run things as to whether too much risk gets built up in a broader sense from the policies.

13 13 The Australian: But it s not inevitable is it that there will be a financial market shake out at the end of tapering because there was a lot of volatility when the Fed, if you like, false started last year early and then they delayed the start, but since then it s been a very smooth response every meeting to tapering. It s been remarkably smooth. I agree. I think that probably in terms of the tapering which they ll finish before the end of the year by the look of it, one would expect that that will be now accomplished fairly smoothly. I would only observe that that s not the same as actually starting to raise the cost of overnight money. Now at this point I think that that s priced into the forward curve in the US so people in some sense have absorbed it and discounted it. Once it gets to be a few months away rather than twelve months or more away, perhaps that will be more of a test and I think one should not discount the possibility that there will be some disruption there and even when that disruption, if it happens...even when it occurs, well that s part of these course changes pretty much every time. The Australian: You mentioned that you know the Australian dollar could well fall in such an event, when the US normalises Or some other set of events for that matter. The Australian: Yes but are there other spill over s that you anticipate for Australian that might follow once the US starts shifting rates? Not necessarily particularly big ones. I think the atmosphere in international financial markets would be different in a world where the Fed is on a path however gradual to raise its rates. I think it would be no secret that our feeling is that we hope to see that for a bunch of reasons, not least of which is that s a further sign of healing in the United States economy. I happen to think the US economy is going pretty well and it s going to be just fine. But further confirmation of that would be when the Fed feels confident enough that they start to normalise the policy rate. I think overall that s a good story. It s a good news story. It s simply that there ll be some bumps along that road for some people. I wouldn t anticipate serious problems for Australia in particular. And most people who are looking for potential problems for us I think will be more likely to think about China than the US at least over the next twelve months. I happen to think China s probably okay too but most of the people that I talk to who want to think about what might go wrong, that s where they re looking. The Australian: IMF has been arguing that inflation targets are too low and that zero bound is too easily reached when you re starting point is two percent. It points not only to the era since the global financial crises but also the Japan having had its extended period of pain. So just interested in your view - Australia hasn t had to go there but is that a reasonable question to be asking of the inflation targeting regime? Well it s interesting that the debate about where inflation targets should be, has now got to the point where some people are arguing they re too low because there certainly was a period when the more strident supporters of price stability all argued they re too high. So that s an interesting observation I think, but just to pick up on the way you framed the question David. Two percent is the starting point for the inflation rate or in our case two and a half. It s not the starting point for the nominal interest rate, I mean normally the

14 14 nominal short rate if your inflation target is two you d think your nominal short rate on average is four point, something. So you ve actually got quite a bit of ammunition there to use. I don't think...i don't really think. I don't find persuasive the argument that an inflation target with a two before the decimal point is too low. And I rather think that the problem in these situations we ve seen is, it is less the wrong inflation target, as I think it s more that things have happened to make what you might call a neutral interest rate much lower than it used to be. There re things in the real economy and once those adverse things have happened - I think this is probably very much the story for Japan. That is a country with a declining population, their productivity growth s okay but not by advanced country standards. So their potential growth rate and their natural interest rate, is actually a very low number regardless of what inflation target they might have chosen. I think that s actually the more fundamental problem. I personally think Japan s bigger problem isn t deflation. That is a problem but the bigger problem is...has been a relatively unattractive potential growth path and what Mr. Abe is trying to do is lift that path. And one can very much hope that he succeeds because if he does that would give Japanese monetary policy more traction for a start, and it would return Japan to being the position of more of a growth dynamic for this region in the world rather than a brake and that would be very welcome. The Australian: Do you buy the arguments of Larry Summers around secular stagnation which I think relates to that point? I would hesitate a long time before getting a public debate with Larry Summers because he s a brilliant man. I guess one could restate what he s saying as maybe he s saying that the natural rate of return s really low or negative and that therefore that condemns you to this very stagnant performance for a long time. I mean one would hope that s not true. I don't know about you but I guess I feel more optimistic about the US certainly than that. I still think that s a very dynamic productive innovative country and I find it hard to believe that their natural rate of return on capital s a negative number. That strikes me personally as not that likely. That one might not have the same confidence of some other jurisdictions but in the US certainly I d have said the natural rates probably prositive. The Australian: On the debates around inflation, a couple of years ago the IMF in its World Economic Outlook referred to the dog that didn t bark, referring to the lack of deflation following the global financial crises. Since then inflation has dropped somewhat but, I guess particularly in Europe. But taking a longer compass on it, from the inflation of the seventies, the great moderation of the nineties, through to you know maybe insipient deflation in Europe, do you think that our models for understanding inflation are sufficient? Are they doing a good enough job of describing the phenomena that we see? Well all models are...most models break down at some point, need recalibration and certainly we should never feel that any particular empirical representation we have of anything is kind of the last word because the economy is dynamic, it evolves, it changes. But just to start where you started with the Fund saying that it s the dog that didn't bark, so that...i think there is an interesting question as to why, given the size of the output gap, that everybody thinks the major economies have had, why didn't inflation go down more? One answer might be that expectations were very strongly anchored at a positive number and that s very helpful actually if that s the story in the episode they ve had. But if that s what you think I don't think that s consistent with the argument that inflation