Is the deflation bugbear heading down under? A case study of Australian Economy
Executive Summary
This respective study is commissioned to provide detailed comprehension regarding the topic of RBA and the threats of deflation. The Australian economy is experiencing certain setbacks due to certain setbacks. There are risks of the increasing inflation rate, higher unemployment level, economic recession, etc. In this context, this study has also discussed the RBA and its role in managing and controlling the monetary policies of the concerned nation. Major attention is also given to discussing the present economic condition of the nation by evaluating the factors like cash rates, inflation rate, employability scales, yields, assets value, etc. Lastly, this study has also discussed the relationship between inflation and recession along with the concepts of the leveraging dynamics by taking into consideration an article in the Morning star, which is also known as “Is the deflation bugbear heading down under?”
Introduction:
In this era of the global economic downturn, the Australian economy has also grown at a slow pace of 2.3% last year. The majority of the expert economist believe that unlikely to last, RBA is presently forecasting to accelerate the economic growth. RBA also believes that accelerating economic growth may be a harder task due to the increase in the propensity of deflation within the economy. In this context, this particular study will emphasize RBA and the threats of deflation along with discussing and evaluating the article published by Morning Star in October 2017, known as “Is the deflation bugbear heading down under?” This study will discuss the current economic environment of Australia like inflation and rate of interest, a monetary policy that is regulated by the RBA, etc. It will also discuss the ways these factors will have an influence on the current financial market, values of the asset as well as the impact on the whole nation.
Roles of RBA in Australia and tools of RBA to perform its functions:
The major role of the RBA (known as the central bank of Australia) is to effectively implement the Reserve Bank Act 1959. The RBA has a huge significance in managing and controlling the monetary policy of the nation. Further, RBA is also responsible for issuing its currency to accelerate financial system stability and uphold the efficiency and safety of the payment systems within Australia. The RBA is also engaged in offering banking services to the government of Australia, managing the nation’s gold and foreign exchange reserves, etc. In general terms, the RBA act as a body corporate that is entirely owned by the Commonwealth of Australia. RBA’s responsibility is to effectively participate in maintaining the stability of the nation’s currency, level of employment, economic prosperity along with the welfare of the people of Australia. For the said purpose, RBA adjusts the cash rate to deal with the medium and long-term inflation target, along with the function to maintain a sturdy financial system within the country (Reserve Bank of Australia, 2018).
The RBA utilizes certain tools for framing and implementing the monetary policy of Australia. The RBA change the cash rate i.e. the interest rates on immediate loans within the money market of Australia for making its monetary policy decisions. Generally, the cash rate is established within the money market by the force of demand and supply for overnight funds. By changing or adjusting the cash rate, the Reserve Bank of Australia can influence the interest rates across Australia’s financial system. Any alteration within the interest rates will eventually influence the economic activity of the people of the nation by changing their investment and saving behaviour, the supply of credit, household expenditure, exchange rates, asset prices, etc (Reserve Bank of Australia, 2018). Another tool that is utilized by the RBA is the open market operations, through which it can aim the cash rate by enhancing or reducing the supply of funds that commercial banks utilize to settle transactions among themselves. For instance, in case the RBA endeavours to reduce the cash rate, it can offer higher exchange settlement money than the funds which the commercial banks want to hold. In such situations, the commercial banks will react by relieving the funds, which ultimately leads to a lower down cash rate. Further, RBA also utilizes the process of issuing and buying back government bonds, as a monetary tool to maintain the supply and demand of the funds within the nation for carrying out the different governmental and private expenditures (Reserve Bank of Australia, 2018).
The current economic environment in Australia, monetary policies employed by the RBA and its influence on the financial market of Australia:
The economic environment and its growth, in comparison to the prior periods, remains quite slow in the present situation. In the context of the growth perspective, the economy of Australia finished the fiscal year 2017 in a tepid way. The RAB kept the cash rate in Australia at a record low of 1.5% in an expectation of enhancing its record period of policy inaction beyond two years, amid low wage growth and weak inflation. The consumer price inflation in Australia increases to 2.1% in the June quarter of 2018 which was 1.9% in the previous period (Tradingeconomics.com, 2018). This inflation rate is highest since the first quarter of 2017. The increasing inflation rate has notably influenced the prices of the products and services in almost every sector of the nation such as transportation, pharmaceuticals, food, and non-alcoholic beverages, health care, housing, etc. When it comes to GDP, the annual growth in 2007 was at 2.3% which is also the lowest annual rate since 2013. Further, it can decline due to the expectation in the strong labour market in which employment was up by 3.3% over the year. However, it can also be explained by a decrease in productivity by 0.8% over the year (McCollum, Shubin, Apsite, and Krisjane, 2013). Thus, the GDP growth of Australia in 2017 has ended close to the forecast of RBA of 2.5%, moreover, the RBA still anticipates the GDP growth to end up at an average of 3% by the end of 2018. These stats highlight the fact that the Australian economy is presently experiencing certain setbacks due to several factors such as sluggish GDP growth, higher unemployment, rising inflation rate, etc (Tradingeconomics.com, 2018). The achievement of this target could be challenging due to the ineffective outlook of the total spending of the consumers as well as a slow down in the housing construction. Similarly, the bond market is a vital indicator of investor confidence within the government.
The Australian economy has been experiencing a substantial increase in the government bonds yield in the last ten year. The yield on US 10-year notes marked a high of 3.09% which is the highest in the last seven years for Australia (Tradingeconomics.com, 2018). It is important to note that the higher yield signifies the larger risks within the economy. The yields increase due to the selling pressure of bonds by the investors resulting in the price drop and increase in the yields. In case the yield offered by the bond is much higher compared to that what it was at the time of its issue, there is a high probability that the government or company that issued the bond is financially hassled and might not be in a position to repay the capital in future. Thus, increasing bond yield within Australia is becoming a matter of deep concern for the economy as a whole (Faust, and Wright, 2013).
The connection between Recession and Inflation and why deflation is so dreaded:
The recession can be described as the comprehensive decline within the economic activities which are happening all across the economy of a nation which lasts for some months and eventually impacts the real GDP, employment, industrial production, real income, purchasing power, wholesale-retail sales, etc. Several factors contribute to the fall of an economy into a recession. It can be understood by the financial crisis that happened in the USA. Apart from other factors, inflation is also considered the major contributor to the economic recession (Linde, 2012). Inflation refers to the general increase in the prices level of products and services over a longer period. The increased level or rate of inflation leads to smaller or lower parentage of products and services which can be bought with the same amount of money as earlier. Further inflation can also happen due to multiple other factors such as enhanced production costs, higher national debts, higher energy costs, etc. In an environment of inflation, people or business organization endeavours to curb their unnecessary spending to save more (Linde, 2012). When individuals and businesses curb the unnecessary expenditure to save costs, GDP tends to decline and the level of unemployment tends to increase because business organizations lay off their employees to reduce unnecessary costs. Thus, various factors are integrated and collectively lead to economic recessions (Barro,2013).
Deflation or low inflation is one of the vital variables and become dreadful over a longer period. It is important to note that the nominal interest rates cannot decline below zero as it will lead to a reduction in the bank balance of the people every month resulting in prompt withdraw of the deposits from the bank and keeping the money in hand. Along with the inflation, it puts extensive pressure on the real interest rates too (Barro, 2013). In case the real rates cannot fall lower enough to accelerate the demand and enhance price level, the demand will get deteriorate further. This phenomenon is also termed a deflation trap. For instance, the recession in the USA becomes a global financial crisis which was happened from 2007 to 2008. According to many economists and experts, the global economic environment has still not recovered from that crisis (Faust, and Wright, 2013). The billions in losses and sluggish global economy manifesting themselves in the present European Sovereign debt crisis leads to the downfall of large numbers of global financial institutions. There are various reasons for the great depression, however, the main trigger will always be assumed to be a crisis of the US housing market (Fairlie, 2013).
Importance of leverage for an economy:
As the article, “Is the deflation bugbear heading down under?” discussed the leverage concepts which act as a driver for the economy. It is important to note that a general agent-based model of financial mechanism comprises leveraged investors like the banks or other financial institutions which invest in the tradable securities and manage their risks by utilizing Value-at-Risk constraints based on past examination of the prices of the securities and assets. Thus, the Value-at-Risk limitation signifies that when apparent risk is low, the leverage is high and vice versa. This entire phenomenon is considered as pro-cyclical leverage. The leverage dynamics is one of the crucial elements which help in sustaining the economy. It may have both positive and negative impacts according to its usage. At the time of recessions, the majority of the theoretical determinants of companies’ financial structures witness the extensive level of shocks (Fairlie, 2013). For instance, in the last few years in Australia, the corporate cash flows have reduced for numerous companies, the equity capital of financial intermediaries has diminished, equity valuation level along with the term structure of interest rates generally get altered, etc. Such situations extensively impact economic growth and increase inflation resulting in an economic recession. In such a condition, the leverage dynamics helps in sustaining the level of cash flow in the entire financial system across the nation (McCollum, Shubin, Apsite, and Krisjane, 2013). But at the same time, it is equally vital for the lending institution to validate the level of leveraging to get exposed to the risks minimally. The excessive risk exposure of the leveraging may fail the financial institution to get back to the mainstream business of lending money. Thus, leveraging has huge significance in the growth and development of the flourishing economy (Karanikolos, et al., 2013).
Conclusion:
From the above-mentioned comprehension, it is apparent that the economic conditions of Australia are experiencing certain setbacks due to the sluggish GDP growth, high unemployment, soaring government or companies’ bond yields, higher than the expected inflation rate, etc. This study has discussed the Reserve Bank of Australia and its role in managing and controlling the different processes of the Australian economy. Being the central bank of the country, the RBA has significantly endeavoured to accelerate the pace of economic growth in Australia. Further, this study has also discussed the relationship between inflation and recession. Further, this study has exhibited the present economic conditions of Australia along with shedding light on the concepts of leveraging dynamics and its role in strengthening the economy.
References:
Barro, R.J., 2013. Inflation and economic growth. Annals of Economics & Finance, 14(1).
Fairlie, R.W., 2013. Entrepreneurship, economic conditions, and the great recession. Journal of Economics & Management Strategy, 22(2), pp.207-231.
Faust, J. and Wright, J.H., 2013. Forecasting inflation. In Handbook of economic forecasting (Vol. 2, pp. 2-56). Elsevier.
Karanikolos, M., Mladovsky, P., Cylus, J., Thomson, S., Basu, S., Stuckler, D., Mackenbach, J.P. and McKee, M., 2013. The financial crisis, austerity, and health in Europe. The Lancet, 381(9874), pp.1323-1331.
Linde, A.D., 2012. Inflation and quantum cosmology. Elsevier.
McCollum, D., Shubin, S., Apsite, E. and Krisjane, Z., 2013. Rethinking labour migration channels: The experience of Latvia from EU accession to economic recession. Population, Space and Place, 19(6), pp.688-702.
Reserve Bank of Australia. (2018). About Monetary Policy | RBA. [online] Available at: https://www.rba.gov.au/monetary-policy/about.html [Accessed 19 Sep. 2018].
Tradingeconomics.com. (2018). Australia – Economic Indicators. [online] Available at: https://tradingeconomics.com/australia/indicators [Accessed 19 Sep. 2018].
