Deflation Threat in Australian Economy: Role of RBA and Monetary Policy

The essay discusses the recent deflation threat of Australian economy raised in recent years. The economy currently suffers with a lower than expected inflation rate. Both domestic and international economic condition explain the below trend inflation rate. RBA sets the inflation target in Australia and adjusts cash rate accordingly. Since last two years, RBA has kept the interest rate fixed at 1.50 percent. The normalized interest rate affects the investors’ decision. Structural factors such as globalization, status of labor market and technical changes explain the low inflationary pressure in Australia.

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Executive Summary
The essay discusses the recent deflation threat of Australian economy raised in recent years. The
economy currently suffers with a lower than expected inflation rate. Both domestic and
interntional economic condition explain the below trend inflation rate. RBA sets the inflation
target in Australia and adjusts cash rate accordingly. Since last two years, RBA has kept the
interest rate fixed at 1.50 percent. The normalized interst rate affects the investors’ decision.
Structural factors such as globalization, status of labor market and technical changes explain the
low inflationary pressure in Australia.

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Table of Contents
Introduction......................................................................................................................................3
Role of RBA in Australia................................................................................................................3
Monetary policy tools of RBA........................................................................................................4
Current economic environment of Australia...................................................................................5
Current monetary policy in Australia..........................................................................................7
Monetary policy and financial condition.....................................................................................7
Connection between recession and inflation...................................................................................8
Importance of leverages in the economy.......................................................................................10
Conclusion.....................................................................................................................................11
References list................................................................................................................................12

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Introduction
Government of a country intervenes in economic activities to ensure a stable economic
performance. Fiscal and monetary policy are the two macroeconomic instrument for influencing
aggregate demand and other economic variables. Monetary policy particularly aims to maintain a
stability in the price level by influencing money supply and interest rate. Every economy tries to
achieve a sustained economic growth along with a low inflation (Bernanke, Antonovics and
Frank 2015). The Reserve Bank of Australia is the central bank of Australia. RBA conducts
monetary policy operation with the objective of maintaining a strong financial system. The essay
evaluates the article named “Is the deflation bugbear heading down under” drawing relevance to
current economic stance of Australia.
Role of RBA in Australia
. RBA also has the responsibility to issue currency. The Reserve Bank being a policy
determining authority provides some selected banking and other registry services the selected
government agencies. It also provides assistance to some overseas central bank and other official
institution. RBA also maintains the gold and foreign exchange reserve of Australia. The role and
responsibilities of RBA is set by different legislation. RBA is a legislative authority which is
established by Parliament’s act, the Reserve Bank Act 1959 (rba.gov.au 2018). The act provides
specific obligation and specific power to RBA. Followed by the act, two boards of the central
banks are: the Payment System Board and the Reserve Bank Board. It is the responsibility of
Reserve Bank to ensure a stable banking and monetary policy directing it to the advantages of
people in Australia. The primary roles of Reserve Bank Board are the following
a. Maintain stability in currency system of Australia

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b. Guarantee full employment in Australia
c. Ensure economic prosperity and enhance wellbeing of people
d. Maintain stability in the price level
The role of Payment System Board is specified as
a. Control risk present in the financial system.
b. Promote efficiency in the financial in the payment system.
c. Promoting competition in payment service market which is consistent with general stability of
financial system (rba.gov.au 2018).
Monetary policy tools of RBA
Monetary policy indicates the actions of central banks to influence the financial and
monetary policy condition. The broader objective is to achieve a low inflation along with a
viable economic growth. The Reserve Bank announces a desired state of monetary policy in
terms of setting a targeted interest rate on overnight borrowed and lent money in the market. This
overnight rate is known as cash rate. This is the interest rate that is directly affected by domestic
market operation of Reserve Bank (Monadjemi and Lodewijks 2014). The targeted cash rate
establishes operating objective for market activities of Bank. The main objective here is to
maintain a balance between supply and demand in the cash market maintain parity with the
desired cash rate.
Domestic market operation of RBA consists of two types of transaction in the market.
The bank stands ready to buy the short term government securities with cash exchange. The
government securities include Commonwealth Government Securities (CGS) that is Treasury

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notes or bond having a maturity period of less than one year. The Reserve Bank might enter in
repurchase agreement. The bank acts with both State and Commonwealth government securities
in the repo transaction (rba.gov.au 2018).
Current economic environment of Australia
Figure 1: Current trend in interest rate
(Source: tradingeconomics.com 2018)
The Reserve Bank of Australia has kept thee cash rate to a recorded low level at 1.5
percent in the September meeting. Interest rate decision of the central bank is consistent with the
market expectation regarding central bank policy action with co-existence of low wage and low
inflation. Worldwide, the inflation rate stays at a low level. In some economies however inflation
has increase and is expected to increase further based on tight condition in the labor market.
There is an ongoing uncertainty in the global market stemming from trade policy in United State.
Central Bank forecast an average growth of Australia a little above 3 percent for the next two

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years. The economy in the first quarter of 2018 was estimated to grow above the trend growth
rate (tradingeconomics.com 2018). There is favorable environment for business and investment
in non-mining sector continues to increase. The economic growth also gains support from the
investment in public infrastructure. The labor market outlook remains positive. The rate of
unemployment has declined to 5.3 percent. The documented unemployment is the lowest in the
past six years. The rate of inflation remains within the targeted inflation rate around 2 percent
(rba.gov.au 2018). The Reserve Bank’s forecasted inflation rate is that the economy is currently
experiencing. The low interest rate continue to support the economic growth. Reserve bank is
expected to take further policy initiative to reduce unemployment rate and maintaining inflation
within the target.
Figure 2: Current trend in inflation in Australia
(Source: tradingeconomics.com 2018)

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Measured inflation recorded in terms of a change in consumer price index hiked to 2.1
percent in the April quarter of 2018 compared to 1.9 percent inflation rate in last quarter. The
expected inflation rate was 2.2 percent. The inflation increased mainly due to an increase in
prices of electricity, tobacco and fuel. Cost of transportation raise by 5.2 percent compared to an
increase by 2.9 percent in the previous quarter. Cost of transportation is mainly drive by the
increase in fuel prices. Price increase significantly for tobacco, alcohol, culture, education,
recreational, financial and insurance service. Price on the other hand has been eased for non-
alcoholic beverages and food, housing mainly include electricity cost and health. Price has also
been declined for clothing, footwear, communication, household equipment and service
(tradingeconomics.com 2018). RBA reports that mean Consumer Price Index has increased by
1.9 percent matching expectation of the market. Based on Quarterly estimate the index increased
by 0.5 percent which is unchanged from its trend from the past three month matching market
estimate.
Current monetary policy in Australia
In determining the monetary policy, the board members considers both domestic and
global economic environment. Most advanced economies have accounted a growth rate that is
beyond the trend growth rate. There is uncertainty regarding the US trade policy and its
consequence on global market. There is evidence of a growing pressure on domestic economy
following a slow growth in wages (Libich, Nguyen and Stehlík 2015). Condition in the global
financial market has been found to be expansionary. Depending on present and future
prospective economic condition, it was expected that Federal Reserve would increase the fund
rate over 2018 and 2019. Present status of the Australian economy is consistent with the market
expectation. Both unemployment and inflation remain within the targeted level. Housing price in

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Australia has declined Melbourne and Sydney. Considering the available condition, the board
members of RBA decides to keep the monetary policy unchanged which would be consistent
with targeted economic growth and inflation rate (thebalance.com 2018).
Monetary policy and financial condition
Financial state of the domestic economy has remained expansionary. Interest rate in the
short term money market is higher than that in the three months ago. The Reserve Bank has kept
the interest rate a 1.50 percent since the last two years Yields received from 10-year Government
securities moved to a relatively lower level of 2.65 percent (rba.gov.au 2018). This has
accounted a little change since the beginning of the year.
Figure 3:10 year government bond yield
(Source: rba.gov.au 2018)
A decline in the neutral cash rate implies a risk free return. This leads to lower earning
yield raising the ratio of price to earnings (morningstar.com.au 2017).

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Connection between recession and inflation
Recession indicates an economic scenario where an economy records a considerable
decline in the economic activities for a period more than six months. The decline in economic
activity is normally traced by a decline in real gross domestic product, employment, real income,
production in different industries and wholesale and retail trade (Goodwin et al. 2015). There are
several factors that headed an economy towards recession. One such factor is inflation. Inflation
represents a situation where average price level accounts a general rise for a period of time.
Higher inflation means lower purchasing power of a certain sum of money. Under inflationary
pressure people tend to reduce spending on leisure to lower overall spending. As a result of cut in
spending, GDP starts to fall and unemployment as businesses lay off workers to lower their cost.
All these mark a decline in economic activity leading to a recession.
At present, the economy of Australia is feared to experience a deflation very soon. This is
because the current inflation rate is even lower than that targeted by the central bank. At present,
price level has increased by only 1.9 percent as against the targeted inflation rate of 2 to 3
percent. There are several structural factors forcing the price level to a lower level. These include
globalization, technological changes, labor market condition and changes in the inflation
targeting policy different central banks. The increasing openness of former Soviet Union and
China in combination with globalization enhance efficiency, provide source of a cheap labor
force and open the domestic market to the competition with international market. In addition,
reforms in labor market along with technological innovation induces a slow wage growth
lowering bargaining power of workers (morningstar.com.au 2017). The global financial crisis
dampened the inflation expectation dragging down further by weak demand, large output gap,
high unemployment and dipping prices of a range of commodities.

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Most countries currently experiencing deflation belong to the European region. Declining
prices has become a trend in nations like Bulgaria, Croatia, Greece, Poland, Sweden and Spain.
Germany, Thailand and Estonia though might not experience deflation on quarterly basis but
there is possibility of deflation in the upcoming months (Libich, Nguyen and Stehlík 2015). In
Italy and United State, the expected average decline in price is likely to be 0.5 percent. The
increased competition and attention towards financial stability makes Australia and New Zealand
more vulnerable to experience a likely deflation in coming months.
Importance of leverages in the economy
Leverage refers to the use of a tool or level in order to influence a larger gain relative to
little effort. Leverage is generally used in debt in to raise profit. Leverage can increase reward
from an investment at a faster pace. It is however also associated with high risk (Halling, Yu and
Zechner 2016). Consequently, leverage is responsible for increasing volatility in the economic
and financial market.
Debt is the lever in financial leverage. An investor can use money of other people that
allows to access to a larger investment (Uribe and Schmitt-Grohe 2017). In Australian, the
central bank has normalized the monetary policy by setting the interest rate to the level of 1.50
percent. Leverages accounts a significant proportion of return to shareholders during the phase of
quantitative easing. The share of leverages was up to 50 percent. However, high level of debt
worldwide has exhausted the return from leverages. This in turn has halted the growth in
productivity.
Leverages affect various aspect of the economy. Future trading of commodities involve
use of leverages (Aymanns and Farmer 2015). That is rather than borrowing at a rate of 50

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percent, a consumer can borrow the same at a rate between 90 to 95 percent at a future contract.
Leverage are also used in the Forex trading. This is because exchange rate accounts a very little
change. The additional leverage is considered as safer than stocks (Ingves 2018). Consumer even
prefers loans and credit. Consumer leverage explains the pattern of spending in an economy.
Conclusion
The Reserve Bank of Australia designs and executes Australia’s monetary policy. The
primary objectives of RBA include issue of currency, maintenance of full employment, control
the price level and finally maximizing the aggregate welfare. Additionally, RBA also controls
money market transaction and aims to ensue financial stability. The main instrument used by
RBA to influence economic activity is the overnight interest rate or cash rate. Currently inflation
in Australia is below the targeted level. The monetary policy is normalized in terms of fixing the
cash rate to a historically low level. The lower than expected inflation is now threating a
deflationary situation with possibility of recession.

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References list
Aymanns, C. and Farmer, J.D., 2015. The dynamics of the leverage cycle. Journal of Economic
Dynamics and Control, 50, pp.155-179.
Bernanke, B., Antonovics, K. and Frank, R., 2015. Principles of macroeconomics. McGraw-Hill
Higher Education.
Goodwin, N., Harris, J.M., Nelson, J.A., Roach, B. and Torras, M., 2015. Macroeconomics in
context. Routledge.
Halling, M., Yu, J. and Zechner, J., 2016. Leverage dynamics over the business cycle. Journal of
Financial Economics, 122(1), pp.21-41.
Ingves, S., 2018. Banking on leverage. [online] Bis.org. Available at:
https://www.bis.org/speeches/sp140226.htm [Accessed 7 Sep. 2018].
Libich, J., Nguyen, D.T. and Stehlík, P., 2015. Monetary exit and fiscal spillovers. European
Journal of Political Economy, 40, pp.184-206.
Monadjemi, M. and Lodewijks, J., 2014. Inflation Targeting and Macroeconomic
Stabilization. Research in World Economy, 5(2), p.93.
Morningstar.com.au., 2017. Is the deflation bugbear heading Down Under? -
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the-deflation-bugbear-heading-Down-Under/8994 [Accessed 7 Sep. 2018].
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minutes/2018/2018-07-03.html [Accessed 7 Sep. 2018].

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Reserve Bank of Australia., 2018. Our Role | RBA. [online] Available at:
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