Monday 21 October 2013

The Great Disinflation

Economic historians and academics specialising in finance and macroeconomics have been and will continue to be the main beneficiaries of the financial crisis.  Academics are still debating the causes of the Great Depression; one can easily extrapolate that academics will be publishing journal articles debating the antecedents of the 2008 Great Recession in 2100 and beyond.

Skeptikoi believes that another phenomenon associated with the financial crisis has not been as well documented as persistently high unemployment; the Great Disinflation.  Inflation and inflation expectations have dropped below the central bank target levels in most developed countries since around 2008.  In the United States, the core CPI (which excludes food and energy) has followed three distinct phases in the past decade.  From 2003 to mid-2008, the core CPI expanded at annualised rate of 2.3%.  This dropped to 1.1% in the two years to September 2010 and has posted compound annual growth of 1.9% since then.

Australia’s disinflation also commenced around the time of the collapse of US investment bank, Lehman Brothers.  The trimmed mean CPI – which excludes items in the CPI basket that experience the most extreme movements – grew at a compound annual rate of 4.3% from March 2007 to September 2008 before slowing to 3.2%pa from September 2008 to March 2010.  Since then, the trimmed mean CPI has grown at 2.2%pa.  So for three years now, underlying inflation has remained at the bottom end of the Reserve Bank of Australia’s (RBA) target range.  This should come as little surprise considering that the RBA’s excessively tight monetary policy coincided with Australia’s deepest nominal recession in over two decades; nominal GDP posted average annual growth of 2.5% in the 2013 financial year.

Labour market developments do a pretty good job of explaining Australia’s disinflation.  Nominal unit labour costs – which are a measure of productivity adjusted wages – are currently at the same level as they were in September 2011.  Excluding the financial crisis, this represents the longest period of stability since the late 1990s.  The unemployment rate of 5.6% remains close to the financial crisis trough and has climbed by close to 15% in the past two years, the largest proportionate rise in over a decade, excluding the crisis.
 
Later this week, the release of Australia’s September quarter CPI will once again bring into focus the RBA’s policy deliberations.  The consensus forecast points to a 0.6% rise in underlying inflation.  The deprecation of the Australian dollar represents some upside risk; the Trade Weighted Index fell by an average of 7% in the September quarter.  But movements in the currency have become less reliable than labour market developments in explaining inflation trends in recent years, possibly reflecting the strength of competitive activity at the retail level.

Some commentators have suggested that the easing cycle is over and are forecasting that the RBA will raise the overnight cash rate (OCR) as soon as in the first half of 2014.  A number of recent developments have brought the RBA some time.  On the local front, there has been a post-election bounce in business confidence and auction clearance rates remain high in Sydney and Melbourne.  Meanwhile, there is growing evidence of a synchronised recovery in world growth; the chances of a hard landing in China have diminished, renewed vigour in quantitative easing is having the desired effect in Japan (Abenomics) and the United Kingdom (Carneynomics), economists are no longer downgrading growth prospects in Europe, and have recently started to upgrade their forecasts, the US recovery remains modest but on track, with tail risk of a default on Treasuries having reduced for now, and the deferral of tapering has stemmed the flight of capital from emerging markets.

But Skeptikoi believes that the RBA’s easing cycle is not over.  The prospect of a synchronised recovery in the world economy is a welcome development for a small open economy like Australia’s, and should help to support commodity prices and the terms of trade.  But the renewed appreciation of the Australian dollar is already mitigating part of the stimulatory benefits of improving global conditions.  And mining companies are unlikely to kick-start large capex programs, having sought to educate the market over the past year of their new 'laser like' cost focus.

Despite the recent significant improvement in business confidence following the Coalition’s decisive victory at the September election, the renewed cost discipline that pervades the corporate sector will keep in check growth in capital investment.  Feedback from the ASX200 companies is that they remain focused on cost containment, the deferral of growth options where feasible and the return of capital to shareholders to cater to the market’s insatiable appetite for income.  Consequently, dividend payout ratios remains close to a record high, no mean feat for a country that already had among the highest payout ratios in the world due to the low effective tax rate on dividends.  Of course, higher payout ratios help to reduce the agency costs of free cash flow, an important development in light of investors’ loss of trust in corporate governance structures since the financial crisis.

A corporate sector that remains focussed on returning capital to shareholders and lifting productivity to combat the prospect of still anaemic revenue growth is good news for earnings growth and investors, but bad news for the labour market and nominal GDP growth.  The RBA reminds us that private sector savings rates remain at two decade highs, that business and household sector balance sheets remain in rude health and that both have the capacity to lift spending and withstand an adverse income shock.  The RBA’s key mandate at present should be to revive the dormant animal spirits that permeate the business and household sectors by further easing monetary policy.  But their reluctance to do so appears to stem from the misguided notion that persistently low interest rates would stoke a future property bubble and undermine financial stability.

The September quarter CPI should confirm that inflation remains benign and that the inflation outlook provides the RBA with ample scope to continue to ease monetary policy.  If the RBA does indeed believe that its job is done and that the OCR has bottomed at 2.5%, Skeptikoi is afraid that labour market conditions will continue to deteriorate and that Australia’s own Great Disinflation will persist.

3 comments:

  1. Interesting article. It seems as though you do not believe the labour market has changed a lot in recent times then.

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  2. This comment has been removed by the author.

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  3. nottrampis, the UE rate did dip down to 5.6% (sa) in September from 5.8%. But the part rate reveals a still weak labour market. The part rate fell to 64.9%, its lowest level in seven years. By gender, males appear to be opting out of the labour force; their part rate declined to 71.2% in September, the lowest monthly reading since the inception of the labour force survey in 1978 (excluding August 2004 which was marginally lower). 3Q underlying inflation was higher than I had anticipated and the RBA will likely keep their powder dry for the remainder of 2013. But the corporate sector's relentless cost focus will undermine any tangible labour market recovery. For instance, BHP's CEO, Colin McKenzie, cited in their 3Q operational review yesterday the 'pursuit of productivity gains' in the first line of the press release, and guided the market to a 25% reduction in capital and exploration expenditure in 2014!

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