The Most Dangerous Idea at the RBA: Monetary Policy Doesn’t Matter

“In the end, though, firms and individuals have to have the confidence to take advantage of the situation.  They have to be willing to take a risk – on a new project, a new product, a new market, a new worker.  Monetary policy can’t force spending to occur.”

Glenn Stevens, Reserve Bank of Australia Governor, December 2013

Leading up to Christmas, Glenn Stevens probably feels that he has received an early Christmas gift in the form of a lower Australian dollar.  For more than a year, he has cited concerns about a persistently high dollar as impeding competitiveness of the non-commodity export sector.  It has finally succumbed recently; at the time of writing, it had depreciated by close to 10% against the US dollar since mid-October and by 7% on a trade weighted basis.  Whether this has been due to Mr Stevens’ jawboning is debatable.

But as Mr Stevens indulges into his Christmas lunch, he might well feel that his glass is half empty.  By his own admission during this week’s opening statement to the House of Representatives Standing Committee on Economics, growth has been below trend this year and he expects this to persist for a bit longer yet.

Nor would this week’s updated Mid-Year Economic & Financial Outlook (MYEFO) provide Mr Stevens with much reason for optimism.  On the heels of a dismal outcome for nominal GDP growth of 2.5% in financial year 2013, the Treasury downgraded growth estimates for nominal GDP to 3.5% in each of the financial years 2014 and 2015, down from the preliminary forecasts of 5% contained in the May Budget and well below the two decade average growth of 5-6%pa.  If this outlook transpires, the RBA’s nominal recession is set to extend for three consecutive years.

But his main concern appears to revolve around what he considers to be the limit of his power as the country’s top central banker; according to Mr Stevens, monetary policy cannot effectively revive animal spirits and encourage households and businesses to take risks.  Skeptikoi is shocked by this.  Yes, monetary policy cannot force spending to occur.  But what is the role of monetary policy, if not to influence people’s perception of risk and discount rates?

To better understand this, it is instructive to re-assess the concept of the neutral rate of interest, originally developed by the Swedish economist, Knut Wicksell.  Monetary equilibrium is achieved when the real rate of interest is equal to the expected real rate of economic return.  A lower real rate of interest encourages businesses to borrow and invest, which leads to inflation and conversely, a higher real interest rate is associated with deleveraging and either disinflation or deflation.

Skeptikoi believes that incorporating risk into Wicksell’s framework can better shed light on the crucial role that central bankers can play to revive the private sector’s appetite for risk.  Investment is still weak in Australia (and most other developed economies) because discount rates or perceived risks are high, which continues to pull down risk adjusted rates of economic return.  Renewed capital discipline, and high business and household savings rates across most of the developed world confirm that animal spirits remain dormant.  No wonder; October 2013 marked only the fifth anniversary of the financial crisis, the largest global downturn since the great depression.

Given the depth and breadth of the crisis, the process of healing could take a long time to play out.  A new and growing literature that marries psychology with economics and finance suggest that macroeconomic developments during a person’s formative years can shape their lifelong attitudes towards risk.  Various academic studies show that firms run by CEOs who grew up during or around the great depression had lower leverage than other firms.  And stock market participation was lower for investors who grew up during the great depression.

Against this backdrop, it is reasonable to think that financial crisis ‘babies’ (and those that have been adversely affected by the financial crisis) will remain cautious for a while yet.  People have either lost their homes or jobs, witnessed the value of their homes decline or have remain employed but with a heightened sense of job insecurity.  Consequently, people are implicitly applying still high discount rates to their stream of expected future cash flows, which is depressing the present value of their human capital.  And the household sector’s lower permanent income flows through to an underwhelming recovery of consumption and still weak investment intentions of corporate sectors around the world.

Central bankers have been on a steep learning curve in the past five years.  Concerns surrounding the liquidity trap associated with zero interest rate policies have given way to the growing realisation that monetary policy can still be effective and affect agents’ expectations, risk taking attitudes and asset prices through forward guidance and large scale asset purchases (LSAPs).  Christina and David Romer from the University of California argue that the most dangerous idea in the Federal Reserve’s history is that monetary policy does not matter.  They attribute the prolonged downturn of the great depression and the great inflation of the 1970s to policy errors committed by the Federal Reserve, stemming from an ‘unduly pessimistic view of what monetary policy can accomplish’.

The authors also draw parallels between prevailing views of monetary policy since the financial crisis with the great depression, regarding the ineffectiveness of monetary policy at the zero lower bound, as well as the costs associated with non-traditional tools.  But more recently, the Federal Reserve’s announcement of QE3 in 2012 suggests that it considers that the benefits of forward guidance and LSAPs outweigh the costs.  And other central banks have clearly reached a similar conclusion, including the Bank of Japan, European Central Bank and Bank of England.

Glenn Stevens is clearly frustrated that monetary policy’s role in promoting the recovery is not getting an assist from government policies that facilitate higher productivity.  While monetary policy is limited in its ability to affect long-run dynamics of productivity growth, it is the role of a central bank to prevent a cyclical shortfall in aggregate demand or act to prevent any shortfall from continuing.  Skeptikoi is afraid that the RBA’s timidity and its unduly pessimistic view that monetary policy does not matter, will unnecessarily condemn Australia to a prolonged nominal recession.

The Bond Conundrum and Global Saving Glut Almost a Decade On

“…the available information increasingly suggested that the economic expansion was becoming less fragile and the risk of an undesirable decline in inflation had greatly diminished…the Federal Reserve came to the judgement that the extraordinary degree of policy accommodation that had been in place…was no longer warranted and…signalled that a firming of policy was likely.”

One could be easily forgiven for thinking this passage is an apt description of recent deliberations at the Federal Reserve.  In fact it was delivered by the then Federal Reserve Chairman, Alan Greenspan, in February 2005, following an eight month period in which the target fed funds rate had been raised by 150 basis points (bps) to 2.5%.  Yet by February 2005, 10 year treasuries were yielding close to 4% significantly lower than 5% in June 2004.  Greenspan described the divergence in the fed funds rate and long term interest rates as a conundrum.

Given the ongoing decline in long term interest rates since then – US 10 year treasuries are yielding less than 3% at present – that semi-annual report to the Congress in 2005 has become amongst the most widely cited speeches from Greenspan’s chairmanship.

A month later, then Governor Bernanke attributed the relatively low long-term real interest rates in the world to an excess of desired saving over investment intentions.  The global saving glut could alternatively be thought of as inadequate or under-investment.  In a closed economy, a country’s saving imposes a constraint on the maximum funds available to the corporate sector for investment.  In the event of a shortfall in desired investment relative to the desired saving, the excess supply of saving causes the price of money (ie. the real interest rate) to decline.  Conversely, when expected domestic investment opportunities exceed desired saving, the real interest rate rises.  So in a closed economy, the current account remains in balance and the real interest rate equilibrates desired levels of investment and saving.

In an open economy, a country’s account balance is equivalent to the imbalance between investment and saving.  When a country’s investment exceeds its saving, it can borrow from abroad, so national saving does not impose a constraint on the maximum funds available for investment.  Although the country runs a current account deficit, its real interest rate is no longer governed by the supply and demand for domestic saving.  The ability to tap into foreign sources of saving lowers the real interest rate relative to a closed economy.  Conversely, a country whose investment opportunities fall short of its desired saving, runs a current account surplus and is a net lender of funds offshore.

According to Bernanke, the global saving glut had its antecedents in a wave of financial crises in emerging markets a decade earlier, which raised the precautionary motive for saving amongst those countries affected directly as well as other emerging markets unscathed.  Developing countries swung from being modest net users of capital in 1996 to being significant net lenders by 2003; according to the IMF, these countries swung from running an aggregate current account deficit of $68 billion in 1996 to a $150 billion surplus in 2003.  The size of the surplus confirms that any growth in investment opportunities during this time was not commensurate with the sharp rise in desired saving to safeguard against future crises.  In contrast, the aggregate current account deficit of developed countries had ballooned to $212 billion by 2003.

Bernanke acknowledged that the new status of developing countries as net lenders of capital to developed countries represented a role reversal from the experience of most of the 1990s and a challenge to the standard neoclassical model which says that capital ought to flow to developing countries; their low capital to labour ratios yield higher expected rates of economic return.  What the neoclassical model neglects is the role of risk.  Many developing countries have poor quality governance and institutions, including vaguely defined property rights, and relatively under-developed contract enforceability mechanisms and financial markets.  Consequently, few of these countries have successfully developed globally tradeable financial assets but have had more success in developing income producing assets.

Following the end of the dotcom boom in 2000, the associated steep decline in stock prices further reduced the appetite for capital investment in the US and globally.  According to Bernanke, “…with desired saving outstripping desired investment, the real rate of interest should fall to equilibrate the market for global saving.”  Ricardo Cabarello from MIT draws an analogy between safe assets and parking slots; a rise in the number of cars and contraction in available car parks causes the equilibrium price of parking slots to increase.

10 year treasury yields have continued to decline since 2005 and are currently yielding less than 3%.  In observations earlier this year, Bernanke attributed lower long-term interest rates primarily to a decline in the term premium with an assist from falls in the expected average real short rate and inflation expectations.  The term premium is the additional return investors demand for holding a long dated bond as opposed to buying and rolling over a series of shorter dated securities.  According to Bernanke, the lower – and at times negative – term premium has reflected among other things, the safe haven status and deep liquidity of longer dated treasuries which has attracted strong demand from foreign central banks and governments.

Those foreign central banks and governments are still predominantly from emerging markets.  Trends in current account balances confirm that developing countries continue to save in excess of their investment requirements; their aggregate current account surplus has grown to almost $240 billion from $150 billion a decade ago.  IMF data shows that the developed economies are also running a current account surplus, the first of its kind since 1998.

While Bernanke did not cite the ‘global saving glut’ in his recent speech to explain why long term interest rates are low, it is clear from developments in current account balances that the financial crisis exacerbated the global savings-investment imbalance; a heightened precautionary saving motive amongst developing (and now developed) nations, coupled with a dearth of perceived investment opportunities in developing (and now developed) countries.  Like the end of the dotcom boom, the financial crisis has ushered in a period of capital discipline and cost restraint, and raised companies’ propensity to either hoard cash or payout cash to shareholders in the form of stock re-purchases and/or dividends.

Looking forward, Skeptikoi expects the global savings-imbalance to persist and believes this can shed light on the outlook for real interest rates and monetary policy.  The depth and proximity of the financial crisis – October marked only the fifth anniversary of the collapse of Lehman Brothers – suggests that the healing process is far from over.  Worldwide, the precautionary savings motive remains strong across corporate, household and public sectors, while dormant animal spirits continue to dull the corporate sector’s appetite for increased leverage, capital investment and new hiring.  Against this backdrop, long-term interest rates are likely to remain low for an extended period.  Skeptikoi believes that monetary policies in developed countries ought to remain accommodative – through ongoing central bank purchases of debt securities and strengthened forward guidance – to revive animal spirits and encourage dissaving.

Looking through the cyclical legacy of the financial crisis, the global saving-investment imbalance will diminish only when emerging markets develop stronger institutions and governance mechanisms that reduce perceived risk and encourage investment - particularly in much needed infrastructure for rapidly growing populations.  But this thematic will take a while to play out.  The persistence of low treasury yields might no longer be a conundrum, but Skeptikoi’s view is that another decade on, the global saving glut and low real interest rates could still be with us.

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.

The Commitment Phobic Fed

Stock market investors have long understood that company guidance can be a double edged sword.  Investors use company guidance to make inferences about trading conditions and the level of conviction that insiders have about their own growth prospects.  But in periods of low earnings visibility, the supply of guidance shrinks at precisely the time that the demand for guidance from investors grows.  During the financial crisis for instance, many listed companies sought to manage their reputational risk by ceasing to give guidance to the market.

Central banks of course don’t have the luxury of ceasing communications to the market when macroeconomic uncertainty increases.  In fact, they should (and most do) talk more during such periods.  In his pioneering paper presented to the 2012 Jackson Hole symposium, Professor Michael Woodford argues that what central bank speak reveals about the bank’s policy reaction function has greater market impact than what the bank says about the economic outlook.  After all, investors can form their own views about the outlook based on alternative sources of information, notably the flow of economic data.

Central bank speak has taken on a new meaning for many central banks in recent years given the unprecedented nature of quantitative easing.  The volatile market reactions in recent months to the Fed’s mixed messages on the likely timing of tapering illustrates the perils of interpreting central bank speak.  The past week was no exception.

The fundamental problem that the Fed faces is that animal spirits remain dormant in the business and housing sector and this continues to weigh on the broader US recovery.  Despite the profit share of GDP being at a record high, corporate gearing remains low, firms continue to hoard cash, real business investment remains marginally below the peak from five years ago and businesses remain reluctant to hire new workers; the hiring rate of 3.2% remains close to historical lows.

Although the flow of residential investment has grown by one-third since 2010, it remains almost 50% below its 2006 peak.  Inflation expectations remain well anchored and various measures point to still substantial slack in the labour market: the employment to population ratio has barely recovered since the financial crisis, the unemployment rate remains above 7% and the participation rate continues to decline to its lowest level in over thirty years.

Given that the Fed Funds rate hit the zero lower bound a number of years ago, the Fed has used the two remaining levers available to it: quantitative easing and forward guidance on the Fed Funds rate.  In so doing, the Fed is seeking to revive animal spirits through the wealth effect – via higher asset prices – and by reducing the level of long term Treasury yields and mortgage rates.

What is crucial to the Fed’s task is using central bank speak to influence and manage investors’ expectations.  But this is turning out to be more difficult than the Fed had probably envisaged.  Woodford argues that the zero lower bound does not render monetary policy impotent, but that effective forward interest rate guidance can influence agents’ expectations of the term structure.  If the central bank can convince economic agents that it will keep interest rates close to zero for an extended period, then it will be more effective in bringing forward agents’ decisions to spend and invest, and in so doing, revive animal spirits.

The problem that the Fed faces relates to its reputation, credibility and commitment; how to credibly convince the market that it is going to commit to a certain course of action in the future.  Skeptikoi’s interpretation of Woodford’s thesis on forward interest rate guidance is that it is best achieved on a calendarised basis; the central bank commits to not raising the operating interest rate for a fixed period, with a clause giving the bank the flexibility to lengthen the amount of time if necessary (but not shorten it).  The market will be sceptical of a central bank’s commitment to keep rates low for an extended period if they believe that the bank will take away the punch bowl just as the recovery is taking hold.  Calendarised forward guidance is credible precisely because it locks central bank into a pre-determined course of action, thus denying the central bank the flexibility to tighten policy during this period.

But Fed speak suggests that it wants to have its cake and eat it too.  Rather than use calendarised forward guidance, it has adopted conditional forward guidance; the interest rate will remain close to zero until (deliberately ambiguous) thresholds relating to unemployment and inflation are hit.  Data dependent forward guidance allows the Fed to retain a fair degree of policy discretion and flexibility to change its course of action.  This represents an important trade-off for the Fed to manage between policy flexibility and committing to a certain course of action in the future.  But the Fed’s desire to retain policy flexibility undermines the efficacy of its forward guidance.  No wonder that markets are confused and frustrated by Fed speak.

Interestingly, the Fed’s decision to defer the tapering of its quantitative easing program demonstrates the central bank’s willingness to sacrifice some policy flexibility for credibility of a different kind.  The decision to defer speaks to the recent rise in uncertainty surrounding the outlook and the Fed’s determination to manage its reputational risk.  Rightly or wrongly, the Fed believes its credibility as a forecaster would be undermined if it needs to re-initiate QE after a decision to taper has been made.  But prior to its recent downgrade to its economic projections, its GDP growth forecasts of 2.45% and 3.25% for 2013 and 2014 respectively, sat well above consensus estimates.

Fed speak suggests that the central bank appears to be more concerned about managing its reputation as an economic forecaster than its credibility to committing to a future course of action of keeping the Fed Funds rate low for an extended period.  But Skeptikoi believes that the Fed’s credibility on forward rate guidance is more important to sustaining the recovery than its own track record as a forecaster.  To re-visit Woodford’s thesis, markets pay more attention to communications that reveal information about a central bank's policy reaction function than its views on the outlook.  

Skeptikoi can only speculate that the Fed’s commitment phobia on forward rate guidance stems from an aversion to inflation that has its antecedents in the spectre of the Great Inflation of the 1970s, a time in which many of the senior members of the Federal Reserve were in the formative (and impressionable) years of their economics training.  The Federal Reserve will continue to be confounded by the market’s reaction to its communications and markets will continue to be frustrated by a lack of clarity in Fed speak as long as the Fed's commitment phobia on forward rate guidance persists.

Overlearning from History and the RBA's Nominal Recession

Most of the recent media’s focus on the Reserve Bank of Australia (RBA) has been on the withering character assessment of Kevin Rudd from RBA board member and former Woolworths CEO, Roger Corbett.  Which is a shame, because the focus should be on the fact that the June quarter National Accounts revealed that in the 2013 financial year, Australia experienced its deepest nominal recession for two decades, due largely to excessively tight monetary policy.

Although many economists focus on the real GDP estimates, Skeptikoi believes that nominal GDP – which captures growth in real GDP and inflation - is a better indicator of the household and business sectors’ cash flows.  The June quarter National Accounts revealed that the nominal economy expanded at an annual average rate of 2.5% in the 2013 financial year.  This represents the softest outcome since the last recession, when nominal GDP grew by less than 2% in 1992.  And it is well below trend growth in nominal GDP, of 5-6%.

The widely used metric for defining a recession in Australia is two consecutive quarterly declines in real GDP.  By this standard, Australia has not had a recession in over two decades.  But if a more comprehensive measure of a recession is used, based on annual average growth in nominal GDP falling below a trigger of 4%, then Australia has just experienced its worst nominal recession since 1992.  By this measure, the economy was also in recession in the 2010 financial year, a period in which average annual growth in nominal GDP was only 3%.

There is a small but growing view that central banks ought to augment or replace inflation targeting with a nominal GDP targeting framework.  On this report card, the RBA scores a fail for two of the past four years.  The 15% decline in the terms of trade from its peak, the associated downgrade to the mining sector’s future growth prospects and persistently high value of the Australian dollar are not responsible for the worst nominal GDP growth outcome for two decades.  Skeptikoi believes that the RBA ‘owns’ the nominal recession.  Despite the record low official cash rate of 2.5%, monetary conditions in Australia remain tight.  Credit growth is tepid, the housing recovery is uneven (approvals for private sector detached dwellings remain at a cyclical low) and the much anticipated handover from mining sector capex to non-mining sector capex remains a long way off. 

The National Accounts provided some encouraging signs.  Nominal GDP posted a 0.9% gain in the June quarter which lifted annualised growth for the June half to 4.5%, while financial sector profits grew by almost 3% to a record high and the terms of trade increased for the second consecutive quarter – albeit marginally – thanks largely to higher iron ore prices.  But non-financial sector profits have now declined for six of the past seven quarters and households remain cautious; the household saving ratio continued to creep up and has averaged more than 10% for the past five years, a level not seen since the mid-1980s.

Animal spirits in the business sector remain dormant and this is unlikely to change in the near-term, even given the likely resolution of uncertainty following the Federal election.  In it updated Economic Statement release in early August, the Treasury downgraded its growth projection for nominal GDP to 4.25% for the 2014 financial year, enough to lift Australia out of its nominal recession, but only just.  The reporting season and cautious guidance comments provided by the ASX200 companies provide further evidence of the unfolding shortfall in aggregate demand.  Large companies including RIO Tinto, BHP, Woolworths, Telstra, Woodside Petroleum, Brambles, Coca Cola Amatail (the list goes on) announced plans to further boost productivity, pare back costs, defer capex plans where feasible and in some instances reduce capex from current levels.

Companies continue to either hoard cash – net gearing levels remain close to record lows – or cater to the market’s insatiable appetite for income; the aggregate dividend payout ratio for the ASX200 has lifted to 70%, close to an historical high.  Corporate Australia’s focus on cost containment is reflected in weakness of the National Accounts measure of unit labour costs – productivity adjusted wages.  Despite a modest 0.8% rise in the June quarter, unit labour costs have stagnated over the past year, the first time this has happened since 1999 (ex the financial crisis).  The guidance comments from the ASX200 companies in the reporting season suggest that growth in unit labour costs (and inflation) will remain well contained, providing scope for the RBA to further ease policy.

The Economist magazine attributes the reluctance of the Obama administration to intervene in Syria to the lessons learnt from the occupations of Iraq and Afghanistan.  Skeptikoi believes that the RBA has been a reluctant rate cutter due to similar ‘overlearning from history’; the view that central banks contributed to the financial crisis by keeping policy too accommodative for too long in the aftermath of the dotcom bust.  The moral hazard view of the crisis largely discounts the role of a range of other proximate factors, notably a glut in global savings and strong demand for safe haven assets.  Importantly it is not clear that the counterfactual of tighter monetary policies through the early to mid-2000s would have prevented the financial crisis, particularly given that long term interest rates – which at the time central banks had little power to influence – continued to decline to record lows during this time.

The RBA would be well placed to learn the lessons from policy errors committed by the Federal Reserve over the past century.  David and Christina Romer present a persuasive thesis that the most dangerous idea in the history of the Federal Reserve is that monetary policy doesn’t matter, a view which they argue contributed to the Great Inflation of the 1970s and Great Depression.  The more the RBA seeks to jawbone the Australian dollar lower – without much success - the more Skeptikoi is convinced that the RBA continues to under-estimate the power of monetary policy to re-balance the economy, revive the business sector’s animal spirits and boost nominal GDP.  In time, Skeptikoi hopes that the RBA’s record as a reluctant rate cutter and its ownership of Australia’s nominal recession will come under greater scrutiny.

The Dumbing Down of Politics in the Information Age

Tonight (Thursday 22^nd August), I attended an engaging panel discussion hosted by the University of Melbourne and moderated by Michael Roland (ABC).  The topic of discussion was the media’s reporting of the Federal election, and quality of political discourse in Australia.  The panel members were Michael Gordon (The Age), Sally Young (University of Melbourne), Kerri-Anne Walsh (author of The Stalking Of Julia Gillard) and John Ferguson (The Australian).

Some really interesting points made in a wide ranging discussion, including the dumbing down of Australian politics and political reporting, the narrowness and shallowness of political discourse and debate, the 24 hour media cycle, lack of diversity in media outlets, the low coverage (relative to history) that the media are giving to the election campaign, and people’s disengagement from and apathy towards political debate.  At the end of the discussion, the key question remained unresolved; who was to blame - politicians, the media or possibly even the public?  Skeptikoi believes that the dumbing down of politics can be traced to the lower attention span that people have for political issues, which reflects a number of factors.

First, it is becoming increasingly difficult to analyse public policy decisions, many of which affect us directly.  Working hours have increased for most people in recent decades and the world has become more complex as the pace of technological advance continues to accelerate.  As a result, public policy has is ever more complex and hard for people to easily digest and understand.  Put simply, most people have less time and inclination to engage in political discourse.

Second, as Sally Young highlighted tonight, the competition for ‘eyeballs’ has increased.  Communication and media channels have become fragmented thanks to the internet, social media, and developments in spectrum technology that has delivered digital TV channels.  A related development has been an explosion in the airtime devoted to sports for a sports mad nation.  I can recall a time when only one game of VFL - as it was known back – was televised per week.  And that was a delayed broadcast, on Saturday night anchored by Peter Landy.  Today, free to air offers no less than four games over a weekend, while Foxtel subscribers can watch all eight games live.  TV coverage of other sports such as cricket (all three forms of the game), tennis and soccer has also grown exponentially.  In short, sports coverage is helping to crowd out serious political discourse.

This then brings us to what was described tonight as the gotcha moment and the focus on political personalities.  Much was made in the media of Kevin Rudd’s apparent abrupt and rude demeanour towards the freelance make-up artist in preparation for Wednesday night’s debate.  There was some frustration that the media would focus scarce space and time to such a trivial matter.  But it is inevitable that the media gravitates towards political personalities in the search for that gotcha moment when the public is disengaged from the political debate because policy detail is difficult to digest.  Against this backdrop, we tend to base our political judgements less on policy merit and detail, and more on personal character and behaviour.  After all, the gotcha moment is far easier and less time consuming to observe, process and judge than wading through the details of the mining tax, ETS or paid parent leave scheme.

Isn’t it ironic that in the information age, politics and political reporting has been dumbed down?  Explanations that assign blame to politicians, the media (or people’s apathy) are overly simplistic.  Rather, Skeptikoi believes the answer lies in the growing complexity of the real world and public policy, less time (and attention) that people have to devote to political issues, and the fragmentation of communication and media channels.  There is still a market for insightful and engaging political discourse and debate, but probably a shrinking one.  If there is any consolation to the Australian public, it is that you are not alone; the dumbing down of politics in the information age represents a global phenomenon.

RBA-Speak, Animal Spirits, and the New Capital Discipline

Central bank speak has come a long way since central banks around the world started to adopt inflation targets from the early 1990s.  As part of the process of learning by doing, central banks have steered a fine balance between greater communication and transparency, while retaining policy flexibility.  As one of the early adopters of inflation targeting, the Reserve Bank of Australia (RBA) has done a better job than most.  Its carefully worded target of ‘maintaining inflation of 2-3% on average through the cycle’ has helped to focus its communications and frame monetary policy decisions, but at the same time provided scope for ample policy discretion.

In an era where the official interest rates across major developed economies have hit the zero lower bound, central bank-speak and forward guidance on monetary policy has taken on a new meaning.  Even for central banks that are not engaging in quantitative easing, deciphering the nuances between a bank’s policy reaction function and its view on the outlook has become increasingly challenging for economists.  At the 2012 Jackson Hole Symposium, Michael Woodford argued that markets are more likely to react to central bank speak about a bank’s policy reaction function because there is less information publicly available about central bankers’ intentions than about the economic outlook.

Both its actions and communications in recent years have suggested that the RBA has been a reluctant rate cutter, influenced by what it has considered to be uncomfortably high inflation in non-tradeables and concerns surrounding financial stability.  The result has been weakness in nominal GDP and profit growth, which is expected to persist.  In its updated Economic Statement released in early August, the Treasury downgraded its growth projections for nominal GDP to 2.5% (FY13) and 4.25% (FY15), which represents a dismal outlook considering that the economy has posted nominal GDP growth of at least 5% in seventeen of the past eighteen financial years.

Skeptikoi believes that the RBA’s quarterly update released on 9^th August had a distinctly dovish tone.  The Statement of Monetary Policy (SMP) and other communications suggest that the Bank’s policy reaction function has probably not changed.  Rather, the Bank continues to be confounded by the persistent weakness in business conditions and non-mining capital investment despite the cumulative 225 basis point cut to the official cash rate (OCR) since October 2011.  It acknowledges that business and labour market conditions remain weak and that there are little signs of a pick-up in growth of either non-mining investment or employment.

Persistent weakness in labour costs has reduced the Bank’s concerns about the outlook for non-tradeables inflation.  The SMP cited that wages growth has slowed to its lowest rate in a decade and combined with strong productivity growth, this has contributed to low growth in unit labour costs.  And its Monetary Policy Statement on 7^th August cited the prospect of further moderation labour cost growth as helping to offset the inflationary impact of the lower dollar and help to keep inflation within the target band.

The continued weakness in business conditions and the labour market can be traced back to what Skeptikoi believes is a deep corporate recession outside of the banking sector that has ended only recently.  Gross Operating Surplus (the National Accounts profits metric) for private non-financial corporations declined in the five quarters to December 2012, the longest stretch of consecutive quarterly declines since the inception of the National Accounts in 1959.  The 12% peak to trough decline in non-financial GOS is comparable to the financial crisis (-13.5%) but not as severe as the recession of 1990-91 (-16%).  The corporate recession has seen the non-financials profit share of GDP decline to 17.8% in December 2012, its lowest level in seven years and well below the record peak of 22% in September 2008.

A rise in the non-financials profit share to 18.3% in the March quarter 2013 and the continued moderation in growth of unit labour costs suggest that the profit cycle probably bottomed in the December quarter.  Unit labour costs are productivity adjusted wages growth and are important in shaping shifts in corporate profitability and inflation.  Low growth in unit labour costs is typically associated with strong earnings growth and low inflation.  After expanding at an annualised rate of almost 4% in the two years to March 2012, unit labour costs have actually declined marginally in the four quarters since.  Outside of the financial crisis, this represents the first time unit labour costs have been flat or declined over four quarters since 1998.

It is little wonder then that companies have been aggressively containing costs.  There are already signs in the early stages in the current reporting season that companies continue to focus their efforts on boosting productivity.  At its interim result, RIO announced that improving performance through cost reductions and efficiency gains remains one of three key priorities.  It flagged that it had achieved cost reductions of $1.5 billion in the first half, significant in the context of a $4.2 billion interim underlying earnings result.  The new capital discipline is not confined to the mining sector.  In its full year result, Telstra announced that it had delivered $1 billion in productivity improvements, and that consequently, operating expenses rose by only 0.5%, the second consecutive year in which they had increased well below inflation.

Skeptikoi believes that the renewed cost consciousness and capital discipline amongst the ASX200 companies will remain a feature of the corporate environment for a while yet, which represents a powerful tailwind for corporate profitability and stock-market returns.  Firms will continue to find ways to deliver productivity improvements, and will tend to defer capital investment where feasible in favour of either returning capital to shareholders or further building up cash balances for a rainy day.  Consequently, the recovery in non-mining capital investment is likely to remain soft.

The RBA’s more sanguine assessment of unit labour costs and inflation reveal that the bank is more alive to the growing risks of a shortfall in aggregate demand stemming from corporates simultaneously containing costs and seeking to boost efficiencies.  Further declines in the OCR are necessary to revive the corporate sector’s dormant animal spirits and encourage companies to invest rather than hoard or return cash to shareholders.  But more aggressive language that points to a change in the central bank’s policy reaction function would also help.

Australia's Productivity Renaissance - The Second Stanza

It has been well over a decade since the ‘Goldilocks economy’ was de rigueur amongst economists.  The US, Australian and other developed economies delivered a cocktail of strong growth, declining unemployment and disinflation from the mid to late 1990s that confounded many analysts and led some to believe that the business cycle was dead.

The Chairman of the Federal Reserve at the time, Alan Greenspan, attributed the Goldilocks Economy to a renaissance in US productivity growth.  Non-farm business productivity (real GDP per hour worked) expanded at an impressive compound annual rate of 3% from 1995 to 2003, double the growth achieved from 1972 to 1994.  In an influential study, two Fed staffers, Stephen Oliner and Daniel Sichel, ascribed the pick-up to the IT revolution.  Using a standard neoclassical model, they showed that innovation within IT producing sectors (ie. multi-factor productivity) and adoption amongst IT intensive sectors (ie. capital deepening) underpinned the productivity enhancing effects of the IT revolution.

Other Anglo Saxon economies also experienced a productivity renaissance thanks to the IT revolution.  Productivity growth in Australia lifted to an annualised rate of 2.9% in the first stanza of its renaissance from mid-1995 to mid-2002, well above the growth of 1.3% pa achieved in the prior two decades.  Rapid diffusion of information & communication technologies across the economy accounted for the lion’s share of the acceleration, given Australia’s small IT producing sector.

Over the past decade, productivity growth in the most developed countries has slowed, in part due to the lingering effects of the financial crisis.  US productivity growth has returned to the trend growth of 1.5% pa that prevailed in the 1970s and 1980s, while productivity growth in Australia moderated to less than 1% pa from 2002 to 2010.  Most industries in Australia experienced a productivity growth slowdown between 1995-2002 and 2002-10, but two sectors in particular posted large outright productivity declines in the past decade: mining and utilities.  The decade long boom in commodity prices has meant that previously marginal or low productivity mines became economically viable, while there are long lead times to production associated with large and complex mining projects.  And the construction of desalinisation plants and a generational upgrade in electricity network and transmission assets has pulled down productivity in utilities.

But Skeptikoi believes that the second stanza of Australia’s productivity renaissance is already well underway which will have important macroeconomic implications.  In the eight quarters since March 2011, productivity growth has picked up to 2.6% pa.  The industry level productivity statistics are not up to date, but a number of developments point to cause for optimism that elevated rates of productivity growth are sustainable.

First, the mining sector will transition from being a significant drag on aggregate productivity growth to being a strong contributor.  The peak in mining sector capital expenditures is imminent and the supply side response to the generational shift in commodity prices is now coming through.  The key iron ore producers in Australia – RIO, BHP and Fortescue – are expected to lift aggregate production by 60% over the next five years, from 500 million tonnes in 2012 to 800 million tonnes in 2017.

Second, the hump in water related capital investment is largely behind us.  In the past eight years, desalinisation plants have been built in Australia with the capacity to treat a total of 1,000 mega-litres per day.  Most of that capacity is currently shut down thanks to record rainfalls in recent years.

Third, upgrades to the electricity network – the wires, poles and other infrastructure used to transport power to consumer from generators – that have been designed to replace ageing assets and improve reliability across a number of states, are largely complete.  The Productivity Commission estimates that capital investment in transmission and distribution assets has contributed no less than half of the 100% rise in NSW retail electricity prices over the past five years.

Fourth, Skeptikoi expects the relentless focus on cost control by the ASX200 companies to continue.  The penny has dropped for corporate Australia that the anaemic revenue environment is the new normal.  Aggregate sales revenue for the ASX200 companies is up by less than 10% - in nominal terms – from the prior peak five years ago.  The outlook for nominal GDP growth – a more reliable top-down indicator than real GDP for company sales revenues – is expected to continue to deteriorate.  In its updated Economic Statement released on Friday (2^nd August 2013), Treasury downgraded its growth projections for nominal GDP to 2.5% (FY13) and 4.25% (FY15), which represents a dismal outlook considering that the economy has posted nominal GDP growth of at least 5% in seventeen of the past eighteen financial years.

The large listed companies – which typically have high operating leverage - are at the forefront of the drive to lift efficiency and contain costs.  Both BHP and RIO continue to divest under-performing businesses.  Telstra, ANZ and QBE are incrementally offshoring back-office operations, while the banks have cut back on staff in areas burdened by excess capacity – institutional and corporate lending for instance.  There has been generational change amongst senior management committees and boards in the new cost conscious environment.  Boards are hiring more cost disciplined CEOs than their predecessors; BHP announced that its new CEO, Andrew McKenzie will be ‘laser like’ on costs and operations.  CEOs and Chairmen that have a demonstrated track record of delivering strong acquisition led growth during the boom years no longer command a premium in the managerial market.

The renewed cost discipline is already paying dividends in terms of the pick-up in aggregate productivity growth in the past two years.  While some express concern that the profitability payoff to cost cutting is one-off in nature, what is often thought of as cost cutting really amounts to a re-organisation of priorities and business processes, and ultimately a lift in efficiency at the enterprise level.  At a macro level, innovation or capital deepening best captures the productivity enhancing benefits associated with business re-organisation.

The corporate focus on cost control represents a rational response to the new normal of weak revenue growth.  But there is a growing risk that companies simultaneously undertaking efforts to lift efficiency will lead to a shortfall in aggregate demand.  The prospect that inflation expectations remain well contained and unemployment continues to rise ought to provide the Reserve Bank ample scope to further ease policy and for the Overnight Cash Rate to stay lower for longer.

The divergence in Australia’s relative economic and stock market performance since the financial crisis has puzzled some commentators.  Although Australia managed to avoid a recession, the ASX200 remains 25% below its prior peak in late 2007, in line with the performance of the Euro Stoxx index, but well below the S&P500 and FTSE indices, which are at or above their respective prior peaks.  The ASX200’s underperformance mirrors poor relative EPS growth.  Skeptikoi is optimistic that the renewed cost discipline willunderpin a catch-up in Australia’s EPS growth and relative market performance, provided that the Reserve Bank continues to ease policy to cushion the effects of the ensuing shortfall in aggregate demand. 

Against the backdrop of rising unemployment and sub-trend growth in nominal GDP, the ‘Goldilocks economy’ is unlikely to be trending on Twitter any time soon.  But the second stanza of Australia’s productivity renaissance promises to be a boom for corporate profitability and stock-market returns.

The Impatient RBA - Waiting For Godot

Central bank speak can be difficult to decipher most of the time.  But an impatient (and frustrated) central bank can make the task of economists that bit easier.  For some time now, the Reserve Bank of Australia has been waiting for more tangible evidence of a handover from the resources sector to the non-mining sectors of the economy.  While it has continued to wait, it has continued - reluctantly - to cut the official cash rate (OCR), which now stands at 2.75%, even lower than the financial crisis trough. 

A seamless transition looks less likely than ever, which Glenn Stevens, the RBA Governor, all but acknowledged in a speech entitled Economic Policy After the Booms.  The Governor re-iterated that there is scope for non-mining economy - notably dwelling investment and non-mining capital investment - to emerge as two key drivers of growth.  But he admitted that although there is ample scope for both to rise, this was no certainty and that while there are signs of an increase in dwelling investment getting underway, a recovery in non-mining capex looks a long way off. 

The RBA has been talking up the cyclical tailwinds supporting dwelling investment, notably low and declining mortgage rates, low rental vacancy rates, strong rental yields and house prices that are well off their 2011-12 troughs in most capital cities.  Building approvals are up strongly over the past year and the RBA recently cited the +15% growth in new mortgage lending in the past 12 months as evidence of a pick-up in housing.   But the breakdown in new finance commitments advises some caution.  Investors and repeat buyers account for all the growth in new lending in the past year; finance commitments to first home buyers have remained flat over this time.  The composition of new mortgage lending is important for broader consumption, because the multiplier effects to consumer durables is likely greater for first home buyers.  Moreover, the release of the June building approvals data - showing a seasonally adjusted 7% decline confirmed the softer trend of recent months.  That approvals for detached dwellings remain close to a cyclical low suggests that the impetus to economic growth is likely to be less than in previous housing recoveries. 

The RBA has clearly over-estimated the prospect of a recovery in non-mining capital investment, both in terms of timing and size, reflected in the frank admission that the recovery was a long way off.  It wasn't meant to come to this of course; as the resources boom came to an end, a decline in the $A associated with lower commodity prices would facilitate the handover from mining to non-mining capex.  The Governor is clearly frustrated the $A hasn't performed its shock absorbing role on cue; according to the RBA, it remains stubbornly high given the decline in the terms of trade. 

The weakness in non-mining investment should come as little surprise to those closely following the fortunes of the stock market.  The key themes from the past two reporting seasons have been widespread cost cutting and a related lift in dividend payout ratios.  Put simply, the market's appetite for income remains insatiable.  When even an investment bank - Macquarie - lifts its payout ratio to 80% with a target of maintaining its payout above 60% for the foreseeable future - the market clearly isn't rewarding companies that invest for growth.  And the three big sectors of the market - banks, resources and telecommunications - remain inwardly focussed on cost control, designed to offset the prospect of weak revenue growth.  Expect leverage to remain low, the corporate savings rate to remain at record highs and the outlook for non-mining business investment to remain weak.

The RBA Governor is clearly frustrated at the low level of confidence, and sees this as a key source of restraint amongst households and businesses.  And reading between the lines, he believes that some of the uncertainty and pessimism stems from Canberra.  But the Governor does not link negative sentiment to the role that excessively tight monetary policy might have played.  Graph 2 in the speech shows that real per capita non-financial assets (mainly housing) have stagnated over the past five years and financial assets remain slightly below their 2007 peak.  The actions of the major central banks in recent years has brought into sharper focus the fact that expectations and the wealth effect are crucial in the monetary policy transmission mechanism.  We can only hope that at some point, the RBA acknowledges - even just internally - that monetary policy has been too tight for too long and that this has contributed to negative sentiment, and the slow recovery in asset values and non-mining sectors of the economy more broadly.

The RBA remains a reluctant rate cutter and this is unlikely to change.  Deteriorating business conditions and benign inflation has forced its hand to some extent, but it remains paranoid about financial stability.  Perhaps it believes that the Greenspan Fed kept policy too loose for too long during the 2000s and this this contributed to the credit and housing booms.  Thus it remains sensitive to stoking another period of strong asset price inflation which would undermine its ability to maintain financial stability.  But with credit growth remaining tepid - it has expanded by 3% in the past year - financial conditions are far from accommodative notwithstanding the low level of the OCR.  And inflation and inflation expectations are likely to remain well contained despite the lower $A, reflecting the cost cutting measures cited above that are being adopted across corporate Australia.  This has been going on for several years now and efforts at the micro level to lift efficiency are now paying dividends in terms of renewed strength in aggregate productivity growth and outright declines in unit labour costs.

The Woolworths quarterly sales conference call held today provides some insights into future trends in food inflation - which comprises 15-20% of the inflation basket.  Woolworths noted that the 'more savings everyday' campaign is working well with the next phase being introduced in coming weeks.  Moreover, Woolworths' ongoing aggressive roll-out of Masters stores will likely see renewed price competition with Bunnings in the hardware, building and garden supplies categories.

Beyond the prospect of a rate cut in August, I believe that continued weakness in non-mining capital investment, a modest and uneven recovery in dwelling investment (by historical standards) and benign inflation will continue to force the hand of the reluctant rate cutter.  I put the probability of an OCR starting with a 1 by March next year at 75%.

For those interested in stock market implications, domestic cyclicals have delivered strong performance this year against the backdrop of monetary easing.  A basket of seven discretionary retail and building material stocks has delivered an accumulated return of over 25% year to date, well above the ASX200 accumulated return of 10%.  Skeptikoi expects these stocks to continue to be re-rated if the RBA continues to lower the OCR as per above.

It is unfortunate that the RBA remains risk averse at a time that risk appetite has deserted the household and corporate sectors.  Surely, the task of a central bank is to be countercyclical; take away the punch bowl as the party is heating up, but conversely, put the punch bowl back and even spike it when the party looks to be coming to a premature end.  If the RBA considers that it has had to steer policy though a difficult course over the past year, the next six months promise to further test the resolve and patience of the reluctant rate cutter.