RBA shoots down inflation hawks

Christopher Joye

Coolabah Capital

In the AFR on Friday I wrote that the wonkish deputy governor of the Reserve Bank of Australia, Guy Debelle, delivered some profoundly important home truths in a recent speech. For all the doomsayers upset by the (predictable) housing boom, and who claim it is precipitating unacceptable inequality, Debelle had a brutal rejoinder: would you rather the much higher unemployment and far greater income inequality that would result from millions of additional Aussies on the dole? Excerpt enclosed:

Debelle stressed that cheaper money, expanded purchasing power, rising asset prices, additional construction, and higher household incomes, consumption, employment, confidence and wealth are all essential elements of the RBA’s stimulus in practice.

“It is important to remember that while housing prices may not rise as fast without the monetary stimulus, unemployment would definitely be materially higher without the monetary stimulus,” Debelle said. And while acknowledging that “housing price rises can have distributional consequences”, he countered that “unemployment clearly has large and persistent distributional consequences”.

Here one of Martin Place’s antagonists, Peter Tulip, exclaimed on Twitter that “it is great that monetary policy now explicitly prioritises unemployment over house prices”, which he said was a “big u-turn from 2015”. (Tulip previously worked at the RBA.)

Reports that investor demand for property has suddenly surged should not be surprising. In March last year we repeatedly argued that after a conventional, purchasing-power-fuelled housing boom started in September 2020, it would eventually be reinforced by renewed investor demand attracted by the prospect of positive, rather than, negative gearing and net rental yields that are multiples of term deposit rates. And so it is proving.

There were many other sobering messages delivered by the dour, though never dull, Debelle. Investors had worked themselves up into a frenzy about a subtle change in the RBA’s language regarding the possibility of rate hikes prior to 2024. Instead of stating that this would not happen, the RBA introduced the qualifier that it was “unlikely” to occur in its statement following Tuesday’s board meeting.

Debelle poured cold water over the distinction, asserting that the board had merely “reiterated” its central scenario. To underscore this point later in his speech, he repeated that the RBA does not expect conditions for a hike “to be met until 2024 at the earliest” with the “unlikely” caveat absent. While these semantics are irrelevant in the long-run, they matter a great deal for traders trying to divine Martin Place’s destiny.

The next salvo delivered by Debelle was aimed at the inflation hawks, who have been soaring of late given Australia’s world-beating economic performance, which the RBA and Treasury can rightly claim a lot of credit for.

Although Australia’s economy is “now back to its pre-pandemic level of GDP”, and the increase in employment has been superior to our rivals, Debelle warned that this “is not the case on the nominal side of the economy in terms of wages and inflation”. “While the economy has experienced better employment outcomes than most other countries, wages growth has been noticeably weaker than in many comparable economies, most notably the United States,” Debelle said.

He highlighted that Australia’s core inflation rate remained less than half where the RBA is targeting “despite the significantly better state of economic activity and employment”. This is a double miss for the central bank: the RBA forecast a much weaker recovery, and if it had been more positive, it would have anticipated substantially higher inflation. It has got neither.

Debelle smashed recent talk of a spike in inflation expectations, explaining that “estimates of inflation in the bond market have inflation just reaching 2% in a few years' time”. “That is only just reaching the bottom of the RBA's inflation target range”, which means that “the bond market is not pricing any material risk of an inflation breakout”.

This brought Debelle to another crucial insight: as tempting as it is to try to predicate policy on forecasts of the future, the central bank is now committed to basing its decisions on realised outcomes rather than unreliable guesses regarding what may transpire.

After his speech, Debelle remarked that this had been a key lesson since the global financial crisis: ie, not being suckered by sanguine projections for wages and inflation. “The Board's guidance has evolved over the past year to emphasise outcomes rather than forecasts,” Debelle explained, adding that “the Board…will not increase the cash rate until actual inflation, not forecast inflation , is sustainably within the target range.”

So for all the ebullience about the fact that Australia’s 5.6 per cent jobless rate is only half a percentage point above its pre-pandemic level, Martin Place knows it has a long way to go before the economy exhausts its excess capacity.

This, importantly, makes a mockery of the idea that the RBA will aggressively taper its current stimulus based on the two volatile unemployment prints published prior to its July meeting. This would directly contradict its new intellectual paradigm by hingeing vital policy decisions on rubbery forecasts of what these employment numbers mean for elusive wages growth and inflation.

Here again, Debelle dismissed media reporting of a jump in wages growth and inflation, asserting that these anecdotes related to small “pockets” of the economy that had little bearing on the anaemic national outcomes. The truth is that wages have been running at less than half the rate required to get sustainable inflation.

Notwithstanding all the recent talk of RBA “tapering” its stimulus, Debelle did not devote a single word to it in what was an incredibly long and technical speech dominated by an evaluation of the conduct of monetary policy.

Debelle disclosed that the RBA assessed that its quantitative easing (QE) program, where it buys 5- to 10-year government bonds to alleviate pressure on longer-term rates, had been responsible for compressing the 10-year government bond yield by 30 basis points. This had in turn kept the exchange rate lower than it might otherwise be, helping exporters and import-competing businesses.

This is all the more important when Australia is being subject to a ferocious, one-sided trade war with its biggest export partner, China, which is bound to deteriorate further as the Middle Kingdom tries to force this small nation to bend its knee in quiescent submission. It is presumably only a matter of time before our biggest export, iron ore, shifts into the aspiring hegemon’s cross-hairs.

If China cannot compel recalcitrant Aussies to bend the knee, this will fundamentally undermine the efficacy of its coercion operations globally. This is precisely why this precedential trading spat will be a full-blown fight to the death. For all the talk of appeasing our North Asian economic master through more deft diplomacy, words count for nought in Beijing. The only thing the party believes in, and responds to, is action. On this note, anyone dismissing the risk of a kinetic conflict with the US does not understand the hard probabilities nor the need to prudently risk-manage these contingencies.

Turning back to QE, Debelle showed that as a share of GDP, the RBA’s QE operations remain a fraction of the support offered by central banks in the US, UK, Europe, Canada and New Zealand. While we have been catching up, the RBA is still miles behind its peers.

This is nevertheless constrained by the fact that Australia has a much smaller stock of government bonds. While acknowledging that excessive QE could eventually create an illiquidity premium, Debelle stated that the RBA does not believe “we are close to that point”.

Sizing its QE investments compared to the stock of government bonds, the RBA is still well behind New Zealand, the UK, Canada and Europe, although it is catching up to the US where fiscal policy is playing a larger role.

Overnight, the Bank of England reaffirmed its commitment to its GBP895 billion QE program while attenuating the pace of its monthly purchases. Given how far the RBA remains from its current wages and inflation targets, and its focus on nowcasting, it would be reasonable to imagine that its highly successful QE initiative will be extended in July into 2022. One might also expect the RBA to reinvest the proceeds of maturing bonds into new purchases to avoid the spectre of shrinking its balance sheet.

There will be a natural tapering of the RBA’s policy stimulus post-June once its $180 billion term funding facility expires. As banks replace this with more expensive wholesale debt, they will have to lift the cost of their ultra-cheap 3-year to 5-year fixed-rate mortgages. Since these loans currently account for 40 per cent of all new approvals, this will conveniently suck the wind out of the sails of the booming housing market at just the right time.

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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