The RBA needs to be careful on the way up.

• My advice for the RBA – wait until September.
• There is little evidence that inflation is spiralling out of control and higher interest rates won’t address the supply chain constraints that that have been driving Australian inflation.
• Higher interest rates will, however, end the current home building boom and suppress the wage growth for which Australians have been waiting for almost a decade.
• The structural factors that dragged on Australia’s economy pre-pandemic still exist.

While the supply chain impacts of the war in Ukraine, and China’s latest lockdowns, have shaken my resolve on this issue, I am still a member of ‘Team Transitory’.

But I appear to be in the minority.

Market consensus has converged on the prediction that the Reserve Bank of Australia (RBA) will begin lifting its benchmark cash rate soon.

The RBA’s cash rate target has been set to 0.1 per cent since November 2020 and some are expecting the first hike to occur as early as June. Market expectations have the RBA’s cash rate above 3 per cent within 18 months, which would be the highest level since 2012.

The RBA needs to be very careful how far and how fast it takes this tightening cycle.

Higher interest rates won’t fix supply constraints

Higher interest rates will do nothing to alleviate the supply constraints currently driving local inflation rates. While Australian headline inflation was 1.3 per cent in the final quarter of 2021, bringing the annual rate up to 3.5 per cent, almost half of it was solely attributable to fuel prices and home building costs.

Fuel prices are entirely an international phenomenon – as the global economy started reopening in the second half of 2020, strengthening demand started pushing up fuel prices. The Russian invasion of Ukraine drove these prices even higher, given Russia’s importance to global oil production.

Higher interest rates in Australia will not fix this problem – and it looks like the latest price shock has stabilised anyway.

Home building costs have also been driven by international factors. The pandemic has produced home building booms – and associated surges in demand for home building materials like timber and steel – across the world. This saw home building costs increase by 3.8 per cent in the final quarter of 2021, bringing the annual increase to 12 per cent – the fastest rate since the early 80s. Reinforcing steel and structural timber increased especially, up by 43 per cent and 40 per cent respectively for the year.

On top of this, households shifted their spending towards goods and away from services during the pandemic, as many activities like travel, entertainment and dining out were prohibited or simply perceived as too risky.

These shifts towards home building and other goods put enormous pressure on global shipping services, with the price of a 40-foot shipping container increasing from under $1,500 to more than $10,000.

Higher interest rates in Australia will not bring global shipping services back online, nor suppress the home building booms occurring overseas.

Freightos Baltic Index (FBX): Global Container Freight Index

Inflationary expectations are still anchored

There is also little evidence that current inflationary pressures are becoming dangerously entrenched.

Wage growth would be the key to such a development. In tight labour markets, workers hypothetically have the bargaining power to demand higher wages. Cost of living pressures are an added motivation to seek higher wages. This feeds back into further inflationary pressures as businesses increase the prices of their goods and services to offset the higher cost of labour. This can then feed back into further wage demands, and so on.

This is called a wage-price spiral and no economy can function with such inflation spiralling out of control. This would force the RBA to raise interest rates to suppress the economy and get inflation back under control.

There is little evidence, however, of the wage growth needed to cause such a spiral. In 2021, only one industry, ‘Accommodation and food services’, saw wage growth above 3 per cent. Wage growth in this industry has proven very susceptible to the frequent locking down and re-opening of states across Australia. Staff shortages associated with the Omicron outbreak, and extended holiday leave taken in early 2022, will also likely affect this industry.

Overall, however, wage growth at the end of 2021 was only running at an annualised 2.6 per cent. While this is the strongest wage growth since 2014, it is still far from what the RBA – and Australian workers – have been seeking for many years.

Inflationary expectations over the coming years are, consequently, hardly spiralling out of control. According to the RBA, as of March 2022, 2-year inflationary expectations from both unions and market economists were still below 3 per cent.

This is why the RBA needs to be careful with interest rates on the way up.

Higher interest rates won’t solve the supply constraints driving our current inflationary pressures and there aren’t many reasons to think these pressures are spiralling out of control anyway.

Higher interest rates will, however, bring an end to the current housing boom and suppress Australian wages.

When interest rates increase, this typically slows down house price growth and can have a negative effect on consumer confidence. Even talk of rising interest rates can have the same impact. Reduced borrowing power and lower consumer confidence makes households more hesitant to pursue large investments such as building a house. The slowing in established house prices, while the cost of new homes continues to rise, will also make banks increasingly reluctant to lend for the construction of a new home.

This reduced borrowing power extends beyond the housing industry. Household purchases of cars, furniture and appliances often involve borrowing. Businesses borrow to finance investments in property, buildings, equipment and technology. Even governments undertake cost-benefit analyses on the projects they finance through borrowing. Higher interest rates will force a reconsideration of all these decisions, reducing expenditure throughout the economy and, therefore, the number of jobs produced.

Fewer jobs means less bargaining power for workers. Australian workers that have already struggled for the best part of a decade to negotiate any substantial pay increases – pay increases that would represent precisely the thing that would allow these workers to handle the kind of cost of living pressures with which they are now faced.

Australia’s structural problems remain unaddressed.

Heading into the pandemic, Australia’s economy had been underperforming ever since the mining boom.

Before the 2019 Federal election, the RBA’s cash rate was just 1.5 per cent and the Australian economy was experiencing weak economic and wage growth, and slow productivity growth. The RBA then dropped the rate to 0.75 per cent – even before the pandemic began – and things were only slowly heading in the right direction.

This is why the market expectation of a 3+ per cent cash rate before the end of 2023 seems so excessive.

Australia’s structural problems haven’t been solved. Australia’s population is still ageing, especially with the absence of overseas migration. There is also still a significant need for infrastructure investment and microeconomic reform in areas of building approvals and urban planning frameworks, tax, energy, industrial relations, skills and training, etc. in order to catalyse the next generation of growth, productivity and prosperity.

Australians have accumulated a lot of excess savings during the pandemic and the government has spent a lot of money “building the bridge” to the other side. But none of this addresses these underlying structural concerns.

Australia also has the luxury of time.

Central banks around the world, including the US Federal Reserve, have already started increasing their benchmark interest rates in response to much higher inflation than Australia is experiencing. Even in Australia, the commercial banks have been lifting their interest rates independently of the RBA.

This allows Australia to see how effectively higher overseas – and domestic – interest rates will be in reducing demand for things like building materials and fuel. It also gives us more time to see global supply chains operating more effectively, helping to ease price pressures.

Central bank credibility is very asymmetric.

The last few decades heading into the pandemic showed clearly on which side the credibility of central banks lies. Thanks to their political quasi-independence and technical expertise, central banks across the world kept inflation – and inflationary expectations – low since the early 90s.

The challenge was on the other side, in driving full and fast recoveries.

Australia’s economy had been underperforming ever since the mining boom. The US took a full decade to recover from the GFC. In Europe, the GFC and the sovereign debt crisis were exacerbated by extreme austerity measures across the Union, and early missteps by the European Central Bank.

If the last decade has taught us anything, it’s that a recovery is hard to generate and easy to cut off.

It would be a great shame if the RBA got carried away, only to force Australia back into the environment of anaemic growth and weak wages that existed before the pandemic. All to defeat an inflation cycle that shows all the signs of being temporary.

Recent inflationary pressures are causing a lot of pain and support needs to be forthcoming – from government. Overly aggressive tightening by the RBA will only cause more pain.

For the RBA, now is the time for it to use its inflation credibility to not prematurely cut off a recovery that will generate precisely the improvement in living standards for which Australians have long been waiting.

My advice – lift the cash rate in September to 0.5 per cent, then STOP!

My official advice is that the RBA waits until September – this will give it two more readings of inflation and wage data from the Australian Bureau of Statistics. If there are no signs of the economy cooling on its own, the cash rate should be lifted to 0.5 per cent. This will mostly represent a ‘symbolic’ hike to transmit to the market that the RBA is willing to act. It will also reflect the fact that we are no longer in the ‘emergency’ environment of the early pandemic.

But I don’t see why the cash rate should go any higher than this when inflationary expectations are still so well anchored.

Over the next couple of years, excess savings will be drawn down and supply chains will be functioning better. Housing markets around the world will have worked down their massive pipelines and demand pressures on building materials will have eased.

After this, Australia will still need an accommodating RBA while the necessary economic reforms and infrastructure investments are undertaken to catalyse the next generation of growth and prosperity.

If helicopter money can't be justified now, it never can.

There are already commentators concerned over the debt burden future generations are going to inherit thanks to current government spending sprees. With risks of inflation and moral hazard about as low as they can be, what harm could be wrought from six months of ‘free’ money?

Helicopter money – having the central bank simply send people ‘free’ money – carries with it a couple of obvious risks.

The most obvious is inflation – more money floating around the system chasing the same number of goods and services can put upward pressure on prices. In recent years though, Australia has been under its 2-3 per cent inflation target. Moreover, the Australian government recently sent out $1,000 tax rebates to a large number of households while the economy was relatively close to full employment and it didn’t spike inflation. A few more checks from the central bank that don’t even replace the income Australians are losing from this pandemic, will surely not be an inflation problem either.

Manufacturing and food production also seem to be maintaining pace during the pandemic (notwithstanding some empty shelves from short term panic buying) so unless there are long term supply constraints as a result of this pandemic, inflation is likely to be the same small risk it has been for the last decade.

A second risk from helicopter money beyond adding more inflation potential into the economy, is moral hazard. Governments seeing their central bank directly transfer money to their people and/or businesses may get the idea that they no longer have to responsibly support their economy – the central bank can just do it for them. Infrastructure investment, structural reform, skills and training – why invest in any of these things if the central bank can just give people ‘free’ money?

Even in the worst of economic depressions we seem to still want elected officials to have ultimate responsibility for economic management. Sure, the central bank can drop interest rates and flood the financial sector with liquidity but we never want the government to get the idea that they can be entirely bailed out of supporting ‘Main Street’. The buck stops with them.

In a pandemic though, what is the moral hazard from giving ‘free’ money to businesses that were ordered to close and people who were ordered to stay at home? What kind of government would perversely benefit from that? Maybe if the central bank directly funded the government, it would give the government the excuse to do all the investments and reforms that they should have done years ago. But the last time a comparable pandemic occurred was the Spanish Flu a century ago, so it’s not as though any government could count on this kind of central bank support again in their lifetime. Moreover, we are talking about sending the money directly to households, not government, in amounts just enough to carry them to the other side of the pandemic. How will that create perverse incentives?

Nor do I think helicopter money during a pandemic would jeopardise government incentives to maintain a robust health care and emergency response system, any more than health insurance would encourage someone to deliberately step in front of a bus. Even if the insurance saves you, it still hurts!

A pandemic is such a rare and well-defined event, (mostly) independent of human blame, so helicopter money in response to such an event would surely not become something upon which people or governments would become dependent.

There is already commentary highlighting concerns over the debt burden future generations are going to inherit thanks to current government spending sprees. With risks of inflation and moral hazard about as low as they can be, what harm could be wrought from six months of ‘free’ money?

The Australian government understands its role in this crisis.

If the central bank is the 'lender of last resort' for the financial sector, then the government is the 'lender of last resort' for the rest of us.

The Australian government has unloaded unprecedented support and stimulus on Australian households and businesses in response to COVID-19. Combined with actions by the Reserve Bank, it has so far totaled $189 billion, with more likely still to come.

The Australian government understands one of its key roles. If the Reserve Bank is the ‘lender of last’ resort for Australia’s financial sector, then the government is the ‘lender of last resort’ for the rest of us.

During a financial crisis, one of the key roles of a central bank is to ensure there is enough liquidity in the financial system so institutions can continue to meet their day-to-day obligations. When everyone is panicking and withdrawing their deposits, banks can run into problems because they don’t hold all of these deposits on hand at all times. During such a panic, even with responsible capital buffers, banks can run out of money, through no fault of their own. Their temporary illiquidity thereby turns into insolvency and collapse.

Even banks that were reckless with their lending practices and are suddenly getting their comeuppance, may be worth supporting by a central bank if the institution is systemically important. The risk of moral hazard (encouraging future reckless behaviour by bailing them out of their bad decisions today) is manageable and regardless, is less than the risk of financial contagion where the collapse of this one institution risks dragging down the entire financial system with it. This is how the Great Depression played out, causing widespread damage to the broader economy on top of immeasurable human hardship.

This is why central banks support the financial system during a crisis and the same applies to government. The Australian government – or rather, the Australian government bond market – is the ‘lender of last resort’ for Australia’s businesses and households, with the government acting as the ‘middle man’, borrowing and paying back on our behalf.

This pandemic was not our fault, nor does everyone have sufficient savings buffers to tie them over until the pandemic ends. It’s only fair that this temporary illiquidity that many households and businesses are facing should not turn into insolvency. For entire industries and even systemically important businesses, it goes beyond fairness and becomes an issue of preventing a contagion where one industry or entity’s collapse results in mass unemployment, fire sales of assets, defaults on debts and the spread of disaster to the entire economy.

The more households and businesses that are brought across the “bridge” over this crisis to the other side, the swifter and more complete also will be the recovery.

All the additional debt the Australian government is taking on in this process naturally must be paid back and with interest rates lower than they have ever been, this has never been easier. To further reduce the burden we’re placing on future generations, the government has an abundance of economists and industry representatives who can all provide sound advice on the most productive investments for that debt – the specific infrastructure projects, the skills and training that will equip the workforces of tomorrow, the tax reforms that minimise economic distortions.

A government that capitalises on these record low borrowing costs and listens to expert advice will have minimal problems producing an economy that simply grows itself out of its debt burden. There would be no need to cut short Australia’s recovery from this pandemic by skimping on financial support for households and businesses, nor sacrifice social programs for current generations or living standards for future generations.

The Australian government understands its role as ‘lender of last resort’ and is to be commended for its action taken to date. The more it supports this “bridge” to the other side for as many people and businesses as possible and invests productively in our future, the faster and more full the subsequent recovery and the more sustainable their own financial position.

Construction workers remain. Construction work, less so.

The pre-COVID19 picture for the construction industry was strong. Even with the cooling of Australia’s largest markets – NSW and Victoria – employment in the industry was still at record levels, including almost 1.2 million workers, or one out of every 11 workers nationwide.

As the housing market cooled, significant State infrastructure pipelines, plus the beginning of several projects from the Australian government’s own pipeline, were continuing to support both the industry and the broader economy.

The advent of the COVID-19 pandemic – with all the trade and travel restrictions, industry shutdowns and social distancing measures it now entails – will leave many of these workers suddenly idle.

Had these workers started more significantly leaving the construction industry following the housing downturn, it would be the industries that absorbed them that would require extra support to weather the coming storm. The fact that these workers remain in the construction industry – but work pipelines increasingly don’t – presents a golden opportunity for government.

Local, state and federal government have the chance to fast-track a significant number of infrastructure projects, absorbing this newly available labour. Even in Sydney and Melbourne – where, until recently, the Australian government was wary of fast-tracking major projects in competition with massive State pipelines that were already competing for scarce skilled labour – a golden opportunity exists.

Infrastructure projects are generally conducted out in the open, unlike say, apartment buildings. This reduces much of the risk of undermining social distancing measures. It also presents a significant opportunity to mitigate some of the damage that COVID-19 is set to wreak on Australian society and the economy.

Don't trip up the recovery - the books can wait.

The stimulus and support being provided by government to manage the impact of – and support a recovery from – the COVID-19 pandemic is most welcome. So far the Australian government and the RBA have announced a combined $189 billion of support and stimulus. Supporting individuals who lose their jobs and facilitating key businesses to stay open and hold onto their employees wherever possible, will be key to riding out the storm and bouncing back as quickly as possible.

There is a dangerous incentive for all levels of government once it appears that things have returned to normal, to balance the books once more. It is crucial that this is not attempted too soon. The raising of taxes and/or withdrawal of stimulus before a recovery is far enough advanced can send the economy straight back down again. This will not just inflict economic damage and human hardship, but can literally worsen the very budget situation that the reversal of policy sought to address.

The last century is littered with examples of premature austerity, including the last decade and even the last few months:

-        Great Depression – the US sent their economy back into recession in 1937 by prematurely tightening monetary policy and attempting to balance the budget after the Depression, an effort which “almost destroyed [FDR’s] New Deal”, according to Nobel Prize-winning economist Paul Krugman.

-        GFC – both the US and the EU turned to austerity in 2010, sending the EU into a full-on repeat of the Great Depression, and the US into a recovery that was much weaker and more prolonged than it should have been.

-        Japan raised its consumption tax in October 2019 from 8 per cent to 10 per cent, contributing to a annualised 6.3 per cent contraction in economic activity in the final quarter of the year.

-        Australia too, has limped through several years of weak wage and productivity growth, and more recently sluggish economic growth following the housing downturn and credit squeeze, while the Australian government preferenced a budget surplus over further stimulus.

When economic activity is weak, government spending has a much stronger impact on boosting activity more broadly. The resources the government absorbs to undertake this spending is not being taken away from the private sector – the private sector wasn’t using them at all. It is pure stimulus. It is only when the private sector starts competing for these resources with the government and bidding up prices, that the government should consider withdrawing stimulus and balancing the books. In other words, not until inflationary pressures emerge.

While these new debts will inevitably have to be paid back, the interest bill on them is negligible, and not just for short term debt. The RBA’s actions have brought the cash rate to 0.25 per cent and the 3-year Australian government bond rate to around 0.3 per cent. Even before the RBA’s announcement of unprecedented stimulus, the 10-year rate reached as low as 0.62 per cent on the 9^th of March and the 30-year rate reached 1.16 per cent.

For a government to not be willing to borrow and spend at rates this low is to suggest that they can think of virtually no investment with a positive return. Even the borrowing required just to cover the loss of revenue and increase in unemployment benefits that will come from this economic downturn will be largely spent by people on goods and services, thereby supporting economic activity – and government revenues.

Australia also has some of the lowest national public debt levels in the world. With net debt at just 20 per cent of GDP in 2018, this is equivalent to Switzerland (21 per cent); below Canada (27 per cent), Taiwan (33 per cent), Germany (43 per cent) and Ireland (55 per cent); and just a fraction of the UK (77 per cent), the US (80 per cent), Italy (120 per cent) and Japan (a whopping 153 per cent).

In current circumstances, there is no reason to think Australian public debt is going to become a bigger priority than the economic recovery, so the economic recovery must not be tripped up for the sake of the books.

Is COVID-19 the unfortunate catalyst for global fiscal stimulus?

Economists have been calling for fiscal stimulus for years. The fact that interest rates are so low around the world means that the private sector doesn’t have enough productive uses for the massive quantities of savings sloshing around the global financial system. Government is required to absorb it, directly stimulating activity with its own investments, and indirectly catalysing further private sector activity. This process would support growth in productivity and wages, help bring interest rates back to ‘normal’ levels, and provide greater central bank ammunition for the next downturn.

Unfortunately, many governments have been unwilling to do this, despite record low borrowing costs and no shortage of investment opportunities – infrastructure, structural reforms like housing taxation, investments in skills and education, even just increased funding for the social safety net.

Why this unwillingness?

Traditional economic downturns, such as those originating from a stock market or housing market crash, can often be viewed as ‘natural’ events requiring correction. Governments may use this ‘necessary correction’ argument to avoid significant costly stimulus (ironically potentially making their budget situation worse, especially long term).

When central banks raise interest rates too fast, thereby tripping up the economy, government can similarly avoid blame and therefore responsibility for stimulus.

Then there is the more simple ‘fiscal responsibility’ argument, that even in the face of high unemployment and recession, governments should ‘live within their means’. The US and EU fell into this trap much too quickly following the GFC, resulting in a sluggish recovery for the US and a true repetition of the Great Depression for Europe. Cutting the recovery short ironically also made national budget situations worse, especially over the long term. Until recently, Australia was falling for a similar argument, preferencing a budget surplus over stimulus for a sluggish economy.

This time, the correction is almost entirely government-mandated – shut downs of entire industries, workers quarantined, drastic trade and travel restrictions. There is no escaping the fact that the government has literally chosen to crash the economy in order to focus on defeating a much larger enemy. This means, for the government, there is no escaping responsibility for building a “bridge”, supporting the economy and the people through the storm, and catalysing a proper recovery as soon as possible. Anything less will unambiguously be viewed as a monumental failure of government who can’t dismiss the situation as a ‘necessary correction’.

Government seems to understand this so far, with massive stimulus and support announced around the world. The Australian government and RBA have announced a combined $189 billion worth of support; $12.1 billion from the NZ government plus additional support from RBNZ; and potentially trillions in the US. Even Germany, the epitome of fiscal prudence, has abandoned its “schwarze Null” balanced budget rule and announced up to 350 billion Euros worth of new debt to combat the pandemic.

Government spending may not just be for tying people over until the pandemic is contained, and then simply putting them back to work in the same economy as before the pandemic. New infrastructure projects can also be fast-tracked to employ a less-than-fully-utilised construction workforce. Once the private sector returns to normal, they will have a whole plethora of new infrastructure upon which to capitalise. It won’t just be a return to normal. It will be a return to an economy with significantly more productive capacity.

The government could create a new golden age of economic activity by using the sudden absence of private sector activity in the short term to undertake all the investments for which economists have been calling for years. It will probably not be enough to fully offset the coming downturn but in the near future, the combination of returning private sector activity and new public infrastructure capacity will set the scene for an economy even stronger than it was before the pandemic.

It is a shame that it may be a pandemic that is the catalyst for this economic stimulus but even a crisis can be an opportunity for something great.

We need a global fiscal push.

I’ve written many times before (at least here, here and here about the need for Australia’s government to pull the fiscal levers more to support the economy. The RBA has all but exhausted the monetary levers. Interest rates are nearing zero and risk creating an asset price bubble in the property market and/or the stock market. Even the Governor of the RBA Philip Lowe acknowledges that “it won’t generate medium term growth and just risks pushing up asset prices”. That’s why we need the government to fast-track more infrastructure investment, enact more training and skills development programs, undertake tax reforms in areas such as housing, and offer private sector investment incentives.

But it still won’t be enough.

Australia could do everything right. The government could go on the most well-targeted unprecedented spending spree in our history. Economic growth could push up over 3 per cent again. Unemployment could fall under the RBA’s 4.5 per cent target. Productivity could start accelerating. Wage growth too could once again have a three in front of it. Even inflation could return to the RBA’s 2-3 per cent target range.

But interest rates will still be too low.

Low interest rates are a global phenomenon. There are enormous amounts of savings sloshing around the global financial system looking for returns. Households and businesses are indeed borrowing it (every dollar of savings naturally represents a dollar of borrowing somewhere in the world – it has to) but it’s not productive investment. Too much of it is speculative. If it were productive, it would generate solid returns and would drive up interest rates. This isn’t happening. The private sector alone can’t find enough productive investments and governments aren’t bold enough to go on an infrastructure spree. Hence low interest rates and bubble-susceptible asset markets.

Australia can’t fight this trend alone. If global interest rates are low, ours will be too, even if our economy is running as well as possible.

This is the problem. During the good times, we want central bank interest rates to be at least 4 per cent. Before the GFC in Australia, they were 7.25 per cent! By some estimates today, good times would only deliver 2-3 per cent interest rates. The reason this is a problem is that during a downturn, it doesn’t leave the central bank much room to cut interest rates to stimulate the economy (unless they wanted to target a higher inflation rate – see my previous work here). This lack of ammunition would once again put the burden on the less efficient and less timely political process to boost the economy – something that independent central banks were supposed to largely mitigate.

This is why we need … A GLOBAL FISCAL PUSH. Trillions of dollars can be borrowed by national governments all over the world at near zero per cent interest rates. Some governments can borrow at LESS than zero. Even mortgage holders in Denmark are enjoying negative interest rates of -0.5 per cent – yes, their monthly bank statement literally includes an interest payment FROM THE BANK TO THE BORROWER! This is unprecedented and our grandchildren won’t believe it – so keep your bank statements as evidence.

I’m old enough to remember a time when it was unthinkable that we couldn’t convince governments to spend MORE and we may be seeing the tide turning. The European Central Bank is increasingly putting pressure on its national governments to spend up big. Even fiscally conservative governments like Germany and the Netherlands are reconsidering their balanced budget rules in light of the ridiculous cheapness of borrowing and the fact that the EU may already be in recession.

And there’s no shortage of projects that could be financed. In Australia, the pipeline of potential public transport projects is virtually endless. In Europe and the US, simply repairing and upgrading existing infrastructure would be a big boost. Given current interest rates, it beggars belief that governments can’t think of a worthwhile way to spend money.

This is one of the biggest moments in the global economy since the 1930s but we don’t need a world war to finish it. We just need governments to invest in their own backyards. It won’t just spur long term economic growth and bring interest rates back up to levels that would provide insurance against the next downturn. It could also show the world what happens when they work together, ushering in a new era of global cooperation that even a decade of insular nationalistic politics hasn’t yet destroyed.