View From The Couch - 22/Feb/2017

A Quick Note About Inflation

It's been this blog's contention that inflation has been under-reported for a very long time. It happened because the incentives were lined up in such a way that under-reporting helped successive governments point at figures that made it look like inflation was tamed, as well as businesses that wanted to borrow money more cheaply from banks, and so it suited them that inflation was under-reported and thus resulted in lower interest rates.

The net result is that we have today whereby Australian households have record debt, and housing affordability is at a minimum, while interest rates are also at a minimum which encourages maximum borrowing, and therefore in a circular manner contributes to the record debt. This is against the context where the ABS cost of living index has come in much higher than the Consumer Price Index for well over a decade.

A week ago Pleiades sent me an AFR article, and lo and behold, somebody is saying exactly that:

Martin Conlon reckons the so-called "great moderation" of the past two decades is, not to mince words, "bollocks". And investors need to wake up to that fact if they hope to get anything out of the local sharemarket in the coming years. 

At this past week's Portfolio Construction forum in Sydney the head of Aussie equities at Schroders Investment Management told a packed auditorium that "we have been sold down the river" by central bankers who "have been asleep at the wheel for 25 years". 

This may all sound like old hat to you, but it's worth taking that little trip down memory lane to appreciate where Conlon is coming from and why it still matters now. 

It was once common currency that central bank mathemagicians had tamed the business cycle. The developed world was growing at a solid and stable economic growth, and those damaging inflationary outbreaks were a thing of the past.

The GFC came along and exploded that conceit. Rather than fostering stability, low rates had fed a massive run-up in debt that, via the US housing market and helped along by dodgy lending and misincentives, almost crashed the world's financial system.

But instead taking a new tack, central bankers doubled down via quantitative easing and pushing rates to zero and below. 

Conlon's biggest bugbear is how this has happened thanks to the narrow definition of inflation as the movement in a basket of consumer prices. CPI growth has indeed been low and contained for many, many years.

But he finds it "anomalous to say the least" (read: bollocks) that we can say that building material prices going up is inflation, and is therefore bad, but you put them all together in a house, and when the price of that goes up, it's good.

The very details of how the central banks calculate inflation is hidden from view, but occasionally we're given a glimpse and we find that it includes things like extreme luxury vehicles. Given that they are by nature stable in pricing, and outweigh the price of household staples of any description, it's easy to see how the Central bankers have found it relatively easy to suppress CPI figures for quite some time. Add in the fact that if you choose to look at things that are least vulnerable to inflation for your index, when there's actually any inflation (or deflation) going on, it's even harder to find any movement to your index.

 So, here we are today and the consequences are what we have - high private sector debt, low growth, historically low interest rates, terrible housing affordability, and a Reserve Bank that is suddenly a little concerned about all this. 

"We have been seeking to balance the risks from having inflation low for a longer period against the risks from attempting to increase inflation more quickly, which would partly occur through encouraging more borrowing," said Lowe, who has kept rates steady since last easing in August. 

While there was a danger low inflation could lead to a self-fulfilling decline in inflation expectations, he did not see "a particularly high risk" of this in Australia. 

However, he did see risks in encouraging more borrowing by households where debt to income ratios were already at record highs. 

"At some point in the future, households having decided that they had borrowed too much, might cut back consumption sharply, hurting the overall economy and employment," he warned.

"It is difficult to quantify this risk, but it is one that is difficult to ignore."
This is a major reason financial markets have almost priced out the chance of another cut in the current 1.5 percent cash rate following two easings last year. 

Lowe noted that high levels of debt combined with subdued wages growth were already making households wary of spending freely, choosing to save more instead.
While some pick up in wages growth was expected, the RBA's liaison with business suggested the upturn was not imminent, he said.

Knowing what we know, that all reads really funnily. The RBA is worried that the illusion of low inflation they've created might lead to a deflation through perception - but the governor doesn't see a high risk. If the CPI is masking inflation, then yes, the physical economy might just prove to be entirely different to the fiction created by the CPI. Given that the CPI is what it is - an elaborate fiction - it's hard to see how there would be a real deflation breaking out anytime soon. 

The governor then follows with the idea that households borrowed too much money and can't spend, so if the interest rates go up, it "would cut back consumption sharply hurting the overall economy". It's contradictory that people have money but won't spend because they have an expectation of deflation, but at the same time have no money because they're stretched to their limits with debt. Furthermore, if inflation has been under-reported for a while, there's a good case to have a bias towards tightening, but the governor seems to be making a case as to keep things as they are.

Should we be worried?

If doing it wrong for 20-odd years has become the new normal, resulting in very distorted outcomes, do we begin to worry or do we consign such worries to outliers and pay no heed? If you set sail from Sydney for LA with a broken compass and three weeks later you find yourself sailing in the antarctic ocean amongst the icebergs and penguins, do you worry? I don't know. I would, but the RBA seems to think not. It's steady as she goes and onward into the storm.
I don't know how this is going to get unwound. I imagine a black swan is going to come and shit all over the status quo. The outlook is rather bleak that way.