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.

Once More For The Dummies Blowing Bubbles

I'm Just Sitting Here Watching The Bubbles Go Up (I Just Had To Let It Go)

Yeah, I know I know. I've been saying there's a property bubble in Australia and it dates back a good decade and a half, but the RBA, Treasury and all governments have been talking it down for the entire time. All of a sudden this quarter, Treasury, then the RBA have come out and stated they've seen the elephant in the room. What's even more astounding is that in the face of expert advice, the Prime Minister said he just wants property prices to go up because it's in his personal financial interest; Worst-Treasurer-Ever Joe Hockey said, get a better job if you want to buy into property; and the real estate sector pundits are coming up with all manners of statistics why it might not be a property bubble that is unfolding. Some are even arguing that it can't be a bubble because it's only a shortage of supply - which makes as much sense as "get a better job". Post-hoc arguments like that don't really count as analysis.

The cycle of blame in the media has gone into overdrive as foreign investors who have bought up the top end of town are blamed, as well as negative gearing and the relative lack of supply, record low interest rates, and the notion that property never goes down. One imagines there are any number of journalists who will never get into the Sydney housing market with their straight up journalist's salary. But they're all barking up the wrong tree. Is there a bubble? Yes. Did it start yesterday? That would depend on what you mean by 'start' and 'yesterday'. I can assure you the phenomenon didn't manifest itself out of the blue, out of seeming nothing.

The point is, when too much money chases too few assets, that's the definition for inflation. In the past when inflation reared its ugly head, central banks would raise interest rates to calm down prices. This was how the inflation component of Stagflation of the late 1970s and early 1980s was tamed in America by Paul Volcker, and is the very mechanism by which we understand "the recession we had to have" in the early 1990s in Australia when interest rates soared to 17.5%. Those were some heady days!

Since then, our central banks and governments have indulged in a few naughty practices and it comes down to this: They've been screwing with the way inflation is measured in such a way as to under-report it. They've been doing it for some time, and to such an extent that inflation looked markedly lower than the Australian Bureau of Statistics' own cost-of-living measures. For a good decade now, we've lived in the condition where inflation has been reported markedly lower than the cost of living.

Simply put, the RBA is setting interest rates too low because it's measuring inflation incorrectly. Why does it do so? Because it gets rewarded easier that way, by lowering the hurdle just a bit each time. And because it's setting it too low, there's a property bubble going on; and because it's measuring it incorrectly, it took until this quarter for both Treasury and the RBA to come out and say there's a bubble.

Seriously folks, if inflation is reported lower, it gives licence to central banks to ease monetary policy rather than tighten it. By underreporting inflation for so long, there has been a cumulative easing of monetary policy to such an extent that we're now at 2% interest rate as a property bubble rages on. There's simply too much money chasing too few assets, but the RBA won't pull back from easing because it's believing its own inflation figures. Meanwhile, the general populace who have inelastic economic needs - food, clothing shelter, power & telco - have faced a rising cost of living for so long that they hardly have the disposable income to keep consuming. Private debt has reached incredible highs in Australia, as it has in other anglophone countries, and it's stopping people spending the way the RBA thinks it should. Adding more credit and easy money to the mix isn't going to work.

So what should they be doing? The answer is pretty simple.
The RBA needs to dust off the old way of calculating inflation used back in the 1980s, and figure out just how much they've under-reported inflation over the years; then they need to jack up interest rates just like they did in the early 1990s, to convincingly take away the punchbowl. But without doing so, they're letting all the easy money take up zombie positions in the economy and there will never be a return to strong growth. And at the end of the day, strong growth is their mandate.

CPI And Cost Of Living Discrepancy

What To Make Of This

Just what good is the CPI - the 'Consumer Price Index - as a measure of inflation when the cost of living surges ahead of the CPI? This is the question in this article here.

Soaring food and rent costs have seen the cost of living outpace inflation over the past year, adding to evidence that households are being squeezed, new figures show.

"Employee" households saw their cost of living shoot up 4.5 per cent in the year to June, driven by soaring increases in the cost for food, alcohol and rent, the Australian Bureau of Statistics said.

The ABS said those rises were "due to increases in mortgage interest charges, fruit, automotive fuel, tobacco, electricity and rents".

The increase surpassed the 3.7 per cent rise in headline inflation over the year to June and comes as rising costs - combined with high debt levels for housing - have been blamed for Australia's slowing economy. The Reserve Bank uses its own underlying gauges of inflation based on data supplied by the ABS when deciding interest rates.

Food costs for employee households increased 5.8 per cent over the year, the ABS said, while alcohol and tobacco prices rose 5.6 per cent in that time. Housing costs, which exclude real estate purchases, increased 5.8 per cent for employee households in the year.

Now, that actually does fall in line with my own experiences of late. That is to say, the day to day things the form the inelastic end of my needs have been creeping up in price, while the things I have a fair bit of elasticity in have been falling in price. So if the CPI is measuring a wider spectrum of goods and it is coming in lower than the cost of living figures, then that indicates there's a bit of deflation going on at the bigger ticket end of the spectrum.

It's hard to say just how much we should be encouraged by the prices of computers today compared to even 5 years ago, but there does seem to be a trend for the bigger ticket items to be sitting cheaper than they did before. It is taking some stupidly obstinate pricing practices in the retail sector to keep the pricing at the same level as before we hit 95cents and above against the US Dollar. Most of anything imported has come down in price.

One imagines it benefits the government coffers greatly for things to be indexed to CPI rather than cost of living; especially things like pension and welfare payments, but that's basically the government making savings in a way that doesn't show up as a cut in the budget. Similarly, the mortgagees benefit greatly because it tempers the degree by which the RBA raises the interest rates. So it's a kind of passive transfer of wealth from the poor to the middle. Though saying that too loudly will get you labelled a crazy Marxist - or a gloating fascist.

 

 

News That's Fit To Punt - 06/Aug/2011

Turning Japanese As A Headline

Last week, the Economist ran with the headline 'Turning Japanese'. The gist of it is that the very model for the current behaviour of both the EU and US governments in propping up the economy with stimulus spending while racking up debt is essentially what Japan did after the property bubble.

In the early days of the economic crisis the West’s leaders did a reasonable job of clearing up a mess that was only partly of their making. Now the politicians have become the problem. In both America and Europe, they are exhibiting the sort of behaviour that could turn a downturn into stagnation. The West’s leaders are not willing to make tough choices; and everybody—the markets, the leaders of the emerging world, the banks, even the voters—knows it. It is a mark of how low expectations have sunk that the euro zone’s half-rescue of Greece on July 21st was greeted with relief. As The Economist went to press, it still was not clear on what terms America’s debt limit would be raised, and for how long. Even if the current crises abate or are averted, the real danger persists: that the West’s political system cannot take the difficult decisions needed to recover from a crisis and prosper in the years ahead.

The world has seen this before. Two decades ago, Japan’s economic bubble popped; since then its leaders have procrastinated and postured. The years of political paralysis have done Japan more harm than the economic excesses of the 1980s. Its economy has barely grown and its regional influence has withered. As a proportion of GDP, its gross public debt is the highest in the world, twice America’s and nearly twice Italy’s. If something similar were to happen to its fellow democracies in Europe and America, the consequences would be far larger. No wonder China’s autocrats, flush with cash and an (only partly deserved) reputation for getting things done, feel as if the future is on their side.

That just about sums up the observation and the rest of the article is a discursive chat about government debt and the inability of politicians to find a way to reduce debt.

Except right now might be the moment of truth for all these people who both hold debt and are indebted. To be honest it is a terrible time to be in debt or to be a lender because it all hinges on whether the mountain of debt can be repaid at all. If it can't, then all bets are off.

Here's yesterday's SMH:

Broadly there seem to be two options on the policy menu. One is the deflation option: let market forces take over, let the defaults begin and provide a social safety net.

The other is the inflation option: keep splashing the cash to reduce the debts to zero. This is clearly the favoured Wall Street option. Wall Street's proxies in Washington may duly deliver more stimulus: stimulus the public can ill afford - stimulus that could bring about another Weimar Republic - but stimulus that will diminish the size of the debt.

Which is of course what I've been seeing articles in  Japan about Japan's debt. Now, the politicians can't readily opt for the former option because this would mean everybody's houses will have to lose value and lots of people will be kicked out of their houses and mortgages. There's really no way either side of politics can bite the bullet and survive such an adjustment in the extreme. Neither side of politics could proscribe this as a solution and stay in office. But that might be the devil you know.

The politicians cannot openly opt for the latter because it means it's going to burn down everybody's retirement savings as well as term deposits and cash. People will rightfully leap toward gold and silver - and other precious metals but not commodities as a whole - in that post-apocalyptic kind of scenario where everybody would be running to the hills with their guns or joining the fascists or communists just to feel safety in numbers (which is what happened in the Weimar Republic. It would be like the fall of Rome if it happened across the USA and Europe. That's the devil you don't know; or maybe it's the Deep Blue Sea.

In the twenty years since the Bubble burst in Japan, no politician has come close to proposing a way out of this situation. In fact Heizo Takenaka who was an economics professor before becoming Koizumi's Finance Minister was looking to opt for the latter with the assumption that even if things get terrible in Japan, the people of Japan would still have a high governability. In other words he was willing to burn down savings in order to get out of debt through inflating the currency. I'm just trying to imagine Obama or Merkel or Gillard or Swan having that kind of gumption with their own people. Needless to say, he's not in office now.

Anyway, I think we're only beginning to see the unraveling of the highly distorted financial system that's been built up over a century and a half.

Inflation Figures Not Adding Up For You?


Long time readers here would know that for some time I've been a big sceptic of the CPI. It turns out that the CPI might have been biased upwards in the last few years.

In a post-mortem of the previous cycle of CPI data, which ran from 2000 to 2005, the bureau found that its methodology over time created an ''upward bias'' in the CPI figures. The methodology assumes that consumers keep buying the same basket of goods and services, regardless of their price. And over time, that increases the relative weighting of items whose prices are rising rapidly, and reduces the weighting of those whose prices are falling or relatively stable.

Over time, the basket of goods and services that comprises the CPI becomes increasingly unrepresentative of the real world of consumer purchasing, because it assumes that consumers pay no heed to price signals. Without correct weightings for each of the 90 categories in its basket, the CPI figures are inaccurate, and so are their derivatives, such as measures of underlying inflation.

This is serious. There is a flaw in the inflation data that we should have known about, but didn't. And it almost cost us dearly.

The bureau's post-mortem estimated that between 2000 and 2005, this upward bias had overstated the level of inflation by a cumulative 1.2 percentage points. In the year to June 2005 alone, inflation was overstated by 0.4 percentage points. That was the fifth and final year of the cycle. Inflation was reported as 2.5 per cent, but when the bureau surveyed what households were actually buying it found the true inflation rate was 2.1 per cent.

All f this is to say that one can't be certain about inflation based on one's own life circumstance. My own view is that regionally speaking, inflation has run higher in Sydney than elsewhere in NSW and if anything the raise in interest rates might be appropriate for Sydney but of course it can't be done like that. Even that is by the by. The important message seems to be that the interest rates are actually too high given the CPI the RBA has been using has had an upward bias, and so interest rates should be lower.

I would like to add into the mix that unemployment figures are not what they used to be. In the old days they'd simply count up the people on the dole. These days they work hard to push and nudge and coax and intimidate and irritate people off the dole queue so there are quite a number of people who are part-time employed with 1-4 hours of work a week but are not considered unemployed. Yet if unemployment figures are to be believed, we're close to maximum employment. So if the RBA is working off "garbage in" figures like that,  no wonder there are people who think the interest rates they are putting up are "garbage out".

It is quite reasonable to argue the interest rates are in fact already too high for the RBA's own stated purpose. Unless of course they want people to voluntarily de-leverage and are concocting an environment for that to happen.