RBA pragmatism and global stagflation

Since the higher than expected CPI print last Wednesday, the economic blogosphere has flooded our screens with opinions on the likely RBA decision at its board meeting tomorrow. Some have argued that the CPI was filled with ‘once-off’ movements in price (eg, the deposit and loan facilities and some fruits) and should therefore be taken with a grain of salt. Others have argued that the CPI is clear evidence that the RBA should move on interest rates to get ahead of the inflation curve.

I have a different opinion.

Raising the cash rate while Australia could be in a technical recession is a situation the RBA needs to avoid more than anything else. Think about the criticisms – “How could our central bank be so out of touch?” “Give Glenn the boot!” The very institution itself would be at risk. Forget demonstrating independence. Self preservation is the name of the game (note also that the inflation target is not a mandate of the RBA, but its own interpretation of how to fulfil is statutory role).

Therefore, the only logical decision for the RBA board tomorrow is to leave the cash rate unchanged, even if it has strong concerns about inflation. It is the same action central banks are taking in the UK and other developed countries in similar situations.

But there is more to this story. The present bout of high inflation and low growth is global, and there is little our domestic policy can do to intervene. Further, I suspect that this has much to do with physical constraints to global oil supply (at least in the short term).

As I said two years ago during the financial crisis –

...some interesting trends should occur in the next year or two. First, we should see the price of oil rise again from its current price of around $60 a barrel. Second, we should see an increase in the inflation rate on a relatively global scale. (Note that in the UK, inflation is currently at 4.4%. With the base interest rate at 4.5%, the real interest rate is now effectively zero). Third, we will see a sustained decline in global output. Taken together, a recipe for stagflation. (I also predict continued volatility on financial markets as demand and supply expectations feed back on each other).

The following three graphs show the oil production, oil price and the correlation between oil price and inflation in Australian, Asia, and other developed markets (DM). (Thanks Ricardian Ambivalence for the third graph).

The simple explanation for oil price led inflation is that a century of capital equipment, particularly in transport, is reliant on oil, has very little ability to substitute to other energy sources.  Therefore, the cost of goods is at the mercy of the oil price due to our invested capital.

Typically, there is an expectation oil production will respond to higher prices. But if there are short term physical and technological limitations, this cannot occur. In 2007 the oil price was double the price in 2005, yet total global oil production was identical. If there was not a physical limit to oil production, oil producers should have responded to this price by greatly increasing supply.

Ricardian Ambivalence has weighed in with an opinion that global inflation is not about oil. Oil price leading inflation globally in the above graph is explained away because “Oil leads CPI, in part, because variations in demand lead variations in CPI”. There may be some element of demand and oil price as co-contributors to price volatility, but my suspicion is that physical production limits to oil are the key.

Indeed, the reason these limits are having such a dramatic effect is because they were not foreseen, and investment decisions were made on the expectation of higher volumes of oil available at similar prices.

As a final statement, I want to address the ‘lunacy’ of peak oil. Many economic thinkers rule out the possibility of such an occurrence, as high prices lead to more inaccessible reserves becoming viable, as well as substitute energy sources becoming economical. Yet the recent evidence is that global oil production is back where it was in the late 1990s even though the oil price is more than 5x higher. This doesn’t seem consistent with the economic rationalism, which ignores the major prolonged adjustments necessary for these investments and subsitutions to occur.

Some may still be arguing in their mind that the reason for lower oil production currently is because of a global demand slump. But again, this fails to explain why we are willing to pay 5x the price for oil, and producers are not willing to sell any more oil at that price.

In the end, Australia is at the mercy of global forces as much as anyone, and it would be foolish for the RBA to believe that our domestic interest rate will have any significant effect on inflation without crushing our economy.

The housing market's 'once-off adjustment' meme

There is a meme floating around which has its origins in Chris Joye's numerous articles on the Australian housing market. While I often challenge Joye's economic arguments on this blog, I hope that readers realise this is simply part of a rigorous intellectual debate, and not a personal attack. Indeed, I admire his quest to provide better housing data, and agree with quite a few of his economic and political beliefs.

The meme is that the surge in debt levels and the price of Australian homes since the late 1990s was a once off adjustment to a period of low interest rates and inflation. Therefore, if these conditions hold, current prices are sustainable.

RBA Governor Glenn Stevens mentioned this 'once-off' adjustment in his recent speech 

The period from the early 1990s to the mid 2000s was characterised by a drawn-out, but one-time, adjustment to a set of powerful forces. Households started the period with relatively little leverage, in large part a legacy of the effect of very high nominal interest rates in the long period of high inflation. But then, inflation and interest rates came down to generational lows. Financial liberalisation and innovation increased the availability of credit. And reasonably stable economic conditions – part of the so-called ‘great moderation’ internationally – made a certain higher degree of leverage seem safe. The result was a lengthy period of rising household leverage, rising housing prices, high levels of confidence, a strong sense of generally rising prosperity, declining saving from current income and strong growth in consumption. (here) 

Chris Joye recently reiterated the argument here

This was a once-off "level-effect" (ie, sustainable adjustment reflecting the huge reduction in the cost of debt), not a permanent growth effect, and now these ratios are flat-lining. This is why the household debt-to-disposable income ratio, as shown below, has gone sideways since 2005, years before the GFC first materialised. That is, credit has been tracking incomes, as you would expect.

The household debt to disposable income graph is below, as is a graph demonstrating the structural adjustment of interest rates.

What makes this meme powerful is its truth. Australian interest rates did see a structural adjustment in the mid 1990s. There is also no denying that lower interest rates should lead to asset values rising relative to other prices in the economy. It also makes sense that the level of debt able to be sustainably managed, as a portion of incomes, is greater.

In the housing context, the 'once-off adjustment' argument can be demonstrated as follows.

Prior to the structural adjustment in interest rates, a buyer looking to buy a home that rents for $15,000pa, who is willing to pay a 20% over the cost of renting to buy the home, would capitalise $18,000 at the going rate of 12.8%. That's a price of $140,625. After a structural adjustment, the cost would be capitalised at 7.3%, giving a price of $246,575. A 75% real price increase should be as sustainable as the previous price (almost).

The same calculation can be made against household income, where for a fixed percentage of incomes, a 75% greater price, and level of debt, can be sustained.

Unfortunately, this logical argument only accounts for a part of the debt build up and house price growth since the mid 1990s. The RBA graphs of household finances and real house prices (below) show clearly why this is the case.

The graph of interest paid as a proportion of disposable income shows that the actual cost of debt relative to incomes has doubled (4% to 8%) since the mid 1990s. This is clear evidence that much of the debt binge, and the subsequent house price inflation, is not attributable to the 'once-off adjustment'. This adjustment would only account for the amount of debt, and home prices, that could be supported with interest costs of 4-5% of household incomes - not 8%.

The RBA also shows that real home prices have more than doubled (100% growth) since the mid 1990s to 2007, rather than seeing 75% real gains. Indeed the 2009 boom saw real home prices inch up again (with some subsequent falls in real terms).

The ABS home price figures (though not ideal for this purpose) suggest that real home prices gained approximately 150% since 1996. That's twice what is expected from interest rate conditions alone.

To get back to that 'sustainable' point, either home prices need to fall by around 30%, or interest rates need to fall by 30% (mortgage rates to 4-5%), or some combination of the two (noting also the geographical disparity any correction is likely to have). With today's CPI print surprising many on the high side, the market prediction (and mine) of rate cuts by year's end seems far less likely.  The negatively geared housing investor should take note.  

In all, the meme is powerful because it is true, but dangerous because alone it is an incomplete explanation of debt and home price trends of the past two decades. What appears clear from the data is that we have overshot the expected price and debt adjustment due to the changing interest rate environment. With this in mind, the downside risks for property values appear to far outweigh any upside potential.

Is Australia a net food importer?

Measuring food is difficult. Do we use kilograms, or calories?

I’ve covered the value of food security before.  But the obvious truth that Australia is a massive exporter of food, in terms of both kilograms and calories, does not stand in the way of the grocery lobby group, the Australian Food and Grocery Council (and yes, I am very late to this story).

Here are some examples

This alarming result shows food and grocery manufacturing – which employs 288,000 people – is now a net-importer of food and grocery products which impacts industry’s growth and competitiveness (here)

But Ross Gittins' b%&*$it detector was straight on to it

According to figures compiled by the Department of Foreign Affairs and Trade, last year we had total exports of food of $25.4 billion and total food imports of $11 billion, leaving us with a surplus of $14.4 billion. Even if we ignore unprocessed and look only at processed food, we still had a trade surplus of $5.8 billion. (here)

He continues to pick apart the claims.

So how did the food and grocery council get exports of $21.5 billion and imports of $23.3 billion for 2009-10, giving that deficit of $1.8 billion? By using its own definition of ''food and groceries''. We're not talking about farmers here, but the people who take their produce and process it for supermarkets.

So the council's figures exclude all our unprocessed food exports, including wheat (worth $4.8 billion in 2009), other grains and live animals. On the other hand, they include ''grocery manufacturing products'' such as medicines and pharmaceuticals, plastic bags and film, paper products and detergents.

That's food? It turns out that our exports of ''groceries'' totalled $4.9 billion in 2009-10, whereas our imports totalled $12.9 billion, leaving us a ''grocery'' trade deficit of $8 billion. This is hardly surprising. Since when was Australia big in the manufacture of medicines? If you leave out groceries, the report's figures show we had exports of processed food and beverages worth $15.9 billion, compared with imports of $9.9 billion, plus exports of fresh produce worth $700 million against imports of less than $500 million.

That leaves us with a trade surplus of $6.2 billion for fresh and processed food and beverages. We've been conned.

This all leads me back to the arguments I made about the value of food security. If food security is important, why isn’t computer security, or medicine security, or car-making security, or plane-making security, or any other "fundamental economic ingredient" security given the same attention? Indeed, we could not produce the amount of food we currently do without imported picking, packing and transport equipment, so unless we secure those, we won’t even have food security.

The graph below is a final reminder about our food net export position relative to other nations, and our relatively low direct agricultural subsidies.

The Believing Brain

Michael Shermer talks about his theory of the brain as a ‘pattern believing machine’.  Put simply, we first believe in patterns subconsciously, then add logical explanations post hoc. This partly explains why debating passionate people on their topic of choice often leads each person more entrenched in their beliefs than afterwards, since logic doesn’t govern our already held subconscious beliefs.

He has a book exploring the idea in more detail, and if you want another brief take on his theories you can read one of his articles here.

And the conclusion from one reviewer -

Having presented the case that we form beliefs on the basis of unconscious, often irrational processes, and that all our argumentation in support of these beliefs is then added post hoc and subject to a wide range of cognitive biases which he lists and explains, Dr. Shermer leaves us in a near-hopeless state. The human condition, according to this perspective, is one of deep-rooted, biased subjectivity and perpetual, unresolvable conflict between believers with different sets of beliefs.

Real per capita wealth trend

As part of my recent habit of examining trends from the perspective of the individual, or household, I have compiled a measure of real net wealth per capita.

The reason for this is to add another perspective to the more general question of how the Australian economy has fared post-GFC.

As you can see, the average Australian's real net wealth is exactly where it was at the end of 2006.  Have we really spent four and a half years just treading water?

The interesting relationship is between the trend in real wealth and the trend in retail turnover.  The 2007 peak of per capita wealth also happened to be the end of the growth trend in retail spending.  It is also important to note that in the last decade, home values have comprised around 60% of total household assets, which leads on to conclude that the fate of retail rests heavily on the fate of home prices.

The Sydney housing boom ripple effect

Sydney is different. Since 2003 rents have risen faster than prices. I imagine the rest of the country would find that hard to believe, given their experience. But this is just one piece of evidence to show that the property cycles in Australian cities are nonsynchronous.

The past twenty-five years of data show that the Sydney residential property market is the least volatile, and is always first to boom. In fact, you can chase the price growth ripples from Sydney and Melbourne across the country – to Adelaide, Brisbane, Perth then Darwin. This might be one reason that such divergent opinions exist in the media, academic and professional circles.



If we looked only at the above graph, we would note that the two biggest markets, and arguably most attractive cities, have had the least growth since 2000. That seems particularly counterintuitive.

But if we look long-term the explanation is clear – Sydney and Melbourne had their major boom years before the other cities in the late 1990s.

Each of the charts that follow this post compare the timing of booms in capital cities against Sydney’s booms. The blue background shading matches the Sydney boom periods, with the red shading the boom periods of comparison cities. This exercise reveals a number of things.

• Sydney and Melbourne booms in the 80s and 90s started and finished within a year of each other. In fact, their cycles are the most in synch of all markets. 
• Brisbane lagged Sydney’s late 1990s boom by 4 years – making it an early 2000’s boom. This appears connected to the fact that Brisbane’s 1980’s boom lasted about 4 years longer than Sydney’s. 
• Adelaide followed Sydney’s lead more closely than Brisbane in the 1990s, and lagged Syndey more closely in the late 1980s. 
• Perth’s 2000s cycle was similar to Brisbane, although in the 1980s it had sharper and shorter price rises. 
• Darwin is a world of its own - booming when other capitals had prices tracking below trend. 
• Brisbane, Melbourne and Perth prices have been ‘catching up’ to Sydney over this 25 year period. This could be because the quality of homes is catching up to those in Sydney, and also due to a convergence of income levels between the cities. 
• For some reason, Adelaide is falling behind other major cities (lowest long term growth trend) 
• Sydney never falls as far below its trend as any other city. My eyeballing suggests that price volatility is lowest in Sydney. 

This might have lessons for property investors outside of Sydney. If you are in Brisbane, Perth or Adelaide and follow the Sydney trend a couple of years behind, you will do well. If prices are flat in the major capitals, take your money to Darwin.

What about from 2011 on? Sydney appears below its long term trend, and it rarely drops far below this trend. The other capitals are above their trend and do fall quite far below trend during economic downturns. My personal view is that Sydney stability will continue.

The other question to ponder is the trends in this period could validly be applied from now on. Deleveraging is the most important new consideration, and we have seen the dramatic affects this can have on asset values if we simply look to the US and some European property markets.

My expectation is that prices will fall until such time as yields are high enough to be attractive to investors who aren’t expecting capital gains in the near future. To me, this might mean yields might get higher, relative to interest rates, than we have seen for 30 years. And for that to happen, prices will fall. Of course, if the RBA drops rates significantly, this will dampen falls, but I doubt lead to the market grinding out modest growth (ie. matching inflation) for a couple more years yet.

Economic images

Sometimes I stumble across humourous images and quotes in which I instantly find a deeper meaning. Here are a few recent ones, and my accompanying thoughts.

The first I stumbled across at Bryan Kavanagh's blog (which is worth a read).

What makes it funny is that it is so close to the truth. To me, the deeper meaning is that we have lost an understanding with what real productivity actually is.

The next image can be found all over the web now, but to me provides insights into exactly how new technology integrates into society. 

While we can laugh that the publicly run enterprise is stuck with 1960s technology, to me it says much more. It shows that aggregating many new technologies (computing, flight control, materials etc) into one much larger and more ambitious technology (the space shuttle) takes a long time. Also, it shows me that there are lock-in effects. The car has not changed much at all. This is partly because roads and associated infrastructure are still much the same, and drivers are trained to use the same controls in the car itself. This limits scope for macro improvements in car transport. The same applies to the space shuttle.

I also stumbled across this quote -

As Douglas Adams wrote in 1999, "Anything that gets invented after you're thirty is against the natural order of things and the beginning of the end of civilisation as we know it until it's been around for about ten years when it gradually turns out to be alright really." Yes, the world is different now. Do try to keep up 

This is an important one to keep in the back of our minds when we imagine seeing society deteriorate before our eyes.  I recall that the ancient Greeks worried about the proliferation of written texts, because it meant people no longer needed to remember and recite long passages. Only if you could remember a passage word for word did it show you truly understood its meaning. 

Retail in detail

My recent post on broad retail trends might have provided a reasonable picture of the sector as a whole, but retailing is a diverse beast. One aggregate number is insufficient to describe the performance of the sector.

My approach is to examine retail from a household perspective. Rather than look at total turnover in current prices, I will examine real spend per capita in each of the main retailing subsectors. I do this because economic theory has a lot to say about changes to household spending patterns during economic cycles.

Economic theory would suggest that in boom times, retailers of luxury goods would see turnover increase more rapidly than incomes. As Wikipedia explains - In economics, a luxury good is a good for which demand increases more than proportionally as income rises. The reverse should also be true for these goods.

Importantly, retail trends need to be seen in the context of a housing driven wealth effect. The wealth effect is an increase in spending that accompanies and increase in perceived wealth, rather than spending which is driven by growth in incomes. 

The wealth effect is also behind many of the saving decisions of households. Since 2005 the trend of declining household savings rates was dramatically reversed. We now have a household saving ratio not seen since 1987 (see the RBA’s chart below). This is an important backdrop to the retail story.

These factors are important to consider if you foresee near term home price declines. In this scenario, spending in wealth driven retail sectors would be expected to fall more than flat or falling household incomes, and increased savings alone would suggest.

Now to the detail.

The graphs below show the performance key subsectors in retailing. Note the log scales, which mean a straight line indicates a constant rate of growth – the steeper the line, the higher the rate of growth. Note also that this is a real per capita measure, which is indicative of trends in household spending decisions. Quarterly chain volume data is used, with May 2011 current price data adjusted to substitute for June 2011 data. The ABS explains some of the trends in more specific subcategories here (definitely worth reading the context of this post).

A few points jump out at me from the graphs. First, household goods (maroon in first graph) have outperformed by a long way, for a long time. This category includes furniture and appliances, hardware and gardening, floor coverings and electrical. This sector also appears to have seen the sharpest shock around the end of 2007 – from having the strongest rate of growth to nearly the weakest. The rising part of the curve might partly be attributed to a greater appetite for expensive furniture and appliances, which is indicative of a luxury good effect. Also important is the impact of the construction boom of the early 2000s which has since collapsed in many areas.

Second, clothing and accessories (green line) was on a declining trend for 14 years until 1997. For a decade since then, the growth rate in this sector was only bettered by household goods. Spending recovered strongly since the GFC. I’m not exactly sure why this might be the case. Perhaps some readers have experience in this sector.

Food retailing has been the steadiest (as you would expect) with only a slight easing from the growth trend since 2009 (maroon in second graph).

Other retailing (which includes pharmaceuticals, recreational goods, cosmetics and books) appears very sensitive to the housing wealth effect, seeing big spending boost during the 2002-03, the 2007, and the 2009 house price booms. Surprisingly spending has remained strong since the GFC – the only retail sector where this has occurred.

We might attribute some of the recent robustness to the high Aussie dollar. The ABS explains that pharmaceuticals and cosmetics and toiletries are the strongest components of this sector.

Cafe and restaurant spending (orange line) also appears sensitive to the wealth effect, and is noticeably one of the more volatile sectors.

Department store spending has been declining steadily since the end of 2007 (purple line). Anyone who had closely examined this data would not have been so surprised about David Jones’ recent profit downgrade. Spending at department stores is now back where it was in 2003 on a per capita basis. 

Finally, the second graph has the period of 2002-03 circled. This is simply to highlight that all retail sectors grew at abnormally high rates during the house price boom of this period. Indeed, we can see the wealth effect correlation between house prices and retail growth in many sectors in 2007 and 2009, although to a lesser extent.

My near term outlook is for a subdued retail sector. As I have said before, I believe that in these challenging times for retailers, innovation will be the key to staying ahead. New business models that use internet shopping to good effect, with a small physical store presence might be one path for many. Those companies who adapt quickest will benefit.

The retail picture

Yesterday, my second favourite blog examined trends in retail spending following David Jones' 'shock' profit warning.  A long discussion about how best to represent the current retail climate ensued.

So to follow up, I have produced a graph of real pre capita trends in retail spending on a log scale to give, what I believe, is the best picture of retail spending patterns over time.  The per capita element is not necessary from an industry perspective, as total turnover drives the health of the industry no matter who spends it. But from a household spending perspective it is revealing.

The peak of this real per capita index is Dec 2007 (dotted line), and is down about 0.35% since that peak.  You could say that each persons retail spending has been flat for three and a half years after more than two decades of consistent growth.  In the decade prior to this peak per capita real growth in retail was 3.5%pa.

From an industry perspective, real turnover has grown at 1.7%pa since that peak, whereas in the decade prior, real total turnover grew at 4.9%pa.  This is clearly quite a shock to the sector, and I hope it stimulates some overdue competition and innovation in retailing in this country (as I have previously discussed).

Bundle of rights explains planning and prices

I have never heard the phrase 'bundle of rights' used in any property market discussions, yet the principle forms the legal basis of property itself.

Put simply, when one buys property they are actually purchasing a bundle of property rights associated with that land title. These rights are granted to the title holder by the State. This bundle of rights approach allows us to distinguish between, and appropriately value, different types of tenure, such as freehold and leasehold, and for differing levels of planning regulation, native title rights, and rights to minerals (which even freehold land owners does not have rights to).

When you value property, you value just those rights that are granted to the title holder by the State. A block of land where the title grants a pastoral lease with 10 years remaining will be valued differently if it was a freehold parcel. Changing the legal rights of the owner may vastly change the market value of the property because the property is different – it is a different set of rights, even though the physical land has not changed.

And so we move on to town planning. Local governments have the power to decide what rights, in terms of land use and scale of development (amongst other things) to grant to which parcels of land through their planning regulations.

When people argue that town planning restricts land market activity and leads to higher values, they are generally confusing basic economic theories of production with fundamental theories of valuation of property rights.