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Podcast episode

Normalization of interest rates & monetary policy – EP173

Last year we saw the beginning of the normalization of interest rates and monetary policy, as central banks responded to accelerating inflation. Show host Gene Tunny talks about the current tightening cycle and when it might end with his colleague Arturo Espinoza. Among other things, Gene and Arturo discuss what history tells us about typical interest rates and returns on capital, referencing UK bank rate since 1694, interest rates on UK government consols, and returns on land written about by Jane Austen and Honoré de Balzac. They also consider whether we might see 17-18 percent interest rates again in Australia, rates which were last seen in 1989-90. 

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What’s covered in EP173

  • What’s been happening with interest rates? [3:00]
  • What is monetary policy normalization? [6:00]
  • How many more interest rate increases will be needed? [11:11]
  • Will we have a recession this year? [19:12]
  • Is there a risk that we could get back to the crazily high interest rates seen in 1989-90 in Australia? [24:00]
  • What is the equilibrium rate of interest? What is the real interest rate? [26:54]
  • The main takeaway from this episode: monetary policy is still in a tightening cycle because inflation is too high [38:43]

Links relevant to the conversation

Data released since the episode was recorded

Australian retail trade fell 3.9% in December, suggesting interest rate increases are starting to bite, meaning the RBA faces an even more difficult challenge in deciding how many more interest rate increases to make:

https://www.abs.gov.au/statistics/industry/retail-and-wholesale-trade/retail-trade-australia/dec-2022

CBC article “U.S. inflation and consumer spending eased in December, new numbers show”:

https://www.cbc.ca/news/business/us-consumer-spending-holidays-1.6728173

Nine News story “Inflation in Australia rises to higher-than-expected 7.8 per cent”:

https://www.9news.com.au/finance/australia-inflation-consumer-price-index-december-quarter/9ef0ed13-e606-4c9e-b7db-feaccfae39fb

Inflation targets

US: 2%; see https://research.stlouisfed.org/publications/economic-synopses/2022/09/02/inflation-part-3-what-is-the-feds-current-goal-has-the-fed-met-its-inflation-mandate

Australia: 2-3%; see https://www.rba.gov.au/inflation/inflation-target.html

UK: 2%; see https://www.bankofengland.co.uk/monetary-policy

Bank of Finland article on monetary policy normalisation:

https://www.bofbulletin.fi/en/2022/3/what-is-monetary-policy-normalisation/

Chatham Financial article on US tightening cycles:

https://www.chathamfinancial.com/insights/historical-interest-rate-tightening-cycles

Jo Masters, Barrenjoey Chief Economist on how “Everything must go right for Australia to dodge a recession”

https://www.afr.com/markets/debt-markets/australia-will-dodge-close-call-recession-20221216-p5c71b

Chart on historical UK bank rate:

https://drive.google.com/file/d/1NDH7WjQBY0ZjWDWgY430qZdrrIf017_4/view?usp=share_link

Chart on central bank policy interest rates since 1960:

https://drive.google.com/file/d/1Mrzre-ijAKAvrU0j4YeQt71FkTr-gzob/view?usp=share_link

Chart on inflation in the US, UK and Australia:

https://drive.google.com/file/d/11lp880Wwb9bk_GI5wJ0EQ975h-ZkAuDK/view?usp=share_link

Wikipedia article on the Fisher equation:

https://en.wikipedia.org/wiki/Fisher_equation

Wikipedia article on UK consols:

https://en.wikipedia.org/wiki/Consol_(bond)

Guardian article on “UK bonds that financed first world war to be redeemed 100 years later”:

https://www.theguardian.com/business/2014/oct/31/uk-first-world-war-bonds-redeemed

What Jane Austen can tell us about historical rates of return:

https://janeaustensworld.com/2008/02/10/the-economics-of-pride-and-prejudice-or-why-a-single-man-with-a-fortune-of-4000-per-year-is-a-desirable-husband/

Transcript: Normalization of interest rates & monetary policy – EP173

N.B. This is a lightly edited version of a transcript originally created using the AI application otter.ai. It may not be 100 percent accurate, but should be pretty close. If you’d like to quote from it, please check the quoted segment in the recording.

Gene Tunny  00:00

Welcome to the Economics Explored podcast, a frank and fearless exploration of important economic issues. I’m your host Gene Tunny. I’m a professional economist and former Australian Treasury official. The aim of this show is to help you better understand the big economic issues affecting all our lives. We do this by considering the theory evidence and by hearing a wide range of views. I’m delighted that you can join me for this episode, please check out the show notes for relevant information. Now on to the show. Hello, thanks for tuning into the show. This episode I talk about the normalisation of interest rates and monetary policy with my colleague Arturo Espinoza. Please note, the episode was recorded on the 11th of January 2023. Now, obviously, we weren’t able to cover any new economic data released after that date. So I’ve added some info into the show notes about important developments since then. One of the most important bits of data was the December US inflation rate. It came in at 6.5% yearly down from 7.1% in November. This figure was interpreted by economists as supporting the view that the US Fed will slow the pace of interest rate hikes in 2023. No longer increasing the federal funds rate in increments of half a percentage point or three quarters of a percentage point. Interest rates still need to increase because inflation is still too high and well above the 2% target. On the first of February, the Fed will probably increase its federal funds rate target by a quarter percentage point from the 4.25 to 4.5% range to the 4.5 to 4.75% range. If it doesn’t do this, I’ll release a short bonus episode looking at what’s going on. Economists expect there’ll be at least another interest rate rise in 2023. Beyond the quarter percentage point increase on the first of February, a view supported by the stronger than expected fourth quarter 2022 GDP figure that came out on the 26th of January. Unlike in the states in Australia, our latest inflation figures surprised on the upside coming in at 7.8% over 2022. I must say I was stunned yesterday when I noticed a 560 gram jar of Vegemite now cost $9 at Woolworths. The Reserve Bank of Australia really has no choice but to continue with its interest rate increases until it sees inflation falling or the economy crashing. As I noted my conversation with Arturo so much depends on how rapidly the economy slows down over 2023. Okay, let’s get into the episode. Please stick around to the end because I have additional thoughts after my conversation with Arturo. Okay, this is episode 173 on the normalisation of monetary policy. So, I’m joined by Arturo, my colleague at Adapt Economics. Arturo, good to have you with me today.

Arturo Espinoza Bocangel  02:58

Hi Gene, it’s my pleasure to be here.

Gene Tunny  03:01

Excellent. Arturo. So I thought for our first episode of the year, it would be good to talk about interest rates. So one of the big developments last year was the, you know, the increases in the interest rates by central banks, their policy interest rates. So the cash rate here in Australia, the federal funds rate, we had some rather unexpected increases in interest rates, all unexpected by many people in response to the high inflation rates that we’ve been experiencing. And so this did catch quite a few people by surprise, and our RBA governor here in Australia, Philip Lowe, as late as I think November 2021, he was saying that, he thought they’d probably be able to keep their cash rate at 0.1% until 2024. So that was his central case scenario, as he was calling it. But it turns out that inflation was ended up being higher than the Reserve Bank expected. And you know, perhaps they should have seen it coming because you would seen inflation accelerating in 2021 in the US and the UK. And so maybe the central bank should have seen it coming, but they didn’t. And we ended up going from a 0.1% cash rate. And now it’s at 3.1%. And that was over a period of from May 2022 to December 2022. And they had the last cash rate increase. So the same three percentage points over seven months or so. So just an extraordinary rate of increase. And similarly in the US, we had high rate of increase. And what we’re seeing is that interest rates are responding to the high inflation. And one thing I thought it’d be good to talk about is, well, where do we think these interest rates are going? Is there any guidance historically, or is there any guidance from theory regarding what’s a normal level of interest rates? So that’s one question we could ask. And how I came to think about this is that I saw increasingly these references to normalisation, so normalisation of monetary policy, normalisation of interest rates, and, and it got me thinking, Okay, well, what’s normal? So I thought that’d be good to explore. Do you have any thoughts on that, Arturo? Does that sound like a reasonable thing to talk about?

Arturo Espinoza Bocangel  05:51

Yeah exactly, that is gonna be an interesting topic, to know, what will be the normal interest rate?

Gene Tunny  05:59

Yes, well, this is a bit of a spoiler, but I think the key message will be that there really isn’t any normal interest rate that we can say that the interest rates are adjusting to that’s one of the challenges it’s it just depends on a whole range of factors, variables that we’ll talk about in this conversation. So to begin with a lot I’d read this article I found from the Bank of Finland, this was back in October and I thought this was really quite a neat way of talking about this normalisation. So they talk about the articles called what is monetary policy normalisation. And so they’re written in monetary policy normalisation, key interest rates or policy rates are once again becoming key instruments of monetary policy. At the same time, the central bank is gradually withdrawing from asset purchases and other unconventional measures. Monetary policy normalisation may also involve adjustments to forward guidance, normalisation leads to a tightening of financial conditions, helping the central bank reduce the inflationary pressures in the economy. Okay. So what they’re talking about there is that during the pandemic, when all of those policy interest rates were effectively cut to zero, our cash rate here in Australia got cut to 0.1%. Right, so it’s effectively zero. That’s what economists call the zero lower bound. So there’s nowhere else for the that policy rate to go, then what central banks what the Australian Central Bank did for the first time. So this has been done previously by the US, and the ECB and Bank of Japan, in response to the financial crisis back in the late 2000s. But we hadn’t done this yet. We did the quantitative easing, what they call quantitative easing, which is printing money. well printing money electronically, and then using that to buy bonds or other financial assets to drive down yields to drive down borrowing costs, with the idea of stimulating the economy that way. So that’s unconventional monetary policy. So what the Bank of Finland saying is that part of this normalisation story is yes, increasing that policy rate getting it away from that zero, lower bound, and moving away from the unconventional monetary policy. Yeah, that’s essentially what they’re saying in that passage there. Okay. And then they go on to talk about where are interest rates going to settle in the future. And this is where this is where they’re essentially saying that will no one, no one really knows, it’s very difficult to forecast that. They’re saying that the normalisation of monetary policy does not mean that the central bank is attempting to restore its balance sheet and interest rates to a past levels such as that preceding the 2008 global financial crisis. Okay, so what they’re saying is don’t necessarily look to what interest rates have been in the past, rather than the aim of monetary policy normalisation is that the inflation rate should accord with the price stability objective. In the absence of further economic shocks, interest rates should in the longer term settle at a level where economic resources are in full use and inflation is at its target, ie at the equilibrium real interest rate, also known as the natural rate of interest. However, the level of the equilibrium real interest rate is affected by a number of factors unrelated to monetary policy. Okay, so, gee, there’s a lot going on that passage there that I’ve just read. The way I interpret this is that essentially, we’ve got to get to an interest rate. So what the central bank is trying to do, its increasing interest rates to get inflation under control. And after it gets inflation under control, the interest rate is going to settle at a rate whereby it’s consistent with keeping inflation in the target band. So in Australia, that’s two to 3%. On average, other countries have similar target rates for inflation and that sort of 2%.

Arturo Espinoza Bocangel  10:28

Between two and 3%. Yeah,

Gene Tunny  10:31

yeah, yeah. So just, I’ll just put some links in the show notes, clarifying that what they are for all other economies. So we’ll end up with an interest rate where it’s consistent with that. And it’s also consistent with a reasonable level of economic activity. So a stable, well, a sustainable rate of economic growth. And I mean, you could call it full employment, but I’d probably say unemployment at what you’d say is the natural rate of unemployment rather than full employment, which is, I think, a difficult concept to actually to define in practice. So, I mean, what would that be? I mean, it’s hard to know, because it depends on how the economy will first we’ve got to find out how the economy responds to the current interest rate increases, and just how far the central bank has to increase the rates from here. So I think there’s generally agree that well, there’s quite a bit of agreement among commentators among the market economists, that interest rates will have to increase a bit more from where they are now. Because we’ve still got inflation in Australia over 7% Us 7% over 7%, we’ve still got these high rates of inflation or higher rates than we’ve experienced for a long time. We’ve pushed the policy interest rates up to 3.1% in Australia, 4.25 to 4.5%. In the US, I think, is the current target band for the federal funds rate. There seems to be a view that there’s still scope for them to push those up further. So in Australia, we could have another maybe two up to two cash rate increases. That seems to be you know, that’s a possibility depends on what your outlook is for the state of the economy. Some people are thinking that might be too much given that, you know, these interest rate increases are really starting to bite already is having a big impact on house prices. We’re seeing that already. So house prices are really coming off. If I look at the ASX this thing called the ASX 30 Day interbank cash rate futures implied yield curve. So this is based on market pricing for financial market products. So this is this What is it 30 Day interbank cash rate future. So, essentially you can bet on what the cash rate is going to be in the future. And from this, it’s showing that the markets essentially expecting that the cash rate will peak at a bit over 3.8% later this year, and then it starts coming off from a peak around I think that’s October, and then it’s slightly falling. And then by June 2024, it’s down around 3.6%. So the market here in Australia is expecting two to three additional increases in the cash rate it appears of around 25 basis points or a quarter of a percentage point. So the markets expecting two to three more increases. I think other economists would be but there’s debate about just how many and the current state of the economy and how the economy will react to that. That’s one of the great unknowns, how will households react to these higher interest rates. And that’s one of the unknowns too in other countries in the States. It looks like there’s probably there will probably be another, at least one more increase in the federal funds rate in the States. There was a report in the Financial Times yesterday regarding some comments from one of the Federal Reserve officials, Mary Daly think she’s from San Francisco fed and the FT reported that Mary Daly became the latest Federal Reserve official to raise the prospect of the US central bank slowing the pace of its interest rate increases to a quarter point rise next month, even as policymakers backed the benchmark rates surpassing 5% Okay, so if you, I think in the Federal Reserve in their publication when they publish their decisions, they have these charts, which show what the Federal Open Markets Committee members, what they forecasting for future federal funds rate, which is a really interesting way to do it. And it gives you some insight and into how the members are thinking and where federal funds rate could be going. It’s really quite a clever thing to do and possibly something the Australian reserve bank could think about doing. And I don’t know whether this is an issue that they’re considering in their manage their review of the reserve bank that’s going on at the moment, I might have to look into that. But it looks like yep, so. So members are the people who are responsible for monetary policy, and the states are expecting a couple more increases in that federal funds rate. So they expect it’ll end up getting beyond 5%. They’re currently targeting 4.25 to 4.5%. But what this is saying is based on recent data in the States, which suggests that the economy might be losing some of the some steam, its inflation may not be as much of a problem as previously, based on that. They’re saying, well, the Federal Reserve can slow down the rate of interest rate increases. So that’s what’s going on there. Okay, so the general expectation that we’d have is that there will still be a few more interest rate increases this year in the US and the in Australia, maybe two, maybe three? I don’t know, it’s so difficult. Everything depends on how the economy reacts. New data. It’s just very difficult to forecast. But one thing I think we can say is that there will be additional interest rate increases. Do you have any thoughts on that? Arturo?

Arturo Espinoza Bocangel  17:01

I have a question about, at what point those heights interest rates will cause a slowdown in the economy. What do you think about that? We will face a slowdown or not?

Gene Tunny  17:21

Yeah, yeah, I think that’s starting to occur. All in Australia, I think households are really starting to feel those interest rate increases and, and more households will this year, because we’re seeing mortgages that were taken out. So the home purchases, they borrowed at fixed rates, and that was for a fixed term, a couple of years, or whatever it was. And then after that, these fixed rates reset to another level. And so that’s going to happen increasingly over this year, we’re going to see more people who borrowed at a fixed rate, they will end up facing a higher interest rate. So those rates that they’re paying reset at a higher level based on current rates, and the current variable rate based on that, and they will therefore have, they will have to pay more to service their mortgage. So there are various estimates of what it means it depends on the type of loan you’ve got, it depends on the amount you’ve got outstanding on your home loan, but for many households, the interest rate rises, we’ve seen it could mean an extra thing is $1,000 a month or something that they have to pay in mortgage

Arturo Espinoza Bocangel  18:43

and depending on what loan.

Gene Tunny  18:46

Yeah, it depends on a whole range of things. It depends on what was the deal you got originally and how much you borrowed, how much is outstanding still in, in what you owe and the principal that you are? So look, it’s going to depend, but there’s no doubt that it will be a substantial hit to the budgets of many households. And we should start seeing consumption spending slow. But look, I mean, the last year the Australian economy performed, I think extraordinarily well. And unemployment got down to under three and a half percent, which is just incredible. Yeah, but I think definitely will go we shouldn’t see, nothing’s definite in economics in macro economics. Yeah. Things could judge. You just don’t know what’s around the corner sometimes. But look, I mean, my guess would be that we will start to see the economy slow this year. Will we have a recession? Well, I hope not. I think I’ve seen some forecasts from some of the bank economists might have been Jo Masters, or I’ll have to dig it up. But basically, they, they’ll say, oh, look, we think it’s more likely than not we won’t have a recession. But the probability of a recession is, I don’t know is 30% or something or 40%. I don’t know, I have to look that up. But I know that there are some people saying, Look, yes, it is possible that there could be a recession here, and also in the States. In fact, there were some people last year saying, Oh, the US had already had a risk that it was in recession last year, because they were two negative quarters of GDP. But it turns out that that was a bit of a statistical anomaly or just a freak result, and really didn’t signal that an economy then in recession. So yeah, look, it’s possible, we could see some recessions. But I mean, as always, I mean, I think, given the complexity of the economy, and all of the moving parts and all of the shocks that could occur, it’s just so hard to actually forecast that sort of thing. I mean, I remember when I was in Treasury, and right up until 2008, we were saying, and most macro economic forecasters, were saying, Oh, we’re in this new era of the Great Moderation, and we didn’t have to worry about the business cycle anymore. And then, I mean, then we have the financial crisis, and it’s the worst, worst crisis since the Great Depression. So things can change the I’m always reluctant to to provide any, any forecasts. Okay. So yeah, those are my thoughts. I mean, what do you think, Arturo, do you have any thoughts on it?

Arturo Espinoza Bocangel  21:42

Well, I think that we are under a period of higher certainty than other times after the global financial crisis. Of course, there are a lot of Australians that are suffering with these higher tax rates. Mortgages, as you have mentioned, I think we need to be cautious about this period.

Gene Tunny  22:07

Yeah, exactly. I found that that article by that mentions, recession forecasts by Jo  masters, she’s with think it’s a bank or some sort of investment being Baron Joey, is it. So masters thinks Australia will avoid a recession, but it will be a very close call. So this is an article in the financial review January 3, this year, so we’re recording this on the 11th of January, everything must go right for Australia to dodge a recession. Okay. So she’s one of the people who is concerned that because of these higher interest rates, then yeah, it’s going to have a significant impact on consumption, then she’s saying that offsetting that is the fact that we’re getting all of these international students coming back into Australia. So that’s one thing that’s going to add to demand. Okay. I’ll put a link in the show notes to this article by that mentions, Jo masters, predictions. Okay. So that’s, that’s where to from here. Okay, we’ll take a short break here for a word from our sponsor.

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Gene Tunny  24:00

Now back to the show. One thing that is concerned some people is wondering, Well, is there a risk that we could get back to some of the crazily high interest rates that have been seen in past periods? So in Australia, for example, we had interest rates at 17 to 18%. At one time, back in the late 80s, early 90s, we had really high interest rates, but that was also at a point in time. When we had inflation of around 8% We had money supply growth of 20% plus. So we had a big boom in the late 80s. This was the age of the entrepreneurs a lot of lending a lot of property, lots of speculation, and I would say that it’s probably unlikely I can’t see interest rates getting back to anywhere near that sort of crazy heights. Given that the macro economic conditions are different today, there was much more entrenched inflation, people expected high inflation. I think if you look one year ahead, some market economists are expecting inflation of over 4% or something like that. But it’s not as if every year we’re expecting inflation of 8% or something like that. So monetary policy doesn’t have to be as restrictive to get inflation under control to to get all of the money creation, all the credit creation that’s leading to the growth in the money supply, it doesn’t need to be as aggressive to get that under control. So my expectation is that we don’t have to, we wouldn’t see that, again, just because inflation is not at those Well, it’s not entrenched at those rates. So we’ve got high inflation at the moment at 7%. If it turns out that the RBA can’t get inflation down, then they will have to increase, keep increasing the cash rate. But I would expect they wouldn’t have to increase it anywhere near some of those really high interest rates that they have in the past, because it seems like your households are already they’re going to start suffering even with the interest rate increases that we’ve seen. So if they increase the interest rates a bit more, say another half a percent, then the hope is that that will start you know slowing the economy taking the heat out of the economy enough that we can get inflation under control. So yeah, we won’t get back to those, those crazy interest rates that have been seen in the past, just because the nature of the economy is different. We haven’t had sustained inflation over such a long period as we had back then over several years. And then having that inflation, getting expected having these entrenched inflation expectations which the central banks have to then act aggressively against. I’ll put some links to some charts on on inflation and interest rates and what we’ve seen in the past, and just so people can see if you’re in the audience, you’re interested, you can have a look at what what these things have been in the past. They what strikes me is when I look at, well, interest rates, which is what we’re talking about today, you look at interest rates historically, and they’ve been all over the place. This is why when we’re talking about normalisation when we’re talking about normalisation to some, what do they call it some equilibrium rate of interest where we’ve got the economy balanced, we’ve got inflation at Target, we’ve got the economy going along smoothly. We don’t know there’s no one interest rate over history, that’s it’s not going to be the same interest rate, it’s going to depend on the macro economic circumstances at the time. There was an estimate that the Reserve Bank put out of what the equilibrium real interest rate is. And the central estimate they came up with, I think it averaged at 1%. Now, that’s a real interest rate. And then if we think about what would the nominal interest rate be, this is something I may not have defined yet, Arturo. But we’ve got to think about, one of the reasons you end up with a 17% or 18% interest rate is because inflation is expected to be about 8% or something, or whatever it is. So the interest rate at least has to compensate for the inflation that’s expected. And then you’ve got the real component of the interest rate, the so called real interest rate. And the inflation gets added to that to get the nominal interest rate. So when this is one of the tricky things with interest rates, it needs to be appreciated. There’s a there’s a nominal interest rate and all of these, these rates that we’ve been talking about the policy, the cash rate, the RBA cash rate, or the federal funds rate, that’s a nominal interest rate. That’s not the real interest rate that has been paid. Because one thing that inflation does, it erodes the real value of debts. So if you’re only earning, I mean, you’d be earning more than the cash rate, if you’ve invested if you’ve bought a you know, an asset of some kind of financial asset. But let’s just say you, the cash rates 3.1% at the moment, the inflation rate 7.1%. Now, you could argue or looking backwards, this is an ex post view of things. So after the fact, if you’re only earning 3.1% per year on your asset and inflation was 7.1% then you’ve gone backwards 4% hit right. Yeah. Now that’s an ex post calculation another way, well, what ends up happening is that the market is going to adjust these interest rates will adjust to incorporate expectations of future inflation. And so, therefore, the interest rate that you see at a point in time, should equal whatever people demand on the market determined real rate of interest, plus the expected rate of inflation, which I think is that’s the Fisher equation, I think, isn’t it? There’s a relationship between inflation and interest rates. That’s called the Fisher equation after Irving Fisher, that I’ll put it in the show notes. Yes. Okay. So that’s a that’s a bit of technical detail. I’ll put some links on all of that. Yeah. And what I find extraordinary is that just over recorded history, there are all these different types of interest rates that we’ve observed. And I always go back to this great passage from John Maynard Keynes, one of the great economists, obviously. And Keynes, in chapter 15 of the general theory, incentives to liquidity wrote that it might be more accurate, perhaps to say that the rate of interest is a highly conventional rather than a highly psychological phenomenon, for its actual value is largely governed by the prevailing view as to what its value is expected to be. Okay, I think that’s quite clever and observation. And, yeah, what he’s getting out there is that it ends up being conventional, in a way, it depends on what it’s expected to be. And I think that’s quite interesting, because for a long time, well, after the financial crisis, there was this expectation of low interest rates, and that was supported by the central bank’s pumping a lot of money into the economy. But now, I mean, who knows, I mean, the expectation could be of higher interest rates. So we’ll have to wait and see where things settle, and what expectations and being and what people, people think as an acceptable interest rate. Historically, we’ve seen interest rates and the ones I’m quoting, they’re going to be nominal interest rates of around three to 4%. On government bonds. And so this can be considered a risk free rate, this could be considered as similar to the the cash rate, although a bit higher due to the fact that there’s a yield curve that if you borrow for, for a longer period, you generally have to pay a higher interest rate. But if we look at what we see in the data, or what we’ve observed in history, these UK consoles, which are perpetual bonds, whereby the government, the UK government borrowed, say, I don’t know let’s say they borrow 100 pounds, and then you get this console, this note that says, The UK government will pay you three to 4% of that. So three pounds or four pounds every year, in perpetuity, on that, that console of 100 pounds. I don’t know if that was the  actual denomination, but this is just to explain it. So these were perpetual bonds that the government never repaid. It just paid an interest rate each year. And historically, that was three to 4%, depending on when they issued the console, and what they thought was necessary to attract the people to buy the console to lend money to the UK Government, it turns out I think was about seven or eight years ago, the UK actually bought back the final consoles that are on issue. So there were these consoles that were that have been on issue for decades or centuries, that were still owned by nothing to various investors in England in the UK that the HM Treasury bought back finally, so I’ll put a link in the show notes there. So if we look at the historical evidence, we see consoles, they were yielding three to 4%. And if we look at the history of what’s called bank rate in the UK, which is the last day, that overnight interest rate, the policy rate, that the Bank of England influences historically, it’s ranged from, if we look at, from when the Bank of England was set up, so in 1694, it was looks like it was 6% or so I’ll put a link in the show notes to the actual data, and then it dropped down to what’s that nearly 3%, around 3%. Then for a long period from 1720 to 1820 it was about it was 5%. And then it fluctuates a bit more, I’ve got a chart that I’ve pulled off macro bond that I think that’s a great chart, I’ll put a link in the show notes. And then in the 19th century, it fluctuates quite a bit. And at times, it gets up to 10%. This must be related to the UK trying to maintain the gold value of sterling. So this is related. I think this is related to the gold standard, and having to maintain that and adjusting bank rate to do that. But I think what’s fascinating about that is for a very long time, so for about 100 years, it had the interest rate it at 5%. And that’s their policy rate. Okay, so we’ve been talking about interest rates, and these are interest rates related to financial securities. And other bit of evidence that is, that is interesting is the evidence, or the data points that you’ll see in novels by Jane Austen or Balzac? So Jane Austen, obviously, right Pride and Prejudice, Sense and Sensibility, etc. Balzac wrote old man glorioso, his French writer, this is something Thomas Piketty pointed out in his book on capital in the 21st century that if you read these novels, you’ll see that it was generally understood that the rate of return on land was about four to 5%. That’s a rate of return on an investment that’s different from the interest rate. But it gives you an idea of what was people were expecting to earn from investments in assets, and there’s some risk associated with land, or owning anything. So it’s not going to be a risk free interest rate. But I think it gives you gives you some idea of what rates of return were so right rate of return on land, historically, 4 to 5%. And it was taken for granted, that land yields 5% is what picket is writing. So the value is equal to roughly 20 years of annual rent. So I think that’s, that’s a really interesting data point. So what we’re getting is that, but another thing to consider is that that’s probably in a time when, historically there wasn’t a lot of inflation. I mean, there was during war time. But generally, until we had this, we adopted fiat currency in the 20th century, inflation wasn’t usually a problem, although you could have episodes of inflation, if there was a crisis of some kind. But I think you could probably interpret that as those is real rates, real rates of return almost. What we could conclude is that, yeah, I mean, interest rates are normalising historically, we’ve seen a range of interest rates, rates of three to 4%, four, or 5%. For risk free rates. That’s something you might expect, where current interest rates and up, it’s difficult to say it’s going to depend on the state of the economy, or how the economy reacts to those rate rises. I mean, this is something we’ll we’ll keep tracking we’ll keep following this year, and provide some more commentary, some more analysis on the future. Arturo, anything else you think we should cover?

Arturo Espinoza Bocangel  38:33

I think you have to cover most of the important things. So that was a good conclusion for this episode of the books.

Gene Tunny  38:43

Okay. Very good. Okay. All right. Thanks so much for your time.

Arturo Espinoza Bocangel  38:47

Thank you for having me.

Gene Tunny  38:50

Okay, have you found that informative and enjoyable. In my view, the main takeaway is that monetary policy is still in what’s called a tightening cycle. Interest rates will have to increase some more because inflation is still too high. It’s hard to know when the tightening will stop. The US experience suggests tightening cycles last a bit under two years on average, according to an informative note from Chatham financial, which I’ll link to in the show notes. The US Fed started tightening in March last year, and the Reserve Bank of Australia started last May, suggesting we could still have many months to go. Of course, this tightening cycle doesn’t necessarily have to conform to the average. Much depends on how the economy responds. In Australia, we’re hopeful we won’t need many more interest rate increases to sufficiently slow demand and get inflation under control. Even though the cash rate hasn’t been pushed up to a very high level in historical terms, the rate increases that we’ve seen could still be effective because of the heavy load of household debt that people have incurred to buy high priced properties. How much will the economy slow down? Will it just be a slowdown a reduction in the GDP growth rate or a contraction in which GDP falls? And we have negative growth for a couple of quarters at least that is a recession. Recessions in both Australia and the US are definitely possible. Indeed, recessions often occur after central banks tighten monetary policy. The 2009, New York Fed paper noted 11 and 14 monetary tightening cycles since 1955, were followed by increases in unemployment. That is, it’s very difficult for central banks to bring about a so-called soft landing. That was me speaking rather than the Fed. I’d note that some economists are even speculating that because economies will slow down substantially, we’ll start seeing interest rate cuts toward the end of 2023. Honestly, I don’t know whether we’ll have soft landings or recessions, a lot depends on psychology, and just how entrenched expectations of high inflation have become, the more entrenched they are, the more interest rates have to keep on increasing. We need to wait and see just how effective the interest rate increases we’ve seen already have been and will be. Obviously, this is one of the big economic issues of the year. And I’ll continue to keep a close eye on it. And I’ll come back to you in a future episode this year. Thanks for listening. Alright, thanks for listening to this episode of Economics Explored. If you have any questions, comments or suggestions, please get in touch. I’d love to hear from you. You can send me an email via contact@economicsexplored.com Or a voicemail via SpeakPipe. You can find the link in the show notes. If you’ve enjoyed the show, I’d be grateful if you could tell anyone you think would be interested about it. Word of mouth is one of the main ways that people learn about the show. Finally, if your podcasting app lets you, then please write a review and leave a rating. Thanks for listening. I hope you can join me again next week.

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Global economic outlook + Aussie inflation & house prices – EP150

The message from the IMF July 2022 World Economic Outlook was that the outlook is “Gloomy and More Uncertain”. This week also saw the United States slide into a technical recession. Certainly there are big risks to the global outlook. It’s possible that central banks could tip many economies into recession as they hike interest rates to tame inflation. This episode considers the global economic outlook as well as the economic challenges facing Australia’s new federal government. It’s an abridged version of a conversation that show host Gene Tunny had with Decactivist host Randall Evans on his show. The conversation was recorded prior to the US GDP release, but Gene remarks on the data in his introduction to this episode.

You can listen to the episode via the embedded player below or via podcasting apps including Google Podcasts, Apple Podcasts, Spotify, and Stitcher.

Randall Evans’ Deactivist show:

https://www.youtube.com/c/Deactivist

IMF World Economic Outlook July 2022: Gloomy and More Uncertain:

https://www.imf.org/en/Publications/WEO/Issues/2022/07/26/world-economic-outlook-update-july-2022

US recession news from NPR:

https://www.npr.org/2022/07/28/1113649843/gdp-2q-economy-2022-recession-two-quarters

Transcript: Global economic outlook + Aussie inflation & house prices – EP150

Gene Tunny  00:01

Coming up on Economics Explored.

Randall Evans  00:04

I don’t know if you saw the lineup for Qantas, I think two days ago. But it was out the door all the way down the road for Qantas flights in Sydney, like all the way out there. Never seen it like that, it’s insane.

Gene Tunny  00:21

Welcome to the Economics Explored podcast, a frank and fearless exploration of important economic issues. I’m your host, Gene Tunny. I’m a professional Economist based in Brisbane, Australia, and I’m a former Australian Treasury official. This is episode 150 on the Economic Outlook. 

We are at a risky point in the global economy. It’s possible that Central banks could tip economies into recession as they hike interest rates to tame inflation. Indeed, I’ve just seen the news that the US has experienced the second quarter of negative economic growth. So, according to the traditional definition, the US economy is in a recession. I’ll have to cover this in more depth in a future episode. But for now, I’ll know that there will be a big debate about this, given the jobs growth has been really good in the States, something noted by US Treasury Secretary, Janet Yellen, she’s claimed the two quarters of negative growth rule for a recession can be misleading. And you need to look at a broader range of indicators, as the National Bureau of Economic Research does when it calls recessions. There’s a lot to explore here, so I’ll leave it to a future episode. 

Okay, I should note that this current episode is an abridged version of a conversation that I had with fellow Australian podcaster, Randall Evans, on his Deactivators show earlier this week, on Wednesday, 27th, July 2022. I’ll put a link to Randall’s YouTube channel in the show notes. So, you can check out the full unedited chat, and Randle’s other videos. 

You may notice I’m short of breath at some points in this episode. That’s because I’m still recovering from COVID. I picked it up at the Conference of Economists in Hobart, two weeks ago. It was an awesome conference, but it was also a super spreader event. Alas. 

In the show notes, you can find relevant links and details of how you can get in touch with any questions, comments or suggestions. Please get in touch and let me know your thoughts on this episode. I’d love to hear from you. 

Right on, for my conversation with Randall on the Economic Outlook. I hope you enjoy it.

Randall Evans  02:38

Hello, everyone and welcome to the show. We’re here with Gene Tunny. Gene, how’re you doing?

Gene Tunny  02:42

Good. Thanks, Randall. How are you?

Randall Evans  02:44

I’m pretty well. For people who don’t know you, why don’t you give us a little background about yourself and what you do?

Gene Tunny  02:52

Okay, I’m an Economist. I’ve got my own consultancy business, Adept Economics. So, I do project work for different clients, private businesses, nonprofits, some government agencies, councils. So, often business cases for different projects or analysis of different policies or programs. So, I’ve been doing that for the last 10 years or so. Before that, I was in the Federal Treasury. So, we’ve got a broad background in Economics.

Randall Evans  03:27

And you’ve also got your podcast as well with over 130 old episodes I think, so far.

Gene Tunny  03:33

Yeah. Economics Explored. Yeah, that’s going well. I’m really happy with how that’s going. I mean, we’ve covered you know, a wide variety of issues on that, including housing and inflation and the RBA and the current review of the RBA. So, yeah, that’s going really well.

Randall Evans  03:55

What’s the current review of the RBA? Is to get rid of it? 

Gene Tunny  04:02

Some people might want that. There are some libertarians out there who are pushing for the abolition of Central banks and the abolition of fiat currency. But no, they’re not going to do that. I mean, they probably won’t do anything too radical, they might make some changes to the board composition, they might make some changes to the language around what the Reserve Bank is supposed to do in terms of targeting inflation. But yeah, there won’t be any radical changes, I’m afraid. Particularly if you look at the people who are who are going to be doing the review. They’ve got an academic Economist. They’ve got a former government bureaucrat, Gordon Brewer, and then they’ve got a deputy head of the Central Bank of Canada. So, you’ve got fairly mainstream people there. So, I don’t think we’ll see big changes. Having said that though, I mean, the Reserve Bank certainly needs reviewing, because there’s been a lot of concern that their policy settings have been wrong at different times. Phil Lowe’s, arguably misled people last year, and there are a lot of people who are concerned about that. His forecast, which was widely reported that interest rates wouldn’t be increasing until 2024. And he was saying that late last year, and now, they’ve already gone up from 0.1; this is the official cash rate, the overnight cash rate, which is lower than what people pay for home mortgages. Now it’s at 1.35. It’ll go up to 1.85 tomorrow, sorry, not tomorrow, on Tuesday, next week.

Randall Evans  06:02

Is that just people wishful thinking that believed that it wouldn’t go up till 2024? I mean, we had mass quantitative easing and the inflation followed, and then the logical step was; interest rates are going to go up. So, who was saying we can hold off till 2024?

Gene Tunny  06:22

Well, I guess there was this view that the economy had changed. And, I mean, there was quantitative easing, not in Australia, but in other countries during and after the financial crisis. So, starting around, 09, 0-10. And there were people forecasting, oh, this is going to lead to runaway inflation at the time, and that didn’t really happen. But what we’re seeing in the last was over the pandemic period, is that we’ve had, you know, more quantitative easing, and we’ve had big budget deficits to try to stimulate the economy as well. And I think the combination of that has meant that, you know, inflation has really soared. So, they were lucky last time, it didn’t happen. Last time, they got away with it. I think perhaps they thought that they might be able to get away with it again. Yeah, they were wrong.

Randall Evans  07:32

Imagine my shock that they might have. So, I guess first off, one of my first questions would be, as you see, is it all doom and gloom for Australia, or are we In a place we have to be? Where do you see us going over the next 12 to 18 months?

Gene Tunny  07:55

Well, I think it’s doom and gloom for Australia. I mean, really, things have been pretty good when you think about it. I mean, we’ve recovered very strongly from the pandemic. And unemployment is now at three and a half percent, right? This is extraordinary. And now there’s talk about sign-on bonuses. I don’t know how legit this report is. But there was a report in Perth now, that McDonalds in WA is paying sign-on bonuses of $1,000 due to the shortage of people; how difficult it is to get people. And the mining sector is paying $10,000 sign-on bonuses just to get people, there’s a shortage. Partly, that’s related to the fact that we haven’t had; I mean, immigration starting to increase now. But we had a year or so when we weren’t letting anyone in the country. So, I guess we’ll start to see that impacting wages. That could end up leading to inflation itself. I mean, one of the things we want to avoid is what they call a wage price spiral, where inflation just keeps feeding on itself. And prices and wages just sort of, go up in this; once leads to so high wages lead to higher prices, higher prices lead to higher wages, because people need to be compensated for that and they push for it in their wage bargaining. So, yeah, that’s the sort of thing that people are concerned about.

Randall Evans  09:35

The unemployment rate, typically, when there’s high inflation will be low. And I think that’s on the Phillips curve, if I’m not mistaken. Can you just explain that for the for the layman viewing?

Gene Tunny  09:52

I probably should finish the previous question, first. I will get on to that, Randall. I just realized you asked me about if it’s gloomy; I don’t want to be too positive, because, there certainly are risks in Australia, I better clarify that. Because of the rising interest rates, and it looks like, people probably; many households possibly overextended themselves, borrowed too much. There was that fear of missing out. And so therefore, as interest rates increase, even though they’re not going to get up to the really crazy levels that they got up to, in the late 80s, when they were up around 17, 18%. I mean, that won’t happen. But I mean, still many households could get into trouble. We’ve seen consumer’s confidence really plummet, and it’s at you would associate with before, like just before a downturn or a recession. So, there are levels that are almost recessionary. I think one of the bank economists, may have been the ANZ, economist, who said that. So, there’s certainly concerns about that.

On this point about unemployment and inflation. Yes, I mean, the traditional view, and this is a view that we learned was not correct. It broke down in the 70s was that, there is this tradeoff between unemployment and inflation; one story you can tell is if you have low unemployment, that means that workers have more bargaining power. Labor is scarce and so, workers are able to negotiate better with their bosses, and that pushes up wages. So, that’s the theory. 

So far, at least in the official data we’ve had up till March, we haven’t really seen a wages breakout in Australia, that’s why there’s was all their talk about declining real wages. And I think that cost Scott Morrison at the last election. That was really a strong attacking point that the then opposition, now government were able to make against the then government that you’ve got inflation running at the time was 5.1%. Now 6.1% yearly, and wages are only grown at 2½%  So, you’ve got a real wage decline of over 2 ½%. So, that was a bit of a worry. 

The traditional story was that, if you had low unemployment, you’d get high inflation. Conversely, you could, if you wanted to reduce inflation, you had to have high unemployment, because that would give workers less bargaining power. Okay, so there’s this tradeoff between unemployment and inflation. And this was based on a study by a New Zealand economist, Bill Phillips, who was actually an engineer, but he was an economist as well. And he might have been at LSE, in London, at the time. But that whole thing sort of, broke down in the 70s because what we noticed is that there wasn’t this stable tradeoff between inflation and unemployment. What there was, was the possibility that you could have both high unemployment and high inflation, and indeed, you could have unemployment increasing and inflation increasing, you could have what’s called stagflation. 

So, there’s no real trade off in the long run between unemployment and inflation. You can have high unemployment and high inflation at the same time, if people come to expect inflation, if there are, what you call inflationary expectations if they increase. So, that’s one of the concerns that people have about the global economy at the moment. The IMF, World Economic Outlook came out overnight. So, it came out Tuesday, in the US, and it’s gloomy; it’s talking about a gloomy outlook, globally. And I think it’s suggesting  we have very high inflation globally. Was it 6 or 7? It was it was a high rate. I’ll have to just check it. But there’s a lot of talk globally about stagflation, where they will end up in stagflation. And then there’s acknowledgement by international agencies that we could end up in a situation with high unemployment and high inflation down the track. I mean, it’s not likely at the moment. I mean, we are having global growth slowdown, because we’ve had this shock from the war in Ukraine, which has increased the oil price and petrol prices. So, one of the reasons you can have a stagflation is if you have this shock to the economy, such as higher oil prices, which push up the costs of production. And that means that it’s less profitable for businesses to produce what they were doing. And so that could lead to reductions in economic activity, and at the same time as costs of production is increasing, that’s passed on to consumers and increases prices. So, that’s one of the great concerns now.

That’s certainly something that, you know, people are concerned about, and you couldn’t rule it out as a possibility. I’d like to be a bit more optimistic than that, though. But so much depends on what happens with this war in Ukraine, and whether we can resolve that; the oil prices are coming down, but they’re still higher than they were a few years ago. So, a lot is going to depend on what happens there. Also the pandemic, which is causing all sorts of problems with the supply chain, it’s very disruptive. Things just don’t work now, as they did before. I mean, you’d see you see all the delays with Qantas and the disruptions that are occurring.

Randall Evans  17:04

I don’t know if you saw the lineup for Qantas, I think two days ago. But it was out the door all the way down the road for Qantas flights in Sydney, like all the way out there. Never seen it like that, it’s insane. I did want to ask you, and perhaps you should explain the theory first because the question from cue, which disappeared off the chat, was whether the RBA will actually increase interest rates enough to slow down inflation. But first of all, what is that theory though? How does that work? And then, what do we expect the right to probably go to?

Gene Tunny  17:46

Okay. Let’s begin with the fact that inflation is a monetary phenomenon. So, this is a famous quote from Milton Friedman. So, inflation is always in everywhere, a monetary phenomenon. In that, it’s associated with an expansion of the supply of money or the stock of money. So, this is currency that we have, but it’s largely; it’s mostly deposits sitting in the bank accounts of households and businesses. Okay, so, there’s the view that although the understanding that we end up with inflation, because the amount of money is expanding, and it’s expanding faster than the capacity of the economy. So, what we have is too much money chasing too few goods. 

So, inflation is a monetary phenomenon. The Central bank, the Reserve Bank is responsible for the money supply. And so therefore, it’s the RBA that has responsibility for dealing with inflation through monetary policy. So, the way they do that is by manipulating the overnight cash rate, this is the standard way of doing it, the official cash rate. This is what they call the cash market, which is a market in which banks and other market participants will borrow money overnight. And banks need money so that they can settle their accounts with each other at the RBA. The RBA controls this overnight interest rate. And what it’s trying to do is it’s trying to influence all the interest rates in the economy that are have a longer term. And so, what happens is as the cash rate increases, though the cost of borrowing money overnight increases, and that has a knock on effect to the cost of borrowing money for 30 days and six months and 12 months, etc. 

What they’re trying to do there is a few things and the RBA talks about different channels by which monetary policy works. Now, let’s think about what those channels are; one of those channels is through the amount of credit that’s created in the economy. One of the reasons we’ve had the big expansion in the money supply in the last couple of years during the pandemic, it’s not just because of the quantitative easing that the bank has engaged in, it’s not just because of their own money printing in their purchases of bonds. It’s also because with the very low interest rates that the bank has said, that’s meant that more people have borrowed money, or the bigger mortgages. So, we’ve had this expansion of Housing Credit. And the new credit, so the net additions the Housing Credit, that is expanding the money supply, I mean, there’s additional money in the economy. 

Okay, so one thing that the bank needs to do through increasing interest rates is reducing the amount of borrowing for housing and new credit creation. So, that’s one thing they’re trying to do. The other way it works is possibly more direct, or more immediate. It’s the fact that I mean, when they increase the cash rate, and that flows through to variable interest rates, mortgage rates, and eventually to fixed rates, when they reset, people have fixed rates for a few years, and then they reset at higher interest rates. What that means is households have less money to spend, they’re paying more to the bank, the bank gets the money, but the bank may not necessarily lend it to someone who’s going to spend it then. So, you have this subtraction from demand that way. So, that’s another channel by which monetary policy works, what the what the bank, what the Reserve Bank, what all Central banks are trying to do is they’re trying to take some of the heat, well, they’re trying to take the heat out of the economy, they want to have the economy go on this Goldilocks path, not too hot, not too cold. So, make sense? 

So, with the interest rate increases, the idea is you can pull some money out of the economy; will have the money supply, expand at a slower rate, or even contract, so that you can get inflation under control. And because you’ve got less, people don’t have as much to spend, that puts less pressure on the economy; it’s not overheating, there’s not as much demand out there. There’s not as much money chasing the few goods that we talked about before; too much money chasing too few goods. So, that’s the general idea. There are multiple channels, we know that if you do increase interest rates, it does eventually slow the economy. The great challenge is knowing how far you have to do that. And it’s not always obvious in advance how much you have to do that. And the problem in the 80s, the late 80s, in the lead up to the recession, is that they discovered that they really did have to increase those interest rates a lot to be able to slow the economy.

Randall Evans  24:18

Yeah. I was going to ask you a question, but then I was reading a comment.

Gene Tunny  24:28

Was the comment okay?

Randall Evans  24:31

Yeah, it was just should Australia be concerned with China’s financial issues that seem to be compounding? And also, these crazy images coming out of China of the tanks rolling in front of the banks not lending money out. What are your thoughts on what’s going on in China, and will it will impact us? I know, that’s kind of off topic to inflation and the housing market, but can we have your initial thoughts?

Gene Tunny  24:59

Clearly, we need to worry about what happens with China given that it has become such an important part of the global economy. And yes, if the Chinese economy did crash; it is slowing. So, we know that it has been slowing down. And the IMF is concerned about the outlook. I mean, there are risks from you know, that the property market, and construction sector, we know about Evergrande. Look, , it could be a could be a real concern for us, because so much of the commodities boom that we experienced, starting around 2003; we had the first phase of that over about 2003 through to 2013. And then, late to late last decade, commodity prices started rising again, then there was a bit of a downturn before; I think coal prices came down even before the pandemic. But since, end of last year, I think this started picking up with the global recovery, the global recovery was stronger than we thought. And then this year, commodity prices have gone absolutely nuts because of what’s happened in Ukraine. So, I guess, China is important. At the moment, it’s hard to forecast what would happen if we did have a downturn in China, because they’re probably, given all the disruptions that have occurred in the world and the fact that they need our; the world needs our coal, and coal prices are crazily high because of that. We probably would be okay in terms of coal. Iron ore would suffer because China has been a major purchaser of that. So, yeah, I mean, it certainly would be a problem. I mean, it’s hard to know what’s going on with China. Just a very difficult place to understand, really?

Randall Evans  27:33

Yeah. I did remember my other question relates to housing as well, you were talking about interest rates in the economy at different times, because a lot of people on mortgages might be on a fixed term mortgage, and that might go for X number of years. So, that flow-in effect might not hit them, and might not actually reflect in the numbers, two years down the track. So, what do we expect for the housing market, even though interest rates just going to keep going up?

Gene Tunny  28:09

Well housing prices are already coming down. I don’t know if you’ve seen those statistics. But Christopher Joy, who’s one of the top financial commentators in Australia, he writes for the Australian Financial Review. I’ve actually done some work for him in the past. He’s incredibly a bright guy. He’s got a company called Coolibar Capital Investment. And they’ve got billions of dollars of money under management. So, they’re really paying attention to this stuff. Look, you just look at the losses in or the reductions in housing prices since the first interest rate increase in May. And this is suggesting that, look, this is already impacting how sales was. I don’t know the exact breakdown; I should have looked it up before I got on. But I mean, there are a lot of households that are on variable rates. We see in the data that house prices are falling. I guess that will be, because as the interest rates increase, people won’t be able to borrow as much as they could have previously. And so that means they don’t have as much or they can’t go to the auction with the same expectations as they did before. Or maybe they’re more cautious about borrowing. They’re more concerned they’re less willing to bid at an auction because they are worried about the future. We know that consumer confidence has dropped. So, I think the interest rate increases have started to have an impact. So, there are obviously enough people worried about it. And it’s also impacting prices because it’s reducing the ability of people to the amounts that they can borrow. So, what was seen as Sydney’s fall and 5%, Melbourne, 3%, Brisbane, around 1%. That since May, since the first rate hike, capital cities overall, that minus 2 ½%. So, look here we prices are going down.

Randall Evans  30:35

I was just saying you’re recovering from COVID and I forgot to thank you for coming on.

Gene Tunny  30:43

Thank you. I usually think I’m okay. I thought I was okay, before I started. And then as I keep talking; should be okay. So, what Chris was writing was, if you look at Sydney, it’s declining at an annual rate of 22%. So, house prices are falling, and it looks like they’re falling at an accelerating rate.

Randall Evans  31:10

That’s a huge number to be dropping at 22%.

Gene Tunny  31:15

That’s if you take the rate it’s dropping out at the moment and annualize it. So, it may not last over the year. Although, it’s possible that it could; house prices soared during that pandemic period, even though many forecasters were expecting they might fall, it actually, surged because there was all this additional borrowing. There’s the fear of missing out. And, the market went nuts. And so, they’ll probably land above where they were at the start of the pandemic, but a lot of the gains will have been lost; it’s looking like that now. Because those interest rate increases are having more of an impact than was expected.

Randall Evans  32:11

Yeah, I couldn’t believe how much housing prices rose during the pandemic, it was just so counter to what I thought was going to happen. But it did, and I guess we’re going to see that correction. Probably not an overcorrection, though maybe, like you said, probably just above pre pandemic levels.

Gene Tunny  32:35

Yeah. And that’s what we’re seeing. It’s it started for sure. The big unknown is just how vulnerable households are to interest rate increases and whether you will start; they will massively cut back on their spending and that could then lead to a downturn. At the moment, the labor markets going ridiculously strongly, we’ve got 3 ½% unemployment, 300,000 vacancies, I think I saw someone report the other day.

Randall Evans  33:11

The unemployment figure that includes people actively looking for work, right. Yes. So, I’m not sure if that’s a great signal to our strength, if there’s a lot of vacancies and a lot of people looking for work, or am I missing something?

Gene Tunny  33:33

But that’s showing that there’s hardly anyone looking for work compared with before the pandemic. And there’s lots of vacancies. So, this is why we would expect wages to start increasing or perhaps we hope that they will. I think they probably are. We’re certainly seeing well, the sign- on bonuses that have been reported, there’s a story about McDonald’s. Possibly, who knows whether that’s true or not, it’s hard to know whether McDonald’s would be paying $1,000 sign-on bonuses, but that was the Perth Now report. I believe it in the mining sector though.

Randall Evans  34:12

Yeah, I could fly to Perth for like 400 bucks, have a job for a week and I’ll pay for my holiday.

Gene Tunny  34:20

You probably have to serve at some time. I’m sure they’ve got something or their agreement to cover that. So, I think the unknown is just how the economy will react as interest rates increase and just how much people will cut back their spending and whether you know, we had a boom and then we’ll have a burst. One of the challenges is going to be; and this is a big issue for the new government. You will recall that the previous government cut the fuel excise in half, so it’s down at about 22 cents a liter now, and what’s going to happen is that that’s going to go up to, it has to be 44 cents because they cut it in half, at the end of September. People will notice that unless petrol prices come down a bit more, they’ll really notice that and that’s going to come at a bad time, because we know interest rates are still going to go up. They’ll go up half a percentage point next week.

Randall Evans  35:38

What are your thoughts on how the Albanese government is going to shake up the economy? I guess some of the things that are promising, like, I guess the government backing certain home loans by 40%, and things like that. Does anything about his election promises stand out to you that will have a big impact?

Gene Tunny  36:06

Not really. They wouldn’t implement policies that I would probably implement at the moment to try to get inflation under control, they wouldn’t do that, they wouldn’t go that far. There was a discussion that we had? Well, I think we have to massively reduce his budget deficit we’ve got now. So, Jim Chalmers, the Treasurer, he’s talking about the need for savings. One of the reasons they’ve got to find savings; they need to get the debt under control – the trillion-dollar debt, but also because the government at the moment is contributing to the inflation problem we’ve got by running these large budget deficits. Still large, what you call a structural budget deficit. so that they’re still running these large structural deficits of 3 to 4% of GDP, if you look at the budget documents. So, what that means is that if you adjust for the state of the economy, you take into account the fact that the economy has been doing very well. At this point in time, the government should be running much smaller deficits or surpluses than they actually are, and they’re not. They’re still running reasonably sizable deficits. So, there’s this structural deficit, and that’s contributing to inflation. They’re adding to the demand in the economy, they’re contributing to the overheating. So, what this federal government has to do is to really cut back on their spending. Or, one alternative, I don’t know whether they’ll do it or not, because they promised that they would follow the stage three tax cuts. I think in stage three. There’s another tax cut coming through, that’s going to knock out one of the marginal tax brackets, if I remember correctly. And so, there are some people on the left who are arguing that the government shouldn’t go through with those, those tax cuts that are programmed in.That’s one possible thing they could do. To address that structural deficit. I’d probably prefer that they cut their spending, because they’ve got some big spending programs that are really getting out of control. So, NDIS, it’s well intentioned; I think a lot of people support the principle of it. But it’s growing, it’s tens of billions of dollars, or 30 billion, or whatever it’s going to overtake Medicare, in terms of the amount of money that’s spent on it over the budget estimates, over the next four years. 

So, that’s something they’ve really got to get under control, but that’s going to be difficult for them. I think it’s a well-intentioned program. The challenge is, where do you limit it? That’s the problem. There’s the desire to keep expanding it and to make it to provide as high level of service as possible and I think yeah, that’s just financially unsustainable at the moment, we need to really fix that up. 

That’s what I think needs to happen. There needs to be the expenditure restraint, or you know, the larger cuts than anything Jim Chalmers would be contemplating. I’m former Treasury, the Treasury would have provided some list of the things that should be cut. And knowing how these things work, Treasury have this huge book full of potential savings that could occur. And the government will probably pick a handful of them, because they look at most of the things Treasury’s proposing and they go, how could you ever contemplate cutting all of these things? Politically naive, so that that’s what will happen, that’ll be the reality. 

Randall Evans  40:38

Well, one of my questions is that, I know the RBA is supposed to be a separate entity, but allowing the RBA to increase interest rates to such a level that’s going to hurt your voter base. It’s almost political suicide. And I know they don’t really have a say, but, there was that kind of situation where I think it was Roosevelt who grabbed one of the members of the Federal Reserve by the scruff of his neck and was like, you’re destroying my presidency. So, is there a situation where the Australian Government can effectively halt the interest rate rise for political reasons? Or do we have enough kind of checks and balances to stop that happening?

Gene Tunny  41:31

Okay, they actually could, there’s, they have the power to do that. I’m trying to remember this is a point that Nick Growing often makes, I’m trying to remember correctly, I think there’s a provision in the Reserve Bank Act that the treasurer can table something in Parliament and tell the RBA what to do, right. So, the Treasurer could direct the RBA. And I don’t know if you remember, back in the 80s, we had a treasurer of Paul Keating, the Labor treasurer at the time, and he gave a famous or probably infamous speech. It was in the lead up to his challenge to Hawk when he said, I am like the Placido Domingo of Australian politics. And I’ve got the Treasury in this pocket, I’ve got the RBA in the other pocket. That was a great speech; it was not a modest man, it was a very coveted man. But yeah, Keating thought he ran the RBA. So, back in the day, the government had a lot more control over the RBA. The problem then is that, you don’t want monetary policy set by the government. Because for that reason, because the government’s going to want to have it more well, looser, they probably want to have the economy more prosperous in time for their reelection. And they’re not thinking longer term about what the inflationary consequences of that are. 

So, what economists have learned from that problem, the problem that if you have a Central bank politically influenced and you can get you can get higher inflation is we need to have Central banks independent of the government. So, we need to give them some independence. And so, what our governments have done is that they’ve struck an agreement with the Reserve Bank, there’s an agreement on the conduct of monetary policy. That was first, I think it was first formalized by Peter Costello, and in the fall, and in the 90s, in 96. And what that did was that codified in an agreement, the inflation targeting goal that we have now. So, the Central bank, the Reserve Bank, is targeting inflation between 2 to 3%, on average, over the economic cycle, so it’s of which means that they don’t have to be zealous or they don’t have to solely target inflation, if they’re going to crash the economy, they could ease up a little bit on interest rate increases, but ultimately, their goal is to get inflation under control, get it 2 to 3%. That’s what they’re accountable for. So, they’re going to be doing everything they can without crashing the economy to get inflation under control. But look, who knows? We hope we’re not in a situation that the Americans or that we were in the late 80s or the Americans were in the sort of early 80s and Britain too when you really had to increase interest rates a lot to get inflation under control because you had double digit inflation. Now we’re not there yet, hopefully we’ve moved in time to prevent that from occurring. But if you get to a situation where you’ve got double digit inflation, then you might have to increase interest rates much more than the economy can bear and then you end up in a crash. 

I’d like to think that we haven’t left it too late. And we’ll need to resort to those measures. But, let’s wait and see. So, I guess the answer is that, the government could direct the RBA. But then, the bad press they would get over that would be incredible. You’d have all the financial journalists around the country, criticizing them over compromising the independence of the RBA, Jim Chalmers wouldn’t be able to finish a press conference.

Randall Evans  45:52

You’re acting like they answer the presses questions. I think Anthony Albanese is the fondest to just brush off questions. But I understand completely what you’re saying. And I wasn’t suggesting; just for my viewers that the government should do that. I was just putting the thought out there. As a former Treasurer, what do you think the current government values most when it comes to the economy? Because everything seems to be a trade-off, right? It’s either we can get inflation under wraps, or we can have high job growth or, we can have housing affordability, so what do you think that they’re actually going to? Because you can’t have all of them or maybe you can? What do you think their focus should be, moving forward?

Gene Tunny  46:49

Well, I think the focus should be on the overall health of the economy. So, it should be about making sure that we’ve got the right tax policy settings or we’re spending on the right things, we’re not wasting money. We’re not contributing to the inflationary situation. We’re not enacting silly policies. 

One thing I have been encouraged by is the fact that they’re not doing really silly things, or they’ve knocked back this idea from the greens that we should have a moratorium on coal and gas projects, right? At a time when the coal price has been; well, that’s what Adam Danza saw, right. And at a time when the global coal prices being up at 500, or 400 US a ton for thermal coal, that’s extraordinary. 500 a ton for metallurgical coal, for coking coal. The idea that you’d actually wouldn’t develop any new coal mines when the world is crying out for it, because there’s no gas. We’ve got a global conflict and Europe’s worried about their gas supplies and whether they’ll have enough gas in the winter. Yeah, it’s a bit crazy. Full credit to the prime minister for knocking that back. 

I think there’ll be broadly sensible, but what you’ll see with a labor government is that they’ll be more aligned to what they perceive as the workers. Okay, and they won’t care as much about the costs they impose on business. Okay. And so, you’ve seen that recently. The problem we’ve got is that there are a lot of well-intentioned policies and so it’s hard to argue against a lot of these things, but they are costly to business. This government will probably do more things like this, we saw that there was that recent decision about from about, what is it? Paid leave for if you suffered domestic violence, or family violence? I can see what why that would be a good thing to have, at the same time, there is already paid leave available, you get four weeks if you’re a full-time employee. And this is an additional cost to employers. And you’d have to be a pretty nasty employer if you didn’t look after an employee of yours who was in that situation. I wonder why this sort of move is necessary from the government. Maybe they think it’s not going to have much of a cost because your employers would probably do the right thing, to begin with. 

I guess it’s a signal that this government is probably going to be more focused on the workers, it’s going to be less concerned about the impacts of its policies on employers. One thing that worried a lot of people, a lot of economists and financial commentators, John Keogh wrote a great column on this in the Finn review was when Anthony Albanese in the lead up to the election, talked about how the Fair Work Commission should just agree to wages going up at the rate of inflation. And there was a concern that, well okay, that’s a good thing that just leads to that wage price spiral where, if prices go up, oh, let’s increase wages by the same amount. And then that increases the cost to employers, they pass it on in prices. And then oh, let’s have wages go up again, prices go up again. And they just sort of gradually creep up a little, not gradually, they can increase, they can go up very quickly. And organizations such as the Bank for International Settlements and various other economic agencies around the world have warned about this wage price spiral, and one of the quickest ways to get there is to have automatic indexation of wages to inflation. 

So, there were people concerned about what the PM said there back in the election campaign. Ultimately, it was up to the Fair Work Commission, the Fair Work Commission recommended an increase that wasn’t complete. It was just a bit; I think it was a bit lower than the inflation rate. For non-minimum wage workers is about 4.6% or something, if I remember correctly.

So, that would be my take on it. I think they won’t do anything too crazy. They’ve resisted that crazy proposal from the greens, so, good on them for that. Sorry, go ahead.

Randall Evans  52:15

I follow a few greeny pages on Facebook just to see what they’re yapping on about. And I did see a lot of angry people today about that very thing you’re talking about. Saying, you can’t be for sustainability, but then allow coal mines to open. 

Gene Tunny  52:42

Yeah, well, just on that. it’s a real threat to labor. So, it was the coalition that got smashed on the climate change issue, last election, they ended up losing some of the blue-ribbon seats. But labor’s similarly threatened, right. Labor got what was it? 31% primary vote. So, labor was lucky to, it’s just the way that it played out in terms of the seats that were that were lost. And it managed to be able to form government, even though it ended up getting fewer votes than the coalition. But yeah, it’s in trouble from the greens as well.

All of these inner city seats are turning green. So, I’d be interested to see what happens in the future, whether Labor has to; how it survives, it’s under threat, as well as the coalition. So, I think that’s one thing that’s going to be fascinating to watch in the next few years.

Just on housing, the government’s policy isn’t going to do much for affordability because it was only going to apply to 10,000 people or so. It was it was limited in the amount of people that would apply to and it has to apply to hundreds of thousands of people to really make any sort of impact. The reality is there’s not much the federal government can do because the states are more relevant when it comes to housing because well, one, they’ve got responsibility for social housing. Now, my view is they’re just never going to be able to build enough of that. One of the problems with social housing is that they’re aiming to offer it at below market rent. The challenge there is you’re going to have a huge demand for your social housing because you’re offering something that’s cheaper than what the market is able to provide right? So, you’re never going to win there. You’re always going to be attracting more people, than you’re going to be able to build houses for. 

So, that’s probably not the answer. I think the answer is having a more liberal approach to development, allowing more development, particularly in the inner cities where we have heritage restrictions. There are all sorts of zoning rules around our capital cities. And even across the whole metro area here in Brisbane, for example, where I am, there’s a ban on townhouses in low density neighborhoods. And that’s just really silly. Because, that’s constraining the supply of housing. And there was research by Peter Tulip, at the Reserve Bank when he was there at the Reserve Bank, that showed that these zoning restrictions, they’re massively increasing the cost of housing, like 50, or 60%, something like that. So, that’s up to councils, but state governments, they possibly could do something like that with some of their planning legislation. But the commonwealth really can’t do much about housing. So, even though it’s an issue, it’s a big issue. I’m not sure they really can do much about that. 

The big issues the Commonwealth is facing; there’s the general economic management issue, what its budget deficit is doing for the economy, what its budget deficit means for the accumulation of debt and risk to the credit rating in the future and our ability to service that debt. And so therefore, that’s why Jim Chalmers is having to trim the budget where he can. He’s going to find it difficult though, just because that reason we discussed. Labor sees itself as the party of the workers, it also sees itself as more socially caring, more compassionate than the conservative side of politics. And so, it’s going to be very hard for them to make the substantial budget savings that are necessary.

Randall Evans  57:15

Well, we’ll touch base with you again, in a couple of months’ time and see where we’re at as a nation. And if people want to watch, we’ve had Gene on before, so you can just search for it in the little YouTube bar and watch that episode too. But apart from that, make sure you check out his website. It’s on the screen right now. If you want to have some more in-depth conversations.

Bye Gene. Thanks for your time. Thanks for being here.

Gene Tunny  57:42

Pleasure. Thanks. Thanks, Randall and thanks to everyone listening. Yeah, glad to be to be connecting with you. So, it’s been great. Thank you. 

Okay, that’s the end of this episode of Economics Explored. I hope you enjoyed it. If so, please tell your family and friends and leave a comment or give us a rating on your podcast app. If you have any comments, questions, suggestions, you can feel free to send them to contact@economicsexplored.com And we’ll aim to address them in a future episode. Thanks for listening. Until next week, goodbye.

Credits

Thanks to Randall Evans for letting us borrow the audio from his latest Deactivist show for this episode. Also, thanks to the show’s sponsor, Gene’s consultancy business www.adepteconomics.com.auPlease consider signing up to receive our email updates and to access our e-book Top Ten Insights from Economics at www.economicsexplored.com. Also, please get in touch with any questions, comments and suggestions by emailing us at contact@economicsexplored.com or sending a voice message via https://www.speakpipe.com/economicsexplored. Economics Explored is available via Apple PodcastsGoogle Podcast, and other podcasting platforms.

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