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RBA Deputy Governor’s ‘Beware False Prophets’ talk: Reactions w/ Michael Knox – EP250

Show host Gene Tunny and Morgans Chief Economist Michael Knox explore the recent insights Reserve Bank of Australia Deputy Governor Andrew Hauser shared on monetary policy at the 2024 Economic Society of Australia (QLD) business lunch. They examine the RBA’s data-driven approach to interest rates,  the equilibrium real interest rate concept, and the impacts of Quantitative Tightening (QT). Michael is one of Australia’s leading market economists and RBA watchers, and he led the Q&A session with the Deputy Governor at the lunch. 

If you have any questions, comments, or suggestions, please email us at contact@economicsexplored.com  or send a voice message via https://www.speakpipe.com/economicsexplored. 

You can listen to the episode via the embedded player below or via podcasting apps including Apple Podcast and Spotify.

What’s covered in EP250

  • Introduction. (0:00)
  • RBA’s monetary policy decisions and the influence of high US debt on interest rates. (4:13)
  • The equilibrium real interest rate. (10:29)
  • Monetary policy, inflation, and interest rates. (14:16)
  • Central bank balance sheet unwind and its potential impact on interest rates. (21:42)
  • US budget deficits, bond yields, and quantitative tightening. (27:09)
  • Chinese RMB’s decline in international reserve currency status. (34:18)

Takeaways

  1. RBA’s Data-Driven Approach: The Reserve Bank of Australia relies on actual data more than forecasts when making interest rate decisions.
  2. Criticism of Overconfidence: RBA Deputy Governor Andrew Hauser criticised the unwarranted confidence with which some commentators argue for monetary policy moves.
  3. Implications of Quantitative Tightening (QT): The recent period of quantitative easing has complicated the relationship between government budget deficits and bond yields. However, there are concerns that as QT continues and deficits remain high, this relationship could reassert itself and lead to higher long-term interest rates than otherwise.

Links relevant to the conversation

RBA Deputy Governor Andrew Hauser’s Beware False Prophets speech:

https://www.rba.gov.au/speeches/2024/sp-dg-2024-08-12.html

Chris Joye’s article ‘Arrogant RBA boss should stop trying to muffle opponents’:

https://www.afr.com/policy/economy/arrogant-rba-boss-should-stop-trying-to-muffle-opponents-20240813-p5k25p

Kevin M Warsh: Financial market turmoil and the Federal Reserve – the plot thickens 

https://www.bis.org/review/r080415e.pdf

Transcript: RBA Deputy Governor’s ‘Beware False Prophets’ talk: Reactions w/ Michael Knox – EP250

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, 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 and welcome to the show. This episode features a conversation that I had with Morgan’s chief economist, Michael Knox, it was about a recent event that the Economic Society of Australia, Queensland branch held with the Reserve Bank of Australia. Deputy Governor, Andrew Houser, it was a business lunch on the 12th of August 2024 in Brisbane. And given that I’m the current president of the Queensland branch of the society. I had to welcome everyone and Michael, he introduced the deputy governor and led the Q and A Michael had that role because Morgan’s sponsored the lunch. In his address, the deputy governor spoke about the challenges of setting monetary policy when there’s so much uncertainty, he suggested that some Australian commentators are overconfident in their assessments of what the central bank ought to do. We’ve had some commentators say the reserve bank hasn’t lifted interest rates enough, and we now have some commentators saying the reserve bank should be cutting interest rates because the economic outlook is so bad. Michael and I start off this episode talking about the deputy Governor’s speech, before we move on to a couple of meaty questions that Michael asked the deputy governor. These questions were about the equilibrium real interest rate and the effect of so called quantitative tightening. I get Michael’s reactions to the answers that the deputy governor gave him I should note that both Michael and I were impressed by the Deputy governor’s remarks, but the deputy governor has received some severe criticism in response to them. One of the strongest bits of criticism has come from well known financial economist and fund manager Chris joy. He’s written in the Australian Financial Review the following the newly appointed English Deputy Governor of the Reserve Bank of Australia, Andrew Hauser, apparently has a proclivity for lecturing Aussies on the history of our penal colonies, arrogance, overconfidence, and the importance of Never daring to criticize our supercilious central bank. Okay, so it’s, it’s a speech that has that’s got everyone talking and I mean, as President of the Economic Society of Australia, Queensland on, I am, I’m happy that people are talking about it. People have taken notice of what the deputy governor has said. What do you think about what he said. I’ll be interested in in your thoughts on it. If you want to get in touch, please do so. My contact details are in the show notes. I’d love to hear from you about the deputy Governor’s speech or his responses to Michael’s questions, or any ideas you have on how I can improve the show. I’d love to hear from you. Okay, without further ado, let’s dive into the episode. I hope you enjoy it. Michael Knox, good to be catching up with you. Good to see you too. We had a great economic society of Australia Queensland Business lunch earlier this week with the RBA deputy governor, Andrew Hauser, and you did a great Q and A session with the deputy governor. So I thought what would be good is to just catch up on that, and you know your reactions to his responses, because at least one of them, I think, was not, probably not what you’re expecting, certainly wasn’t what I was expecting. So just interested in your your thoughts on that. But to start with, what did you think generally of the deputy governor’s talk about the wearing urging us to be what is it? Beware of false prophets?

Michael Knox  04:12

Well, when I got up, I asked I before I asked him the scheduled questions that he and I had talked about before the presentation, I said to him, so it’s really true that the RBA makes its decisions on monetary policy on an inter rated basis, one step at a time. At every meeting, they are looking at the data. They are looking at where employment is. They are looking at what the inflation data is saying, and they and they’re looking at all the other variables and then, and then they’re making the decision on the data a step at a time, yes, yeah. And he said, and he said, Yes. He said, does that mean? I. Don’t have to answer any of your other questions.

Gene Tunny  05:06

Yes, I think that was actually something that the Kook, Steven kookis reacted to on Twitter, like when he heard the speech, his initial like he I think he liked the speech, but his reaction to it was, look, the RBA is confirming that they’re only going to move on hard data. They’re not going to move on, you know, people in the business community saying things are tough and you should cut rates now. They’re not going to move on forecasts from market economists as to what’s going to happen. They’re going to be solely focused on hard data, at least that’s what he took out of it.

Michael Knox  05:37

Yeah. Well, I think that, though, what he talked to me about before, before we were when he went up, was the the influence, and not so much the influence. But I think the annoyance of people like Warren Hogan and other economists saying that the rate should, rate should go up, yeah, or another people saying that rates should go down, and they’re more having their own theory on it, yes. And whereas the he felt that they were looking pretty much at everything that they needed to look at and making the decision the right way. And I think the presentation was about how is about? Was about false positives. Yeah, yeah. People make decisions on a view of what the RBA does, which is their view of what the RBA is doing, but the RBA is actually operating in a different way. Yeah,

Gene Tunny  06:28

yeah. I think so too. I think that gave us a really great insight into how the RBA is thinking about the cash rate decision. I thought that was I thought it was really useful. Can I ask you about the questions that you asked the deputy governor. So the first one you asked about was regarding the equilibrium real federal funds rate. Wasn’t it you were asking, you’re talking about, well, Larry. Was it? Larry Summers had argued that because of the Highland Olivier Blanchard and Olivia Blanchard, right? So some pretty heavy hitters, right? Yeah, real heavy hitters. And you are. They’re arguing that the because of the high level of US debt, you mentioned, that sovereign, net sovereign debt for the United States is going to get to 100% of GDP, of their GDP. And what that means is that the equilibrium federal funds rate nominal is 4% which means, in real terms, it’s 2% have I got that? Right? That’s

Michael Knox  07:29

exactly right, right? That’s what they’ve said. And if you look at the Peterson Institute, they in fact, have five published research papers, not just from them, but for other people who’ve done for the Peterson Institute and and they done over time and their empirical research, and they actually come up with the number of each 1% increase in net G debt to GDP increases the the the equilibrium Fed funds rate by a little over four basis points. So you get Right exactly. You get 450 basis points. Is the equilibrium level of of the Fed funds rate at 100% of GDP, the now the now the net debt of 100% of GDP, that’s a forecast from the International Monetary Fund. So if you go on their their quarterly database, and you’ll see the updated forecast for that 100% of GDP. Very interestingly, Andrews come from the Bank of England, yes, and the UK has exactly the same debt problem that their debt, net debt, is now 100% of GDP. So all of that debt that they paid back from North Sea oil and Margaret Thatcher and all of that kind of thing, they blew it all again, and maybe Boris blew a good bit of it, by the look of it. And and so they’re now in as much debt as they’ve ever been. I

Gene Tunny  09:02

mean, it’s like with all the, you know, many advanced economy governments after the financial crisis, there was, we just took we had the view, oh yeah, we’ve got to spend money to deal with this crisis, and then we don’t really have to worry about debt anymore because interest rates are so low. Larry Summers had secular the secular stagnation hypothesis. I think that’s part of it. There’s some changed attitudes. I mean, I don’t agree with that, but that’s what would you should we go over what? How Andrew responded?

Michael Knox  09:34

Okay, Andrew, so the first question was, in your presentation of 27 June, you showed that historically, Australia has been an importer of capital. And I remark that two noted economists, Larry Summers and Olivier Blanchard of the Pearson Institute, have suggested that the high level of us net sovereign debt to GDP, which reaches a. 100% of GDP next year, according to the IMF estimates, will generate an equilibrium Fed funds rate. This is, according to Larry and Olivier, an equilibrium Fed funds rate of not less than 4% that is to say a real rate of around about 2% so does this mean that the equilibrium real short rate in Australia is likely to move to higher a higher level going forward?

Andrew Hauser 10:29

So I think the this concept of equilibrium real exchange rate [NB he means equilibrium real interest rate] is a bit like the supply capacity number in my speech. It’s a latent variable. You can’t go and look for it anywhere, right if you if someone we Bank of England joined the first week. He wrote, and he said, Can somebody tell me where the measure of the equilibrium interest rate is? And some whip rope out? He says, the same place as the NAIRU, you know, and the sustainable level of output. In other words, who knows? And so that’s an important point to start with. Nobody knows the answer to that. Larry Summers is quite good at saying he does know the answer, although sometimes, if you look back over its forecasting record, it’s not quite, doesn’t always follow quite the certainty of his, of his predictions when you so there’s huge uncertainty about what this number is. It is interest when he when he says real rate of 2% he’s been provocative, right? Because if you look at the fomc.so called dots, for example, at the estimate of FOMC members, that’s us monetary policy makers estimates for the long term real interest rate, they have a number like half a percent. It’s quite low the John Williams estimate. John Williams is head of the New York Fed, the US, who’s made a bit of a name at running various models on this is probably somewhere between nought point five and one. So the two is a higher number, and that’s your point, or his point that he thinks it’s going to be higher. There are enormous number of different drivers of this number, right? I mean, ultimately, our star as it were, sorry to use the phrase, our star equilibrium. Real rate is the outcome of equilibrium in the savings and investment market. And if you think about all the things that could drive that, those who think that number, including John and others, is relatively low, will put weight on things like, well, demographics. People get their countries are getting older, so they’re having to dissave Rather than save they’ll put weight on things like productivity. Whereas when, you know, in Australia and elsewhere, productivity rate, growth rates in most Western countries, not the US, actually, but most countries, have been quite low. And we’ll say, Well, look, actually, I don’t buy this number like 2% it’s a lot lower than that. There’ll be others like summers and others who say, Well, look, you know, there’s new shocks and new issues around I mean, I think in talking about the US debt, he must be talking about a risk premium, if that’s right, which is to say, look, there’s so much debt that the US and the 7% deficit of GDP is pretty impressive. Sometimes there’s some they’re issuing so much debt, at some point there’ll be a wobble. There may even be concerns about default risk premium will go up and that our number will go up as people start charging up to lend to the US. And you could think of other reasons too many people who will think that the energy transition, for example, is going to lead to higher investment demand, which will raise that number. You know, who knows? Is the honest answer, whether it’s 2% 1% or half. You asked a question about Australia, and because it’s actually difficult to take no view on this at all, we have a swathe for our own equilibrium, short rate, equilibrium rate, which is similar to that swathe of numbers that I showed you for unemployment. And actually that’s all that has a central point of something like three and a half, three and three quarters in nominal space. Obviously, our current cash rate is a little bit above that. So I think you pay your money and you take your choice. I wouldn’t want to be someone actually trying to invest on the basis of these numbers. Summers may be right, but it may be wildly wrong.

Michael Knox  13:58

Okay, so what I’ve said about that is, if you go to the Peterson Institute website, you’ll find five studies, different done at different periods, and the most recent one is actually that you get, it’s actually four and a half percent, 450 basis points, 100% of GDP. That’s where you concluded. But what the real test of this when Larry Summers was and actually, Larry Summers did this talk last year, yes. So I’d actually saved this question up for a year, because I’ve been, I’ve been I model bonds myself, and I use deficits and that kind of things in my bond models. But the position that Larry Summers was putting when he talked about this last year, was that when the Fed started cutting rates for 535 basis points, it would be difficult to sustainably cut it below 400 basis points. Yeah. Okay, and so when you got to 400 basis points or lower. Up or you got below 400 basis points, there would be some reaction, either in inflation or the US dollar, which might would make it difficult to continue to cut rates to where the Fed that currently projects they’ll get to, which is 250 basis points, sometime at the end of 25 or 26 Yeah, is where they think on the summary of economic projections, yeah, but they put out every quarter, so, yeah. So expectations of the Fed, of interest rates falling down to two and a half percent might crash into the reality of net debt as proposed by Larry Summers and leveling a Blanchard on the way down, we’re going to find out, yeah, that’s one of the part of the adventure of economics, yeah?

Gene Tunny  15:44

So this equilibrium nominal cash rate, or federal funds rate, so the overnight money market rate, yeah, this is the rate that they believe is, is essentially that it corresponds to neither a monetary policy stance that is neither expansionary nor contractionary. It’s a, it’s a neutral monetary policy, stand. It’s

Michael Knox  16:06

a neutral monetary policy, but it’s, it’s the basic problem here is that there’s the net debt to GDP goes up in the United States. Yeah, the real rate has to rise to attract the inflow of savings to finance that higher level of debt. So the real rate, nominal rate, plus your inflation target goes up, okay, as net the jet to GDP, right? That’s the that’s the problem.

Gene Tunny  16:33

And what did you think of his like the the RBA view? So their view of the neutral cash rate in Australia, in nominal terms, is, was he saying three and a half or three and three quarters percent? Does that sound

Michael Knox  16:46

well, where they’ve where, where it is thought to be. Okay. So when Michelle Bullock, when she herself, presented in the Hilton for us two years ago when she was also deputy governor. At that time, she then thought that the equilibrium real rate in Australia was 50 basis points. That’s what she said at the time. Now, the commentaries of the of the RBA that I’ve read and the surveys they’ve read, so that’s now increased to 75 basis points. So instead of an equilibrium short rate of inflation at two and a half percent plus 50 basis points, saying that 3% is where the equilibrium short rate is, now that’s risen to 325, basis points, or 350 right? So in the surveys they put out in part of their publication in the quarterly outlook for the summit of their not the summary of economic projections, but the statement on monetary policy in their detailed section they they look at, they do a forecast of the detailed cash rate, and they see the detail they in that detailed forecast they see in 26 December, 26 the real cash rate will get down to three and a quarter percent, but that means the inflation of two and a half percent plus 75 basis points for the real rate. They now therefore see that that real rate is 75 basis points. So

Gene Tunny  18:35

real rate 775 basis points and a target, the inflation, the target band of two and a half percent, so that gives us three and a quarter percent. That’s where they expect it to be at equilibrium, right? Gotcha. Okay,

Michael Knox  18:50

so Larry Summers are saying, but I mean, our debt to GDP is half or less, yeah, debt to GDP is half or less what it is in the US. So summers and Blanchard suggest that their equilibrium will be higher,

Gene Tunny  19:03

yeah. Okay, yep. Now that all makes sense. Okay, very good. We might go to the next question that the second question you asked, also an excellent question. So we’ll just, we’ll just play that and then we’ll catch up on that one.

Michael Knox  19:19

So the second question is Kevin Warsh. Kevin Warsh is a previous member of the Federal Reserve Board of Governors, and now he’s he did that job for five years, and now he’s a visiting distinguished fellow at the Hoover Institute at Stanford. In an article on in Wall Street Journal on the 28th of July, Kevin Warsh said that US inflation and interest rates would be rising if the Fed was not reducing the size of its balance sheet. And if it’s reducing the size of its balance sheet, it’s reducing the money base and. Or that’s what’s driving inflation down. So my question is, the RBA is currently running down its balance sheet, and it’s quantitative tightening, and you can see this in the RBA chart book. So is this one of the reasons that the RBA has not have had, has not been forced to increase interest rates.

Andrew Hauser 20:21

So could I give you a one word answer, which is, no, you might not like that quite as much as you like my previous answer. So let me sort of elaborate a bit on that. The reason why people ask this question is obviously when interest rates were at zero or the effective lower bound during the covid period and beforehand in the UK, central banks had to find other ways of expanding of easing policy. And as you know, they did it in the most part, by buying assets, and actually also by lending to banks at longer than normal maturities, both of which the RBA also did before I before I arrived here. But certainly the Bank of England did a great deal of this as well. And it was fairly commonly felt that that effectively added to the amount of monetary stimulus in the economy, that, if you like, the effective short term interest rate went negative to some extent, right? So the thought underpinning the Kevin argument, I guess, is that if it worked on the way in, why wouldn’t it work on the way out? The trouble with that is that, by and large, and people are looking at this very carefully, can’t really find any material macroeconomic effect of unwinding the balance sheet at all, maybe a few basis points here or there, but no major central bank that’s doing it really considers that To be any part of its monetary policy strategy. We’re all watching in case that view learning turns out to be wrong. But our central estimate is that it’s likely that QE unwind, or so called Qt quantitative tightening, actually a bad phrase, right? Because the T implies more of an impact of the kind you’re describing than is actually the case. But there’s the most the central estimate at the moment across countries is the multiplier of the kuti effect is very, very small. Now, I have a particular personal engagement in this, because the Bank of England was one of the very few central banks. In fact, I think the only one that ran down its balance sheet, not only by allowing assets to mature, but by actively selling them back to the market. The New Zealand, RBN said, has been selling assets back to its own debt management agency and the RICS bank. The Swedish central bank has been doing active sales more recently. But when we first announced we had to do this, a reason we felt we had to do this is that the average maturity of the debt stock in the UK is very long, and we faced the prospect of having to hold gilts, government bonds, UK gun bonds, more or less forever, unless we started actively selling. Whereas for most countries, including Australia, the average maturity of bonds is far shorter. You can just let them roll off. We felt we had to do those active sales. I still think we had to do them. But the market, financial market, through its hands up in horror and said, This is a nightmare. You’re going to bring the market, the world to an end. You’re going to drive interest rates up in exactly the way that Warsh is describing, that will cause mayhem in the financial markets. And they were very pleased to say that prediction was another overconfident prediction of mayhem that turned out to be completely wrong. There is very little evidence so far that balance sheet unwind has driven market interest rate rates up materially, though we must continue to watch. So no, it’s not one of the reasons why the RBA has not had to lift rates. There’s one other reason before I finish, which is actually the big unwind in the balance sheet of the RBA that’s happened over the past six or 12 months has not been primarily allowing bonds to unwind. But as you probably know, it’s the maturity of the so called TFF, the term Funding Facility, which is a lending facility to banks. Again, I think there was a considerable concern here. It was, largely before I arrived, that that unwind might cause difficulties. It’s a very sharp reduction in the stock of money in the in Australia. But it has gone by practically without a whimper. So so far so good. At some point, if you keep reducing your balance sheet, you the stock of reserves will hit the demand for reserves. And if you hit that at two sort of sharpen angle, you may find that financial, you know, these relatively calm financial conditions turn into considerable instability again, and a lot of central banks are watching for that moment, but it hasn’t come yet.

Michael Knox  24:28

Okay, so, Kevin Warsh, yes, yes. I think I’ve always loved Kevin Warsh as a character, but particularly when he’s on the Fed, yeah, and he gives a speech, which you can google. Kevin Warsh, fish don’t know they’re wet. And it’s one of the great speeches I’d given at the worst part of the financial crisis about the need for liquidity and the fish. He’s describing other people in the financial market who don’t know that they’ve been swimming in this sea of liquidity until it’s. All gone, and then they they’re all flapping on the flapping on the beach in totally unable to cope with the situation. So I think that’s something you should read. Kevin Warsh fish don’t know they’re wet on the which is a speech of his when he was part of the Fed. So I think the problem, I think the problem that Andrew Hauser is talking about, when you examine this hypothesis now it’s difficult to measure it empirically. Yeah, and I think that’s true, but it doesn’t mean the fact that you can’t measure it empirically doesn’t mean that Kevin wash is wrong. I think Kevin Warsh is right, but talking about the problem of measurement, I’ve been running bond models for Australian bonds and US bonds for a couple of decades now, okay? And I know in that there’s a really big response to increases in decreases in deficit. Yeah, I remember back in the 90s at an Australian economist conference, which was in Tasmania. And at that time, bond yields, the Australian 10 year bond yield, was 9% yield was 9% Yeah. And I showed a model of based on forecasts of where the US budget deficit was going to go, because at that time what was under Clinton, yeah, and Gingrich, the US budget deficit was going back to balance. Yeah, it was extraordinary. And what I said is that that would reduce the budget reduction of budget deficit would drive bond yields down to 5% and I remember at this conference, doing this speech and being met with absolute disbelief that Australian 10 year bond yields, and us 10 year bond yields could ever fall again to 5% I mean, there was, it would be both miraculous and absurd if that, if that occurred. But it is, in fact, exactly what happened when the US balances budget deficit so but what’s happened is, but during the recent period, if you’ve got, if you’re running big budget deficits, at whiz we have in the last couple of couple of years, and at the same time, you’ve got quantitative easing, yeah, it’s what’s actually driving the market. Is not the theoretical level of the deficit, it’s the actual flow of funds, yeah, into the bond market, correct out of the bond market, yeah. And if you’re the Treasury, US Treasury, or the Australian treasury, is issuing a lot of debt, but at exactly the same time they’re being bought by the Central Bank, they’re having no effect upon the upon the bond yields, yeah, some interest rates, yeah. So it’s what happens is that that whites out this effect, which in previous periods you can see very strongly in the relationship between budget deficits and and bond yields. In this period because of quantitative easing and tightening, it’s wided out because you’ve got this influences of what the Reserve Bank is doing in each country, the reverse of what the Treasury is doing and but, but I confidently would suggest that as we go forward and we find that you’ve got big budget deficits, and the Fed is winding down smell and shoot the same time, bigger supply of bonds coming forward to the market in the next couple, one or two or three years time, that will begin to have significant effects upon bond yields. So what we saw two years ago was the lowest level of US Treasury bond yields since Alexander Hamilton invented the US Treasury bond in July 1799 and I believe he had it passed by two votes, maybe one, but I think it was a very small majority for passing the US Treasury bond back in July 1799 I’ve stood on the same floor of the old Congress building in in Philadelphia, where the bill was passed, you know. And I thought at the moment, you know, but as we go forward and we’re trying to the US is trying to finance these big deficits and yeah, and unwind the balance sheet at the same time, I think we will see that those low bond yields two years ago won’t probably be repeated for another 200 years.

Gene Tunny  29:46

Okay, so the Federal Reserve’s going to start or everyone expects them to cut. So we’ll see cuts in the federal funds rate, and so therefore longer term yields should theoretically go down as well. But. You’re saying that if you’ve got this quantitative tightening happening as well, they wouldn’t go down as much as otherwise. Is that? Is that how you’re thinking about it?

Michael Knox  30:07

Well, in the bond models, the bond models are a composition of different variables, yeah, things like budget deficits, things like inflation, short rates, are there. Yeah, capital inflow is really important, also in the early part of this century. So there’s a whole bunch of things in those bond models, but Well, firstly, what you would find is, if Olivier Blanchard and Larry sums are right, the Fed funds rate can’t go down as far as was previously thought. It doesn’t get to two and a half percent. It just gets to 4% or three and a half or something like that. And then they run into a wall for some reason. And that provides a floor in the model that will fly the floor to the to the US Treasury bond yield. And in addition that, what’s if we look at the IMF forecasts for the US budget deficit going forward to the end of this decade, you’ve got average deficits between six and 7% of GDP. Yeah, they have, and they’re really there because of the size of the debt and the amount that has to be refined, yeah, every year. And so you’ve got those two things so that’s supporting in my bond models, that itself is supporting the higher yield for us, treasuries and the and it’s working back in the Larry Summers thing, giving you a higher Fed funds rate. So both of those things will push up the equilibrium yield for the US 10 year bond over the next 10 years. So I think that, in short, the best way of looking at it is we had a bull market in bonds from 19, from when Paul Volcker was around in 8132 until about 2020, and that was a great bull market in bonds. But if you look at what happened during the 60s and the 70s, that was a bull market in bonds was followed by a bear market in bonds of about 15 years. Yeah. So I think the US Treasury bonds and our bonds are going to be in a bear market for about 15 years. And I think that’s the problem that is visitors upon us by the belief that you can spend money on whatever you like, particularly during the Biden Harris period or Biden Harris administration, and run big deficits forever, and it’s never going to cost you anything. And I think that’s wrong, and I think Larry Summers and Olivier Blanchard are right,

Gene Tunny  32:42

yeah. I agree with you about what the Biden, Biden Harris, or the Biden administration has done with inflation Reduction Act, I think that looks excessive. But I mean, if Trump gets in, he’s going to have a big tax cut, isn’t he, so that’s going to have a similar impact on the deficit, isn’t it? I mean, it’s going to potentially blow out the budget deficit, yeah,

Michael Knox  33:00

but empirically, if you actually look at the Trump period, yeah, Trump cut tax corporate taxes during that period. Yes, he put up import taxes on on China. And there was one other thing that he did, but if you remember it, I’ll, I’ll talk about that as well. And these are the things that are supposed to be inflation. But in fact, the average rate of inflation in during the Trump period was 1.9% which was one of the lowest rates of inflation of any presidential period since 1953 on the other hand, Biden and Harris didn’t do any of those things, but they had, I think it was four really big spending programs for which the inflation Reduction Act is the tiniest of those. I think there were four other ones, the American rescue plan, and all over a trillion dollars for each of the each of the those bills. Yeah, and it’s that combination of big budget deficits. It’s not just the big budget deficits, which is not was, wasn’t just short term relief spending. They built out major programs which are going out to the end of the decade. You know, they increased education spending on the on the premise that over the next 12 years there’ll be bigger school rooms and lower bigger school rooms, and therefore lower teacher student ratios in in public schools. And the reason, of course, for that was that if you had graduate dispersion of people in the in the classroom, you’d have lower, lower passage of covid, you see, because Okay, gotcha, and everything had to be Okay, gotcha. So there’s always. Endless spending, and in the inflation Reduction Act, as I’ve noted, the subsidies for making electric cars are only provided to work sites or companies that employ workers that are part of the United order Workers Union, yeah, and the International Brotherhood of electricians too, by the way, interestingly enough, both of these are significant donors to the Democratic Party. And interestingly, the and this is the subsidies for making electric cars. And interestingly, Elon Musk, who in Tesla, is the biggest single manufacturer of electric cars, receives none of these subsidies because he doesn’t employ workers who are part of the United order Workers Union or the International Brotherhood of electricians, and so his employees are not necessarily donors for the Democratic Party, so He doesn’t get a subsidy. So I think there’s that kind of thing built into a lot of these Biden Harris spending bills,

Gene Tunny  36:07

right? Michael Knox, it’s been a pleasure. I’ve really enjoyed your reactions, reflections on the the excellent Q and A session you had with Reserve Bank of Australia deputy governor, Andrew Hauser, anything before we wrap up? Anything else?

Michael Knox  36:23

You didn’t ask me the question about the run on the Chinese RMB,

Gene Tunny  36:28

oh, if we’ve got time for it, tell us what’s happening with the run on the Chinese RMB, please.

Michael Knox  36:33

Well, it’s very interesting that the RMB is, it is China’s announced plan to make it a dominant reserve currency, yeah, in the international monetary system. And it does appear that from by 2020 there was $230 billion worth of bonds held in the international monetary system, RMB bonds, and that was rocketing up. And by the end of 2024 that had got to about $340 billion worth of bonds. And in comparison, at that time, the level of bonds held in Australian dollars was about 215 billion, and the level held in Canadian dollars was about two 70 billion. And that so it rocketed well past the international reserves held in Canadian dollars and Australian dollars, which, by the way, are at that we are at the minnow end of international reserve currency. Yes, yes, but it’s a great thing that the RBA is an international reserve currency and but since that time, what’s actually happened is that the level of international reserves held in RMBs, in fact, crashing. There’s been a run on the RMB and it’s now fallen from about $340 billion at the end of 24 to about 200 less than $240 billion at the end of so the peak was at the fourth quarter of 21 Yeah. And now, at the in the first quarter of 24 it’s fallen from three and $40 billion to $240 billion and is now less than the amount of international reserves held in the Australian dollar. So the question is, why is that run happening? Yeah. And that was my one of my questions. And I said, Is it, is it just because of the trust that people put in the Reserve Bank of Australia that they prefer to hold Reserve Bank of Australia bonds rather or Australian bonds rather than Chinese bonds? And why do why do they trust the RBA so much? Yeah, my unanswered question. But having looked at it, it’s really nothing to do with any of that. It’s really just the fact that at the end of 21 international bond yields, US bond yields, Australian bond yields and Canadian bond yields, with a very, very low yield, the lowest yield for decades, if not, if not centuries. Yeah. And since then, those yields have been going up, whereas the yield on RMB bonds peak. Back then, there’s now, we now bonds are paying 4% RMB bonds are paying a little over 2% so that’s right, and that’s the reason the demand for RMB is forward. It’s just the market, just the market, and the fact that they’ve got a managed exchange rate rather than a floating exchange rate, yeah, so has an effect, but we might talk about that again another time. I think we’ll have

Gene Tunny  39:33

to, I think, yeah, we’ll have to come back to it. But you figured it out. You didn’t need Andrew Hauser to know to answer it in the

Michael Knox  39:40

just wondered what he thought about it. Yeah,

Gene Tunny  39:44

okay. Michael Knox, Chief Economist at Morgans, it’s been a pleasure. We’d better wrap up there. Thanks again. Thank you. You.

Credits

Thanks to the show’s sponsor, Gene’s consultancy business, www.adepteconomics.com.au. Full transcripts are available a few days after the episode is first published at www.economicsexplored.com. Economics Explored is available via Apple Podcasts and other podcasting platforms.

Categories
Podcast episode

Alternative Investments & Investable Mega-Trends w/ Ben Fraser, Aspen Funds – EP231

Ben Fraser, Managing Director of Aspen Funds, argues “there’s a huge opportunity to get into fossil fuel production.” He discusses macro-driven alternative investments, investable megatrends, including the disruption to energy markets as advanced economies decarbonise, and the outlook for the US economy, particularly inflation. Disclaimer: this episode presents general information only and is not financial or investment advice. 

Please get in touch with us with any questions, comments and suggestions by emailing us at contact@economicsexplored.com or sending a voice message via https://www.speakpipe.com/economicsexplored. 

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

About this episode’s guest: Ben Fraser 

Ben Fraser is the Chief Investment Officer at Aspen Funds, where he combines his analytical nature with a passion for delivering outstanding client service and strong returns through out-of-the-box investments. With a professional background that spans over a decade, Ben has become an expert in the field of investment management and has worked for several reputable financial institutions.

Ben is the co-host of the Invest Like a Billionaire podcast, where he joins his father, Robert, co-founder and CFO of Aspen Funds, along with co-founder Jim Maffuccio, to discuss economic trends and best practices for alternative investing.

Prior to joining Aspen, Ben served as a Commercial Lender at First Business Bank, one of the top SBA lenders in the nation. There, he specialized in government-backed loan originations, specifically SBA and USDA loans. Before that, he worked as a Commercial Credit Underwriter for Crossfirst Bank, where he personally underwrote over $125MM in C&I and CRE loans across various industries.

Ben also has experience working in the asset management industry, having served as a key member of the team at Tortoise Capital Advisors. At Tortoise, he helped grow institutional managed accounts from ~$3BN AUM to ~$7BN AUM.

Ben holds an MBA from Azusa Pacific University and a Bachelor of Science in Finance from the University of Kansas, where he graduated magna cum laude. Ben’s commitment to excellence and his ability to deliver strong returns for clients make him an invaluable asset to the Aspen Funds team.

What’s covered in EP231

  • 00:00:04 – Global Energy from Fossil Fuels (excerpt from interview)
  • 00:00:33 – Introduction to Economics Explored Podcast
  • 00:01:06 – Guest Introduction: Ben Fraser of Aspen Funds
  • 00:02:08 – Aspen Funds’ Investment Focus
  • 00:05:17 – Accredited Investors and Investment Opportunities
  • 00:06:04 – Expanding Accredited Investor Definitions
  • 00:08:47 – Alternative Investments and Client Strategy
  • 00:11:29 – Investable Megatrends for the Next Decade
  • 00:13:03 – Inflation and Energy Market Outlook
  • 00:15:37 – Private Credit in Real Estate
  • 00:20:37 – Commercial Real Estate Market Dynamics
  • 00:23:42 – Energy Investments and Fossil Fuel Outlook
  • 00:29:10 – OPEC’s Influence on Oil Prices
  • 00:31:28 – Gold, Bitcoin, and Investment Hedges
  • 00:35:09 – US Fiscal Policy and Debt Concerns
  • 00:38:40 – Closing Remarks

Takeaways

  1. Macro-Driven Alternative Investments: Aspen Funds focuses on macro-driven alternative investments, which involve understanding long-term economic trends to identify investment opportunities.
  2. Investable Megatrends: Aspen Funds has identified investable megatrends for the next decade, including higher inflation for longer and an energy crisis due to a transition to green energy.
  3. Opportunities in Real Estate: Aspen Funds sees opportunities in private credit within the real estate market, particularly in the midsection of the capital stack, where risk can be reduced while achieving good returns.
  4. Energy Market Insights: Ben Fraser discusses the impact of transitioning to green energy on fossil fuel production, highlighting potential supply shortages and investment opportunities in fossil fuel production.
  5. Views on Gold and Bitcoin: Ben Fraser comments on gold and Bitcoin as alternative investments, acknowledging their role as hedges against fiat currency but cautioning against heavy allocations due to the risks involved.

Links relevant to the conversation

Aspen Funds

Invest Like a Billionaire Podcast 

Transcript: Alternative Investments & Investable Mega-Trends w/ Ben Fraser, Aspen Funds – EP231

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.

Ben Fraser  00:04

Right now about I think it’s 83% of all of our global energy needs come from fossil fuels. And that’s usually pretty shocking number for people to hear. They think we’re way farther along. Right. You mentioned nucular, which I’m a huge proponent of, but that only makes up I think it’s less than 5% of total global energy needs.

Gene Tunny  00:33

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 in to the show. This episode, we’re joined by Ben Fraser, Managing Director and Chief Investment Officer of aspen funds, which offers alternative investment opportunities for accredited investors that concentrates on real estate credit and energy markets. In this episode, Ben explains what he means by macro driven alternative investments. Ben and I discuss what he sees as investable mega trends. And we also talk about the outlook for interest rates in the US economy. Among other things, venture is some great insights into what’s coming up in energy markets as advanced economies decarbonize right, oh, we’d better get into it. I hope you enjoy my conversation with Ben Fraser of aspen funds. Then Fraser from Aspen fans, welcome to the programme.

Ben Fraser  01:50

Hey, thanks for having me, Jean.

Gene Tunny  01:52

Oh, it’s good to have you on Ben. And I’ve been listening to episodes of your invest like a billionaire podcast that you do with your father. So good work on that. And I’ve got a couple of questions coming from that, to start with grass. Q, what’s the what’s the pitch of aspen fans? Like, based on what I’ve seen, you’re focused on macro driven alternative investments. What do you mean by that, then?

Ben Fraser  02:21

Yeah, well, great question. And, you know, it really kind of ties in both to our podcast platform as well as what we do on the investment side. But the podcast invests like a billionaire is really intended to educate, you know, what I call the everyday millionaire strategies and tactics that the ultra wealthy are using, and have been using for many, many decades in growing and preserving their wealth. And usually, the biggest difference for what we find from the ultra wealthy calm institutional investors, family offices, the endowments, and pensions, relative to say the retail or the everyday millionaire, is the allocation to alternative investments, and specifically private alternatives. And that usually is comprised of the private equity, hedge funds and real estate really being one of the bigger ones. And so what we’ve found is there’s a huge gap of knowledge for the retail investors in understanding how to invest these asset classes. That’s really kind of what we we focus on. But then comes the question of, well, where do I invest, because there’s a myriad of opportunities to invest in kind of the alternative space. So then we use our framework that we tagged, you know, macro driven alternative investments, and really comes from the experience a lot from my father’s background, which we could talk a little bit about this, this driven kind of focus here of our economic themes. But really, the whole idea behind the tides are different than the waves, right? We can understand that there’s economic tides that are you know, seismic level shifts that happen usually over a slow period of time like these, these tectonic plates that are shifting, right. And we don’t really necessarily does nothing big are kind of boring, you kind of see it happening. But those create the the tailwinds the rising tide that lifts all boats that position you if you’re as an investor in pay attention to these, and a way to outperform because of where you’re positioned. And so what we usually kind of use that phrase for macro driven is we’re looking at it top down approach, we’re looking at what are the long term economic trends that are creating opportunities that then we can take advantage of as investors and outperform over a period of time from a allocation perspective, not just a individual investment perspective? Rod

Gene Tunny  04:58

Okay. So, your, your clients, the people who invest with you, you’re focused on accredited investors, is that right? So that’s a segment of the market where people have a particular level of income or level of net worth, is that correct? Right?

Ben Fraser  05:16

Yeah. So you’re in the US, we have a definition called accredited investors. And that’s basically driven by the SEC that says, you have to meet some minimum requirements to be able to invest in a lot of these types of deals. And so it’s really kind of driven from the regulation side of it, though, we do try to educate people that aren’t quite there, you know, the not quite yet accredited, because there are opportunities, and we actually believe the expansion of that definition will continue to go downstream. Because some of the changes they’ve made to the rules for accreditation have actually been expansionary to include more people over the past decade. And so we’re hopeful that they continue to make it more accessible for people. Yeah,

Gene Tunny  06:04

yeah, I’m interested in that, because I’ve been listening to Tony Robbins, his latest book, The Holy Grail of investing. And I mean, he has a case talking about the value of alternative investments. And he’s saying that a lot of people are locked out of them. Because of they don’t meet this accredited investor threshold. And I think he mentioned that there is or there was an act of Congress last year that is requiring the SEC to now bring in a test whereby you can establish your credentials as an accredited investor, if you pass the test to do you know where that’s up to you? Is that something you’re following, then? Absolutely, yeah,

Ben Fraser  06:46

that’s, that’s a pretty big deal. That’s kind of what I was referring to is, you know, from, from our standpoint, having a certain number financially, whether the income you make or the net worth you have is is an okay proxy to establish? Are you sophisticated enough to invest in something as gentle if you have to make a good amount of money and you have a lot of money? You know, theoretically, you’re, you’re, you’re smart enough to make these decisions. But what about the people that have studied this as a career and they’re maybe earlier in their career, and they want to make inroads into the alternative space, they’re trying to expand it based on knowledge, not just purely based on financial status. And so I don’t know the exact status of over that sat, it seems to me from what I’ve read recently, that that is either in play currently or about to be in play as an option. So it still requires a test, right. And there’s, you know, something you have to pass, I don’t think it’s terribly difficult, but it is an extra layer. But by doing that, you can, theoretically become accredited just through passing a test. Now, they’ve also included, they did this couple of years back where they, if you worked for a provider of alternative investments and operator or sponsor, after one year anniversary, you become what’s called a knowledgeable employee, to where you now have access to invest as an accredited investor into these types of investments that are being offered by your firm. And so, you know, I’ve told young people and love people that work for me, you know, I’m encouraging them to hit that one year mark, as to, hey, you’re now credited. So, you know, we’re going to try and wait minimums, or we can and make it easier for you to participate in a way that it’s comfortable for you at this point. But yeah, there’s definitely a cool trend for that. And we’re hoping that it continues, because there’s definitely some pretty big advantages when investing in alternatives. Right

Gene Tunny  08:47

now, I mean, the alternative investments so they can bring higher returns, obviously, there’s higher risk associated with that. Well, how does it work? I mean, if I come to you, so say, I’m a high net worth individual and I come to you and invest the funds, I come to Aspen funds, do we sit down? Or do you work out a portfolio? Do you say, you work out there’s this allocation, alternative investments is this much in domestic equities, this much international this much fixed income? How does that work? Ben?

Ben Fraser  09:18

Yeah, you know, it’s probably a little bit different than what you’re describing sounds more like meeting with a financial advisor. And, you know, to be clear, we’re not financial advisors. We don’t ever anticipate being that and I think there’s a role for a financial adviser, though, I do think a lot of the big shops they just kind of create echo chambers that don’t really know what they’re talking about and they just spout here’s the three things you should do. And honestly, isn’t that helpful, but we actually work with a lot of investment advisors that understand the importance of alternatives in a portfolio and actually are pretty big feeder system for us to help their clients allocate to what we’re working on. But you know, Working with us, it’s it’s a little bit different in the sense of, we have a few different opportunities, right, and we try to present here’s the characteristics of both the risk and the reward of each set of opportunities. Here’s the reason why we like you, I believe it. But ultimately, it’s up to you to decide what fits your investment profile, what fits the status of where you’re at, in your career, and your areas, spectrum and all those kinds of things, then, you know, we can help provide information, but we actually legally cannot give advice because we’re not advisors. So it’s really more of a here’s, here’s all the options, you get to pick and choose what what works best for you. And I always recommend, right finding an advisor that likes alternatives can be actually a great resource because they can help you not only on the portfolio allocation standpoint, a lot of times they can help you on the tax implications, and the basic financial planning of say, a budget and those kind of things. Estate planning, asset protection, a lot of broader topics that are important, but way outside the scope of what I’m an expert in, right.

Gene Tunny  11:06

Okay, gotcha. On your website on the Aspen funds website, which I’ll link to, in the show notes, or might have been on your podcast website, you’ve got the there’s a webinar about investable mega trends for the next decade. Could you tell us so what are some of those mega trends that you’re looking out for?

Ben Fraser  11:29

Yeah, so it kind of stems back from our approach of finding the best opportunities. And, you know, what’s, what’s different about us and maybe other operators, or sponsors of investment offerings is we’re not a hammer and everything is a nail, right? Well we try to do is identify where are the opportunities first, right, without any dog in the fight without us forcing a square peg into a round hole. And then we’ll actually create the strategies, build the teams, and put together these kind of investor friendly structures. And in terms to put together an offer that fits is supported by by these trends. So for us, it really comes down to where do we really believe the opportunity is because that sets the, the, you know, the next levels of dominoes to determine what how we present offerings for investors. And so, our research, we kind of consolidated into what we call an investable megatrends for the next decade. And so we these are trends that we believe are in play right now, and will be in play for a long period of time, that are really shaping the economy, and both right now and in the future. And those that are standing up, see this, and position themselves will be rewarded by the market. And so that’s really how we’re looking at it, you know, some of the things and we have a whole presentation, it’s a very long presentation. So I won’t get to all the details in this interview. But you know, some of the snippets, and we’ve been saying this for a little while, is we believe inflation is going to be higher for longer. And that has now become more popular sentiment. But you know, was it for for a period of time where inflation is more transitory. This is a short term phenomena. And there’s really two reasons that we believe are driving inflation likely been higher for longer. And this is, again, mostly in the US. But one of those being the huge labour shortage. And so we’ve really, since COVID, ended pressures in the BNF cover, we had a huge spike in unemployment. And then that kind of came down. There’s an interesting chart that we have in our presentations that, you know, shows there’s this huge gap that has continued to grow over the course of the past year to have job openings relative to those looking for full time employment. And it’s a pretty big gap by a factor of a million to several million job openings that can’t be filled. And a lot of it’s because the labour left the market after COVID, a lot of late stage career, folks took early retirement, a lot of dual income families went to single income and one of the spouses decide to stay home. And so the reason that’s important is the labour shortage puts a lot of pressure on wages increasing, which is very inflationary, because the primary driver of GDP is consumer spending. And so if the consumer continues to have more earnings, and they continue to spend that that will continue to contribute to a higher inflation number. And the other one is really we think it’s playing out right now, but we haven’t seen we go into the early stages of it and we think we’re at the early stages of a an energy crisis that we hadn’t seen in a long time. And it’s really going to be driven by a supply shortage of fossil fuels. As we’re making a transition into more green energy, renewable energy sources that is really being driven by a political narrative that, hey, as best as well, attention at its worst is creating a huge gap of understanding what it’s going to take to make this transition. And really putting ourselves in a really bad position from a production and supply standpoint of fossil fuels over the next several decades that we believe is going to be pretty, pretty severe.

Gene Tunny  15:38

Right? Yeah. Yeah. I mean, we’ve got some of the world that energy issue here, arguably in Australia to their concerns about reliability of the network as our coal fired, power stations are decommissioned or shut down over the next couple of decades. And so that’s, that’s a big issue were grappling with here at the moment. And there’s a big debate about nuclear energy, and whether that’s an alternative and that that’s becoming incredibly political. Over here, so yeah, good points, then can ask how do they affect your, your investment strategies is mean, inflation higher for longer, okay. Yep. Yep. Yeah, that that’s, that’s plausible. And then the energy, shock or crisis, or whatever you want to call it? How does that affect your investment choices?

Ben Fraser  16:35

Yeah, absolutely. So if, if we believe inflation is going to be higher, for longer, it really kind of sets the stage for where opportunities will kind of be over the next several years. If that’s the case, right here in the US, the Federal Reserve is really become the point of a lot of conversation, a lot of emphasis in trying to decipher what their approach is going to be. And they’ve been pretty clear from the get go, Jerome Powell stated, they need to get to a sustained level of comfortable GDP growth, which he stayed is 2% and Intel, and when that happens, they’re going to maintain a more aggressive monetary policy to bring inflation back into check. And so obviously, we’ve come way down from the highs of a year or two ago, you know, six and 8%, inflation numbers, you know, we’re down into the threes, which feels like a huge, you know, improvement, which it is, but it’s still very far off the mark. And there may be periods where we kind of dip down to the twos potentially. But given the things I just shared, that we think are systemic issues that are going to be very inflationary, they’re gonna have a hard time keeping interest rates or inflation to where they want to be. And that really drives monetary policy and interest rates. And so we’ve seen, obviously here in the US the fastest increase in interest rates that we’ve ever seen, that has caused a pretty big shock through the commercial real estate market, that we think is still being digested and will really start to play out over the next price several years, depending on what happens, but what our approach is that because inflation is gonna be higher, for longer interest rates will likely be higher for longer, the markets already priced in several rate cuts. This year, I think that’s pretty optimistic, or even heard some economists say that they think we could see six rate cuts this year. I think that’s very, very optimistic, given some of the numbers we just saw reported for q4 for both GDP and unemployment numbers. And, you know, we’re actually even seeing a probability now have an interest rate increase in very small probability. But you know, that’s back on the table if these numbers continue to come in, and you know, beyond expectations, and so we’re this driving opportunity is where we kind of see the biggest opportunity in the real estate market right now is in private credit. And so what that means is playing in this kind of mid section of the capital stack, if you understand what that means, but basically, generally in every deal, you have a senior lender, and you have equity investors, right. And right now, both of these parts of the capital stack are standstills. The lenders are pulling back, they’re tightening credit, they don’t want to put more money out, thanks for getting nervous equity investors, they’re getting capital calls, they want to preserve cash, they don’t want to put more money into deals. And so it’s providing opportunity for the market to come in across the middle part of the capital stack. So you can actually reduce your risk because you can get priority of payment. And you can help inject Apple into a project that, you know has a great path to stabilisation, a great path to reach its ultimate value, but needs a little bit of capital to get there, you come in with with pretty incredible rates of return for pretty minimal risk at this point of credit cycle. So we think it’s a great opportunity, kind of in this transition of the credit cycle, to take advantage of well positioned real estate and good markets with good operators that just need a little bit of extra cash to kind of take it to that next level to make it through and ride out was probably gonna be a pretty bumpy ride in commercial real estate the next few years. Yeah,

Gene Tunny  20:37

yeah, for sure. So I saw your you know, I listened to your episode on what’s been happening with the banks, and he was stunned by just how bad commercial property suffered in the States during the pandemic, and I mean, we had a bit of that, but the, the the plunge in values looks a lot larger in the States. Where’s the market at now? I mean, what’s it like? I mean, are there just parts of CBDs? That are the empty office buildings? Is that is that essentially what’s going on? What what’s the what’s the story there, Ben? Yeah,

Ben Fraser  21:14

so it’s, it’s interesting, because you see the headlines saying commercial real estate is down 30% or 40%. And, you know, as we all know, headlines are usually exaggerated, exaggerating what’s really going on. And while there are certain parts of the market, they’ve definitely been impacted to that degree, what most people think of when they hear commercial real estate, when they think of the big distress. In course, real estate is office. And, you know, when I say commercial real estate, I mean, the whole broad spectrum of all types of real estate, including office, multifamily apartments, you know, single family residences, industrial properties, retail, et cetera, et cetera, et cetera. So there’s lots of components within that big category. And everyone’s performing differently. So there’s some measures of Office that say, Yeah, values are probably dropped 30 to 40%. And, you know, I still think it’s a knife that’s, that’s falling, that we don’t really know where it’s going to where it’s gonna land, because we don’t really know what the value of an office property is that, say 50% occupancy and not probably going to improve from here on, you know, what’s the use case of that property going forward? How much is it worth? Well, I think the market is trying to digest that. But in other asset classes, we’re seeing a pretty different story industrial real estate, it’s actually it’s probably the least impacted by some estimates, it’s maybe only been impacted five, maybe 10%. Values. Retail similar way, apartments are probably the next biggest impact. And a lot of it’s because some of these really hot markets here, the Sunbelt markets are, we’re we’re very, very, the guy very aggressive in the prices. And so we’re seeing kind of a tail off some of these these high prices, but long term trends still support strong values, and housing and multifamily. And so it’s really trying to decipher, you know, here’s the big the big picture narrative, but then where’s the real opportunity to where maybe there’s a dislocation between the headline understanding the narrative and the actual underlying data. And that’s we’re always trying to look for that gap. Because if the market believes there’s a big issue, but the data supports something different, that’s where you can kind of come in and capture the opportunity.

Gene Tunny  23:36

Okay, we’ll take a short break here for a word from our sponsor.

Female speaker  23:42

If you need to crunch the numbers, then get in touch with adept economics. We offer you Frank and fearless economic analysis and advice. We can help you with funding submissions, cost benefit analysis, studies, and economic modelling of all sorts. Our head office is in Brisbane, Australia, but we work all over the world. You can get in touch via our website, www dot adapt economics.com.au. We’d love to hear from you.

Gene Tunny  24:11

Now back to the show. And what about energy? Ben? What what is your analysis? What does that tell you about where your investments should be focused?

Ben Fraser  24:25

Yeah, so try continuing what I was saying a minute ago on fossil fuels. We’ve really seen a pretty big shift or the past decade from investment into new production. And if you think about fossil fuels, it’s very different than real estate where real estate naturally appreciates. Over time with inflation. The fossil fuels naturally deplete over time as we pull more resources out of the ground, there’s less and reserves and by some estimates, it’s somewhere between you know, five to 8%. have total global production is depleted every year. So just by normal usage and demand, numbers, we’re depleting about 5% of all the production that we’re using every year. And just to maintain the same levels of production, there has to be new levels of investment to find, you know, new wells and new reservoirs and build out the infrastructure to increase production, or just to maintain production. So, what’s been interesting is about 10 years ago, we saw a pretty big shift from the the political narrative of the environmental societal governance standards that have been imposed on not only the operators of these assets, but also the capital allocators. And so a lot of the allocators that are investing into different energy verticals are being either penalised for investing in fossil fuels, or they’ve been rewarded for investing in renewables. So it’s created this incentive structure that is moving capital away from fossil fuel production and development into other technologies. And I’m not saying we should suspend all investment into green energy, you know, that, you know, to put on the fossil fuels, but we can’t do the the inverse of bomb or capitalist to new technologies and, and not realise the impact that would have in current energy needs. Because right now about, I think it’s 83% of all of our global energy needs come from fossil fuels. And that’s usually pretty shocking number for most people to hear they think we’re way farther along, right. You mentioned nuclear, which I’m a huge proponent of. But that only makes up I think it’s less than 5% of total global energy needs. And we’re not seeing these these big shifts, we’ve been trying to invest herbal energies for many, many decades. And so to think we’re going to be 100%, the transition to green energy in the next 10 years is just completely irrational. So what’s really happening is this lack of investment is going to cause a future supply issue, right, because as we’re not reinvesting that supply curves continuing to decline, and By most estimates, including the most far left leaning the most renewable, energy focused agencies are predicting that demand for fossil fuels will at least be the same 10 years from now, but most estimates actually anticipate that’d be higher, because we have population growth. And here, at least in America, and so they’re, you know, JP Morgan, just put out a report a month or so ago, predicting a 7.1 million barrel per day shortfall of oil and gas, actually just oil, just oil needs per day. By 2030. If if we don’t have a massive course correction. And so the opportunity is we really believe there’s a huge opportunity to get into fossil fuel production. So we’re investing a lot into these operating wells at really good prices. And we’re, we have pre distort prices right now. But we also think of the probabilities and, and, you know, there’s probabilities to the upside and price as we kind of go later into this energy. kind of issue. Yeah. Good

Gene Tunny  28:30

points there. It’s just I was just thinking that, you know, Saudi Arabia and, and Russia, they’ll be, they’ll be happy because you’re talking about oil, and, you know, potential, you know, shortages and, you know, implications for prices, higher prices in the future. They’ve been trying to engineer that, haven’t they recently, so there was a report in the Financial Times. Yesterday, so OPEC plus members extend production cuts in bid to boost oil price. So they, they’ve been trying to get that up. And it’s been, it’s been quite stubborn that even with all of the geopolitical tensions, I don’t know if you’ve been following that at all.

Ben Fraser  29:10

Yeah, yeah. Yeah. I mean, it’s there’s a lot of game that ship that goes on with with OPEC. And, I mean, what’s interesting, now people don’t realise is that the US is actually the largest exporter of oil in the world. Right. So Saudi Arabia is huge. And they’re, they’re a big player in this, but most people don’t realise that the US is actually the largest. So we have a pretty big place to play in this global geopolitical thing. But in the short term, there’s a lot of, you know, supply cuts or, you know, we’re going to flood the market and there’s a lot of kind of gamesmanship to a certain degree on the short term, you know, prices but at a certain point, you know, supply is inelastic because you can’t just flip a switch and all of a sudden, you know, we just have so much more oil there’s there’s a stir certain range, right, they can they can reduce supply the short term and just keep certain wells not producing. But if your capacity is x, you can’t do more than that, right. So at a certain point, there’s going to be this divergence between supply and demand. And I think that’s where, in a longer term timeframe, we’re gonna run into some bigger issues. But in the short term, I mean, I don’t mind higher oil prices, because I’m a seller of oil, because of my made the investments that we’ve made. So, you know, it’s been interesting to there’s been a lot of shift of the market from kind of years past, here in the US, at least, where, you know, they’re, they got a very aggressive and drill and very aggressive and trying to produce as much oil as possible, kind of flooding the market and got a little bit in front of their skis to where prices dropped massively. But the the market is kind of pulled back today was kind of like these higher oil prices, and we’re okay to, you know, not massively increased supply, because one we’re getting, you know, bad mouth from the politicians and two, will make a lot more when prices are high. And so it’s kind of created this really unique environment where we’re, we’re sitting it kind of elevated prices from a historical standpoint, and, you know, some of this interaction interplay between OPEC in the US, and, you know, other players of oil, like Russia, are, you know, intentionally keeping prices higher in the short term, and I think it’s only going to continue wrong.

Gene Tunny  31:29

Okay. That’s a good insights there, Ben. Now, before we go, I’ve got to ask, I’ve got some of my listeners would describe themselves as libertarian, and they’re very much in or they’re, they’re concerned, or they’re Austrian economists, you could say and they’re very much concerned about the actions of central banks and their money creation and all that and the risks of fiat money. And so they’re very, they’re very interested in gold and I see gold as you know, that’s what is it? It’s was it 2600 Or something an hour or maybe 2100 USD announcer saw the other day, so it’s getting it’s getting up there near the, the historic high. And, you know, so gold’s something that is up again and Bitcoin is dead, it’s had a bit of a surge, particularly since the these Bitcoin ETFs have been allowed. Do you have any thoughts on gold Bitcoin? Where does that fit into your evey alternative investments that you’re looking at?

Ben Fraser  32:33

Yeah, I think they definitely are categorised as alternative investments. This is outside the scope of what we invest in as Aspen. But we definitely comment on gold a lot in our podcast, because we have a lot of listeners probably like you that, you know, want to get have a hedge against, you know, fiat currency. And I mean, I haven’t been around the game, as long as some, but you know, to me, it’s whenever there is maybe undisciplined from central banks, all the gold bugs come out and say, See, we told you so and I think there’s an element of truth. But it also never plays out the way that they expect. It For Me, gold has always had an identity identity crisis, right? Is it a currency? Is it a hedge store value? I think there’s an element of it’s all the above. But I think Bitcoin is also confused the use case for gold as well. Right. And so I do think it’s good to have hedges, I think it’s good to have as a portion of the portfolio, just like a lot of these different things that we’re saying. But people that have really heavy allocations into gold and, and other Kryptos for that matter, I think, take a lot of extra risks, they probably don’t need to, because of, you know, some of these things that are hard to know where they go, I think, you know, the I used to be a much more staunch Austrian economist and, you know, hard money, kind of side of things. But from what we’ve seen since COVID, the modern monetary theory, principles have played out and just certain degree have kind of worked and I think I’ve had to kind of readjust some of my initial thoughts because we would have expected a massive amount of, of deflation throughout the game, we are seeing some higher inflation, but definitely not to the degree that of the stimulus and monetization of what we saw over the past few years. And so I think it definitely can drive higher inflation, but I think it’s only to a certain point. And meanwhile, we’re having a really strong assumer in the US a really strong economy from a GDP standpoint, that continues to support a stronger dollar and so, you know, I’m not, I’m not a, you know, gonna take a big bet against the dollar. anytime soon. And, you know, I think it’s good to have edges, just like anything. But I also think it’s important to have have that imbalance and and measure.

Gene Tunny  35:08

Gotcha. Yeah, yeah. Yeah, I wouldn’t be necessarily betting against it anytime soon that that’s for sure. One thing I guess I should ask because just before we go, because this is something that does, as an external observer, looking at the US and looking at the budget situation, and that big structural deficit that the federal government has, and the debt to GDP ratio just keeps climbing. And, you know, you’re always there’s always talk of a potential shutdown from time to time. And it just, I just wonder, Where are we going to get to a point where there will be a US fiscal crisis at some stage, I’ve had one guest on from Cato Institute’s she was warning against that in the future. Do do you have concerns about the state of US public finances?

Ben Fraser  36:01

Yeah. I mean, it’s no one likes a budget deficit, right. I mean, there’s a lot of reasons that doesn’t work. The thing that’s interesting now is the US of all developed economies, you know, is doing the same thing everyone else is doing, and probably to a lesser degree from a debt to GDP GDP standpoint, you know, we we have one of the better ratios. And you also think about inflation, what does that do to borrowers? Right, it benefits borrowers, if you have higher inflation, the value of the dollars, you take on now, and you pay back later are worth less. And so the US government being the largest borrower, I don’t think I think they want to get inflation down for other reasons, you know, whether it’s political or keep the economy in check, but they also don’t mind a little bit of extra inflation in the short term to erode the value that they gotta pay back. I think the bigger question becomes, at a certain point, do you know government bonds become less attractive than, than other countries and people aren’t willing to take the risk on the government be able to pay back the all the money they’re printing? So I think, at a certain point, yeah, maybe the, you know, that things have big fiscal breakdown. But as of now, I don’t see that happening. Is it happening anytime soon? And, you know, when we’re able to continue to pray, and we saw buyers for, you know, all the bonds, then we can continue to keep it going.

Gene Tunny  37:37

Yeah, that seems to it seems to be the case for the moment. It’s interesting. You mentioned the Yeah, it doesn’t look as bad as some other countries. I mean, you’re talking about I suppose Japan and Greece, I mean, Japan show that you could actually, oh, it’s just extraordinary what Japan has been able to get away with for decades now. Yeah. And the US seems to be, you know, just just keeps going along there. The other point you may, which is a good one is on inflation and inflation, eroding the real value of the debt that’s got to be paid back. There was a famous study by I think it was Robert Eisner in the late 80s, which showed that a lot of the the budget deficit was in the 80s was being offset by that reduction in the real value of the debt, which was quite a clever paper at the time. I put a link in the show notes. It’s very good. Good piece of work. Yeah. Yeah. But I’ve been it’s been terrific. Any, any final points before we wrap up? Now?

Ben Fraser  38:34

This is a fun conversation. And I love love the good question. So appreciate you having me on.

Gene Tunny  38:40

Very good Ben. We’ll all put a link in the show notes to Aspen funds and also invest like a billionaire podcast, which I’ll definitely recommend. I’ve been getting some great insights out of it. I think you’ve got a great interaction with your with your dad on the show. So yeah, really, really good stuff. So again, thanks so much for your time.

Ben Fraser  38:57

I appreciate it dude with fun

Gene Tunny  39:00

rato 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 at economics explore.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.

39:47

Thank you for listening. We hope you enjoyed the episode. For more content like this where to begin your own podcasting journey head on over to obsidian-productions.com

Credits

Thanks to Obsidian Productions for mixing the episode and to the show’s sponsor, Gene’s consultancy business www.adepteconomics.com.au. Full transcripts are available a few days after the episode is first published at www.economicsexplored.com. Economics Explored is available via Apple Podcasts, Google Podcast, and other podcasting platforms.

Categories
Economic update

Mounting evidence of Superforecaster success

There is mounting evidence of the superiority of the Superforecasting approach, which Economics Explored hosts Gene Tunny and Tim Hughes discussed with Warren Hatch, CEO of Good Judgment, on an episode earlier this year (see How to be a superforecaster, or at least a better forecaster). Superforecasting is an approach to forecasting that, as the blurb for the 2015 book Superforecasting notes, “involves gathering evidence from a variety of sources, thinking probabilistically, working in teams, keeping score, and being willing to admit error and change course.”  

The success of Good Judgment’s superforecasters in forecasting the US Federal Reserve’s policy decisions was profiled in the New York Times last month. Good Judgment has been asking its superforecasters an ongoing series of questions about the upcoming three meetings of the Fed, asking if they will cut, hold, or raise. For the four meetings so far in 2023, the superforecasters were spot on with their probabilities for three hikes and a pause. For the next three meetings, they forecast two hikes followed by a longer pause. 

Good Judgement data scientist Chris Karvetski has prepared an analysis showing the superforecasters extraordinary performance in forecasting the Federal Funds rate targeted by the Fed (see Superforecasting the Fed’s Target Range). He has calculated Brier scores of forecast accuracy, where 0 denotes perfect accuracy and 1 denotes perfect inaccuracy, for different sets of forecasts. The Superforecasters are doing 3x better than CME futures for the Federal Funds rate, with far less volatility.

Separately, superforecasting pioneer and Good Judgment co-founder Philip Tetlock and his research colleagues just released a study on existential risk with interesting approaches to generate forecasts for low probability but high impact events, such as an AI apocalypse (see Results from the 2022 Existential Risk Persuasion Tournament). This study was summarised by The Economist earlier this month: What are the chances of an AI apocalypse? Thankfully, as The Economist observes:  

Professional “superforecasters” are more optimistic about the future than AI experts.

For more information on the superforecasting approach, check out the Economics Explored podcast episode from earlier this year:

Superforecasting w/ Warren Hatch, CEO of Good Judgment – EP176 – Economics Explored

Several clips from the video of the interview are available via YouTube. The first clip is “What Makes a Superforecaster?”:

It identifies the importance of being cognitively reflective and having good pattern recognition skills. Incidentally, one way to identify people with good pattern recognition is to test them with Raven’s progressive matrices, as noted by Warren Hatch in this clip:

Another clip covers how we can overcome our own prejudices and biases to make better forecasts:

Tips from Warren in this regard include:

  • self-awareness;
  • getting feedback; and
  • forecasting teams in which members can interact with each other anonymously so everyone’s views are considered solely on their merits with no prejudices.
Categories
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. 

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. 

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

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.

Female speaker  23:31

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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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Credits

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Podcast episode

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.au. Please 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 Podcasts, Google Podcast, and other podcasting platforms.