Bad parenting as the RBA over-stimulates financial markets with false praise.

Recently the RBA published minutes of their discussion about the new 'neutral rate', resulting in a huge 'own goal' when forex markets sharply pushed up the AUD. This had precisely the opposite effect to that desired in the RBA's stated objective for our currency. It actually doesn’t even matter what the Neutral Rate* is or what it does. What really does matter is the alarming disconnect between the RBA’s theoretical world and the world the rest of us are living in.

The RBA is like a bad parent who keeps pumping red cordial into over-stimulated kids and then is surprised when they spiral up, and up and then out of control. In this story, the kids are our asset markets and the cordial is the RBA's lack of awareness of the impact a few optimistic words can have on these kids.

After years of feeding sugar to global asset markets, most central banks around the world are now very sensitive in what they tell markets as they are acutely aware that markets are looking for any excuse to justify high valuations. Learning from past mistakes, the central banks are now obsessively focussed on avoiding stimulating these hyperactive children even further. US analysts now obsess over the exact wording used in their central bank’s minutes from one month to the next. After pumping more liquidity into global markets than ever seen before, and seeing equity markets approach the overvaluation peaks of pre-GFC months, these competent central bankers are understandably diligent in their comments. 

But not our central bankers. Instead, the people at the helm of the RBA decided that nothing could possibly go wrong, publishing optimistic commentary about labour markets, the economic outlook which they then quantified by an apparent but indefensible expectation of 3.5% per annum interest rates in the foreseeable future.

That is the biggest dose of undiluted cordial with all the preservatives, colouring and real sugar the market bulls could possibly ask for! And like any hyperactive child, these overstimulated kids don’t care what’s good for them. They just gulped the sugar hit down and pushed the AUD nearly to 80 cents. They will probably think about asking some questions later when the subsequent sugar-low hits.

The RBA, apparently out of practice in the complex art of parenting an economy, seemed surprised by this behaviour and the outcomes.  In the next two days after dosing the kids up, the Deputy Governor and then the Governor started trying to talk down the optimism. Both expressed surprise that raspberry cordial could have such an impact. 

You can choose to give kids the stimulant or avoid it. But, as every good parent knows, you cannot give them the stimulant and then plan for peace, quiet and predictable behaviour. 

RBA needs to study up, and get back in control.

The new RBA governor can learn a lot from Yellen in the US or any of the central bankers in the major economies as they know how the kids minds work. They've been at this parenting game a lot longer.

Governor Lowe still can't seem to understand why wages aren’t rising. And the RBA’s commentary keeps focusing on unemployment. But linking unemployment and wage growth, and quoting old textbook theories such as the Phillips Curve** as a reason to believe that wage growth and inflation will soon return, shows an alarming reliance on looking backward to find explanations for what's happening today and projected future behaviour. Either they are intentionally searching for data to support their optimism, hoping this in turn boosts the economy, or there are so hopelessly stuck in the past that they don’t understand the world the rest of us live in.  The optimism campaign might work, but it is a huge gamble.

Underemployment is the more relevant measure the RBA should focus on. Ironically, that's actually what the Phillips Curve theory was based on. Phillips' theory linked labour market slack with low inflation and vice versa, but at the time only 'unemployment' was measured so that is what he included in his paper.

Underemployment is not unemployment which is related to inflation because 'unemployment' is a measure of the population that hasn’t been able to find one hour of work in the past week, regardless of how much they want or need to work. As an example, if I'm willing and available to work 40 hours per week but I can only get 1 hour, I'm not included in the unemployment rate. However, I am included in the underemployment rate which measures how many people would work more hours if they could find the work. 

Given the RBA’s job is to maximise employment without exceeding their stated inflation target, unemployment is a terrible benchmark for them to rely upon.

Right now, underemployment in Australia (called 'underutilisation' by the Australian Bureau of Statistics) is hovering at levels last seen at the back end of the 1990s recession. Unemployment is quite low, but the gap between unemployment and underemployment has risen like never before. The reason for this is not at all surprising to those of us living in the real world. We can see the obvious evidence that it has changed dramatically, probably forever, and continues to change rapidly. The digital economy has already started to reduce the demand for labour, shifting full time jobs to casual roles. While this is, so far, an issue for the retail, wholesale and professional services industries, the impact will really bite when the construction industry slows down in 2018 and there is no other industry ready to step up.

Governor Lowe’s comments about strengths in labour market data, made as recently as Tuesday this week, are clearly overly optimistic. 

Now I hope this is because the RBA is trying to talk the Australian economy into action and not because they have missed this structural change that makes the Phillips Curve, and all other theories written over 50 years ago, redundant.

If the RBA wants the AUD to fall from popularity, they must stop telling the markets how hot it is.

This is the fundamental flaw in Lowe’s approach, at least as it appears from the outside. From Day One he has been trying to talk the Australian economy into action. Every speech includes and extremely glass-is-half-full read of the data. This is a big gamble which can work occasionally. But in this case it has been very counter-productive. 

This week’s comments are a great example of the risks associated with this approach. Coming out with a read on the economy that business optimism and a couple of months of positive employment data mean that the economy is strengthening, timed perfectly with the falling confidence in the Trump administration, has resulted in the Australian dollar rising sharply. 

So what's the problem with that?

The Australian economy is already suffering from its lowest ever wage growth, coupled with the highest level of household debt relative to household incomes. High debt and lower wage growth means household spending will be increasingly constrained. And this in turns means weaker economic growth, which means lower wage growth and so on, and so on. 

This vicious cycle needs a circuit breaker.

We need an industry or two to step up and increase the demand for labour. After the end of the mining investment boom, construction took off and sustained the economy for a few more years. But construction is coming to a very sudden stop, thanks to both looming oversupply and a sharp cut in the availability of investor lending. Once construction slows, we need other industries to take up the slack. Given current conditions globally, education and tourism are the obvious candidates, unless we can suddenly convince the world we are the next Israel or Silicon Valley. Now both education and tourism require a lower Australian dollar so the RBA talking up the outlook for interest rates, with optimism about the economy or by naming the Neutral Rate, pushes up the dollar is counterproductive. 80 cents instead of 70 cents (against the USD) makes a huge difference to both these sectors, and there goes our saviour. 

It's time for the RBA to take the harder path of the good parent. Stimulate if you want to, but get ready for volatility. Or choose the more measured response and guide them through the rough times. Right now I not getting on the phone to DOCS, but I'm also not putting Governor Lowe up for parent of the year.

*Neutral Rate is a mostly theoretical construct relating to the level of interest rates at which the economy is neither stimulating nor constrained. The theory implies that interest rates will average the Neutral Rate over the long-term, so when the RBA suggested the Neutral Rate was 3.5% per annum it could have, naively, been read that rates were going to rise from their current 1.5% per annum to 3.5% per annum sometime in the next few years. 

 **The ”Phillips Curve” is a 1958 theory which suggests that as economic growth pushes unemployment down beyond a certain level, labour shortages will cause wage growth which will, in turn, cause inflation. Therefore inflation and unemployment are inversely correlated, meaning they move in opposite directions.