A chat with Alan Kohler
Economic Video, Publications | 19th October 2021
Hello, I’m Alan Kohler, Editor in Chief of Eureka Report and welcome to The Money Café. Joining me today is Saul Eslake, independent economist, used to be Chief Economist at ANZ and now – have you got a name for a company anymore, Saul, or is it just you?
Yes, my business is called Corinna Economic Advisory and Corinna is the Tasmanian aboriginal name for the thylacine or Tasmanian Tiger, so that’s where it comes from.
That’s what you are, a thylacine – not quite extinct…
Well, thylacines are extinct, yes, so I’m still here.
You’re not extinct, you are still here and in fact, you are in Tasmania and we speak to you from beautiful Hobart, do we not?
Just outside Hobart, yes.
I’m sure it’s fabulous where you are and it’s fantastic of you to join us, Saul, so thanks very much for that.
It’s a pleasure.
Now, firstly, let’s talk about what’s going on with bond rates. The three and five-year, in particular, bond rates are leaping at the moment, not just here but all around the world, in particular in the US. What’s going on?
Well, two things. One, bond markets, like financial markets more broadly, are anticipating the beginning of the end of the “money printing” that all advanced economies and central banks have been undertaking since the onset of COVID-19 and in the case of some of them, since the beginning of the global financial crisis, or in Japan’s case for most of the last 20 years. Japan isn’t going to walk away from so called quantitative easing any time soon and the European Central Bank may not, but it seems increasingly clear that the US Federal Reserve will begin tapering, that is, winding back its weekly purchases of…
But are the market’s also anticipating inflation?
Well, yes, I think they are and that’s the other thing…
Are you anticipating inflation?
Not just anticipating it, it’s here, at least it’s present in a number of important economies around the world. What’s being debated is whether the assurances that central bank officials have been giving in advanced economies at least since earlier this year, that the spikes in inflation we’ve seen will be transitory and won’t prompt them to lift their policy interest rates any sooner than they previously indicated. Markets are becoming a bit sceptical about that in some cases.
In fact, the economics world, as far as I can tell, has divided itself into ‘team transitory’ and ‘team persistent’. Which team are you on, Saul?
For the most part, I’m in the ‘team transitory’ camp and the basis for that is acknowledging that around the world, almost everywhere, there have been significant upward pressures on producer prices, that is, prices at the top end of supply chains. In particular, a significant increase in a broad range of commodity prices, food, metals and energy. On top of that, significant – and by that, I mean hundreds of percentage points – increases in prices of things that are actually much more important than we might have realised, such as semiconductor chips which go into an extraordinary array of products these days, not just mobile phones and flat screen TVs, but in particular motor vehicles, which in some ways are computers on wheels.
Also, container shipping costs that have risen by between 500 and 600 per cent since the onset of COVID and that of course all feeds into an extraordinary range of prices as well. Around the world we’re seeing significant upward pressure on prices at the top end of supply chains. What I think is interesting and what has kept me in the transitory camp up to this point has been that it’s only really been in the United States and to a lesser extent in the United Kingdom among major advanced economies that these upstream price pressures have flowed through into the prices that consumers are paying in stores and elsewhere. In the US in particular, in April, May and June we saw a significant jump in monthly inflation reads, most of which was due either to price increases associated with owning new or used motor vehicles, renting them, insuring them or running them…
But what about New Zealand, that was 4.9 per cent on Monday?
That’s right. New Zealand’s a bit of an outlier in global terms, it’s important to us because…
Geographically as well, of course.
…things that affect them, affect us. But the big contributor to the surprisingly high inflation rates that have been recorded in New Zealand, not just in the last quarter but in the previous one, has been rapid growth in house prices that has fed through into the CPI in New Zealand and that’s something that the New Zealanders have been onto for quite some time. They’ve had three tightenings of so called macroprudential policy, that is, restrictions on various types of riskier loans that banks are allowed to write. And of course, notoriously in March last year the New Zealand Government went far further in clamping down on the tax preferences that property investors enjoy than the Australian Labor Party had ever proposed at the 2016 or 2019 elections…
And got knocked off for its troubles, of course.
Well, that’s the popular theory, I mean the Labor Party almost won the 2016 election with those policies and they only lost the 2019 election I think by one seat more than they lost the 2016 election and they had a lot more policy baggage, including in relation to the taxation of franked dividends than they had in the 2016 election. I’m actually not sure that their policies on property investment taxation cost them the 2019 election, that’s the popular myth and they’ve walked away from those…
Well, they certainly have, they’ve dumped it, they’ve run away from it!
Right, and at the same time as their counterparts on the other side of the Tasman have gone much further than Australian Labor ever had proposed. As I say, you’ve got this increasing housing costs in New Zealand…
Can I put a proposition to you? Which is that the transitory inflation is pandemic related and the persistent inflation is climate change related and also demographic related due to the decline in working age population which will lead to persistently higher wage costs. Energy costs rising due to climate change and other costs as well, so we’re moving from a COVID related transitory inflation into a longer-term inflation due to climate change and demographics, what do you reckon?
There might be something in that, Alan, and that’s why I was saying before that I think the spike in inflation that scared financial markets earlier this year has turned out to be transitory and the last two US monthly CPI inflation reads are certainly consistent with that view. But what we’ve seen more in Europe and North Asia, actually, than in the United States in the last month or so has been, in particular, a surge in the price of natural gas. That might be, in a way, climate change related but there are also some other complex factors behind it. In particular, part of the story in my view is China’s refusal to buy Australian coal, thermal coal in particular, which has prompted the Chinese to scour the world for other sources of thermal coal that aren’t as effective in generating electricity as Australian coal has been because it’s of a higher quality.
That’s driven up the price of coal all over the world, prompting other people who might have used coal, to instead switch where they can to natural gas as a source of energy generation, which has put the price of natural gas up significantly. I think the Russians are also playing a role here by, I think, withholding gas supplies from European markets in particular as a way of creating a situation where Russia can subsequently appear to be the solution to a problem that they have helped to create.
Then overlayed on this, and this may be part of the climate change story, is that the wind on which Europe in particular has increasingly come to rely as a source of renewable energy hasn’t been blowing at the rates that it had been assumed it would – not every hour of every day, of course, but in a more sustained way the winds haven’t been blowing and some scientists think that that shortfall in wind could also be a side effect of climate change that’s affecting patterns of wind flows across Europe.
That’s interesting, I didn’t know that.
Just to finish that point, Alan, if we are in for an extended period of elevated gas, oil and coal prices, then it could well be that the second increase in inflation that we’re starting to see in particular in Europe could be something that central banks do have to deal with by raising interest rates earlier than they’ve previously foreshadowed and I think that is what’s behind the most recent surge in bond yields that’s occurring all over the world. Meanwhile, of course, outside of advanced economies, inflation has been rising quite significantly at the consumer level in a whole raft of emerging economies in Latin America and Eastern Europe and that’s why at my last count there’ve been some 30 central banks around the world that have raised rates so far this year and some of them, Brazil, Russia and Hungary among others have raised them four or five times.
Now, I can hear in the background the dogs are barking, “Higher mortgage rates,” in fact and already we’re starting to see Westpac and Commonwealth Bank increasing their fixed home loan rates, this is because of the rise in bond rates. Do you think that this will start to put a bit of a dampener on the housing market?
In some ways I hope it does because I don’t think the dramatic increase in house prices that’s occurred over the last 15 months or so, completely contrary to the expectations that many people had 15 months ago, is really doing either Australia’s economy or our society more broadly any good. Indeed, I think it’s potentially doing some harm, so if at the margin increases in fixed rate serve to dampen demand for housing, then I’d actually regard that as a good thing. Mind you, of course, people who might be deterred from borrowing at fixed rates by rising fixed rates still of course have the option of going variable and some of the banks which are raising their fixed rates have also been cutting at the margin some of their variable rates and the Reserve Bank is still saying that they don’t think they will be raising the cash rate until 2024…
The market reckons it’ll be next year.
Yeah, I think the market’s jumping the gun here, frankly. My own view is, and it’s been this for a while, that the most likely time for the Reserve Bank to begin increasing rates is the second quarter of 2023.
You’re splitting the difference between the market and the RBA?
Well, yes, although that’s a view I’ve had now for about six months, that that was the most likely time. Two points to remember on that. One, is that there actually is very little sign of inflationary pressure in Australia except in the dwelling construction industry. If you look at our producer price indexes, for example, which measure the upstream price pressures that I was referring to earlier, they haven’t moved nearly as much upwards as they have in other countries, despite the fact that some of our materials are imported and therefore would have been affected by the fall in the exchange rate over the last six months, but that doesn’t seem to be there.
If you strip out the effects of things like the provision of free childcare in the June quarter last year and look at the Reserve Bank’s preferred measures of underlying inflation, they’re still running at 1.75 to 1.5 per cent. It’s been five and a half years since the underlying inflation rate was in the Reserve Bank’s 2 to 3 per cent target range. There is almost no evidence of upward pressure on wages in Australia and there wasn’t before the lockdowns, even though the unemployment rate had before the lockdowns in Sydney begun, got down to 4.6 per cent. Again, that’s in contrast to New Zealand where there is sign of upward pressure on wages, or the United States where at least in some industries there’s sign of upward pressure on wages or the UK where the Government’s actually encouraging upward pressure on wages. We’re just not seeing that here.
The other thing about Australia is that the Reserve Bank’s inflation target is actually looser than that of most other advanced economy central banks. Most other advanced economy central banks have targets which are either 2 per cent or 1 to 3 per cent with 2 per cent as the middle. Our target is 2 to 3 with 2.5 per cent as the middle. The Reserve Bank is likely to be one of the last central banks in the developed world…
In fact, in the minutes the other day they said, not for the first time, that they’re going to wait to see actual inflation between 2 and 3 per cent on a sustainable basis, which is really amazing. I reckon it’s for the first time. They always in the past have anticipated inflation, so they’ve jacked up rates because they think inflation’s coming, but this time they’re saying, “No, no, we’re going to wait until we see it actually happen.”
That’s right, that’s a big turnaround from what Glenn Stevens used to characterise the Reserve Bank’s approach as being an inflation forecast targeting framework. As you say, the Reserve Bank used to react to forecasts that inflation would be within the target band if they were starting from below it, or if inflation was within the target band, if their staff were forecasting that it would exceed the target band then they would respond to those forecasts by raising interest rates. The reason that they used to do that, as other central banks used to do, was because economic theory and the experience during the 70s, 80s and 90s had told them that if you waited until inflation had actually started to accelerate before you did anything about it, given the lags between monetary policy decisions and their impact on the economy, inflation would have risen to unacceptable levels by the time whatever you did had its impact on the economy. That was the experience that the Reserve Bank had had, for example, in the late 1980s leading up to the early 1990s recession.
But the Reserve Bank, like other central banks around the advanced world, has come to the conclusion that the dynamics of inflation have changed and because inflation has been below their target for so long, for more than five years, they think that they can actually wait until they see the whites of inflation’s eyes before they respond to it by raising interest rates. I guess, although they’re not saying so explicitly, it’s also an acknowledgement that their staff forecasts of rising inflation have been wrong for five years and that therefore, maybe they shouldn’t be relying on those forecasts in making decisions with such potentially momentous consequences as putting interest rates up.
But do you think it guarantees an overshoot on inflation?
Not necessarily, but that’s a risk. However, the Reserve Bank’s view – and they’re taking the same position as the US Federal Reserve in this – is that because inflation has been below target for so long, if there happens to be a brief period – and obviously brief might be in the eye of the beholder – but if there happens to be a brief period where inflation is above target, the actual level of consumer prices after that period could still well be below where it would have been if inflation had been 2.5 per cent consistently over the past five years.
In a sense, because the Reserve Bank has undershot it’s target for so long, the possibility that they might overshoot it for a year or so, not that that’s what they’re contemplating, but if that were to happen, it wouldn’t necessarily be a bad thing especially if – and here the Reserve Bank’s view about the relevant importance of things has changed – but especially if that enables Australia to consolidate a lower unemployment rate than we have had since the mid-1970s.
You never worked at the Reserve Bank, did you, you started in Treasury?
No, I worked for the Treasury during what people who worked for the Treasury at that time call, ‘The Stone Age’.
Oh, for John Stone?
Reference to John Stone having been the Head of the Treasury, yes.
And aptly known as and called ‘The Stone Age’, I would imagine. Were you there when they floated the Dollar?
No, I had left Treasury in 1981. It was just about to start…
You should have stuck around, it would have been exciting!
Well, you might remember of course that at that stage at least John Stone was opposed to the floating of the…
He was indeed, exactly.
…and it was officials a few rungs below Mr Stone who persuaded Paul Keating to do that. I mean, John Stone had his reasons for being opposed to floating of the exchange rate, in particular he had felt that keeping the Dollar overvalued deliberately was a way of keeping inflation under control during a period when the Arbitration Commission, as it then was, was deliberately fuelling it by granting excessive wage increases in order to buy industrial peace.
Couldn’t have that!
But I think, to be fair, I think John Stone has since recanted and agrees that the floating of the exchange rate was a decision that was very much in Australia’s interests and we’re a much better place because we have a floating exchange rate, as indeed most countries around the world now do.
You’ve got some very interesting views about housing affordability too, Saul, and the sources of high house prices in Australia. Give us a one minute burst on that.
The price of housing, like the price of almost anything else, is the result of the interplay of supply and demand. In Australia, the demand for housing in an underlying sense of course has been supported by strong growth in the population, in which strong growth in immigration has played historically a significant part. We’ve actually had an interesting test of the proposition that’s been put by some that the solution to our housing affordability problems was drastically to cut immigration which we’ve done, by a bigger amount than advocates of that had ever seriously proposed, since March last year and that self-evidently hasn’t done anything to improve housing affordability.
My concern about policy in the context of the demand for housing, is that since the mid-1960s Government policy has been quite consciously and deliberately inflating the demand for housing by giving ever-larger cash grants to would-be first home owners in the stated belief that that increases the home ownership rate, which it self-evidently hasn’t, but in practice of course just adds to the demand for housing and the money that Governments pretend to give first home owners ends up in the pockets of second home vendors or builders and land developers, and since there are far more owners of existing homes than there are would-be first home buyers of them, that’s why those policies are so popular despite the fact that they self-evidently don’t work.
On top of that, of course, since the early 90s the increasing presence of investors in the housing market partly fuelled by lower interest rates and more readily available credit, but particularly fuelled by the change to the capital gains tax regime in 1999, has seen on repeated occasions would-be first home buyers squeezed out of the market by investors who get their borrowing costs subsidised by other taxpayers through negative gearing. Then, of course, those investors turn around and rent the properties that they’ve bought to the first home buyers who otherwise would have been able to buy them and live in them themselves, and that’s why the home ownership rate is, at the 2016 Census, the lowest it’s been since the Census of 1954 and for people under the age of 40, the lowest it’s been since the Census of 1947…
It’ll be interesting to see what it is this year.
Well, yes, I suspect in June next year or thereabouts when we get the results of the 2021 Census, those home ownership rates will be even lower. Now, it’s also true, of course, that Government policies have since the 1970s shifted away from boosting supply, which was the emphasis of Government housing policy for 30 years after the end of World War II, increasingly towards restraining supply. Governments don’t do nearly as much as they used to to build social housing themselves or to fund community housing associations to provide low-income rental affordable housing and State and Local Governments have, over the last 25 years, particularly in New South Wales, made it increasingly expensive and difficult to either build new housing on greenfield housing estates or to redevelop existing areas at higher densities. You’re pandering to existing residents at the expense of would-be new ones. This combination of policies that inflate demand and restrain supply have resulted in a situation where Australia has some of the most expensive residential real estate in the world and the home ownership rate which used to be one of the highest in the developed world is now one of the lowest in the developed world.
But the reason we keep pursuing policies that have the opposite effect to their stated intentions is because politicians know that there are at least 11 million Australians who own at least one property, within those there are more than 2 million who own two or more and there’s a lot more of them, therefore, than there are people who don’t own homes but would like to and for all the crocodile tears that they shed about the difficulties faced by would-be young home buyers, the reality is they don’t want to offend the vastly greater number of people who like house prices going up faster than incomes year after year and so they don’t do anything about it.
Yes, there you are. We actually have a couple of questions, Saul, so let’s deal with those. Alex says, “I hear talk about investment bonds as a way to grow money for your kids. However, from what I’ve heard from most people they’re not that great. Is there a way to grow money for your kids? CommSec allows you to open an account as trustee for a child, does this work? How about buying some shares or ETFs for the child using one of those accounts? I understand you can then transfer to the child once they turn 18 without attractive CGT on the transfer.” What do you reckon?
Well, funnily enough, I just in the last month or so have done precisely that for my two children, that is to say I’ve established small investment funds for them, seeded it myself, created a channel for them to put additional money in if they want to and put rules around it such that they can’t take the money out until they reach an age which we think that they might be mature enough to make their own financial decisions…
Is that a trust that you’ve created or trusts?
It’s a managed investment account…
And who manages it, you?
No, I don’t even manage my own share portfolio…
I was going to ask you about that.
…for now more than 20 years ago and that was, I think, the smartest financial decision I ever made because I wasn’t doing any good at managing a share portfolio.
Who did you give it to?
The same people who manage my self-managed super fund will manage these accounts on behalf of my kids, my kids will have the opportunity if they want to to nominate shares in which they would like to put additional funds. But as they now clearly understand, share investment is for the long-term, this is something I hope will help them get a deposit on their own homes if and when they eventually move out and start lives of their own. But yeah, I think this is a good thing to do if they can. Not everyone’s in a position where they can do it, but if you can I think it’s a very good thing not only because of what I hope will be the long-term financial gain for my kids, but also to give them some insight into how financial markets work and how they should think about their own investment strategies.
Are there any tax implications? My understanding is that if you setup an account as trustee for a child that you wear the tax on it?
That may well be right and if so, I’m happy enough to wear the tax on it as an additional contribution to their long-term wellbeing. Neither of my kids at the moment earn enough to attract the attention of the tax man, but if they do I’ll sort it out between me and them.
Chris from Newcastle says, “G’day. When I receive extra shares in a company via a DRP, a dividend reinvestment plan, where do they come from? Are they bought on the market? Is it a secret vault? Three, somewhere else? The company sometimes has a 2.5 per cent discount however I didn’t see that this time.” So, DRPs, they often buy them on the market, sometimes they issue them as new shares that they get, it depends a bit on the circumstances of the company at the time. Look, the question of whether they have discount or not depends on what the company wants to use these schemes to raise money or not.
I think that’s right. My recollection when I worked at ANZ and part of my pay came in the form of shares in ANZ, so you would see these dividend reinvestment programs. ANZ used to issue new shares for dividend reinvestment programs and they obviously needed to have resolutions of shareholders at annual meetings in order to authorise that, but I don’t think that was ever a problem. I mean, it’s not at all uncommon when companies issue new equity through what we used to call a rights issue or a placement, that they do that at a discount to the prevailing share price, so it’s not surprising that dividend reinvestment plans have something conceptually similar.
But as you say, it’s really a decision by the company as to how much they want new capital, as to how attractive the terms they make the issue of shares through dividend reinvestment plans to be.
Companies use DRPs as a way of kind of dribbling money in, to raise money that way.
If they don’t need the capital, then they probably won’t offer a particularly attractive discount. If they do need capital, then they may well make that discount bigger as companies typically do when they’re forced to raise capital because they have suffered some exigency that requires them to hold more capital.
Exactly, that’s right, very good. Okay, well I think we’re out of time, Saul. It’s been fantastic, as always, as I expected, so thanks very much for joining us today on The Money Café.
That’s a pleasure, Alan, thank you.
And thanks, everyone, for listening to today’s episode of Money Café, hope you enjoyed it. Send in your questions and we’ll get to them next week, email them to email@example.com. Until next week, I’m Alan Kohler, Editor in Chief of Eureka Report and I’ve been joined by Saul Eslake, independent economist, his business’s name, Corinna Advisory. There you are, thanks very much, talk to you next week.