The economic arc of recent history
Having celebrated his 30th anniversary with Westpac Banking Corporation in 2021, chief economist Bill Evans is in a unique position to view the challenges facing markets and economies thanks to his deep understanding of how they have responded to comparable events in the past. Evans speaks to KangaNews about the economic outlook, the wealth trade-off between wage earners and asset owners, the risk of deglobalisation and how sustainability is factoring in to his forecasting.
We are not necessarily good at calling inflection points when we are living through them, but it seems apparent that this is a change in era for markets. What are the uncertainty factors in in how you are thinking about where economies are going in the coming years?
The uncertainty in the policy environment is whether central banks will be able to achieve their objectives without moving significantly into contractionary territory – whether they can achieve a balance that is not very damaging for asset markets. Major global downturns have almost always been associated with the bursting of asset bubbles related to policy mistakes.
What we should not take our eyes off is the fact QE has two aspects: the flow of new bonds and the size of central-bank balance sheets. The latter remains stimulatory. For instance, we are seeing the Fed [US Federal Reserve] tapering bond purchases but it has no immediate intention of actually shrinking its balance sheet. It is the same for the RBA [Reserve Bank of Australia] and the Bank of Canada.
These central banks are maintaining a very high level of stimulus, supplementing negative real rates. This means central banks can be reasonably comfortable allowing long-term rates to move back to the inflation rate rather than having to keep them in negative territory.
This also means the policy rate could remain in the negative real space – with a positive yield curve. The risk is the central banks assume they can lift cash rates, potentially out of the negative real space, without risking a recession.
However, if they overestimate the stimulatory benefits of their expanded balance sheets and push rates too far they could end up with the familiar problem of bursting asset bubbles and another major downturn.
How far they need to go really depends on how labour markets respond to current inflationary shocks from supply-chain disruption and whether wage growth gets embedded in the system in the way we saw in the 1970s. There were so-called cost-of-living adjustments that meant wages went up when prices went up. This was boosted by sharp increases in inflation expectations. Accordingly, households and businesses felt they had pricing power, which spiralled into the mess that needed [Fed chair Paul] Volcker to push rates up to 20 per cent later in the decade.
Two of the things I believe are helping us now are that the labour market is not geared to indexation – if it was it would embed price rises into the system – and we do not have a business sector with sufficient confidence in its pricing power to pass on large wage increases. This is protecting us for now – and, once the supply chain starts to mend, international competition will hold down prices.
On the other hand, inflation expectations will surge if the supply chain doesn’t come back as expected and businesses feel they have got pricing power back and lose their discipline on cost control. This will push up wages and lead to a very nasty end game – given our overvalued asset markets.
I am reasonably optimistic that the structure of labour markets, businesses’ commitment to cost control and the recovery in international competition will be enough to avoid the sort of embedded inflationary pressures that require overshooting interest rates.
This pernicious cycle cannot necessarily be averted even if the price pressures associated with the supply shocks – both goods and labour – ease back, if the damage has already been done with wages and inflationary expectations. This may already be the case in the US.
“The labour market is not geared to indexation style and thus embedding price rises into the system, while the business sector does not have sufficient confidence in its pricing power to pass on large wage increases. This is protecting us for now – and, once the supply chain starts to mend, international competition will hold down prices.”
There is some suggestion that the next phase of world politics and policy will feature renewed demand for, effectively, redistribution of wealth from asset owners to wage earners. Is this what we are really discussing when we talk about asset prices and wages growth?
For the system to adjust in a way that would accommodate a shift toward labour’s share, we would likely need to see businesses believing they have pricing power to support paying higher wages, unions making a comeback to embed much bigger wage increases or labour shortages becoming permanent as, say, lower participation rates become structural.
The pricing-power aspect would likely need competition from the developing world to dissipate – deglobalisation, if you like. This is a realistic prospect. Take for example China persevering with trying to remain COVID-19 free. This policy may lead to ongoing lockdowns, disrupted supply chains and some potential upward pressure on Chinese inflation – as we have seen with other countries that tried to eliminate rather than live with COVID-19.
The point about the redistribution of wealth would also occur if we saw a move to positive real rates as the current global glut in savings reversed. Savers would be rewarded at the expense of borrowers, whose asset prices would come under pressure. This would be achieved by boosting investment and spending, encouraging animal spirits. China would be a great place to start, although recent political developments are not encouraging from this perspective.
This is where the comparison to the 1970s seems to run out of road. Household indebtedness was much lower because asset prices – particularly housing – were also lower. From what you are saying, we are now in a position where we cannot allow wages to rise, even if prices do, because our economies are so exposed to asset markets. Is an unwind necessary or even inevitable?
Central banks are aware of the feedback effects of unwinding asset bubbles and history has not been kind to how they have managed those issues. Take the 1990s. [Fed chair Alan] Greenspan rattled markets by referring to “irrational exuberance”, but then we had the Russian crisis and the collapse of Long Term Capital Management – and he responded by slashing rates further and feeding the tech boom.
The response to the 1987 share-market crash was also to slash rates, which supported a property boom. In other words, when one asset bubble bursts central banks have responded in a way that risks inflating another one.
We get back to how much liquidity has been created by QE programmes over the past two years: balance-sheet expansions of 10-20 per cent of GDP in the G7. This liquidity is going to sit there and not be unwound. The Fed tried to unwind a little in 2018 and almost ended up with a liquidity crisis. I think this QE-created liquidity is going to be more or less a permanent support for asset markets.
In other words, even as central banks start to think about raising rates they also have to account for this other stimulus, which will complicate their assessment of their policy stance.
“Central banks are aware of the feedback effects of unwinding asset bubbles and history has not been kind to how they have managed those issues. In other words, when one asset bubble bursts central banks have responded in a way that risks inflating another one.”
If we have price inflation but not wage inflation, is it a given that the developed world is confronting a retreat in standard of living?
No, because price inflation will not be sustained without wage inflation and supply chains will not stay broken forever. To be sustainable, inflation has to trigger both rising wage growth and inflation expectations for households – to encourage higher wage claims – and business, to allow higher costs to be passed on.
This outcome is possible but dangerous. The markets are betting on an early beginning to tightening cycles with relatively low peaks – generally in negative real territory. Whereas the central banks expect a slower beginning but assume some type of equilibrium at positive real rates without factoring in feedback loops from asset markets to the real economy. It is almost as if the central banks are factoring in a policy mistake by leaving the tightening cycle too late, eventually needing a policy overshoot – a likely hard landing for asset markets – to be followed by a quick policy reversal, as we have seen before.
Are you watching New Zealand closely? It seems to be a canary in the coal mine in the sense of ultra-low unemployment, wages pressure, inflation and the rates outlook.
We pay attention to New Zealand but, as the small closed economy it has become since COVID-19, it has more extremes. To take just one example, it had a 4.2 per cent increase in the cost of building a house last quarter – it was 1.8 per cent in Australia. New Zealand also has a tighter labour market with a lower unemployment rate – although we are predicting a record low 3.8 per cent unemployment rate for Australia by the end of 2022.
Our New Zealand economists have a 3 per cent cash-rate forecast in 2023, which is about 1 per cent higher than inflation – so dangerous positive real-rate territory. I’m not across the detail, but this is the point I was making about rates moving into deeply contractionary territory. It would end up with severe implications for New Zealand housing, which has moved much further than Australia. Since 2017, New Zealand house prices are up around 55 per cent compared with 20 per cent for Australia.
The Reserve Bank of New Zealand talks about the “path of least regrets” as a key element of its monetary-policy approach. Is this the main dilemma central banks face today: of having to hike early, with the potential impact on asset prices for something that may not in the end be necessary, or pause and risk having to overshoot later?
This has always been the risk. It has just been so long since central banks have seen inflation getting away from them. This is why many have decided not to move until inflation is definitely there. In the old days, they had to be pre-emptive – to head inflation off at the pass – because it could move very quickly.
But when central banks have been pre-emptive over the past 10-15 years – which they have done on a number of occasions – they have invariably ended up moving too soon. A classic example is when the RBA went to 4.75 per cent from 3 per cent in 2008-9 in anticipation of a mining boom that was ultimately somewhat benign for inflation.
This is why the RBA is waiting to see inflation sustainably reach the target – as is the Fed. They don’t believe inflation can overshoot, so they would rather wait to get there and then rein it in. It seems to be a more urgent approach in New Zealand – and markets are priced for a peak of around 2.25 per cent in 2023.
“The worry for me is the way global investors might start to view a country, like Australia, that is seen to be underperforming on its domestic policies and at the same time is the world’s second-largest exporter of thermal coal. It looks to be a risky mix.”
How is sustainability influencing your work and, in particular, do you see environmental transition as more of an opportunity or a challenge for Australia?
I have given most attention to implications for markets. Australia is unusual in this respect. It is a developed economy that, while signed up to the net-zero by 2050 target, is lagging behind other developed economies on its 2030 target. At the same time, forecasts for our thermal-coal exports are 200 million tonnes for the next few years; there is no sign of these exports scaling back in the near future. We also export about 80 per cent of our production, so what we do domestically is much less important than our global role.
The worry for me is the way global investors might start to view a country, like Australia, that is seen to be underperforming on its domestic policies and at the same time is the world’s second-largest exporter of thermal coal.
It looks to be a risky mix. If we were really overperforming on our domestic objectives, perhaps international investors would take the view that if everyone else follows our example our exports would soon start to fall. But if we are disappointing domestically, the spotlight might shift to those exports.
We have already seen some examples of investors responding. In 2019, Riksbank divested its holdings in Queensland and Western Australia. Fortunately this is an isolated example but investors are moving quickly and we cannot be oblivious to the risks.
Given how much Australia relies on foreign capital – half our sovereign bonds are owned offshore and the banks source 20-30 per cent of their funding offshore – we need to be careful. The prospect of having to rely on second-order, more expensive capital markets is not attractive.
This would not just be a problem for the sovereign. Even corporates and banks could become tainted by perceptions of the sovereign, challenging their access to the most efficient markets.
WOMEN IN CAPITAL MARKETS Yearbook 2021
KangaNews's annual yearbook amplifying female voices in the Australian capital market.
KANGANEWS SUSTAINABLE FINANCE H2 2021
KangaNews is proud to share cutting-edge information from the global and Australasian sustainable debt market.