Saturday, 9 June 2012

RBA Governor Stevens' "Glass Half Full" Speech - The Party is Over!




Awesome speech. My estimation of the guy has gone up 500%. You can almost feel the ructions in the force and smell the property speculators soiling themselves.

There was an expectation by the herd (bordering on a perception of an unalienable right) that the Reserve Bank would keep the property bubble inflated even if it went to Zero Interest Rate Policy (ZIRP) and money printing. Well guess what? You're in trouble.

The speech is here: The Glass Half Ful (with graphs)

Excerpt:

But there is another aspect of the ‘multi-speed’ experience, which I suspect explains a good deal of the dissatisfaction we see, and it has to do with the behaviour of the household sector. Some parts of the economy that depend on household spending are still experiencing relatively weak conditions, compared with what they have been used to. But this isn’t because the mining boom spillovers have failed to arrive. It is, instead, the result of other changes that actually have nothing to do with the mining boom per se, but a lot to do with events that occurred largely before the mining boom really began.

The story is summed up in the two charts shown below. The first shows household consumption spending and income, both measured in per capita terms, and adjusting for inflation (Graph 2).[2] In brief, household spending grew faster than income for a lengthy period up to about 2005. The arithmetically equivalent statement is that the rate of saving from current income declined, by about 5 percentage points over that period.

It was no coincidence that households felt they were getting wealthier. Gross assets held by households more than doubled between 1995 and 2007. The value of real assets – principally dwellings – rose by more than 6 per cent per annum in real, per capita terms over the period (Graph 3).

Only a small part of this was explained by an increase in per capita expenditure on dwellings. The bulk of it came from rising prices. Moreover, a good deal of borrowing was done to hold these assets and household leverage increased. The ratio of aggregate household debt to gross assets rose, peaking at about 20 per cent. There was definitely a large rise in measured net worth, but relative to aggregate annual income, gross debt rose from 70 per cent in 1995, to about 150 per cent in 2007. Correspondingly, by 2007 the share of current income devoted to servicing that debt had risen from 7 per cent to 12 per cent, despite interest rates in 2007 being below those in 1995.

It is still not generally appreciated how striking these trends were. I cannot say that it is unprecedented for spending to grow consistently faster than income, because it had already been doing that for the 20 years prior to 1995. That is, the saving rate had been on a long-term downward trend since the mid 1970s. But it is very unusual in history for people to save as little from current income as they were doing by the mid 2000s. And it is very unusual, historically, for real assets per person to rise at 6 per cent or more per annum. It is also very unusual for households actually to withdraw equity from their houses, to use for other purposes, but for a few years in the mid 2000s that seemed to have been occurring.

Of course, Australia was not alone in seeing trends like this. There were qualitatively similar trends in several other countries, particularly English-speaking countries that experienced financial innovation. The international backdrop to this period was the so-called ‘great moderation’, in which there was a decline in macroeconomic variability. There were still business cycles but downturns were much less severe than in the 1970s or 1980s, inflation was low and not very variable, which meant that nominal interest rates also were generally low and not very variable, and compensation for risk became very modest.[3]

This ‘moderation’ came to an end with the crisis beginning in 2007. And with a few years of perspective, it is increasingly clear that Australian households began to change their behaviour at that time, or even a little before. The rate of saving from current income stopped falling probably around 2003 or 2004, and began to increase (we now know), slowly at first as the income gains from the first phase of the resources boom started in about 2005 or 2006, and then more quickly in 2008 and 2009.

Real consumption spending per head initially remained pretty strong in this period, reaching a peak in 2008. It then declined for a year or so, before resuming growth in the second half of 2009. That growth has, however, been much slower than had been observed previously. In the nearly three years from mid 2009 through to the March quarter 2012, real consumption per head rose at an annual pace of about 1½ per cent.

This is more than a full percentage point lower than the growth rate from 1995 to 2005. But this sort of growth is in fact quite comparable with the kind of growth seen in the couple of decades leading up to 1995. It is line with the quite respectable growth in income. But the gap between the current level of consumption and where it would have been had the previous trend continued is quite significant. If we then consider the growth of foreign online sales and so on, and the fact that consumers seem more inclined to consume services – experiences, as opposed to goods – we can see this is a significant change for the retail sector.

No doubt reinforcing this trend towards more circumspect, but more typical, behaviour is that the earlier strong upward trend in real assets per head has abated over recent years. In fact, real household assets per head today are about the same as they were five years ago, with a dip during the crisis, a subsequent partial recovery and then a slow drift down over the past couple of years. Both dwelling prices and share prices – the two really big components of wealth – have followed that pattern.

At some point, wealth will begin to increase again. After all, people are saving a reasonable amount from current income and placing the proceeds into various assets (especially, of late, deposits in financial institutions). That is, they are building wealth the old fashioned way. Ultimately these flows will be reflected in higher holdings of real and financial assets, at least once debt levels are regarded as comfortable. Asset valuation changes can of course dominate saving flows in shifting wealth over short periods and they are inherently unpredictable. So no one can predict the course of these measures of wealth over any particular short period. But wealth will surely resume an upward track, sooner or later.[4]

When it does, however, it is unlikely to be at 6 or 7 per cent per year in real, per capita terms. I would guess that over the long term, something more like 3 per cent would be nearer the mark.

I think this is a profoundly important point and worth emphasising. The decade or more up to about 2007 was unusual. It would be quite surprising, really, if the same trends – persistent strong increases in asset values, very strong growth in per capita consumption, increasing leverage, little or no saving from current income – were to re-emerge any time soon. That is, the gap between consumption today and the old trend level on the chart is not going to close. I noted to another audience about three years ago that the prominence of household demand in driving growth in the 1990s and 2000s was unlikely to be repeated.[5] If there were business strategies that assumed a resumption of the earlier trend, they will surely be disappointed in time, if they have not been already.

There were several parts of the economy that benefited from that earlier period, and that are finding the going much tougher now. Retailing was obviously one, but so was banking. Banks and other financial institutions enjoyed rapid balance sheet and profit expansion as they lent to households and some businesses. But they can see that period has now finished. Businesses that serviced rapid turnover in the dwelling stock (such as real estate agents, mortgage brokers) are seeing those revenue streams considerably reduced, and are having to adjust their strategies and capacity to suit changed conditions. For example, the rate of dwelling turnover is about one-third less than it was on average over the previous decade, and about half its peak levels. This is affecting state government stamp duty collections as well as the real estate sector.

We can also see some echoes of these changing trends in household demand in business investment spending.

This chart shows business investment, split into mining and non-mining, and measured in real, per capita terms, so as to be consistent with the earlier charts (Graph 4). Investment has been on a stronger upward trend since the mid 1990s than it had been for a number of years before that. In particular, business investment in real per capita terms has grown, on average, by over 6 per cent per annum since 1995, more than double the average pace over the preceding 35 years. Moreover a lot of this was in the non-mining sector, and it began before the present run up in mining investment really got going. Some of this growth reflected the same ‘consumer facing’ growth sectors mentioned above. Of the four sectors that had the fastest growing investment spending over that period, three were finance, one called ‘rental hiring and real estate services’, and retail trade. Some of these sectors are slowing their investment rates now.

Meanwhile, mining investment has recently been rising at an extraordinary pace. In 2005, mining investment was near its long-run average of around 2 per cent of GDP. By mid 2014 we expect it to reach at least 9 per cent of GDP. If that occurs, mining investment will be about as large as business investment in the rest of the private economy combined. As a result of that, total business investment will reach new highs this year, and next. Hence there is a very large build-up in the nation's capital stock occurring. If it is well managed and soundly based, that ought to allow the possibility of further growth in output and incomes. The investment phase of the mining boom will start to tail off in a couple of years' time, after which the shipments of natural resources should step up significantly.

We might expect by then as well that some other areas of investment spending that are weak at present will be picking up. More generally, I suspect we will discuss the nature of investment quite a bit in coming years as we grapple with structural change in the economy and powerful shifts in the population's needs (think of investment in the aged-care sector, for example, or public infrastructure needs). We will also be looking for productivity pay-offs from the various investments.

But the key message for today is that the multi-speed economy is not just about the mining sector squeezing other sectors by drawing away labour and capital and pushing up the exchange rate. It is doing that, but slower growth in sectors that had earlier done well from unusually strong gains in household spending would have been occurring anyway, even if the mining boom had never come along. It is these changes in behaviour by households, in asset markets and in credit demand, that I think lie behind much of the disquiet – dissatisfaction even – that so many seem to have been expressing. But this would, as I say, have occurred with or without the mining boom. In fact, without the mining boom and its spillovers, we would have been feeling the effects of those adjustments rather more acutely than we do now. The period of household gearing up could have ended in a much less benign way.

Implications for Policy

What are the implications of these trends for economic policy, and particularly monetary policy? Does it have a role in helping the adjustment?

One thing we should not do, in my judgement, is to try to engineer a return to the boom. Many people say that we need more ‘confidence’ in the economy among both households and businesses. We do, but it has to be the right sort of confidence. The kind of confidence based on nothing more than expectations of ever-increasing housing prices, with the associated willingness to continue increasing leverage, on the assumption that this is a sure way to wealth, would not be the right kind. Unfortunately, we have been rather too prone to that misplaced optimism on occasion. You don’t have to be a believer in bubbles to think that a return to sizeable price increases and higher household gearing from still reasonably high current levels would be a risky approach. It would surely be a false basis for confidence. The intended effect of recent policy actions is certainly not to pump up speculative demand for assets.[6] As it happens, our judgement is that the risk of re-igniting a boom in borrowing and prices is not very high, and this was a key consideration in decisions to lower interest rates over the past eight months.

Hence, I do not think we should set monetary policy to foster a renewed gearing up by households. We can help, at the margin, the process of borrowers getting their balance sheets into better shape. To the extent that softer demand conditions have resulted from households or some businesses restraining spending in an effort to get debt down, and this leads to lower inflation, our inflation targeting framework tells us to ease monetary policy. That is what we have been doing. The reduction in interest rates over the past eight months or so – 125 basis points on the cash rate and something less than that, but still quite a significant fall, in the structure of intermediaries' lending rates – will speed up, at the margin, the process of deleveraging for those who need or want to undertake it.

In saying that, of course, we cannot neglect the interests of those who live off the return from their savings and who rightly expect us to preserve the real value of those savings. Popular discussion of interest rates routinely ignores this element, focusing almost exclusively on the minority of the population – just over one-third – who occupy a dwelling they have mortgaged. The central bank has to adopt a broader focus. And to repeat, it is not our intention either to engineer a return to a housing price boom, or to overturn the current prudent habits of households. All that said, returns available to savers in deposits (with a little shopping around) remain well ahead of inflation, and have very low risk.

So monetary policy has been cognisant of the changed habits of households and the process of balance sheet strengthening, and has been set accordingly. As such, it has been responding, to the extent it prudently can, to one element of the multi-speed economy – the one where it is most relevant.

What monetary policy cannot do is make the broader pressures for structural adjustment go away. Not only are the consumption boom and the household borrowing boom not coming back, but the industry and geographical shifts in the drivers of growth cannot be much affected by monetary policy. To a large extent, they reflect changes in the world economy, which monetary policy cannot influence. Even if, as a society, we wanted to resist the implications of those changes other tools would be needed.

In fact Australia does better to accommodate these changes, and to think about what other policies might make adjustment less difficult and quicker for those adversely affected. It is in this area, in fact, that we need more confidence: confidence in our capacity to respond to changed circumstances, to respond to new opportunities, and to produce goods and services which meet market demands. It is also to be hoped that some of the recent positive data outcomes will give pause to reflect that, actually, things have so far turned out not too badly.

Key Points:

Trend data
  • Household spending grew faster than income for a lengthy period up to about 2005
  • Households felt they were getting wealthier
  • Gross assets held by households more than doubled between 1995 and 2007. The value of real assets – principally dwellings – rose by more than 6 per cent per annum in real, per capita terms over the period (John Howard's bubbliciously prosperous years)
  • Only a small part of this was explained by an increase in per capita expenditure on dwellings. The bulk of it came from rising prices
  • Borrowing was done to hold these assets and household leverage increased
  • The ratio of aggregate household debt to gross assets rose, peaking at about 20 per cent
  • There was definitely a large rise in measured net worth, fuelled by debt (if I hear one more lemming say "I've had success with property", I'm getting a gun licence - EVERYBODY got ahead)
  • Relative to aggregate annual income, gross debt rose from 70 per cent in 1995, to about 150 per cent in 2007 (but Peter Costello was the world's greatest treasurer, you mean were just doubled the credit limit and felt richer?)
  • By 2007 the share of current income devoted to servicing that debt had risen from 7 per cent to 12 per cent, despite interest rates in 2007 being below those in 1995

An aberration
  • It is still not generally appreciated how striking these trends were (the Wildebeeste mated with an Ostrich factor)
  • It is very unusual in history for people to save as little from current income as they were doing by the mid 2000s
  • It is very unusual, historically, for real assets per person to rise at 6 per cent or more per annum
  • It is also very unusual for households actually to withdraw equity from their houses, to use for other purposes, but for a few years in the mid 2000s that seemed to have been occurring (PONZI cash in !!!)

Global banking
  • Australia was not alone in seeing trends like this. There were qualitatively similar trends in several other countries, particularly English-speaking countries that experienced financial innovation (Ireland, UK and USA)
  • Taking risks became almost risk free

Savings, consumption and reality
  • The rate of saving from current income stopped falling probably around 2003 or 2004, and began to increase (we now know), slowly at first as the income gains from the first phase of the resources boom started in about 2005 or 2006, and then more quickly in 2008 and 2009 (borrow and speculate in a Ponzi scheme and use the gains to spend)
  • Real consumption spending per head initially remained pretty strong in this period, reaching a peak in 2008
  • It then declined for a year or so, before resuming growth in the second half of 2009 (GFC then Rudd stimulus and FHOG grants boosting home equity)
  • In the nearly three years from mid 2009 through to the March quarter 2012, real consumption per head rose at an annual pace of about 1½ per cent  (home quity ATM is 'out of service')
  • This is more than a full percentage point lower than the growth rate from 1995 to 2005. But this sort of growth is in fact quite comparable with the kind of growth seen in the couple of decades leading up to 1995. It is line with the quite respectable growth in income
  • The gap between the current level of consumption and where it would have been had the previous trend continued is quite significant  (party is over! bar is closed!)

Pop goes the bubble
  • Real household assets per head today are about the same as they were five years ago, with a dip during the crisis, a subsequent partial recovery and then a slow drift down over the past couple of years. Both dwelling prices and share prices – the two really big components of wealth – have followed that pattern (its effectively 2007, FIVE YEARS OF GAINS ARE GONE!!! How far back will we go?)

The glimmer of the false dawn?
  • At some point, wealth will begin to increase again (When? At least 6 years from 2009 peak?)
  • After all, people are saving a reasonable amount from current income and placing the proceeds into various assets (especially, of late, deposits in financial institutions). That is, they are building wealth the old fashioned way
  • Ultimately these flows will be reflected in higher holdings of real and financial assets, at least once debt levels are regarded as comfortable (It won't fall forever and there will be a bottom, though the Irish, Spanish and Americans etc are still waiting for theirs. Mariana's Trench is 35,800ft deep but it does have a bottom!)
  • The RBA can't predict the course of these measures of wealth over any particular short period. But wealth will surely resume an upward track, sooner or later (Japan is near the bottom 22 years from the top)

When the party starts again, the bar will be closed and its square dancing only
  • When it does bottom future gains are unlikely to be at 6 or 7 per cent per year in real, per capita terms. I would guess that over the long term, something more like 3 per cent would be nearer the mark (CPI gains only - the doubling every 7 or 10 years bullsh*t is OVER!!)
  • The decade or more up to about 2007 was unusual (lets call it the Howard Era or GADO period - Greed And Debt Orgy)
  • It would be quite surprising, really, if the same trends – persistent strong increases in asset values, very strong growth in per capita consumption, increasing leverage, little or no saving from current income – were to re-emerge any time soon
  • The prominence of household demand in driving growth in the 1990s and 2000s was unlikely to be repeated
  • If there were business strategies that assumed a resumption of the earlier trend, they will surely be disappointed in time, if they have not been already

Who needs to seriously look at alternative career options
  • There were several parts of the economy that benefited from that earlier period, and that are finding the going much tougher now. Retailing was obviously one, but so was banking. Banks and other financial institutions enjoyed rapid balance sheet and profit expansion as they lent to households and some businesses. But they can see that period has now finished  (FINITO!!)
  • Businesses that serviced rapid turnover in the dwelling stock (such as real estate agents, mortgage brokers) are seeing those revenue streams considerably reduced, and are having to adjust their strategies and capacity to suit changed conditions
  • For example, the rate of dwelling turnover is about one-third less than it was on average over the previous decade, and about half its peak levels
  • Low turnover is affecting state government stamp duty collections as well as the real estate sector (they'll slash the public service, scrimp on infrastructure and get their debt ratings downgraded)
  • We can also see some echoes of these changing trends in household demand in business investment spending
  • Of the four sectors that had the fastest growing investment spending over that period, three were finance, one called ‘rental hiring and real estate services’, and retail trade. Some of these sectors are slowing their investment rates now
  • The investment phase of the mining boom will start to tail off in a couple of years' time
  • The multi-speed economy is NOT about the mining sector squeezing other sectors by drawing away labour and capital and pushing up the exchange rate
  • Slower growth in sectors that had earlier done well from unusually strong gains in household spending (fuelled by house price rises) would have been occurring anyway, even if the mining boom had never come along
  • The Changes in behaviour by households, in asset markets and in credit demand, that lie behind much of the disquiet – dissatisfaction even – that so many seem to have been expressing stems from the lack of home equity growth (disquiet? Some are sh*tting themselves on realising it was just a Ponzi scheme)

All bubbles burst and the RBA will not reinflate Australia's
  • Without the mining boom and its spillovers, we would have been feeling the effects of those adjustments rather more acutely than we do now
  • The period of household gearing up could have ended in a much less benign way (its not over Glenn, its only starting)
  • The RBA should not do try to engineer a return to the boom (come on Glenn, stop f*cking around, call it a bubble)
  • Many people say that we need more ‘confidence’ in the economy among both households and businesses. We do, but it has to be the right sort of confidence
  • The kind of confidence based on nothing more than expectations of ever-increasing housing prices, with the associated willingness to continue increasing leverage, on the assumption that this is a sure way to wealth, would not be the right kind

Herd theory, naivety and stupidity
  • We have been rather too prone to the misplaced optimism on the expectation of ever increasing house prices (Wildebeeste factor)
  • You don’t have to be a believer in bubbles to think that a return to sizeable price increases and higher household gearing from still reasonably high current levels would be a risky approach and a false basis for confidence
  • The intended effect of recent policy actions is certainly not to pump up speculative demand for assets. The risk of re-igniting a boom in borrowing and prices is not very high, and this was a key consideration in decisions to lower interest rates over the past eight months (start bubbling again and UP those interest rates will go!!)

RBA policy on the indebted and savers and re affirming the party is over
  • Inflation targeting framework sets monetary policy. The reduction in interest rates over the past eight months or so – 125 basis points on the cash rate and something less than that, but still quite a significant fall, in the structure of intermediaries' lending rates – will speed up, at the margin, the process of deleveraging for those who need or want to undertake it (don't take on more debt, pay down the loans you have)
  • The RBA cannot neglect the interests of those who live off the return from their savings and who rightly expect us to preserve the real value of those savings (this is important, the RBA will NOT go to zero rates, returns on deposits are important)
  • Popular discussion of interest rates routinely ignores savers, focusing almost exclusively on the minority of the population – just over one-third – who occupy a dwelling they have mortgaged
  • The central bank has to adopt a broader focus and it is not the intention either to engineer a return to a housing price boom, or to overturn the current prudent habits of households (keep saying it Glenn and the Wildebeeste may listen)
  • Returns available to savers in deposits (with a little shopping around) remain well ahead of inflation, and have very low risk
  • Monetary policy has been cognisant of the changed habits of households and the process of balance sheet strengthening, and has been set accordingly
  • It has been responding, to the extent it prudently can, to one element of the multi-speed economy – the one where it is most relevant.
  • Monetary policy cannot make the broader pressures for structural adjustment go away (ie the recessions you HAVE to HAVE in a market economy)
  • The consumption boom and the household borrowing boom not coming back (keep saying it Glenn and the Wildebeeste may listen)
  • Industry and geographical shifts in the drivers of growth cannot be much affected by monetary policy. To a large extent, they reflect changes in the world economy, which monetary policy cannot influence. Even if, as a society, we wanted to resist the implications of those changes other tools would be needed (ie in case of a mining slowdown due China's hard landing and/or Euro/USA meltdown)
Well that sucks. No more risk free real estate to riches schemes. Baby boomers with investment properties are going to jump? First in best dressed or hope to hell and hang in there?

Don't you just hate waking up the day after a crazy party, one that you thought would never end?


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