RBA-Speak, Animal Spirits, and the New Capital Discipline

Central bank speak has come a long way since central banks around the world started to adopt inflation targets from the early 1990s.  As part of the process of learning by doing, central banks have steered a fine balance between greater communication and transparency, while retaining policy flexibility.  As one of the early adopters of inflation targeting, the Reserve Bank of Australia (RBA) has done a better job than most.  Its carefully worded target of ‘maintaining inflation of 2-3% on average through the cycle’ has helped to focus its communications and frame monetary policy decisions, but at the same time provided scope for ample policy discretion.

In an era where the official interest rates across major developed economies have hit the zero lower bound, central bank-speak and forward guidance on monetary policy has taken on a new meaning.  Even for central banks that are not engaging in quantitative easing, deciphering the nuances between a bank’s policy reaction function and its view on the outlook has become increasingly challenging for economists.  At the 2012 Jackson Hole Symposium, Michael Woodford argued that markets are more likely to react to central bank speak about a bank’s policy reaction function because there is less information publicly available about central bankers’ intentions than about the economic outlook.

Both its actions and communications in recent years have suggested that the RBA has been a reluctant rate cutter, influenced by what it has considered to be uncomfortably high inflation in non-tradeables and concerns surrounding financial stability.  The result has been weakness in nominal GDP and profit growth, which is expected to persist.  In its updated Economic Statement released in early August, the Treasury downgraded its growth projections for nominal GDP to 2.5% (FY13) and 4.25% (FY15), which represents a dismal outlook considering that the economy has posted nominal GDP growth of at least 5% in seventeen of the past eighteen financial years.

Skeptikoi believes that the RBA’s quarterly update released on 9^th August had a distinctly dovish tone.  The Statement of Monetary Policy (SMP) and other communications suggest that the Bank’s policy reaction function has probably not changed.  Rather, the Bank continues to be confounded by the persistent weakness in business conditions and non-mining capital investment despite the cumulative 225 basis point cut to the official cash rate (OCR) since October 2011.  It acknowledges that business and labour market conditions remain weak and that there are little signs of a pick-up in growth of either non-mining investment or employment.

Persistent weakness in labour costs has reduced the Bank’s concerns about the outlook for non-tradeables inflation.  The SMP cited that wages growth has slowed to its lowest rate in a decade and combined with strong productivity growth, this has contributed to low growth in unit labour costs.  And its Monetary Policy Statement on 7^th August cited the prospect of further moderation labour cost growth as helping to offset the inflationary impact of the lower dollar and help to keep inflation within the target band.

The continued weakness in business conditions and the labour market can be traced back to what Skeptikoi believes is a deep corporate recession outside of the banking sector that has ended only recently.  Gross Operating Surplus (the National Accounts profits metric) for private non-financial corporations declined in the five quarters to December 2012, the longest stretch of consecutive quarterly declines since the inception of the National Accounts in 1959.  The 12% peak to trough decline in non-financial GOS is comparable to the financial crisis (-13.5%) but not as severe as the recession of 1990-91 (-16%).  The corporate recession has seen the non-financials profit share of GDP decline to 17.8% in December 2012, its lowest level in seven years and well below the record peak of 22% in September 2008.

A rise in the non-financials profit share to 18.3% in the March quarter 2013 and the continued moderation in growth of unit labour costs suggest that the profit cycle probably bottomed in the December quarter.  Unit labour costs are productivity adjusted wages growth and are important in shaping shifts in corporate profitability and inflation.  Low growth in unit labour costs is typically associated with strong earnings growth and low inflation.  After expanding at an annualised rate of almost 4% in the two years to March 2012, unit labour costs have actually declined marginally in the four quarters since.  Outside of the financial crisis, this represents the first time unit labour costs have been flat or declined over four quarters since 1998.

It is little wonder then that companies have been aggressively containing costs.  There are already signs in the early stages in the current reporting season that companies continue to focus their efforts on boosting productivity.  At its interim result, RIO announced that improving performance through cost reductions and efficiency gains remains one of three key priorities.  It flagged that it had achieved cost reductions of $1.5 billion in the first half, significant in the context of a $4.2 billion interim underlying earnings result.  The new capital discipline is not confined to the mining sector.  In its full year result, Telstra announced that it had delivered $1 billion in productivity improvements, and that consequently, operating expenses rose by only 0.5%, the second consecutive year in which they had increased well below inflation.

Skeptikoi believes that the renewed cost consciousness and capital discipline amongst the ASX200 companies will remain a feature of the corporate environment for a while yet, which represents a powerful tailwind for corporate profitability and stock-market returns.  Firms will continue to find ways to deliver productivity improvements, and will tend to defer capital investment where feasible in favour of either returning capital to shareholders or further building up cash balances for a rainy day.  Consequently, the recovery in non-mining capital investment is likely to remain soft.

The RBA’s more sanguine assessment of unit labour costs and inflation reveal that the bank is more alive to the growing risks of a shortfall in aggregate demand stemming from corporates simultaneously containing costs and seeking to boost efficiencies.  Further declines in the OCR are necessary to revive the corporate sector’s dormant animal spirits and encourage companies to invest rather than hoard or return cash to shareholders.  But more aggressive language that points to a change in the central bank’s policy reaction function would also help.