Overlearning from History and the RBA's Nominal Recession

Most of the recent media’s focus on the Reserve Bank of Australia (RBA) has been on the withering character assessment of Kevin Rudd from RBA board member and former Woolworths CEO, Roger Corbett.  Which is a shame, because the focus should be on the fact that the June quarter National Accounts revealed that in the 2013 financial year, Australia experienced its deepest nominal recession for two decades, due largely to excessively tight monetary policy.

Although many economists focus on the real GDP estimates, Skeptikoi believes that nominal GDP – which captures growth in real GDP and inflation - is a better indicator of the household and business sectors’ cash flows.  The June quarter National Accounts revealed that the nominal economy expanded at an annual average rate of 2.5% in the 2013 financial year.  This represents the softest outcome since the last recession, when nominal GDP grew by less than 2% in 1992.  And it is well below trend growth in nominal GDP, of 5-6%.

The widely used metric for defining a recession in Australia is two consecutive quarterly declines in real GDP.  By this standard, Australia has not had a recession in over two decades.  But if a more comprehensive measure of a recession is used, based on annual average growth in nominal GDP falling below a trigger of 4%, then Australia has just experienced its worst nominal recession since 1992.  By this measure, the economy was also in recession in the 2010 financial year, a period in which average annual growth in nominal GDP was only 3%.

There is a small but growing view that central banks ought to augment or replace inflation targeting with a nominal GDP targeting framework.  On this report card, the RBA scores a fail for two of the past four years.  The 15% decline in the terms of trade from its peak, the associated downgrade to the mining sector’s future growth prospects and persistently high value of the Australian dollar are not responsible for the worst nominal GDP growth outcome for two decades.  Skeptikoi believes that the RBA ‘owns’ the nominal recession.  Despite the record low official cash rate of 2.5%, monetary conditions in Australia remain tight.  Credit growth is tepid, the housing recovery is uneven (approvals for private sector detached dwellings remain at a cyclical low) and the much anticipated handover from mining sector capex to non-mining sector capex remains a long way off. 

The National Accounts provided some encouraging signs.  Nominal GDP posted a 0.9% gain in the June quarter which lifted annualised growth for the June half to 4.5%, while financial sector profits grew by almost 3% to a record high and the terms of trade increased for the second consecutive quarter – albeit marginally – thanks largely to higher iron ore prices.  But non-financial sector profits have now declined for six of the past seven quarters and households remain cautious; the household saving ratio continued to creep up and has averaged more than 10% for the past five years, a level not seen since the mid-1980s.

Animal spirits in the business sector remain dormant and this is unlikely to change in the near-term, even given the likely resolution of uncertainty following the Federal election.  In it updated Economic Statement release in early August, the Treasury downgraded its growth projection for nominal GDP to 4.25% for the 2014 financial year, enough to lift Australia out of its nominal recession, but only just.  The reporting season and cautious guidance comments provided by the ASX200 companies provide further evidence of the unfolding shortfall in aggregate demand.  Large companies including RIO Tinto, BHP, Woolworths, Telstra, Woodside Petroleum, Brambles, Coca Cola Amatail (the list goes on) announced plans to further boost productivity, pare back costs, defer capex plans where feasible and in some instances reduce capex from current levels.

Companies continue to either hoard cash – net gearing levels remain close to record lows – or cater to the market’s insatiable appetite for income; the aggregate dividend payout ratio for the ASX200 has lifted to 70%, close to an historical high.  Corporate Australia’s focus on cost containment is reflected in weakness of the National Accounts measure of unit labour costs – productivity adjusted wages.  Despite a modest 0.8% rise in the June quarter, unit labour costs have stagnated over the past year, the first time this has happened since 1999 (ex the financial crisis).  The guidance comments from the ASX200 companies in the reporting season suggest that growth in unit labour costs (and inflation) will remain well contained, providing scope for the RBA to further ease policy.

The Economist magazine attributes the reluctance of the Obama administration to intervene in Syria to the lessons learnt from the occupations of Iraq and Afghanistan.  Skeptikoi believes that the RBA has been a reluctant rate cutter due to similar ‘overlearning from history’; the view that central banks contributed to the financial crisis by keeping policy too accommodative for too long in the aftermath of the dotcom bust.  The moral hazard view of the crisis largely discounts the role of a range of other proximate factors, notably a glut in global savings and strong demand for safe haven assets.  Importantly it is not clear that the counterfactual of tighter monetary policies through the early to mid-2000s would have prevented the financial crisis, particularly given that long term interest rates – which at the time central banks had little power to influence – continued to decline to record lows during this time.

The RBA would be well placed to learn the lessons from policy errors committed by the Federal Reserve over the past century.  David and Christina Romer present a persuasive thesis that the most dangerous idea in the history of the Federal Reserve is that monetary policy doesn’t matter, a view which they argue contributed to the Great Inflation of the 1970s and Great Depression.  The more the RBA seeks to jawbone the Australian dollar lower – without much success - the more Skeptikoi is convinced that the RBA continues to under-estimate the power of monetary policy to re-balance the economy, revive the business sector’s animal spirits and boost nominal GDP.  In time, Skeptikoi hopes that the RBA’s record as a reluctant rate cutter and its ownership of Australia’s nominal recession will come under greater scrutiny.