Transcript of Question & Answer Session Beware False Prophets

Andrew, so the first question was in your presentation of 27 June, you showed that historically Australia has been an importer of capital, and I remarked that two noted economists, Larry Somers and Olivier Blanchard of the Pearson Institute, have suggested that the high level of US net sovereign debt to GDP, which reaches 100 per cent of GDP next year according to the IMF estimates, will generate an equilibrium Fed- funds rate, this is according to Larry and Olivier, of not less than 4 per cent, that is to say a real rate of around about 2 per cent. Does this mean that the equilibrium real short rate in Australia is likely to move to a higher level going forward?

I think this concept of equilibrium real exchange rate is a bit like the supply capacity number in my speech, it’s a latent variable. You can’t go and look for it anywhere. Someone at the Bank of England joined and in the first week he wrote and said, ‘can somebody tell me where the measure of the equilibrium interest rate is’ and some wit wrote back and said ‘it’s the same place as the NAIRU and the sustainable level of output’. In other words, who knows. That’s an important point to start with. Nobody knows the answer to that. Larry Somers who is quite good at saying he does know the answer, although sometimes if you look back over his forecasting record it doesn’t always follow quite the certainty of his predictions. There’s huge uncertainty about what this number is. When he says real rate of 2per cent, he’s being provocative because if you look at the FOMC circle dots, for example, at the estimate of FOMC members – that’s US monetary policymakers estimates for the long-term real interest rate – they have a number like ½ per cent. It’s quite low. The John Williams estimate – John Williams is Head of the New York Fed in the US who has made a bit of a name on running various models on this – is probably somewhere between 0.5 and 1. So the 2 is higher, and that’s his point, that he thinks it’s going to be higher. There are an enormous number of different drivers of this number, right.

Ultimately R-star as it were, sorry to use the phrase R-star equilibrium real rate, is the outcome of equilibrium in the savings and investment market. And if you think about all the things that can drive that, those who think that number, including John and others, is relatively low will put weight on things like well demographics, their countries are getting older so they’re having to dissave rather than save. They will put weight on things like productivity, whereas in Australia and elsewhere productivity growth rates in most western countries – not the US – but most countries have been quite low. And they will say: ‘Actually I don’t buy this number like 2 per cent, it’s a lot lower than that. There’ll be others like Somers and others who say there’s new shocks and new issues around. I think in talking about the US debt he must be talking about a risk premium, if that’s right, which is to say look there’s so much debt that the US – 7 per cent deficit of GDP is pretty impressive – they’re issuing so much debt at some point there’ll be a wobble, there may even be concerns about default, risk premiums will go up and the R-star number will go up as people start charging up to lend to the US. You can think of other reasons too. Many people will think that the energy transition, for example, is going to lead to higher investment demand, which will raise that number. Who knows is the honest answer, whether it’s 2 per cent, 1 per cent or ½.

You asked the question about Australia and because it’s actually difficult to take no view on this at all we have a swathe for our own equilibrium short rate, equilibrium rate, which is similar to that swathe of numbers I showed you for unemployment and actually that has a central point of something like 3½, 3¾ in the nominal space. Obviously, our current cash rate is a little bit above that. I think you pay your money and you take your choice. I wouldn’t want to be someone trying to invest on the basis of these numbers. Somers may be right, but he may be wildly wrong.

Excellent. It’s a terrible thing to confess in front of a public audience, but I really enjoyed listening to that answer.

We’ll take a poll later if everyone agrees with that. It’s good to have an audience of one.

The second question is Kevin Walsh is a previous member of the Federal Reserve Board of Governors. He did that job for five years and now he’s a visiting distinguished fellow at the Hoover Institute at Stanford. In an article in the Wall Street Journal on 28 July, Kevin Walsh said that US inflation and interest rates would be rising if the Fed was not reducing the size of its balance sheet, and if it’s reducing the size of its balance sheet it’s reducing the money base and therefore that’s what’s driving inflation down. My question is, the RBA is currently running down its balance sheet and its quantitative tightening and you can see this in the RBA chart book. Is this one of the reasons that the RBA has not been forced to increase interest rates?

I could give you a one-word answer which is no. You might not like that quite as much as you liked my previous answer so let me elaborate a bit on that. The reason why people ask this question is obviously when interest rates were at zero or the effective lower bound during the COVID period and beforehand in the UK, central banks had to find other ways of expanding, of easing policy, and as you know they did it in the most part by buying assets and actually also by lending banks at longer than normal maturities, both of which the RBA also did before I arrived here, but certainly the Bank of England did a great deal of this as well. It was fairly commonly felt that effectively added to the amount of monetary stimulus in the economy, that if you like the effective short-term interest rate went negative to some extent. So, the thought underpinning the Kevin argument, I guess, is that if it worked on the way in, why wouldn’t it work on the way out. The trouble with that is that by and large, and people are looking at this very carefully, can’t really find any material macroeconomic effect of unwinding the balance sheet at all. Maybe a few basis points here or there, but no major central bank that’s doing it really considers that to be any part of its monetary policy strategy. We’re all watching in case that view/learning turns out to you are wrong, but our central estimate is that it is likely that QE unwind, or so-called QT, quantitative tightening – actually a bad phrase, right, because the ‘T’ implies more of an impact to the kind you’re describing than is actually the case. The central estimate at the moment across countries is the multiplier of the QT effect is very, very small.

I have a particular personal engagement in this because the Bank of England was one of the very few central banks, in fact I think the only one, that ran down its balance sheet not only by allowing assets to mature but by actively selling them back to the market. The New Zealand RBNZ has been selling assets back to its own debt management agency and the Riksbank, the Swedish central bank has been doing active sales more recently. But when we first announced we had to do this, the reason we felt we had to do this is that the average maturity of the debt stock in the UK is very long and we faced the prospect of having to hold gilts, UK government bonds, more or less forever unless we started actively selling whereas for most countries, including Australia, the average maturity of bonds is far shorter, you can just let them roll off. We felt we had to do those active sales, I still think we had to do them, but the financial market threw its hands up in horror and said: ‘This is a nightmare; you’re going to bring the world to an end, drive interest rates up’ in exactly the way that Walsh is describing. That will cause mayhem in financial markets and I’m very pleased to say that prediction was another over-confident prediction of mayhem that turned out to be completely wrong. There is very little evidence so far that balance sheet unwind has driven market interest rates up materially, though we must continue to watch.

So, no, it’s not one of the reasons why the RBA has not had to lift rates. There’s one other reason before I finish, which is that actually the big unwind in the balance sheet of the RBA that’s happened in the past six or 12 months, has not been primarily allowing bonds to unwind, but, as you probably know, it’s the maturity of the so-called TFF, the Term Funding Facility, which is a lending facility to banks. Again, I think there was a considerable concern here, it was largely before I arrived, that that unwind might cause difficulties. It’s a very sharp reduction in the stock of money in Australia but it has gone by practically without a whimper. So far, so good. At some point if you keep reducing your balance sheet the stock of reserves will hit the demand for reserves and if you hit that at too sharp an angle you may find that these relatively calm financial conditions turn into considerable instability again and a lot of central banks are watching for that moment, but it hasn’t come yet.

Thanks very much for that window into how the Bank makes its decisions. I’ve got one on that theme. When assessing its base rate decision making and reflecting on the inflationary environment, in relative terms, is the Bank currently looking for greater easing of indicators in private or public sector activity and which of those indicators currently carries the greatest weight?

Are you drawing particular focus on the public versus private or …? So, most prices – I say most prices, this may be an overstatement – the prices that demand factors affect are predominantly set in the private sector. You know that. Therefore, many of the tools that we’ve used that I’ve described today, the Philips curve and the output gaps and all of those things, are really describing a pricing process which is a pricing process that is followed by private companies. So, I think the easy and straightforward answer is to say that we expect that most of the change in inflation is going to come through those private sector pricing decisions. There’s been an interesting debate about whether a so-called administered prices or prices that are either partly or wholly affected by public or institutional rules of some kind – I guess it’s quite hard actually to pin down exactly what that means. Is it purely the price of a public good or is it the price of a private good that’s affected by private rules etc. etc. There’s been some interesting discussions about whether people think those are components – and maybe this is the point of your question – sort of holding inflation up. Those elements are relatively high as part of the basket, but they’re always relatively high. What is different about the current environment, and we looked at this quite carefully in the last Statement on Monetary Policy, is the private sector prices or inflation, rather, are somewhat elevated to their normal level. That felt like a slightly rambling answer to your question, but I think it’s certainly the case that the majority of our analytical tools have greatest purchase on private sector price setting.

Just interested in any reflections you might have on the intergenerational wealth transfer that’s obviously going to flow in the next decade or so as well as all that superannuation money as baby boomers and others reach their retirement. How is that going to drive inflation, consumption etc.?

It’s a very interesting question. As a veteran of the LDI crisis, some of you, maybe you, in the room will know what I mean by that, maybe not everyone does. At the back end of 2022 a fairly dramatic budget by the newly appointed Prime Minister Liz Truss in the UK at the time sent the UK gilt market into a tailspin and that caused the pension industry in the UK – which is different from the superannuation industry here, as you know, it’s based predominantly on defined benefit schemes and much more mature in terms of the average age of those pension funds – sent them into a tailspin and we had to intervene, the Bank of England, in large size to prevent a small wobble becoming a major crisis. One of the earliest things that people said to me when I was coming to Australia was ‘get your head around the super fund industry, they’re big, getting bigger, it’s a very important positive part of the Australian policy environment but one that you will need to understand’.

Now, as you say I think implicit in your question, –the age of the average member of a super fund at the moment is relatively young and that has influenced the portfolio composition of super funds which is predominantly in equities and notoriously quite heavily in terms of the marginal dollar is invested overseas as well. How that will affect inflation in the future sounds like a harder question than the one you’ve asked me and I’m playing for time in the hope that my brain will snap into gear. The R-star argument is interesting there coming back to the earlier point. Is Australia’s R-star different to the global R-star? I think probably most models will tell you that it shouldn’t be because the market for global capital is global and if we seek to set interest rates, real interest rates at a materially different level from global rates that will probably end in tears and won’t be possible, but gosh, I mark myself minus on that. Why don’t you have a go while I’m thinking.

I think there’s a lot of confusion in people trying to measure it against the stock of debt whereas to me what I find has a lot of explanatory power is the size of the budget deficit. So as budget deficits increase then the real yield on bonds increases and so what … I find this to be true, I’ve measured this, and so I think what we’ve got is these continuing US budget deficits because of increasing debt to GDP. So, you’re going to have to sell more and more bonds and the more and more bonds you sell into the market the real price of those bonds goes down. That’s what I think.

If you think that an ageing society drives R-star down, and we just discussed a bunch of reasons that suggest maybe it will drive R-star down but other things will drive it up, but if you think it will drive it down then we are going to go back to a period of relatively low interest rates. Now, obviously as we discovered during COVID and before, having equilibrium rates near zero is a bit of a pain in the neck because it means you have to use things other than interest rates in order to control inflation and if you fail to do that sufficiently effectively you’re going to get deflation, which of course is painful in lots of ways. I think predicting that ageing societies will lead to deflation because central banks don’t do their job effectively is probably building a set of stories up to Armageddon that’s probably a lit overstated, if I’m honest. I need to give you a better answer to your question and I apologise for not doing very well on that.