Working Papers

2007 01

Inflation, Interest Rates, the RBA and John Howard

Take two central banks, both with 3% as the upper bound of their inflation targets.  One is presiding over an inflation rate of 3.3%, the other 2.6%.  Which central bank would you think is more likely to raise interest rates?  According to financial markets, it’s the latter, otherwise known as the Reserve Bank of New Zealand.  RBNZ Governor Bollard this week warned that further increases in interest rates were likely, causing NZ interest rate futures to tumble and the New Zealand dollar to rally. 

Yet across the Tasman, interest rate futures in Australia rallied and the Australian dollar fell sharply as the Q4 CPI came in lower than expected, causing markets to all but price out any future interest rate increases by the Reserve Bank of Australia.  The RBA’s preferred measures of underlying inflation are all running at the top end of the 2-3% target range and Australia faces capacity constraints almost as severe as those in NZ, yet there is a much higher level of complacency about inflation and interest rates in Australia than in NZ.  This says a great deal about the very different operating styles of the RBA and RBNZ, despite having superficially similar inflation targeting regimes.

The RBA will likely leave its inflation forecast unchanged in its February Statement on Monetary Policy.  Coupled with its usual reluctance to venture any meaningful discussion of the policy outlook, this will almost certainly lead many observers to conclude that the interest rate cycle in Australia has peaked, a conclusion that has been erroneously drawn after several Statements this cycle. 

The Australian Financial Review’s discussion of the Q4 CPI and interest rates was conducted almost entirely in terms of its implications for federal politics, as if interest rates determined election rather than inflation outcomes.  In particular, it was suggested that Prime Minister John Howard might be ‘fortunate’ enough to go into this year’s federal election with interest rates heading down rather than up.  But as we have pointed out previously, turning points in the official cash rate are closely related to turning points in the unemployment rate in the opposite direction.  If interest rates are heading lower into the federal election, the unemployment rate will almost certainly be heading higher.  Which has better predicative power for the two-party preferred vote?  According to the models, it’s the unemployment rate.  Higher interest rates reflect good economic news, not bad.  As an incumbent, I would rather go into a federal election with rising interest rates and a falling unemployment rate than vice versa.  My suggestion for John Howard’s next campaign slogan: ‘Who do you trust to keep the unemployment rate low?’

posted on 26 January 2007 by skirchner in Economics, Financial Markets

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Doomsday in Davos

Brian Wesbury reviews the sorry record of the great and the good assembled in Davos:

In January 2006, the global glitterati of business, politics and economics gathered in Davos, Switzerland at the World Economic Forum.  A number of participants including Martin Wolf of the Financial Times, Stephen Roach and Lawrence Summers argued that the global economy was unbalanced, and they warned of a potential “adjustment.”

This “adjustment,” many felt, could have serious negative consequences for the global economy.  But, even though global economic activity slowed in the second-half of 2006, led by a sharp slowdown in the US housing market, global real GDP growth was 3.9% - an acceleration from 2005 and the third year in a row of robust global growth.

Ironically, this excellent worldwide economic performance, and a continued surge in global liquidity is fueling another round of pessimism this year.  With just a few days remaining before the 2007 World Economic Forum in Davos kicks off, there are already news stories that some of these same themes will be discussed again.

As reported by Bloomberg News, Lawrence Summers and ECB Bank President Jean-Claude Trichet will tell the world that it has “become too complacent about risks ranging from trade imbalances to terrorism.”  Dr. Summers will warn that markets were very upbeat in mid-1914 before the world turned very ugly.  He says that, “complacency can be a self-denying prophecy” - whatever that means.

According to some Nervous Nellie’s, a recent 25% drop in Venezuela’s stock market is a stress fracture in the global financial architecture and indicative of potential problems.  But, this is not a very good example.  Venezuela’s president Hugo Chavez has just pledged to nationalize many industries, which will cause a huge drop in investment.  Economic catastrophes do not happen out of the blue, just because people are complacent, they happen because governments make mistakes.

Freedom and good public policy are the keys to long-term economic growth and market performance, not trade balances, the price of oil or how optimistic private-equity firms become.  A sharp movement away from freedom, or a significant mistake in monetary policy are what markets should really worry about.  Right now, these mistakes do not appear likely.  As a result, the ice cold water at Davos is unlikely to spill over the globe.

Needless to say, Nouriel Roubini will be there again this year, having failed to take the advice of Italy’s economy minister last year.  Note that Nouriel is now quietly backing away from his recession forecast:

The US is also fragile as it is not clear whether the bust of the housing bubble in the US will lead to a soft landing as the consensus view goes or a hard landing that could take the form of a growth recession or, less likely now, an outright recession.

Since when does a ‘growth recession’ qualify as a hard-landing?  This sounds like a desperate fudge.  Nouriel, we know what you did last summer!

Incidentally, when in Davos, be sure to check out the excellent Kirchner Museum.


posted on 23 January 2007 by skirchner in Economics, Financial Markets

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Socially Irresponsible Investing

Chris Dillow points to the Vice Fund, which has achieved an 18% annual average return since inception, with its portfolio of alcohol, tobacco, gaming and defence stocks.  Dillow attributes this outperformance to the defensive nature of these stocks.  A ‘vice’-oriented fund could conceivably also help investors to achieve diversification, and thereby enhance returns to a wider portfolio, by offsetting the trend in the broader wealth management industry to ‘socially responsible investing’ and the politicisation of both private and public sector investment mandates.

posted on 22 January 2007 by skirchner in Economics, Financial Markets

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More of What Nouriel Roubini Won’t Tell You About the US Economy

Yet more of what Nouriel Roubini won’t tell you about the US economy, from my associates at Action Economics:

The robust round of Michigan sentiment figures for January have closed out a week of solid reports that have all but put to rest fears of a hard landing for the economy. These solid confidence readings join solid consumer spending figures, robust labor market reports, solid wage and income trajectories, and an improving outlook for U.S. trade to round out a picture of a healthy overall economy.  The figures have correctly brought the market focus back to the more relevant question all along of whether the slowdown in the economy will prove adequate to reduce inflation pressures, and not whether the slowdown will prove excessive. Though our expectation that the next Fed move would be a tightening looked like quite an outlier two months ago, expectations of any near-term easing are now quickly dissipating with each new upside surprise.


posted on 21 January 2007 by skirchner in Economics, Financial Markets

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Yet More Federal Persecution of the Online Payments Industry

The US feds continue their persecution of those who facilitate capitalist acts between consenting adults:

Stephen Lawrence and John Lefebvre, founders of Neteller, the UK-listed online payments company, were last night charged with conspiracy in connection with a multibillion-dollar money laundering scheme linked to internet gambling.

The pair were arrested on Monday after an FBI sting operation discovered that Neteller was being used to allow Americans to place illegal bets on sporting events via internet gambling companies based in foreign countries…

Neteller claims to operate the largest independent online money transfer business in the world with 3 million customers in 160 countries and over $7 billion in annual transactions.

It specialises in providing instant payment services where money transfer is difficult or risky because of issues of identity, trust, currency exchange, or distance. In the past, it handled funds for online gamblers in the US but it is said to have stopped the practice when tough new laws banned internet gambling in America last October.

Last year authorities arrested a number of prominent executives for breaching US gambling laws, including two from Britain. David Carruthers, the former chief executive of BetOnSports, was arrested in July while Peter Dicks, former non-executive chairman of Sportingbet, was arrested in September.


posted on 21 January 2007 by skirchner in Economics, Financial Markets

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G20 Most Wanted

Do you recognise anyone in these photos?  If so, the Victorian Police would like to hear from you.

(via Andrew Norton)

posted on 19 January 2007 by skirchner in Culture & Society

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Does Australia Have More Economic Freedom than the US?

I attended a CIS function, at which the Heritage Foundation’s Tim Kane presented their 2007 Economic Freedom Index.  The new methodology employed by Heritage is notable for ranking Australia third, ahead of the US, but behind Singapore and HK, in its overall score of economic freedom.  Australia does less well in alternative rankings produced by the Cato/Fraser Institute.

Former Treasury Secretary John Stone was quick to point out that the Heritage Foundation’s claim that overall tax revenue is 24.1% of GDP and that government spending is 35.3% of GDP implies a budget deficit of over 11% of GDP, which would not only come as a big surprise to the Treasury (Australia’s budget is officially in surplus), but would shame even Japan. Far from being a criticism of Heritage, this is perhaps more of a comment on the state of fiscal transparency in Australia.

Australia gets a score of 84.8%, above the US score of 83.8%, for monetary freedom.  This seems to overlook the fact that Australia’s inflation target, at 2-3%, is above the 1-2% that seems to serve as an implicit inflation target in the US.  The RBA takes considerable pride in the fact that inflation has averaged almost exactly 2.5% since 1996, yet this would be considered uncomfortably high by the Fed and under some inflation targeting regimes.  For example, the RBNZ’s 1-3% range produces a lower mid-point than the RBA’s inflation target.

Australia’s monetary freedom ranking is sure to slip as more recent inflation outcomes are incorporated into the index.  Australia’s rather loose approach to inflation targeting risks institutionalising a higher average rate of inflation in Australia than in the US.  This in turn has negative long-run implications for the exchange rate, assuming purchasing power parity holds.

There are certainly dimensions along which Australia could genuinely make a claim to greater economic freedom than in the US, such as in the regulation of financial markets and financial institutions, although this would be hard to quantify.

posted on 18 January 2007 by skirchner in Economics

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Pink’s Ban Australia Bullshit (or Biting the Hand that Feeds Me)

Compare and contrast the Blog Ad at the right hand side bar with the following story:

US pop singer Pink has backed down from her call to boycott Australian wool over animal cruelty claims, admitting she failed to fully research the issue.

The singer, who has sold around 200,000 tickets for dozens of shows in her upcoming April tour of Australia, appeared in an animal rights group video last year branding the practice of sheep mulesing “sadistic”.

But today, Pink admitted she was misinformed about the issue and had failed to do enough research.

“I probably could have done a lot more research on my own,” she told the Nine Network.

“That’s the lesson I’m taking from this.

“My message was, in my mind, boycott animal cruelty - not an entire industry, not Australia, obviously, because it’s my favourite country.

“Then going back, I was speaking without thinking and I actually did say ban Australia, which is bullshit. It’s not something that I can agree with.”

Pink made the video as part of the US-based People for the Ethical Treatment of Animals’ (PETA) three-year campaign to end mulesing.

Sorry PETA, no refunds!

posted on 18 January 2007 by skirchner in Culture & Society

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I Know What Nouriel Roubini Did Last Summer II

The slow death of Nouriel Roubini’s forecast for flat US GDP growth in Q4 continues, with the December retail trade report.  One economist’s reaction:

Almost every piece of recent economic data - employment, unemployment claims, car and truck production, construction, and the ISM indexes for both manufacturing and services - has come in above expectations.  Today’s report on retail sales is no different.  The economy ended 2006 with a full head off steam.  Weakness in housing has not filtered through to the rest of the economy.  Retail sales, excluding autos and building materials, are a direct feed into GDP data (auto sales data come from another source and building materials are counted as investment).  With these sales up 1.3% in December after a revised 0.9% gain in November, real consumption growth likely increased about 4.5% at an annual rate in the fourth quarter.  Our forecast for fourth quarter real GDP growth is now 3.5%, a significant improvement from the second and third quarter average growth rate of 2.4%.  At this rate of growth the Fed is going to get increasingly uncomfortable with market expectations of its next move being a rate cut rather than a rate hike.


posted on 13 January 2007 by skirchner in Economics, Financial Markets

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‘The Most Important Novel of the 20th Century that was Never a Film’

The IHT on Atlas Shrugged - The Movie:

Randall Wallace, who wrote “Braveheart” and “We Were Soldiers,” is working on compressing the nearly 1,200-page book into a conventional two- hour screenplay. Howard and Karen Baldwin, the husband-and-wife producers of “Ray,” are overseeing the project, and Lions Gate Entertainment is footing the bill.

Whether Jolie, who has called herself something of a Rand fan, will bring the novel’s heroine, Dagny Taggart, to life on screen, or merely wind up on a list with other actresses who sought or were sought for the role remains to be seen. Until now, at least, no one in Hollywood has figured out a formula that promises both to sell popcorn and to do justice to the original text, let alone to the philosophy that it hammers home endlessly, at times in lengthy speeches. (The final one is 60 pages long.) But Baldwin said he believed that Wallace and the rest of their team were up to the task. “We all believe in the book, and will be true to the book,” he said…

As for how he is distilling Rand’s novel to a two-hour screenplay, Wallace insisted he had the material under control and was on course to deliver a draft this month.

“I can pretty much guarantee you that there won’t be a 30-page speech at the end of the movie,” he said. “I have two hours to try to express what Rand believed to an audience, and my responsibility is not only to Ayn Rand, but to the audience, that this be a compelling movie. More people will see the movie than will read ‘Atlas Shrugged.’ And the movie has to work.”

posted on 12 January 2007 by skirchner in Culture & Society

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I Know What Nouriel Roubini Did Last Summer

We have previously noted that the US November retail trade report almost single-handedly tanked Nouriel Roubini’s call for flat US GDP growth in Q4 2006.  The November trade and wholesale trade data releases have seen economists further revising their Q4 growth forecasts, with some seeing a 3%-handle as increasingly likely.

posted on 11 January 2007 by skirchner in Economics, Financial Markets

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More on TEN’s US 2007 Recession Contract

At the instigation of James Hamilton, TEN has tightened up the specification of its US 2007 recession contract:

Expiry will be based on the data reported by the U.S. Department of Commerce (Bureau of Economic Analysis, Table 1.1.1, “Percent Change From Preceding Period in Real Gross Domestic Product”) as reported by the BEA as of February 15, 2008.

If the table as reported at that time indicates that any two consecutive quarters between (and including) 2006:Q4 and 2007:Q4 are negative, then the contract will expire at 100. Otherwise, the contract will expire at 0.

This is a considerable improvement on the former contract specification (although the press release with the previous contract specification is still showing at Tradesports’ sister site Intrade).  TEN could benefit from closer collaboration with the economics community in the design of their contracts, preferably before the contracts are actually listed for trading!

UPDATE: Felix Salmon shorts Nouriel:

Economonitor is going to make a bold prediction, though: that the contract won’t trade higher than 25 any time soon. I’m a seller at these levels.

UPDATE II: Felix once again proves the value of RGE Monitor as a contrarian indicator:

OK, so I was completely wrong yesterday afternoon when I said that the Intrade recession contract wouldn’t rise above 25: the first thing I see when I walk into the office this morning is that it managed to trade at an eye-popping 35 overnight.

posted on 09 January 2007 by skirchner in Economics, Financial Markets

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True Confessions of Peter Costello

Treasurer Costello is quoted in the weekend Australian Financial Review (no link) saying:

I think there is also evidence now that the round of tax cuts in May could well have been used to boost savings [sic].  The interesting thing is that although they were very substantial tax cuts, consumption didn’t grow by that much.  It looks like people have taken the opportunity of the tax cuts to put some money away.  Although I can’t give you figures yet, I do believe that a lot of money is being put into superannuation in preparation for the changes next year.

There is indeed very little evidence that recent tax cuts have boosted consumption.  Costello probably doesn’t realise it, but these remarks effectively concede the point often made on this blog, that the government’s budget surpluses come partly at the expense of private sector saving.  They make a nonsense of claims that tax cuts might result in higher interest rates, since the substitution between public and private saving leaves national saving unchanged.  Household sector dissaving (on a national accounts basis) is largely a function of households paying more tax (and mortgage debt interest) as a share of GDP to keep their consumption share steady, while gross national saving has also remained approximately steady.

posted on 08 January 2007 by skirchner in Economics, Financial Markets

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Nouriel Roubini Can Now Put His Money Where His Mouth Is

Doomsday cultists like Nouriel Roubini can now put their money where their mouth is with Intrade’s 2007 US recession contract:

Contract on US Economy going into Recession

Thursday, Jan 4, 2007

The Exchange has listed a contract on the United States economy going into recession during 2007. This contract can be found under Financial—Economic Numbers—US Economy in Recession.

This contract will expire at 100 if the United States economy goes into recession during 2007. The contract will expire at 0 if it does not.

For expiry purposes a recession is defined as two successive quarters of negative real economic growth. Expiry will be based on figures released by the United States Department of Commerce and reported in three independent and reliable media sources.

The contract will be expired once the 2007 fourth-quarter figures are released (may not be until 2008). If however the 2007 third-quarter figures show positive growth the contract will be expired at 0.

As is often the case with prediction markets, the contract specification raises more questions than it answers.  There is no reference to whether the contract expires with the advance, preliminary or final GDP releases.  The potential expiry with the Q3 release still leaves open the possibility of a recession in 2007 as a result of revisions to historical data.  You could be right about a recession in 2007 and still lose money with this contract specification.  And why do we need the media to confirm data released by the BEA?  Perhaps Intrade are trying to avoid the problems that arose with their North Korean missile launch contract.


posted on 05 January 2007 by skirchner in Economics, Financial Markets

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Does No New Spending Qualify as Expenditure Restraint?

We have previously noted that the federal government’s concern for the supposed impact of tax cuts on interest rates does not extend to new spending measures.  Reports in the lead-up to the Expenditure Review Committee process now suggest that the government is ‘putting the squeeze on spending.’  But note that this does not refer to existing spending programs, only to ministers’ wish-lists for new spending:

BILLIONS of dollars in potential budget measures - including a costly schools and science package - have been dumped as the Howard Government puts the squeeze on spending…

Mr Howard, the Treasurer, Deputy Prime Minister Mark Vaile and Finance Minister Nick Minchin have already scrubbed out dozens of new initiatives brought forward by ministers before Christmas…

Decisions to curtail spending spread across health, welfare, indigenous policies, agriculture and industry.

“This is a very, very tough budget,” said one senior government figure. “It’s very tight and there’s not much joy for new (spending) initiatives.”

The linked article gives an interesting insight into the political economy of the ERC process when it says:

[Treasurer] Costello has indicated that he does not want the 2007-08 surplus to drop below its projected level of $9.7 billion, equivalent to 1 per cent of gross domestic product.  Any new spending would depend on the economy producing more revenue than expected, although Mr Costello is also committed to preventing any increase in the tax burden.

In other words, the government will spend whatever it can get its hands on, subject to revenue and the budget balance remaining steady as shares of GDP.  This hardly qualifies as expenditure ‘restraint,’ something the government has shown no interest in since its first budget.


posted on 04 January 2007 by skirchner in Economics, Financial Markets

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