24: Interest Rates. Where from here? Have bond traders got it wrong?

Transcript of Burgernomics Podcast 28 June 2022

Alan Oster. Chief Economist. NAB

Ross MacDowell. Burgernomics host.

Interest Rates. Where to from here? Have the bond traders got it wrong?

Voiceover: Welcome to Burgernomics, Demystifying Economics with Ross MacDowell.

[music]

Ross MacDowell: Welcome to the Burgernomics podcast where we demystify the economics affecting your life. I'm your host, Ross MacDowell. We are here in the library at Royal Brighton Yacht Club, overlooking beautiful Port Philip Bay. Lean back, close your eyes and think about all the interest you pay in your lifetime on your mortgage, personal loans, lease payments, and credit cards.

Take your home loan for example. If you borrowed $1 million at 4.2%, over 30 years, you will have paid $760,000 in interest. What if you became an interest-rate clairvoyant and could predict interest rates into the future? If you knew rates were going to rise, you might decide to increase your debt repayments, reducing your interest bill by hundreds of thousands of dollars over the term of the loan.

In today's Burgernomics podcast, we're going to discuss a group of people who many believe can predict interest rates. Sometimes seen as a controversial group, they trade Australian financial instruments worth $1.6 trillion each year. They are a group who remain largely nameless and in the shadows. You rarely see them in the media.

To talk about this mysterious group of financial traders, I have with me the gentleman in charge of Global Economic and Financial Forecasting for the National Australia Bank. It's their chief economist, Mr. Alan Oster. Prior to joining the NAB in 1992, Alan was a senior advisor with Australia's Federal Treasury and has also spent four years in Paris with Australia's delegation to the OECD. Alan, welcome to the Burgernomics podcast.

Alan Oster: Thank you, Ross. Pleasure to be here.

Ross: This mysterious group I'm describing are bond traders. Now, as soon as I mention the word bonds, many people will want to fall asleep as they believe the concept of a bond is hard to understand. Before we explain the concept of bonds and their importance to interest rates, we need to emphasize just how important interest rates are to Australian households and our economy.

Australia has the second-highest level of household debt in the world. I think the first is Switzerland. Interest rates and therefore mortgage rate increases have a dramatic effect on families' spending and their standard of living. Household spending is a contributor to inflation and employment and the reserve bank recently increased its cash rate quite dramatically. Ask 10 economists where interest rates will be in 1, 3, 5, or 10 years' time, and you will get a variety of answers. Alan, why are interest rates so hard to predict?

Alan: Basically what you're trying to do, is you're trying to figure out what's happening to the economy. Then you look at the various policy measures you can use. There's normally three groups. One is structural policy. That's basically trying to make the economy more productive. Second one is fiscal policy, and the third one is monetary policy. That's interest rates. Really, when we are looking at where are interest rates going to go, you need to know in a lot of ways what's happening to the economy.

If you like a 5-year or 10-year bond should really just be, if you like an averaging of those next 12 months by 10 years to get us a field. Then you put a bit of a premium in there because you're never sure exactly what's going to happen, so you have what they call a term premium. In other words, how much will you pay to keep your money locked up for another 10 years.

Bond traders are just basically trying to guess where interest rates will be on average over the next 10 years, for which they need to know, is there a recession coming? What's happening to inflation? I would also say that whilst economists are not very good at predicting interest rates, and remember there are a lot of economists in central banks, bond traders are, if you look at their historical record, even worse.

Ross: Great. We're going to come to their historical record and how they're going, what their scoreboard is. Now, I'm going to take a massive chance and try and explain a bond using Burgernomics to do it.

Alan: Oh God. [laughs]
Ross: I know that as we've said, if you want to put everyone to sleep at a dinner party, just talk about bonds, but here we go.

Alan: Good luck.

Ross: Jump in when I start to staff it up. Now, a bond is basically a loan with interest payments up until the date of when that loan is repaid. It can be in the public or the private sector. Let's just confine ourselves to government bonds for this one. Let's say I've got $100 and if hamburgers were $10 each, my $100 would buy me 10 hamburgers, or I could lend the Australian government my $100 by buying an Australian government 10-year bond. The Australian government will pay me $2 every year for 10 years in interest and then give me back my $100. We're using simple numbers here.

Alan: That's right.

Ross: They're paying me the equivalent of 2% per year in interest. Now, this is where people get confused. That 2% is called the yield on the bond and it's calculated on the price that I paid on the bond at that time. After 10 years, I will have received 10, lots of $2 interest payments, and my $100 back. I'd have $120 in my pocket. If the hamburger cost $10, then I would then be able to buy 12 hamburgers, 2 more hamburgers than I could buy at the current time with my $100. Am I going okay?

Alan: You're going well.

Ross: Let's say after seven years of owning the bond inflation erupts. Hamburger prices increase by 20% and so a hamburger becomes $12 each. The $120, my government bond will make me after 10 years of ownership will not buy me the 12 hamburgers I was expecting after that time. It's only going to, in fact, buy me 10 hamburgers, the same as what I would've had at the beginning.

I go, "Well, what's the point of owning this bond?" I'm not happy. I'm going to sell my bond but because there's inflation, it's eaten away the value of everything, including obviously my bond. The bond traders come out from the shadows and they are only going to offer me $89 for my bond, $11, less than I paid for, which I have to take because that's all that's being offered. The new owner of the bond, he still gets the $2 being paid by the government. That doesn't change.

That $2 interest payment, as a percentage of the $89 that he paid is more than my 2% that I was getting. It's 2.2% even it's still the same $2. It's just an arithmetic calculation. The higher the percentage, then we say the higher the yield. I guess that's where people always, they come undone about yield and percentages. It's just simply a ratio of whatever is the market value of the bond because the interest amount always remains the same. Therefore this yield is the percentage number that a lot of people want to say correlates to interest rates and where they're going up or down. Would you agree with that?

Alan: Basically, and these days, you can even buy a bond that will have an inflation adjustment for it. You can do-- Well, that's a bit more complicated, I suppose.

Ross: Now what they do, it's a CPI added to the bond.

Alan: Yes, and so you do get a feel, is it a real change or is it a nominal change? The other thing that's important in the bond is you're making assumptions about where the cash rate or where the yield's going to be going forward. If you're worried that there might be a recession, you can see the gap between the current yield that you're going to get for year one, versus the yield you're going to get in year 10 and you might make an adjustment, therefore. Some people then say, the difference between the current cash rate and the 10-year bond will give you an indication of whether people are prepared to pay for uncertainty, such as a recession.

Ross: That's really the definition of an interest rate is risk. It's just a measurement of risk.

Alan: Yes. Exactly.

Ross: That's the reason why a government bond will have a lower interest rate than a commercial bond because-

Alan: She'll be less risky. The government won't default.

Ross: In our government, we're okay. Many economists and financial market operators use the 5, 10-year and the 3-year government bond yields, to try and lock on to where they think--

Alan: Yes, inflation or economies go.

Ross: They're doing that because that's the easiest indicator for them to do it. The most independent easy indicator?

Alan: Well, what they're trying to do is they're saying, "Okay, I can go out, anyone can buy a bond. I don't want a 2% interest. I want something better than that. What I'll do is, I'll try and offer you to use your analogy $80 for your $100. Then I'll still get my 2% yield. If I'm getting 80 cents, I'm sort of getting a 4% return. That's what they're trying to do. They're trying to maximize what they call fixed interest market returns. What they're really doing is paying with the price of the bond.

Ross: Now they're doing this because they're trying to make a profit.

Alan: Yes, exactly. They're being paid to try and make a profit.

Ross: It's in their interest to beat you down. Basically.

Alan: Yes, it's in you their interest. The lower the return, the higher the yield. Everything is like an inverse relationship [unintelligible 00:11:41]

Ross: The yields really is, in some ways, kind of irrelevant, because they're trying to beat you down on a price they're paying for the bond. The yields is just to a calculation.

Alan: Well, the other thing is that if you hold your burgers for 10 years, you will still get your 2% back. The only reason you will sell it is if you think "Oh, it not only might go to $80 it might go to $60. That's the sort of, do they know better than anybody else?

Ross: Yes.
Alan: Their answer is "Yes, we do." Therefore, they make a bet on interest rates. They make a bet on where the economy is going.

Ross: Let's have a little look at their scoreboard, some of their scoreboard. If we look at 2019. For use, there is the 3-year government bond. 3 years ago, at the start of June, this month, 2019, the Reserve Bank cash rate was 1.25%. At the same time, the 3-year government bond, its yield was 0.942%. In June 2019, the 3-year government bond, which would have been repaid to you this month, in 2022, it was predicting that the cash rate today would be 0.942%. That was if you want the bond yield prediction 3 years ago. Now, that's not bad, is it because if the today's cash rate is 0.85%. They're only 0.092% out. That's pretty accurate?

Alan: That's accurate. Of course, if you traded a little bit differently, a 3-year bond in '21 after the reserve bank decided they'd have yield curve control, so they try and control the 3-year.

Ross: The yield curve? Let's explain the yield curve. File name: Draft 2 Alan

Alan: The yield curve is basically the difference as you go from one year to two years to three years to four years to five years. What's the gap between the cash at present versus the maturity of the bond?

Ross: Yes.
Alan: As you go further out, the yield curve should go higher, because there's more uncertainty in it.

Ross: Right. So it should go up? such just a, it's a graph of the yield or the percentage interest rates, and it should go up like a hill.

Alan: Yes.
Ross: Because [crosstalk]
Alan: More uncertainty.
Ross: It's more risk involved.
Alan: It's more risk, yes.
Ross: It's not going to be a steep mountain. Hopefully, it should be a slight hill.

Alan: Yes. Then the government came along, or sorry, the central bank came along and said for the next three years, I'm going to guarantee the bond market for three years is 0.1. They got hammered.

Ross: How can they do that? How did they do that?

Alan: Well, what they were doing is they basically said, "Okay, we think the economy stuffed. We're really worried about COVID. We can't see inflation going up. Part of this is we're going to ensure that the bond market is going to stay at 0.1 for 3 years." How are they doing? "I'll come and buy them." I can use money that I print, essentially, to do this.

Ross: They're gaming the system, aren't they?

Alan: Well, they were basically coming in to say, "Hey, we are going to keep bonds really low for a really long time." Now, to be fair, what happened was a couple of years ago,

I bet 18 months ago, the Reserve Bank gave up. Because everyone else around the bond traders are saying, "Hey, it ain't going to stay at 0.1 forever. You're wrong. You can't afford just to basically pull money up against the wall." If you look at what's been happening recently, the bond traders have been saying, "Oh, now rates are now going to go to implied. When you look at the bond market, something like, well, a couple of weeks ago, 4%, by the end of the year, now about 3%, by the end of the year." They've forced the reserve bank by everybody basically, saying, "Well, we're just going to take a position against you." They forced the Reserve Bank, essentially, to give up. The reserve bank gave up. That caused a lot of credibility issues.

Ross: Why didn't the reserve bank give up? Because it didn't have enough?

Alan: Not it had enough. Basically said, we're just making losses, and nobody believes us. Maybe the economy's not as bad as we thought, because we soon as you reopen parts of the economy, it rolls back. The other issue is that when you're looking at more recent times, the bond market look at Australia and say, "You guys are just the US lagging nine months." Look what the US has had to do now in terms of interest rates. They're assuming that will happen again now.

Just at present, economists are basically saying, "Well, we think you're overdoing it, we do not think Australia's the same as the US. US doesn't have wage growth under three, for example, we haven't had the damage that the US had had. Yes, we're starting to get some inflation but, we can work out essentially, what an interest rate increase will do in terms of it will cost the consumer in terms of what they're paying." If interest rates, for example, go from .85 to let's call it 2 to 2.5, on average, when we look at our book, we can say the average household will be paying $300 to $400 a month extra in terms of servicing that loan.

Ross: Let's look at that because in terms of mortgages and cash rates, that's a pretty important thing for Australian households. Today, the bond markets are saying that in 3 years' time that the Reserve Bank cash rate will rise from today's .85% to 3.31%. That's today's 3-year.

Alan: Two weeks ago, it was 3.99. It did move. [chuckles]

Ross: Yes, yes, it just cut off sharply. Now, if we convert that through to a 30-year $1 million home loan. If I look at the margin that, for example, your bank currently charges between up standard variable mortgage and the cash rate. If I use that margin, that means that the bond markets are saying that the variable mortgage is going to be 6.66% in 3 years' time. That means an increase in a total interest bill over 30 years, from $760,000 to $1.3 million, basically. Because you repay your variable mortgage with the interest component and a principal component, you would need a 20% increase in your gross salary, just to be able to cope with that monthly interest rate.

Alan: What the bond market typically overlooks is if you basically increase rates that much, you'll cause a recession.

Ross: Yes.

Alan: That's why economists-- Well, me, for example, our view would be, we would expect the cash rate to get to let's call it 2.75% sometime next year, no higher. That will in a very simple way to think about it is if you're an average weekly earner, okay. You've just had a 4.5% increase, that the $300 to $400 you've got to pay back per month more than wipes out the entire increase in your wages. I think you need to be really careful because the other thing that people say, oh, neutral is two and a half sort of thing for the cash rate. It's not really because that assumes everything else is the same. Everybody's paying higher petrol, everybody's paying higher electricity. You don't need that. The other issue people tend to say is, oh, you've got a lot of savings out there, but if you take out the top 10% to 15%, there's not many savings at all.

Ross: We're meant to have, depending upon who you want to listen to on what day of the week, somewhere between $200 and $250 billion worth of savings sitting in all of our bank accounts. You are saying these average figures are meaningless?

Alan: We look at the cash flow of the consumer. Okay, maybe they're all NAB customers, but I think they're pretty much the same in the financial accounts. What we're saying is most of the savings are held by the top 10% to 15% of the population and that's always true. The last official data unfortunately is 2019. You don't get an update. I would be very cautious. When we look at say the impact of these interest rates, we basically say, okay, in the tails, in other words, at the extremes, there might be someone who's just bought a house, he's got one income, he's under stress, et cetera, et cetera, there may be problems, but we don't see the consumer as massively over-geared.

You mentioned, for example recently in your thing that we're second highest in the world in terms of debt. That's gross debt. If I add the assets back, we're the second- lowest in the world. They've got about $2 trillion worth of debt, but they've got $12 trillion of assets. What we look at is we look at the consumer and we say, okay, the consumer, other than in the tails is basically okay. The average loan to valuation ratio, people across our book is something like 40%.

They're not over-geared overall, but there will be tails. The banks are not going to fall over because they've got huge amounts of capital. The problem is the consumer out there, here is that house prices are going to fall, they see that their wages are not going to basically go up much or not as much as they think, and then the reserve bank's going to take it away from them. Therefore they're going to panic.

Ross: They'll stop spending.

Alan: They'll stop spending. In economics, there's such a thing called the paradox of thrift. The paradox of thrift said you think it's really good everybody saves, but nobody spends and therefore the economy falls over. It's not actually that good if everyone saves.

Ross: No. Right.

Alan: I think really what we're at in current circumstances, the bond market is interesting. We can look at the difference in the yield curves and once it starts to look like the long bond is not very much higher than the cash rate, in other words, instead of having that 100 points, you probably 10, 15, 20 points, that normally in the past has signaled the recession within 12 to 18 months. That's what you are already getting in the US. In Australia, you don't get that. You get a big slowing. Growth goes from 4% to 2% because it hurts, but it doesn't look like it's signaling that you're going to have a recession. Why? Because I don't burn the bond market. If the bond market actually was right, and cash rates went to three or whatever or three and a half, I think that would be enough to cause a recession.

I think you just need to be a bit careful because central banks always say, "Oh, it's not our fault." I think one of the interesting things recently is in the federal reserve and this has caused a lot of kerfuffles in equity markets. We're basically saying, "Well, we've got inflation, we've got it away. We've got to do these interest rates. Maybe it's a bit difficult and maybe probably we have a recession." That suddenly started to change the tone of equity markets, it changed where the bond markets were. It's why the bond markets in Australia went from 3.9 to 3.1, one in a week. You then start to put that in.

Ross: Sir, this is probably just a little bit off-topic, but it's on topic. No, no, no. All the numbers that we are talking about now in terms of cash rates, wage increases, variable mortgage rates, if there's any small deviation from them, everybody goes into this massive panic these days. Whereas 20 years ago, 30 years ago, 40 years ago, nobody would've gone into a massive panic. We coped with 17.7% mortgage rates. We coped with 10% unemployment. We coped with a whole range of things. Now it's almost as if we must have a real cash rate. In other words, the cash rate of the reserve bank minus inflation, it must be zero almost.

Alan: Yes. Most people say that in a normal circumstance, you should at least have a positive real rate, which is where you get the two and three quarters or more. Then some people say, "Oh, you need a lot more than that." There's a lot more gearing and the other issues, people are not necessarily rational, by which I mean, what they're saying is, "Oh, I'm scared and I will then do my paradox of thrift problem."

Ross: Pull their horns in.

Alan: Pull their horns in. Now when we look at our book and we look at everybody else's book to the extent we can in terms of banks, we don't see a liquidity impact until at least next year. We may well start to see slowing in consumption soon and it looks like it might have even started to happen now. We're just watching there. It is not a liquidity impact, it's, I'm scared impact.

Ross: You see, we're in a situation now where we've got the definition, which still amuses me a little bit, of full employment, is 4% unemployment.

Alan: Yes, I think is a bit lower than that, but that's all right.

Ross: We're at 3.8% at the moment.
Alan: 3.9%, yes.

Ross: If that was to increase a little bit and we were to have the technical definition of a recession, there's two consecutive quarters of negative, which I just think is [crosstalk] a rubbish. It was developed by the head of the labor department in the United States, I think a bloke called Suskin or Siskin. Everybody's grabbed onto this as being a definition of a recession.

Alan: Let me give you a really good example of why that's garbage. Let's assume our economy goes along and quarter number one it falls 4%. Quarter number two, it goes up 0.1, quarter number three, goes down to number 3%. That's not a recession, that's silly. I generally say if you can't grow your economy in a 12-month period or the other one they use in the US all the time is if unemployment goes up by more than half a percent within a year. That's a recession.

Ross: You think, maybe a little bit old-fashioned like what I think is, that recessions are really about unemployment?

Alan: Yes. It's about people can't get a job.
Ross: Yes. Do you think we've become all a little bit too precious?

Alan: I don't know whether you're too precious, but people get scared and so they can honestly say, "Well, how am I going to live?" If most of them are spending as much as what they're currently getting and they know electricity prices are going to go up, they can see food prices going up, they can see interest rates going up. Their sort of response is, well, I'm not going to spend as much. We try and look as much as we possibly can to see how consumers are behaving.

We say, we are going to spend your money and we see big falls in overseas holidays, we see I'm not going to do renovations anymore, I'm not going to pay school fees anymore. I'll move in and out. The other thing you normally see in a recession is instead of, we used to say, instead of buying meat, you buy chicken. What we also see is people going, they still go out and buy whatever they need, but let's say instead of buying really good dog bones, they might buy really cheap dog food. They switch and say, you need to watch that as well. At this stage, I think based on what we see and based off what we think people are going to do to push the cash rate above three soon is asking for trouble.

One last comment that's really important on monetary policy. It normally takes at least six to 12 months before you see the impact, mainly because its liquidity. I would up put it to most people that anyone who's looking for an impact from the interest rates that already happen, never happens. You are flying blind.

That's why as our governor said the other day, that it's a narrow path that they've got to get to try and get inflation down because there's nothing that interest rates are going to do to get inflation down in the next six months. All the monetary policy and increase in interest rates does is it flattens the economy and therefore increases unemployment, and therefore people don't get as much wage rises and therefore inflation comes down. It takes a long time.

Ross: The elastic band

Alan: Well, yes, and a really good example to use that one, we used to in-- I won't say in NAD, but certainly in Treasury, we used to talk monetary policy is a rock with a piece of elastic attached to it and you pull, you pull, nothing happens bang you get a black eye. The example of that was the late '80s where we put there was a really bad crunch in the equity markets in about 88. Then we started putting rates up and kept putting them up. Nothing happened and they just kept going and they got to about 18 and then banged crack. The whole economy fell over. You do need to be really careful with monetary policy.

Ross: You talked about '88 and there seems in economics, there always seems to be these areas of immense fear. There's the immense fear of printing money because we're going to end up with the six-year-old girls taking the wheelbarrows full of money to get the life of bread and the black and white photos from the 1930s in Germany. Yes. The high-interest rates. Are we still running economics mostly from a central bank point of view on some of these fear factors that we hold off and hold off doing something and then we get quantitative easing, which to me just seems completely if you're scared of printing money, why would you have quantitative easing?

Alan: Yes. Well, they're trying to basically quantitative easing was really trying to get the currency down in a lot of ways, but yes, there's fears out there. The one good thing that is very different to what it was in the '90s and the '80s and the '70s is the amount of information we've currently got. I can remember in treasury, it was six months before we realized we had a recession.

The peak in unemployment was about 18 months after the start of the recession. Whereas these days based on the data, so we get real data. I can see every transaction that goes across NAB's electronic systems on the Wednesday following the Saturday. I'm about three days out of [unintelligible 00:32:09]. I can actually see it. Yes. When the virus first hit, we could see what was happening to spending in say Box Hill and it was falling 30%, not at an annualized rate, it was falling 30%.

You can see the impact, so you don't necessarily have to worry about, oh, I won't know when this happens, you can actually watch it and see what's happening. The best thing that we've got now is our weekly data. That gives you lots of information. Because we can see what the customer is buying and what is getting, we can see how many of our customers are being paid the doll within a week.

Ross: Right. That's fantastic.
Alan: We give it to the government, we give it to the bureau of stats. We give it to the opposition, we give it to everybody.

Ross: We compare this to our CPI. I think we---[crosstalk]

Alan: Now New Zealand, New Zealand doesn't have a quarter. Yes. Well.

Ross: I mean our CPI, we get that once every quarter four times a year. Most other countries get it at least every year.

Alan: No, they get it monthly

Ross: Monthly. If we've got your organ, you've got the NAB giving the government data that it really should be.

Alan: Yes but what our data, we can't give them the CPI data so if I go out to, I don't know, Bunnings or whatever. I can see a hundred dollars being spent but I can't see what's actually they're purchasing. What we're trying to do is get that ability. Then we can see what they're doing, but to be brutally honest, what the bureau of stats was said to the government last time they looked at it, well, this will cost us a fortune and we don't have the money. You have to say, well, is that good use of your--

Ross: What the bureau stats? Didn't they have a massive reduction in their budget a few years ago?

Alan: Yes they did. You look around and for political reasons, they say, well, I'll tell you what, you can get data about mushroom productions in Queensland. You can get data about whiskey distillation in these various other states, but you can't get a monthly CPI. Now, I personally think you have to be careful with monthly data. It's very volatile. I can send you bump steers, but it would be useful to know what's in it.

Ross: Why did that happen? Why doesn't our government want to have that degree of live data?

Alan: Well, they do now. I definitely do now.

Ross: Are they going to give them the hundreds of dollars they stripped off them?

Alan: I've got no idea. Remember it wasn't that long ago, then they were thinking about seriously pulling the sensors. I think that would be a good use of a hundred million dollars or something. If that's all it cost to get a monthly CPI, but you do need to be careful. Remember we used to have a monthly current account deficit and I can remember when I was in treasury, I used to think, wow, we are really good at forecasting this. Then what I hadn't realized they were using our forecast for the actual data and then about a year and a half later they get the actual data and completely different numbers. You do need to be a bit careful about monthly data cause it'd be volatile and the weekly data you have to be really careful about because you get things like Chinese new year or Easter that changes and so you've got to try and adjust for it and think about it.

Ross: You've got currently a governor, the reserve bank who is on the back foot. You think that if you had too much instant data and then there's too much political pressure on what's meant to be an independent central bank, you might get them making too many rapid decisions.

Alan: Well, they meet monthly most central banks around the world meet every six weeks. They're more up-to-date. Look I think the best thing you can get is you give the central bank, the data as much data as you can, and that makes them less likely to make a fundamental mistake.

To me, I would go back and say a fundamental mistake would be put a cash rate with a three in front of it by the end of this year. That would be a fundamental mistake because you would then get the liquidity impacts. You'd get a lot of people moving off fixed loans into variable loans where you get below 2% up to over four. Now, okay, you've still got a buffer and et cetera and so you'd be fine. You're trying to avoid accidents that if you've got data you could avoid.

Ross: At the moment you've got the reserve bank talking about the increase in petrol prices, which is really substantial and electricity and gas and now groceries are beginning to go up. They're trying to say, well, inflation maybe not quite as bad as we had first thought or whatever, but then you've still got the bond market. I know it's come off a little bit lately but you've still got the bond market pitching numbers up there.

Alan: Yes. The bond market, I think to be fair, if I'm saying, where are they getting that idea from? I think a lot of them are saying, well, you are just like the United States of America, except you're nine months behind them. In the States, they were arguing last year that inflation was temporary, et cetera, et cetera, and then you get inflation up at 8% or 9%. Then the central bank says, oh, I don't like this and so I'm going to go aggressively and trying to get it under control.

They may well as part of that process, because they're going so good. They're going to be 3.25% by the end of the year. The next couple of meetings, 75 basis points, almost certain going to happen. They're going to take their cash rate from roundabout our level to three and a bit or 3.5% by Christmas and you sit back and watch.

Ross: The bond traders are the saying?

Alan: The bond traders said, well, right. What's really strange is you go to the bond traders and they say in Australia, it's going to be even worse than that go figure is my answer.

Ross: What information do the bond traders think that they have that makes them superior forecasters than the reserve bank?

Alan: I don't know. If I can go back through history and give you lots of examples where back in the '90s, they were talking about interest rates getting to 10% plus never did. There's a wonderful curve where you've got the bond traders against the US actual cash rate and they're incredibly wrong for 30 years You're still trading these things and you'd have to say in the last 12 to 18 months the bond traders have been right. That central banks had to basically start to increase.

Ross: Well, Dr. Lowe said, and I quote him here, "The financial market has been a better judge than we have over the past few years. You have to pay attention to them." That was almost a capitulation to say, "Listen to the bond traders and don't listen to me."

Alan: I wouldn't say that far. I'm sure Phil didn't mean that. He'd say that they have been right then inflation will get away from them. Now, I don't really see there's a lot that you can do with monetary policy to help essentially an inflation shock that's come from supply chain issues and basically Ukraine and the Russian war.

Ross: What about though the $3.8 billion per week of quantitative easing that was pumped into the economy?

Alan: Well, that was just basically trying to keep the cash rate at 0.1 and they blew that up. You would argue and the central bank has argued that it worked really well, but when they ran up against problems where the market lost faith in them, they hurt their own credibility.

Ross: Okay, and so then they can reverse that by quantitative tightening. Alan: Which is what they're doing by the way.

Ross: Yes, which is what they're doing. That's almost what you are saying is zero- sum game in terms of really basically printing money.

Alan: Yes, look, QE, you can argue, there's a very close to printing money.
Ross: Printing money, and what they're now is basically burning the money that they printed.

Alan: Yes, that's right, and what they're doing is they're essentially when the bond comes up, rather than reinvesting it and avoids keeping the rates at the same level, they're leading it at mature.

Ross: Take the fireplace.
Alan: Take the fire. Yes, so take goes away.

Ross: Okay, so one of the methods that the reserve bank uses in an attempt not to get to fights where they've got to spend billions of dollars of their money to change the bond market is something called jawboning.

Alan: Oh yes, it’s “we talk a lot.”
Ross: Tell me about the effectiveness of jawboning and its credibility now compared to maybe 20 or 30 years ago.

Alan: Well, jawboning is basically saying to the market, "You guys are wrong," or "You guys need to listen to us. If you don't listen to us, we'll use the firepower." In the past, that's been quite successful but the problem is if you've got a credibility issue with the central bank's forecast the market might be inclined to say, "Well, we'll set it out." You can burn some money and we'll be right and you'll be wrong.

The jawboning, I don't think works anywhere near as well as what it used to because the bank used to be credible. I think they admit internally that your curve control or getting rid of it eventually in a very undisciplined matter that they didn't defend it for about a week, which might not sound a lot, but a lot of bond traders lost a lot of money in that week. They did hurt their credibility and they've said that and I think that'll be another issue about credibility.

How do you get the reserve bank to have more credibility? You have more people on it that know what they're talking about on monetary policy don't have any problem with having someone from the unions. For example, on the RBA, you might remember back in the time of Hawk, et cetera. They had Bill Kelty on the central bank. You need some people that will basically be able to say, well, guys, I don't believe you because I'm an expert in monetary policy. They've only got one economist sitting on the reserve bank board that is independent. Most of the reserve bank board outside of the treasury and the governor are basically industry people. 

Ross: The point of a central bank for it to work effectively to give all of the sovereign bonds that we're talking about, their value, their risk-free value is to have an independent central bank.

Alan: We do have one. The question is, do you change this structure a little bit to make it more professional in the sense of there's you listen to a number of economists who have expertise in monetary policy who can push back against views. I think the central bank is credible or should be credible, but I think their forecasting record recently has not been great and that's a problem.

You can get more pushback. You can do a lot of other central banks around the world individual members vote, and that's recorded. In the bank of England, it's nine- level five-four so five-four makes it really tricky. In the fed, you've got what they call the dots, which is where each of the members on the board puts their forecast in for what's going to happen then. They just put a dot as in it's in the range two to three, three to four or whatever. That's in send some more messages.

Ross: Isn't there always going to be a conflict though with the central bank and the government of the day between monetary policy and fiscal policy. Fiscal policy being the government, basically spending all our taxes to run the country. The government goes out there wants to be re-elected. Therefore goes, right we need to make everybody happy with us and so we're going to do something which is going to increase employment, and we are going to run a budget. That's a deficit. In other words, an overdraft, in other words, we are going to spend more money than we receive of which has an effect on inflation has an inflationary effect.

Alan: What's happened in the last couple of years is really, the government has tried to make sure that the economy did not fall over. I don't have a problem with that. My problem is I would like both sides of politics to try and also think about how you might run the economy a bit more productively.

For example, when the governor talks about, "Oh, we can maintain 3.5% wage rises, but not five." What he's really implicitly saying is, yes, let's assume productivity's one. I take my wages at three and a half, take away one, two and a half. That's my band. That's where I want to be. That's what he's saying. It would be good. I don't have a problem with the idea and I didn't have a problem. During the GFC, when they started posting checks. Basically what you're trying to do is keep the economy going.

I think in the medium term, Australia's outlook was really good because we did not get the damage that a lot of other countries had. We've still got a lot of positives going forward. We've still got our AAA rating and you can argue about-- Okay, so our debt to GDP ratio went from 19 to 40. The world went from 90 to about 110. The Americans went from 90 to about 130 and the Japanese and the Greeks are what? 160 and the Japanese are 250, but so relatively, we still look pretty good. I think a lot of people in the medium term will say provided, we get over this and don't have a really bad recession. This is a good place to live, to invest, and all those sort of thing. The outlook's good.

Ross: That's good, when you say get over this, what you are really talking about is we as a country now are going through a bit of the collywobbles in terms of worrying about fear. This is the first time that it's happened in 30 years.

Alan: Well, a lot of people out there with a mortgage, why have I never seen this guy?

Ross: No, they've never been, it's only been onward and upward and everything's rosy and every day's better and they don't need to worry about economics because I'm being looked after. Maybe that stopped and we are back to, well, I'm going to, I don't want to say reality, but a much wider horizon than we've always had.

Alan: In some ways you've got to have real interest rates that are positive. Ross: Which we don't have.

Alan: Well, we don't have and what I'm saying is you need to get rates back up to two and three quarters, but you don't need to do it straight away.

Ross: Slowly, and gradually.

Alan: Slowly, see what happens, and if things are okay then-- The other big positive for Australia is we've got very low levels of unemployment. When you look at bad debts and you try and model bad debts, interest rates matter, economy matters. Unemployment is much more important than any of these other words.

Ross: Yeas, because in a 30 years there's never really been any unemployment people haven't felt that fear of losing the job or hanging on, or yes.

Alan: You had those high levels of unemployment during the '70s and during the recessions yes. You got to about 11% unemployment in '91.

Ross: Still 30 years ago, we're still talking. I'm quite sure you do sit with people and they roll their eyes. When the conversation comes up about working from home or working via Zoom or whatever, because as people have said to me, Ross, what we need is just a little touch of unemployment and productivity would go through the roof.

Everybody would be back into the CBDs of Sydney, Brisbane, and Melbourne. There'd be no discussion by an employee about, well, I think I'd prefer not to come in on Monday or Friday because they'd be going, I need to hang onto my job because I've got one mortgage to pay. That's right, and we haven't heard that in Australia for 30 years.

Alan: Years, you do need to be careful because that, by necessity, doesn't mean that the economy goes faster. If they all go back in the CBD because what's happening now is people are spending money out in the suburbs where they live. What you're going to get is a switch between spending out in the suburbs, versus sending money in the CBD but there's no doubt that in the CB-- A statistic that's I think is interesting is post the pandemic, Australian retail is roughly up 26%-27% in the CBD in Melbourne, and Sydney it's flat.

Ross: It's been spent.

Alan: It's been spent elsewhere and that's why house prices further out and particularly outside of the bush so if you're in areas, I don't know in Geelong, and that area, as long as you got good internet, that's where you spend your money and that's why house prices in those areas are gone up more than the CBD.

Ross: The house price thing is connected to the- what we were talking about before the wealth effect my house has gone up in value and I feel secure and I've got my job and therefore want to go and spend money and everything's wonderful. If house prices come back-- Some people have said house prices are going to come back 10, some people have said 20, some people have said more than that. That's going to destroy that wealth effect. People's consumption is going to fall. We would probably go into a recession.

Alan: No, because what you're doing is you're just wiping out what you've had the increase in the last 18 months. Let's say, we are saying roughly minus 20, in the last 18 months, it's up 22. What it might do is it might make people feel uneasy, and therefore paradox of thrift comes back. Therefore you basically-- We basically say growth halves next year, as a result of what we're seeing but we don't see growth going to zero and we don't see unemployment with a five in front of it. We see something like maybe flourish, which is good.

Ross: Glamour figures.

Alan: Yes.

Ross: Glamour, you think about 30 years ago. This is we're talking about dream economics here, aren't we?

Alan: Yes so if you said to the central bank, you're going to have Alan's forecast. You going to have the economy growing at 2%, rather than 4%, inflation's going to stay higher for till 24, but then come back to the roughly where they want it to be, they'd say that's great. We'll make that but you never know whether the consumer becomes very thingy and that becomes an issue.

Ross: Do you think the consumer now is more to use your word thingy than they were previously, do you think there's a sensitivity that's so much more heightened now that they can turn the tap off quicker than previous generations?

Alan: No I think they'll still probably do the same. It's always a problem about how the consumer would behave and so it's still there and we just don't know but you get bigger swings in the house prices now and so that might have bigger impacts. Basically you haven't normally lived in a world where food electricity prices, et cetera, have gone up. There'll be some people falling over and people and the government will be saying, oh, I need to lower the fiscal stimulus a bit more. People will-- I think potentially be a little bit nervous and they, we can already see discretionary retail has come off a bit because people are paying for petrol and we can see that in our data.

Ross: You would probably expect to see after they get a few electricity bills and gas bills too.

Alan: That's right. When we look at the electricity market we also worry a little bit that the big guys will be fine because they've got contracts, but the small guys in electricity supplies have to, if they go have to go to the spot market they're going bust.

Ross: Okay. Now in terms of bond traders, you have to do now the Burgernomics test and in looking at these mysterious people that spend $1.6 trillion, which is more than the equity market and think that they can be interest rate clear voice and they try and shift markets. The effect of what they do in trying affecting interest rate through yields on hamburgers. Good luck.

Alan: I've got no idea to be honest there. What they'll do, I suspect, is that they will basically mean that people won't be as much employed and won't be able to buy as many hamburgers therefore the price of the hamburger might come down but it's very let's face it. I just worry that if the bond market is right and the central banks essentially follow the bond market, I don't think it'll be a pleasant experience for people who want to buy hamburgers.

Ross: But you don't think that's going to happen. Do you?

Alan: I don't think that's going to happen.

Ross: A last question. We've talked about so many topics today. Where in all of this, do you think the economist is the hero in our story?

Alan: Me, I'll answer it a different way to the way you've put it. People say, "Why do you go off and do masters of economics and econometrics and all that stuff? It's hard." and my answer is, "The reason I did it is as an economist I want my kids to have a job and if as an economist, we can help the government not to make big mistakes, keep people employed, I think that's a really good job and I think there's a lot of social welfare in that."

Ross: My thanks to Alan Oster, National Australia Bank's chief economist for being my expert guest on today's Burgernomics podcast. I really enjoyed discussing the rough and tumble of economics with the revered economist who has seen it all recessions, stagflation, 10% unemployment, and interest rates above 17%. These days, that level of experience is a rare gem. If you have any comments on our discussion, don't hold back, let's hear them on Twitter, Instagram, LinkedIn, or Facebook. My thanks to Ology Creative, the brains behind the design elements of Burgernomics, and Oliver and York who handle our PR and marketing.

We have some fascinating discussions coming up on the Burgernomics podcast, the true economics behind electric vehicles for the Australian market, why many tradees earn more than your GP, and economic and financial terms, you hear daily, your standard of living depends upon them, but you've probably got no idea what they mean. Look forward to you tuning in soon.

[00:57:57] [END OF AUDIO]