Revisiting the Big Aussie Short
Revisiting the Big Aussie Short
Plus, the RBA review goes forth; and the Q3 inflation outlook
Goldman Sachs was out with a note last week, The housing downturn: A bigger deal down under and up north, which singled out Australia, Canada and New Zealand for their vulnerability to a housing downturn. The obligatory Bloomberg op-eds were not far behind
That’s a good enough excuse to revisit one of my most viewed posts, The Big Aussie Short, in which I noted that the history of macro punditry with respect to Australia is littered with the corpses of failed house price predictions. Had you asked people in December 2019 for a 2020 house price forecast conditional on the expectation of the biggest negative shock to the global and domestic economy in 100 years, most of the responses would have been pretty dire, but also very wrong:
Source: Proptrack
To be fair, that was the broader public’s expectation during the early stages of the pandemic as well, at least if we go by the Melbourne Institute’s survey of house price expectations, but those expectations soon caught up with one of the most spectacular house price booms in Australian history:
The other point of that post was to question the relevance of house price cycles as the forcing variable for the macro economy. If you think an exogenous shock is going to tank the housing market, then that is the shock you should be worried about. If you think the housing market is endogenously unstable, a la Minsky, that’s fair enough, but as I noted in my Big Aussie Short post, the Minsky hypothesis nests every possible state of the world, making it useless as a framework for forecasting.
There are some moderately dire forecasts for Australian prices based on expectations for further RBA tightening. Many are based on the Saunders and Tulip model of house prices, although some of these forecast fail to distinguish (as Trent and Peter did) between a permanent and temporary change in the cash rate.
It is also worth recalling that in their model, interest rates affect dwelling prices partly via the user cost of housing, which cointegrates with rental yields. House prices are subject to an arbitrage condition between rents and the costs of owner-occupation. These long-run equilibrium relationships drive a very large elasticity of house prices to interest rates, but also demonstrate that ‘bubble’ dynamics are not needed to explain house prices. You can use the model to benchmark house prices and claim that deviations from predicted values are a ‘bubble,’ but as I argued in respect of another one of Peter’s papers with Ryan Fox on buying versus renting, transaction costs in substituting between renting and owner-occupation would readily explain these apparently predictable violations of the arbitrage condition. I think the more relevant interpretation of these dynamics is that observed house price cycles are endogenously stable and mostly consistent with fundamentals, not that they occasionally exhibit exuberance inconsistent with fundamentals.
Barrenjoey Capital put out a note that sought to put the expected decline in house price into the context of previous downturns:
But what really stands out from their chart is the resilience of house prices to major historical shocks and past interest rate cycles. Indeed, the second biggest decline shown is due to APRA and ASIC trying to throttle the market with credit rationing from 2014-17 in the middle of a RBA easing cycle. If you think house prices are at risk from a higher cost of credit, just wait until the regulators go after the quantity. And they call monetary policy a blunt instrument! The downturn many are expecting (Barrenjoey’s estimates shown in the chart are representative) would be large by historical standards, but that’s also a big caution against leaning too heavily on expectations for the terminal cash rate as the main conditioning variable for a forecast of house prices, as well as whatever macro implications you might see flowing from that decline.
As things stand, the decline in national dwelling prices has taken their level all the way back to that prevailing in November 2021, which is to say, not very far at all. The chart of the level of house prices above is in logs, so read your preferred percent decline from the chart and see how far back in history you go. The Big Aussie Short may (once again) be alot smaller than you think.
The RBA review goes forth
The RBA Review has released into the wild a discussion paper that has been doing the rounds confidentially in draft form for some time now. The paper has formed the basis for consultations with a wide-range of stakeholders and the review is now inviting public submissions. The closing date for submissions is 31 October. There is provision to make confidential submissions and Governor Lowe has taken the gag off staff to speak confidentially to the review team.
The discussion paper does a good job delineating the issues raised by the terms of reference and the questions that need to be addressed by the review. However, there are two elements of the paper I will take issue with. While a discussion paper is obviously not the place to settle these issues, it also important to get the framing right.
The paper defines monetary policy as ‘influencing various interest rates – to keep inflation low and stable.’ Both elements of the definition are incomplete and pre-empt to some extent some of the issues the review should consider. For a fuller definition, see Scott Sumner’s ‘what is monetary policy.’ See also his A Critique of Interest Rate–Oriented Monetary Economics. Sumner is in the process of writing a book on exactly this question, which will hopefully be ready before the review concludes its work.
The review also notes that ‘During the COVID-19 pandemic, fiscal policy played a larger role than usual in supporting the economy, when monetary policy was constrained by the effective lower bound on policy interest rates.’ As we have argued many times in this space, there is no basis to conclude that monetary policy was constrained by the lower bound during the pandemic. The cash rate was not at zero when most of the fiscal policy response was instituted. The RBA was able to further lower interest rates and use alternative operating instruments later in the pandemic, demonstrating that the previously assumed effective lower bound was a self-imposed constraint that partly reflects the same conception of monetary policy adopted by the discussion paper.
It should be recalled that during the early stages of the pandemic, Governor Lowe was calling on state and federal governments to do more with fiscal policy. Those calls effectively conceded that more macro stimulus was needed at the time. Fiscal policy was arguably even more constrained because it is embedded in institutional and political processes that are difficult to mobilise effectively. The constraint on monetary policy, by contrast, was purely intellectual rather than technical or operational. The RBA could have supplied more stimulus in March 2020, but declined to do so. We know that is true because it did exactly that from November 2020.
It is hard to properly evaluate the RBA’s pandemic response on the basis of the discussion paper’s premises about an effective lower bound that was not actually binding and its assumed implications for monetary-fiscal interactions. A key test of the review will be how it evaluates the RBA’s response to the most serious shock to the economy since the 1930s. Despite a widely held view to the contrary, the mistakes were made going into the shock more so than coming out of it.
I will be making a confidential submission to the review, largely based on material already in the public domain discussing the leaning against the wind episode from 2016-19 and the early stages of the pandemic response from March 2020 to November 2020. The confidential part of the submission will put those episodes in their broader institutional and political context and highlight the significant obligation on the review panel to serve a public accountability function in respect of these episodes. The review has cautioned that confidential submissions are potentially in scope for FOI legislation. The last time I showed up in a FOI request to the RBA, it was because someone was looking for RBA documents referencing the Spice Girls and got me instead. Imagine the disappointment.
Inflation outlook
The stronger than expected outcome for the US August CPI has not changed our model’s expectation for Australia’s Q3 trimmed mean inflation rate. The Cleveland Fed’s trimmed mean picked-up from 0.4% in July to 0.6% in August, but is still tracking below the 0.7% average increase for Q2. The Melbourne Institute’s trimmed mean is tracking at an average 1.3% for Q3 compared to 1.4% in Q2. Putting these two together, we still get a forecast of 1.4% q/q for the Q3 trimmed mean inflation rate, taking the annual rate to 5.5% compared to 4.9% previously. This would represent a slight moderation on the 1.5% rise in Q2. Worth noting that the Melbourne Institute’s diffusion index of price changes also moderated in August:
ICYMI
Scott Sumner is retiring from Mercatus. When he was an academic, I told him he would make a great think-tanker and I wasn’t wrong!
Scott Sumner reflects on his career arc and discusses his new book. It’s not in his nature, but Scott should be very proud of his achievements.
Nowcasting the Australian Labour Market at Disaggregated Levels.
The Vanguard of the Revolution: Index funds are socialism (in the best and worst sense!):
Meme stocks:
The RNBZ and its increase in media management staff reminds me of the point that the Scottish Government have more media management staff than 10 Downing. This does not include professional output by men like McCulloch but also monitoring social media output. Crackpot tweets even.