When the Pitchford thesis goes into reverse: Australia’s net capital outflows
Plus, Lowe versus Svensson on flexible inflation targeting
Last year, we lost both John Pitchford and Tony Makin, two of Australia’s best macroeconomists, who changed the way policymakers think about our economic interactions with the rest of the world. In particular, they argued that Australia’s current account deficit was a sign of both cyclical and structural strength. The excess of investment demand over domestic saving reflected growth opportunities that foreign investors were willing to fund. An economy that ran a current account surplus, by contrast, implied that there were better investment opportunities and returns abroad than at home. Their insights rescued Australia from bad macro policy inspired by a mercantilist preoccupation with external balance.
There is something eerie about their passing coinciding with Australia turning into a net capital exporter. It would be tempting to view the change in Australia’s net capital flows as cyclical and/or a function of the pandemic, but the shift to current account surpluses began two quarters before the pandemic started and reflects a declining trend in the business investment share of GDP. Even when we were still running current account deficits, a few analysts warned that Australia would begin running structural current account surpluses. The argument was that as domestic capital markets became saturated with superannuation saving, capital would increasingly have to flow abroad. But the real story is subdued investment demand, which has been on a declining trend as a share of GDP.
Australia recorded the 13th consecutive quarter of current account surpluses in the June quarter. I had to dig out my Cambridge Economic History of Australia to find similar three-or-more year runs of current account surpluses. There was one in 1944-46 and another longer run from 1904-11. There have been only 24 years between 1861 and 2018 in which Australia ran a surplus (15% of the time).
In net terms, we sent $18.7 billion abroad over the quarter and $48.4 billion over the year. In terms of FDI flows, we recorded the second consecutive quarter of net outflows to the tune of $7bn over the quarter and $63.8 billion over the year.
Gross FDI outflows were $11.6 billion after the March quarter’s monster $123.9 billion, yielding $158.6 billion in gross outflows for the year. Australian business is on an international acquisitions spree, not a bad thing in itself.
By comparison, gross inflows were a meager $4.7 billion over the quarter, although up $94.8 billion over the year, mostly consisting of reinvested earnings. While Australia has only recently become a net exporter of direct investment capital, the change in direction clearly pre-dates the pandemic:
Portfolio investment recorded a healthy net inflow of $42.5 billion, consisting not just of $26.7 billion in gross inflows, but also the repatriation of $15.8 billion in Australian investment abroad. This was more than fully accounted for by $19.4 billion in repatriation flows of equity and fund shares. Over the year, we still managed to send a net $88.8 billion abroad, including gross portfolio outflows of $114.5 billion into foreign stocks and bonds.
As noted in this space previously, in absolute dollar terms, Australia is now a bigger investor in the United States than the US is in Australia:
US capital markets are the default location for the world’s excess saving. The Pitchford thesis is now running in reverse. In an op-ed last year, I suggested that restoring net inflows of people and capital should be viewed as complementary elements of the post-pandemic recovery. We are still coming up short.
Governor Lowe on flexible inflation targeting
RBA Lowe gave the annual Anika Foundation talk to Australian Business Economists this week, having delivered another 50 basis point increase in the cash rate earlier in the week, taking the cash rate to 2.35%, the highest level since 2015. The accompanying statement dropped the reference to ‘normalising’ monetary policy. This was widely interpreted as a signal the RBA would soon fade the pace of tightening, although this was already implied in Lowe’s previous characterisation of the neutral cash rate as being around 2.5%. Markets further dialled back their expectations for tightening in the wake of Lowe’s speech.
The speech was notable for Lowe’s defence of the RBA’s big miss on the inflation forecast, which largely consisted of pointing out that the Bank was keeping a large amount of very good company. Monetarists like Scott Grannis and Tim Congdon were among the few to call the surge in inflation, at least in the US, but you won’t hear much mention of them from central bankers.
In the context of the review of the RBA, Lowe addressed some issues around the monetary policy framework. While arguing that the existing inflation target had served Australia well, he suggested the target range of 2-3% should be up for examination, noting that other DM central banks typically have a target anchored on 2%. Lowe seems to be suggesting the target should be lowered, although that would make the RBA’s job harder rather than easier in the current environment.
He went on to defend the RBA’s flexible approach to inflation targeting, which he framed in terms of the flexibility to manage trade-offs, including what he sees as a trade-off between lower interest rates and financial stability.
The public perception is that the abandonment of yield curve control and forward guidance, the big miss on inflation and subsequent tightening cycle are the main reputational risks for Lowe that may be picked-up the review. While I thought the yield target was a mistake, in contrast to the widespread cheering-leading for it at the time of its introduction, this also implies that the decision to let it go was the right one. Ironically, people have been more critical of the exit than the entry into the yield target, even though exit was clearly the appropriate response. The earlier than expected tightening in monetary policy is also a symptom of policy success rather than failure. The bigger risk for Lowe and the RBA is the review’s assessment of pre-pandemic monetary policy. The pandemic showed what macro policy could achieve when it made an effort. By contrast, pre-pandemic monetary policy was not even trying.
Lowe’s understanding of flexible inflation targeting as the flexibility to manage trade-offs unbound by rules is not what other central bankers typically understand by the term. According to Svensson:
Flexible inflation targeting means that monetary policy aims at stabilizing both inflation around the inflation target and the real economy, whereas strict inflation targeting aims at stabilising inflation only, without regard to the stability of the real economy…Flexible inflation targeting can be described as “forecast targeting”: The central bank chooses a policy-rate path so that the forecast of inflation and resource utilization “looks good.” By a forecast that looks good I mean a forecast either in which inflation is already on target and resource utilization is already normal, or in which inflation is approaching the target.
Yet the RBA’s pre-pandemic rate path and forecasts were routinely inconsistent with its targets because it a assumed trade-off with financial stability risks that was more apprehended that real. The back end of the forecast period was where the inflation target went to die. That’s not best practice flexible inflation targeting, even on its own terms.
We could also cite former RBA Deputy Governor Guy Debelle’s observation that ‘I am not convinced that flexible inflation targeting of the sort practiced in Australia is significantly different from nominal income targeting in most states of the world.’ That was the point of my estimated nominal income targeting rule for Australia, which was partly inspired by Guy’s observation.
Lowe noted the tension between flexibility and accountability, saying that ‘Given the flexibility, the Bank's performance is sometimes hard to judge at any single point in time. This can complicate the task of holding us to account.’ Indeed. Lowe did not say it, but less rule-bound approaches to monetary policy demand even stronger accountability mechanisms. Lowe has previously suggested the RBA’s existing accountability mechanisms are adequate, but it would be surprising if the RBA review reached a similar conclusion.
US August non-farm payrolls
US August non-farm payrolls came in higher than the market expected at 315k, although disappointed our own forecast. Much of the strength we were anticipating for the month landed on the labour force more broadly, which rose by nearly 800k. The labour force participation rate rose to 62.4% from 62.1%, which also saw the unemployment rate rise to 3.7%. This is a welcome sign of a labour supply-driven easing in labour market tightness. It is also a rebuke to the perverse market reaction to the higher-than-expected payrolls outcome that we warned about in forecasting an even higher payrolls print. As Skanda Amarnath from Employ America was quick to highlight, the prime age full-time employment rate has now staged a complete recovery from the pandemic:
Bill Kelty on The Australia Institute: ‘That is half our argument, with loony tune organisations – including that odd-bod show, the Australia Institute – with essentially Marxist predilections, that it’s only ever a choice between wages or profits.’
This used the example of Australia as a counterargument to the "unsustainability" of current account deficits!
I suppose with the reported LNG exports fron Australia to Europe via the UK, the surplus will continue.