Monetary policy no villain

There is a widespread view among financial market participants that attributes much of the world economy's ills to irresponsibly loose monetary policy.  Many central banks have reached their zero lower bound and been there for a while, and pursued unconventional policies such as quantitative easing and forward guidance, designed to kick-start the psychology of risk taking.  But the headwinds facing the global economy have been far stronger and persistent than many had anticipated.

The RBA has not had to resort to such measures and although the cash rate of 2% is anchored at multi-decade lows, it remains among the highest official interest rates across advanced economies.  The interbank futures market assigns a probability of less than 10% that the RBA will cut the cash rate at the August board meeting.  In recent communications, RBA Governor, Mr Glenn Stevens, has highlighted his view that financial conditions remain accommodative and that the central bank will continue to monitor the effects of interest rate cuts in February and May.

Mr Stevens has speculated recently that Australia's growth speed limit might have declined due to slower population growth and that this might have also contributed to the stability in the unemployment rate.  Estimating potential growth or the structural unemployment rate is a notoriously difficult exercise.  But with private sector wages growing at their slowest rate since the late 1990s and underlying inflation anchored in the bottom half of the RBA's target range of 2-3%, it is hard to mount a case that the economy is hitting up against its speed limit.  Indeed, Mr Stevens himself has previously observed that the economy could do with more demand growth.  It is therefore reasonable to expect that there ought to be an easing bias, even if the RBA has not formally adopted one since cutting interest rates in May. 

For institutional investors, the outlook for monetary policy in Australia is likely to remain a sideshow to other macro themes, notably what the spill-over effects will be of the turmoil in China's stock markets, and the prospect of a lift in the US Federal Funds rate.  Nonetheless, investors will continue to field questions from those concerned that low interest rates in Australia run the risk of stoking speculative bubble in residential property markets, in high yielding stocks and encourage firms to lift payout ratios, thus under-investing for future growth.

Some of these concerns remain largely misplaced.  First, low interest rates have led to a lift in dwelling investment, which has been desirable given the mining and energy sector CAPEX cliffs.  But supply side constraints in the major cities - thanks to onerous regulatory restrictions on new high-rise developments - have also contributed to higher prices.

Second, high yielding stocks haven't actually out-performed.  Low beta stocks - many of which have strong earnings predictability - have delivered strong returns and are trading on higher multiples than historical norms.  But this has less to do with low interest rates and more to do with the fact that the risk premium has increased, as investors remain reluctant to take on too much risk.

Third, the sweep of the past 25 years shows that there the aggregate payout ratio is well within historical norms, despite the RBA official cash rate being at its lowest level over this period.  In fact, the chart below highlights five periods in the past 25 years where the aggregate payout ratio has peaked at levels above the current rate of 75% (see chart).  In previous blog posts, I attribute the rise in the payout ratio since the financial crisis to a loss of trust in CEOs' abilities to undertake value accretive growth projects and acquisitions.  Moreover, in a world awash with excess capacity and suffering from deficient demand, what incentive do CEOs have to undertake large growth projects?

Interbank futures are right to not expect the RBA to cut interest rates at the August board meeting.  But if the economy is still suffering from a shortfall in aggregate demand by year end (my expectation) there will be a growing chorus for further monetary stimulus.  APRA seems to be doing a good job of jawboning the banks to continue to lift the amount of equity capital in their liability mix, thus giving the RBA more scope to ease policy without stoking a property bubble.  The jawboning and other macro-prudential measures adopted by APRA have already led to a lift in lending rates for housing investors across the major banks in the past month.