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RBA: “We’re happy to inflate house prices”

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The RBA has changed its tune. Look out.

Rates are going to get cheaper.

That was the key take-away from a speech from the RBA Governor Phil Lowe last week, which I’ve seen at least one commentator describe as “the most dovish speech ever.”

(If you’re new to the lexicon, dovish means inclined to rate cuts, hawkish means inclined to rate hikes.)

So yeah, it seems pretty clear to me that the RBA will cut rates a fraction lower at their November meeting, they’ll extend the TFF (cheap money for banks), and maybe even try and crunch the longer end of the yield curve.

That is, our super cheap money is about to get even cheaper.

But I’ll talk more about that, but there were a few interesting things in his speech I wanted to pull out.

First, I noted last week that the Covid crisis is having a disproportionately strong impact on small and medium sized businesses.

The RBA actually has clear data on that, which shows the huge hit to SME revenue, while big business has largely sailed through the crisis unscathed, and then saw a big bounce in sales once the money started flowing into the system. 

(I’m sure they’re going to hand back all the money they took in Jobkeeper. That’s totally going to happen.)

The other thing ol Phil noted was that even though incomes are holding up, households have bunkered. Consumption has tanked and savings have spiked to the highest level on record.

As he notes, the really interesting question is what they do with all that money once the crisis passes. Might make for a nice deposit on a house, for example.

He also notes that part of that saving spree is heading in to mortgage and offset accounts, as people pay down debt.

And he also notes that even though our government debt has exploded, it’s still pretty small in the scheme of things.

So, we can be relaxed about that.

And we can be extra relaxed about it because the RBA is just buying up all the debt anyway, as their balance sheet doubles:

But the key take-aways were around the direction of monetary policy.

First up, they now reckon that more rate cuts could be useful:

When the pandemic was at its worst and there were severe restrictions on activity we judged that there was little to be gained from further monetary easing. The solutions to the problems the country faced lay elsewhere. As the economy opens up, though, it is reasonable to expect that further monetary easing would get more traction than was the case earlier.

They’re also pretty relaxed about the potential for super-cheap money to create asset-bubbles.

A second issue is the possible effect of further monetary easing on financial stability and longer-term macroeconomic stability. This is an issue that we have paid close attention to in the past when we were considering reducing interest rates in a relatively robust economic environment… To the extent that an easing of monetary policy helps people get jobs it will help private sector balance sheets and lessen the number of problem loans. In so doing, it can reduce financial stability risks.

That is, we don’t mind inflating house prices, so long as people have jobs.

So that’s why it’s a super-dovish speech.

The economy is still struggling. More rate cuts will be useful. We don’t care if asset prices inflate.

Let’s get this party started!

JG

No BS: My hot take on the budget

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The shape of the country of Australia in the colours of its national australian dollar currency recessed into an isolated white surface

The Budget was massive, but I think we have more in store.

What do I make of this week’s budget?

It’s massive. But there’s more coming.

That’s what I reckon.

First up, the headline numbers are huge. We’re looking at a budget deficit of almost half a trillion dollars. We are still well and truly in unchartered territory here. No one could have ever imagined that the Australian government would be handing down that kind of deficit a year ago, let alone a “debt and deficits disaster” Coalition government.

But this is where we’re at.

It’s a huge amount of money.

But I still think there’s more coming.

And I say that because the two key centre-pieces of the budget – the wage subsidy for young workers, and the instant asset write-offs for business investment – are activity generated.

That is, they rely on the private sector doing stuff for them to come into effect.

So if you’re going to give companies a subsidy if they employed a 19-35 year old from the ranks of the unemployed, that requires firms to actual go out and hire people.

While this measure is estimated to be worth billions of dollars, it is theoretically possible that if no firms employed no new workers, that the total cost to the budget would be a doughnut $0.

Same story with the asset write down. If firms invest, there might be a certain tax advantage for that. But if no firms invest in no new things, then the measure is worthless.

That means that this free-spending budget actually needs a catalyst before it become active.

And what’s the catalyst?

Economic activity itself. It needs firms to hire and invest. If they don’t, then there’s nothing.

So this epic budget positions itself as a rocket pack strapped to the top of an economy that’s already moving.

But what if the economy isn’t moving?

It’s possible.

The government’s projections for growth and jobs were characteristically over-optimistic, but not wildly so.

But still, there’s a lot of money exiting the economy right now, as the governments front-line support measures – particularly JobKeeper and the JobSeeker supplement – are already being wound back.

This chart from the AFR shows you what the ‘fiscal cliff’ we’ve been hearing about for so long is now looking like:

And that’s at a time where private demand has already fallen through the floor, and public spending is the only thing propping up the economy.

And so what you’ve got is about $30 billion worth of direct government spending being replaced by a wage subsidy worth $4bn, and an asset write-down worth $27bn.

So it kinda balances out, right?

Well, no, not exactly.

It’s a bit apples and oranges because you’re replacing a direct cash injection, with indirect support that’s conditional on firms taking the risks involved in hiring and investing.

What it means is that if the economy is already recovering and continues to recover, and firms are happy to hire and invest, then we should get a reasonably smooth transition.

But if they don’t – if firms and households are still spooked – especially as JobKeeper winds up – they we might end up with a very bumpy transition.

In the short term, that will lead to two things. The first is that the government will decide it needs to support the economy more directly, and it will go back to mainlining money straight into the economy.

The second is that it will call in the RBA artillery, and we’ll get further rate cuts and reduced mortgage rates.

My guess is we’ll get both.

My hunch, based on what I know about animal spirits, is that everyone will want to take a wait-and-see approach, and the government we’ll be forced to intervene more aggressively.

In the long run, that means even more money finding it’s way into the system, and we’ll have an even bigger rebound boom baked into the outlook.

So that’s my take on the budget.

It’s huge. It’s massive.

And it’s only round one.

JG.

Aussies cop $24bn windfall

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When you look at how Aussie households are actually doing, you get a very surprising story…

Are Australian households actually building up a massive war-chest?

Are they about to unleash a surge of cash onto the asset markets?

Maybe.

WE’re getting pretty used to all the bad numbers. The scary numbers. The Australian Bureau of Statistics has numbers. Lots of numbers. Most of those numbers are scary.

Sad.

So sure, we’re hearing a lot about how stuffed the economy is.

But on the other side of that ledger sits the government.

And while Covid has torn a path of carnage through the economy, the government has also rushed in to try and patch that up with cash. Mountains and mountains of cash.

Happy.

And how is it all balancing out?

Pretty well actually. Australian households are actually in a better financial position than they were at the start of the crisis.

Wait, say what?

No seriously, that’s what the data says.

And look yes, some individual households are doing it tough. They’ve lost jobs or lost businesses, and they’re hurting. Absolutely no denying it.

But for every household that’s gone backwards, another has gone forward, and averaging it out over the entire population, you’ve got a net positive.

We’ve got a few data sources telling us this now.

First there’s analytics firm AlphaBeta:

Analysis of household cashflow by analytics firm AlphaBeta, a part of Accenture, shows the slump in wages suffered by households due to the pandemic (plus and the fall in unincorporated business income flowing to households) was more than offset by government payments, superannuation withdrawals and private sector hardship support between April and June.

It reveals a net increase in household cashflow of nearly $24 billion over that period.

Yep. You read that right. Aussie households have picked up a windfall $24 billion!

$24 billion! That’s not nothing. That’s a long way from nothing.

Happy.

The CBA are telling a similar story, based on the flows they’re monitoring into customer accounts. They reckon that on the back of government support programs and the early access to super, households are in a stronger financial position.

The income of the average household rose by 4.2% over the year to Q2 20, up from 2.4% over the previous year. Salaries have fallen due to coronavirus job losses. But investment income and government benefits have increased sharply. Investment income is capturing the early withdrawal of super which is part of the COVID-19 response

That investment income is a doozy, but remember it’s all about the super withdrawal.

Still, in aggregate and on average, households are substantially better off.

And at the same time, they’re spending less. Spending has fallen by around 9% over the year to Q2 2020.

So if they’re earning more and spending less, that must mean that households are saving more. That’s a good thing. That’s shoring up their long-term financial position.

So this is a story about households having more money.

It’s also a story about households putting that money aside for a rainy day.

But what if the rain never comes?

What if things get back to normal pretty quickly, and Aussie households just find themselves $24 billion better off?

Where does that money go then?

It goes into Jet skis obviously, and then into asset markets after that.

Boom.

JG

Why I was right

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I flagged a pivot from commercial to residential property a few months ago. Looks like its taking shape.

At the start of the crisis I talked about a potential pivot from Commercial to Residential property.

Things seem to be playing out more or less as I expected, though it’s still early days.

The basic idea here is that commercial property is going to struggle with the Covid economy – much more than residential property will.

As comparative asset classes, that means residential will become relatively more attractive.

Now the flows here aren’t direct. The people who invest in high-rise office towers aren’t the mum and dads who invest in a two-bedroom bungalow in Geelong.

But everything in our crazy old, highly-financialised economy is connected. Residential property will benefit from capital outflows, lower interest rates, and higher prices as investors gear out of commercial.

And the first waves of that are emerging.

The AFR is reporting that retail vacancy rates have spiked to the highest level in 20 years:

The vacancy rate across the nation’s shopping malls is the highest in more than two decades as the coronavirus crisis accelerates a wave of store closures in a sector already under challenge.

The national average shopping centre vacancy rate rose to 5.1 per cent in June from 3.8 per cent six months earlier, according to a survey by JLL.

Factoring in both CBD shopping destinations, where the rate has soared past 10 per cent and the relatively more resilient large format retail hubs, the vacancy rate rose to 6.3 per cent from 4.8 per cent in the past six months.

The JLL survey excluded temporary store closures in its count.

That last point is very important. This doesn’t include stores that have temporarily closed. Now, how many of those are actually just going to stay closed?

My bet is that at least some will. And if any do, that pushes the vacancy rate even higher.

The RBA in its recent Financial Stability Review, has already flagged commercial property as a flash point.

Office space in particular is set to see considerable new supply come on-line in the next couple of years:

Conditions in office markets were previously strong, but these are also expected to deteriorate in the period ahead. Of note, an above-average volume of office supply is due to be delivered into the Sydney and Melbourne CBD markets this year and demand will be unlikely to keep pace with this stronger supply (Graph 2.12).

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So with an over-supply building in office-space, and record vacancy rates building in retail, the outlook for commercial property remains tough. Really tough.

But as I said, I expect residential to hold up much better over the longer term. Vacancy rates are edging higher, but so far it’s not too remarkable. And the supply/demand balance will remain tilted to under-supply.

Add record low interest rates to the mix, and residential property should perform well…

Well… it will perform better than commercial at least, and that might be all matters.

JG.

Banks set for a fall in October

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Mortgage holidays are hiding a lot of pain. But if that pain makes it way on to the banks’ books, they’re in real trouble.

In less than 100 days, the Australian economy will topple over a cliff.

Australia is doing better than most nations right now (tell that to the one in five workers who lost work!), but the mountain of stimulus and support we’ve put in place is all due to end in September.

We’re talking about JobKeeper and the JobSeeker supplement, but we’re also talking about mortgage deferrals.

Remember that banks have been offering borrowers a ‘holiday’ from their repayments.

According to the Australian Banking Association, 772,600 loans have been deferred across Australia, including 480,700 mortgages.

That’s one in 14 mortgage holders – about 7% of the market. Substantial.

And while mortgages account for a bit more than half of the number of loans, they account for about three quarters of the value of loans deferred. $234.1 billion total loans have been deferred, of which $173.5 billion are mortgages:

So… so far, so good. A substantial number of loans have been deferred, but we’re not talking about the collapse of the mortgage market.

But the key thing here is how this shows up on the banks’ books.

Remember that when the deferrals were announced, some people wondered why the banks weren’t going further.

Because the loans aren’t simply being paused. Anything you miss has to be made up, in the time that remains. That pushes your minimum monthly repayments up somewhat.

And when they were asked why they were deferring rather than pausing the loans, the banks said that if they ‘paused’ the loans, they would be technically “impaired”.

An impaired loan is a loan that has gone bad, with a higher risk that it will not be repaid.

That has serious implications for the banks. APRA – the banking regulator – has rules about how much capital you hold against your loan book, and it depends on loan quality.

So, to make some numbers up, if you have $100 of high-quality loans, you might have to hold $10 in cash.

But if you have $100 of impaired loans, you might need to hold $20 or $30 in cash.

That is, if the banks pause the loans, the loans get treated as ‘impaired’ and that means the banks have got to come up with extra money to hold against those loans. 

How much of a problem is that?

Well, economics grey-beard Alan Kohler does some back of the envelope calculations.

If the deferred loans were treated as impaired this year rather than deferred, and the big four’s share of them was the same as their 80 per cent share of total loans and advances – probably a safe assumption – impaired loan expense would be 16.6 per cent of their loans and advances and would more or less wipe out their capital…

After six months, the support program runs out in September, at which point, it is assumed, $224 billion in loans, plus whatever is deferred between now and then, would instantly become 90 to 180 days in arrears…

September is rushing towards the banks. How many of the 744,904 people and businesses, and counting, will be able to resume repayments? How long can loan deferrals go for? What proportion of the loans must be classified as impaired at September 30? What provisions must be struck for future impairments? How much capital would need to be raised to cover these sums? If it’s a 12-figure amount (that is, more than $100 billion), who will supply it?…

But if the government’s various income support packages end in September and October, as planned, the bank support will have to begin, or else the pandemic crisis will turn into a financial crisis like no other.

Yup. If October comes, JobKeeper ends and all these loans move from deferred to impaired (not even assuming more people end up in default), the banks get “wiped out”.

And it seems to leave the government with the choice of either nationalising the job market, or nationalising the banking sector.

Both options are ugly.

This is going to take some fancy footwork to get out of this one.

… and we’ve got 100 days and counting.

JG.

Exposed: Banks’ secret against rate cuts

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The banks don’t want you to enjoy lower rates.

One of the things about being trained in the dark-arts of marketing like I am, is that you recognise a publicity campaign when you see one.

They happen all the time. Most of them just slip under the radar. They subtly slip into the collective consciousness, and just become fact.

“Women need to eat more meat, because iron,” for example. 

Anyway, one of these clandestine campaigns came up on my radar the other day. While most people were celebrating last week’s rate cut, The Australian Financial Review was not loving it.

In fact, it started running a bunch of articles about how we didn’t really need rate cuts, and in fact, rate cuts weren’t good for us anyway.

Like this little nugget from Morgan Stanley’s James Gorman:

Morgan Stanley chief executive James Gorman has warned central banks that further cuts to official interest rates risk reducing their “firepower” to deal with an unforseen geopolitical crisis.

After Reserve Bank of Australia governor Philip Lowe suggested the official cash rate could fall to 1 per cent and US Federal Reserve chairman Jay Powell indicated US rates could move lower amid fears escalating trade tensions will hit the US economy, Mr Gorman described monetary policy as unpredictable and limited in its impact.

Won’t somebody think of the unforseen factors?

Or there was former RBA Deputy Governor Stephen Grenville:

Former Reserve Bank of Australia deputy governor Stephen Grenville has challenged the effectiveness of the RBA’s inflation target and interest rate cut, as he warned that cheap borrowing costs distort housing and stockmarkets.

Following the historic reduction in the RBA’s cash rate to a record-low 1.25 per cent on Tuesday, Dr Grenville writes in The Australian Financial Review today that negative real (inflation adjusted) interest rates “don’t make much sense” and fiscal policy should play a larger role to stimulate the economy.

Yeah, kinda. Fiscal policy (government spending) could definitely be doing a bit more heavy lifting, but that’s hardly news.

And there was a raft of others, none of them any more insightful or persuasive than these.

And so when you see a string of weak arguments for something, all supposedly unrelated, but adding together to give the impression of a broad consensus, then you know you’re in a clandestine publicity campaign.

But I’m like, why? Who doesn’t love rate cuts?

So I did a bit of digging. And you know who doesn’t love rate cuts?

The Banks.

Turns out that when interest rates get super-low, the banks have much less flexibility to manage their money, and that starts cutting into their profit margins.

That’s what the analysts at Goldman Sachs reckon:

…if the cash rate was to fall below 1.50%, every additional rate cut thereafter would shave about 5 bp off sector margins. The sensitivity of margins to falling rates accelerates once the cash rate falls below 1.50% because the various levers the banks have at their disposal become less flexible as the cash rate approaches zero and we would particularly highlight the following:

So banks don’t like rate cuts because the lower rates go, the more it binds their hands, and the less profit they can make.

And so what do you do? You use your mouth piece (The Australian Financial Review) to start campaigning against rate cuts…

… no matter what the country needs, no matter what the economy needs, and no matter what the property market or individual borrowers need.

Nope. It’s bank profits and everyone else be damned.

That Royal Commission sure was money well spent, wasn’t it?

JG

Bears go bananas. Must be a good sign for the market.

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The property-doomsayers are getting hysterical. That’s always an interesting signal.

I’m actually ready to call the bottom on this market.

The declines are coming to an end. The market is about to turn.

And what data am I basing this bold prediction on? None. I don’t actually have any evidence.

But it does appear to me that we have hit peak crazy, and that’s got to be a market signal for something.

I’m talking about ‘news’ headlines like this one: Property ‘Armageddon’: House prices could fall by 50 per cent.

Yup. They’re going all in with this one.

With Sydney and Melbourne’s falling house prices infecting other capitals such as Brisbane, Darwin and Perth, some doomsayers say property prices could slump by as much as 50 per cent by 2022.

Digital Finance Analytics chief Martin North says Sydney and Melbourne houses will suffer price falls of 20 to 30 per cent, while high-rise units could slide by up to 50 per cent from their peak prices in 2017.

North says prices in Melbourne, parts of Brisbane, Perth and Sydney will fall the most between now and 2022, but it is outer suburbs that will be hit with the largest price falls.

“Prices will unwind in Sydney and Melbourne for at least another three years,” he says. “The problem is a lot of the high level data is averaged and averaging tells you nothing at all. Prices are not dropping by the same rates everywhere.

“In some places, for example western Sydney, prices are 23 to 25 per cent down or more, but areas closer into the city, particularly houses, are probably only 3 to 5 per cent down.

“If you look at Newcastle or the Illawarra, it’s 7.5 per cent down but there are other areas out in those regions where prices that have hardly moved at all.

“Perth is down 15 to 18 per cent on average. And if you look at Darwin, it could be 25 to 28 per cent. So these are big movements, they really are.”

Economist former government adviser John Adams — who once worked for Liberal senator Arthur Sinodinos — believes economic armageddon is coming.

Adams says Melbourne’s falling house prices are in a devastating slide that will go beyond Moody’s forecasts and could reach more than 40 per cent from peak to trough.

Meh.

I’ve heard all this before. North has been trotting the same numbers out for about six months now.

And I think the bears are getting more excited and shrill because the data does seem to be turning.

The pace of declines in the big capitals is getting slower, not faster.

And that’s because, despite the headline falls, most things have been running in the property market’s favour in recent months.

  • The Hayne Royal Commission wound up and was a lot better for banks than a lot of people were expecting. Financial sector funding costs had blown out to 60bps above the cash rate in anticipation of the worst, but are now back down to a 24bps premium.
  • At the same time, some banks are cutting their retail rates, so funding costs are down overall.
  • The APRA restrictions caused a bit of logjam in the mortgage market as everyone tried to get themselves up to speed. That seems to be clearing now, and the market has found its feet.
  • The RBA has clearly moved to an easing bias, and rate cuts seem likely in 2H2019.
  • And the election should give things a bit of certainty, and the market a bit of a bump, as it normally does.

Add to that some property bears screaming at their coming irrelevance, and I think you have the making of a bottom.

Too soon?

The budget is a lie!

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This economic revolution is playing out in real time. Today, they attack the budget.

The budget is built on a lie. Everything we know about the budget is wrong. Every number Josh Frydenburg laid out for us on Tuesday misses the point.

That’s the word from MMT – modern monetary theory.

Ok, so we’re picking up from last week and the week before. I’ve been explaining that the ideological dam has broken. People now realise that the tools we have for managing the economy just don’t work the way we expected them to work.

Quantitative Easing (QE aka printing crap-cans of money) should have created inflation. It didn’t.

So we need a new theory for understanding the economy, and with any new theory comes a new set of tools.

And as I said last week, Munters (my name for MMT proponents) believe that:

  • Capacity constraints, not money, create inflation;
  • Interest rates are a useless policy tool if there’s no demand (looking at you RBA); and
  • Governments are not constrained in the way we thought they were.

The second point there potentially kills off monetary policy and the RBA’s agenda completely, but point three could be a complete game changer.

And budget night will never be the same again.

The key point the Munters make is that the way we’ve been trained to think about the government budget is wrong. It’s the wrong metaphor.

The metaphor we’ve been trained to use is to think of governments as a household. Households can’t live beyond their means, so neither can governments. Households have to balance their budgets, and so do governments. If households are saving money (earning more than they spend) that’s a sign of good money management. The same is true for governments.

All of this is simplistic in the extreme, but Munters are also keen to point out that it’s actually wrong too.

It’s wrong for two reasons:

1. Governments can print money

If a nation is ‘monetarily sovereign’ (it has a flexible exchange rate and issues debts in its own currency), then are no hard constraints on how much money it can print. It might create inflation that way, or it might devalue the currency, but both of these things can be managed, and depend a lot on what else is happening in the local and global economy.

As Munters argue, inflation only comes from capacity constraints, not automatically out of money creation – as QE has proved.

A household obviously cannot print money to pay its debts. If I tried to pay my creditors in JonCoins, I’d probably end up in jail.

Munters argue that given this important difference, it makes almost no sense to compare governments to households.

2. Governments are not in the business of making money

Munters also argue that it’s not helpful to have a government that is motivated like a household (maximising its own wealth) or a business (maximising profits.)

Here the idea of ‘sectoral balances’ comes in. This is just the accounting identity that if the government sector is in surplus then it is lending money to the other sectors in the economy. That necessarily means that the other sectors must be a net borrower, and must be in debt.

So a government that forces itself into surplus, forces households and business into debt.

Is that a great outcome?

And if point one above is true, it’s much worse for households and businesses to be in debt since they can’t print money to pay off their debts.

So while it might be nice at the individual level for governments to be running a surplus, taking the economy as a whole, it’s not clear that a wealth-maximising government is that great a thing.

Not a Free-for-all

This is not to say that Munters think it is a free-for-all and that governments can do whatever they want. It is only to say that governments are not constrained in the way we thought they were – in the way that the ridiculous governments-as-a-household metaphor would have us believe.

And that means that there is a much greater role for governments to print money and support demand than we previously believed.

This idea runs totally against the prevailing economic wisdom.

But the prevailing economic wisdom has failed.

And MMT is an idea who’s time has come.

I’m not arguing it one way or the other. I don’t have a horse in this race. But I can see the writing on the wall. Momentum is with the Munters.

And the implications are going to be huge.

More on that next week.

Negative Gearing Reckoning: who will it hurt?

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If Labor wins, negative gearing reform is go. But who is it going to hurt?

Labor has announced that their negative gearing and capital gains tax reforms will come into effect on January 1, 2020.

Like most people, I was expecting them to go for the end of the 19/20 financial year, so this means two things:

  1. there’s going to be a rip-the-bandage off approach, and I think that’s probably a good thing.
  2. Labor knows it’s onto a vote-winner and is happy to double-down.

But like all things in politics, there must be winners and losers, so who is going to be worse off under the new policy settings?

Well, literally everyone, according to the Real Estate Institute of Australia:

“The REIA has always been concerned with the impact the policy would have on housing markets, buyers, renters and economic activity,” REIA President Adrian Kelly said.

“This concern is magnified in the current market.

“There is almost truck loads of analysis and reports showing the adverse impacts of the policy on mum and dad investors, home owners, renters, the construction industry, state governments and the economy.

Investors, home-owners AND renters?

How does that even work? I actually struggle to think of a scenario where all three are made worse off under ANY policy proposal – maybe something like “All housing will be nationalised and turned into jumping castles for Swedish tourists.”

Or are we using a definition of “worse-off” that I’m not aware of?

I want to pick this apart a bit, not to be cruel to REIA, but to make a point about how the housing market actually fits together. I think it will be useful.

Anyway, if we’re saying everyone in the market is going to be worse off, then I assume we’re saying that house prices are going to fall (bad for investors and owner-occupiers) and rents are going to rise (bad for renters).

That’s the only scenario that makes sense. If rents fell, that’d be bad for investors, but you’d have to chalk that up as a win for renters.

Likewise, if houses became more expensive that would be bad for renters looking to buy, but would be a win for owner-occupiers and investors.

So we’re talking about falling house prices (though I know a café full of millenials cheering that on), and rising rents. But how would negatively gearing actually make rents go up?

They might go up if the reforms exacerbated our housing shortage, but since negative gearing will remain in place for new stock, it’s hard to see how removing it for existing homes will have any affect on construction rates…

But, just for arguments sake, let’s imagine that somehow negative gearing reform does increase rents.

What happens then?

The point to remember here is that since housing is an asset, like all financial assets, the return is linked to the price.

The link between the rental return and property prices is captured by “yield”.

Now the thing to note about property yields is that they’re affected by structural conditions in the market – interest rates, risk appetites etc. Yields are not determined by rents and prices themselves.

That may sound counter-intuitive, given that yields are a calculation of prices and rents, but the causation actually runs the other way. Yields determine prices.

If you track yields over recent years, you’ll see that they’ve been very stable.

For 15 years, they’ve barely deviated from 4%. Even though rents and prices have been all over the shop, yields have barely changed.

So if rents go up, what happens to yields?

Well, you’d think yields would go up as well. But that doesn’t happen, because prices are set by people buying property, and the people buying property are happy with yields of 4%, on average.

So if rents go up, yields stay constant, and the adjustment is forced on to prices. Prices go up and yields remain at 4%.

Statistically, that’s been true for as long as we have data for.

But if prices go up, isn’t that a win for owner-occupiers and investors?

Yes.

Personally, I think the reforms will have no impact on rents, and push prices down at the margin, but not by a huge amount. Yields will adjust a little because the ‘cost of carry’ appetite will have changed (I’ll talk more about that another time).

But all this ‘everyone is worse off’ is just BS.

But remember this. If you want to know what’s happening to prices, look to rents and yields first.

Heads up! This is a ‘seismic shift’ in the global economy

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There’s some big shifts going on in the way we understand how the economy works. The playing field is about to get turned on its head.

Let’s pick up where we left off last week. As I was saying, we’re on the brink of seismic shift in the economy. It’s going to be huge. Mark my words. In 18 months I’ll be digging this up and telling I told you so.

Anyway, our understanding of what the economy is and how it works is about to change. And the drive for this change is coming from a massive failure.

It comes from the massive failure of money printing (Quantitative Easing) following the GFC to juice the economy and to create any inflation at all.

It comes from the massive failure of central bankers to predict that first failure, or even to come up with a plausible story with the benefit of hindsight.

And it comes from the massive failure of policy makers to stop the tidal wave of money they unleashed ending up in the pockets of the ultra-wealthy.

Big fat ‘F’ for failure.

This has sort of been obvious for a while now, but it now feels like there’s a shift in the collective consciousness. Maybe it’s those catchy milestones. We’ve now had ten years of money printing in the US and Europe, and 20 years in Japan – to most reasonable people, ten years seems like a fair amount of time to let an experiment run before you call it off.

And that’s where we’re at now.

And central bankers and orthodox economists are still scratching their heads. Policy makers are at a loss. Everyone’s wondering what the hell is going on.

Now enter MMT.

Take note of that acronym. You’re going to be hearing a lot more about it.

MMT stands for Modern Monetary Theory. From what I can gather it’s a pretty broad church. MMT proponents (I’m going to call them Munters from now on) tend to be more of your ‘soft hearted economist’ version, though people will point out that MMT is just an analytical framework. What policies you want to throw into that framework are up to you.

Anyway, MMT has actually been around for a while, but the Munters are now in a position to claim that the QE experiment that’s been running since the GFC proves that their lens for viewing the world is the clearest lens on offer.

They’re giving us three observations (that seem important to me):

1. Inflation comes from capacity constraints, not money.

The old view of the world said that all money-printing results in inflation, but QE showed us this is not the case.

Munters say that inflation comes from capacity constraints – when demand for goods and services outstrips labour and capital’s ability to produce those goods and services. Money doesn’t necessarily come into it.

QE failed because it did nothing to address this demand-supply balance.

2. Interest rates are impotent if there’s no demand.

QE was the end game in a doctrine where interest rates were seen as the primary tool for managing the economy. Lower interest rates means people borrow more and do more economicy stuff like spend and consume.

And QE was very effective at lowering the price of money and creating the (ongoing) era of super-cheap money. However if firms have nothing worthwhile to invest in, then it doesn’t matter how cheap money is. And if consumers feel like they’re over-leveraged already (which they were following the GFC), then you do literally have to pay them to borrow money.

So lower rates do nothing, which is kind of what they did.

And so this is where the QE transmission broke down. All that money didn’t make its way into the real economy where it might have been able to generate inflation. Rather, it got caught up in the financial sector, where it simply bid up the price of financial assets (including real estate).

3. If money printing doesn’t create inflation, then governments are not constrained in the way that we thought they were.

We used to think printing money was a pure evil. Munters say that we now know that’s not the case. It’s more nuanced than that.

However if that’s true, then governments are not constrained in the way we thought they were. It may be possible for governments to print money, to consume and invest, all in a way that doesn’t lead to an outbreak of inflation.

This is a game-changer.

The New Rules

I think you can probably get a sense of how this could fundamentally recalibrate the economy.

It’s going to be massive. But I’ll go in to that, and the quirky politics of it all, next week.