This along with the fact that the “valuations” topic is probably more a series of short explanations (and these ares supposed to be 2-3 pages), means I’ve decided to go back to my original topic. How to value things will be covered in the new year, so hopefully you’ll have something to look forward to!?
The RBA position
As you’ve no doubt heard, the RBA’s job is to keep inflation under control, which the board has determined means a CPI level of 2-3% per annum.
What is inflation?
Before we get too far into this we should be clear on our definitions. Whilst many people understand that CPI has something to do with measuring inflation, very few actually understand what inflation really is. Inflation isn’t prices going up, inflation is too much cash in the system. The theory goes, if there’s too much cash chasing a limited number of goods and services. Since we have a heaps of cash, weȁ
Now because we can’t measure exactly how much money is in the system at any one time (like when money was backed by gold), and money can be created by both Central and other Banks, we have to basically guess how much there us at any one time.
The way the RBA does this is through the CPI measuring a basket of stuff and seeing if on the whole, process went up, down or stayed about the same. Now here’s where it get’s interesting (if you’re not excited enough already). Rather than use the ABS official CPI numbers, the RBA applies its collective wisdom to pick which components of the official CPI they will include in their own measure.
How good is that! If you don’t like what the numbers tell you, you can change them to suit yourself! But surely they are applying a sensible filter to these numbers to weed out any irregularities, to make sure there’s a proper picture? Actually, as it turns out, that is quite important because short-term price spikes driven by supply\demand imbalances can play havoc with the number from quarter to quarter.
The only problem is, the RBA doesn’t seem to apply any sensible, reliable or predictable logic to how it does this. I’m happy to provide examples (see articles from 2008-9) but in the interest of brevity I’ll refrain here. In fact, since Governor Stephens took the helm, the best guide to interest rate decisions has been the unemployment rate.
This graph tracks the unemployment rate against RBA interest rates and clearly there is a relationship here. From September 2006 as the unemployment rate dropped (blue line moves to the left), the RBA increased rates consistently until, apparently in response to the GFC, rates plummeted to from 7.25% to 3%. This period also saw unemployment “blow-out” to 5.8%. This was almost certainly due to a cautious approach to new hires by employers facing the impending devastation of the GFC, which employment data supports.
As the “greatest economic challenge of 70 years” seem to go by relatively painlessly, employers began hiring again and hours worked increased. Then as the unemployment rate began decreasing the RBA returned to its crusade of saving us from all having a job.
Why does the RBA want Unemployment above 5%?
As you can see from the graph above, higher interest rates means more out of work, or more “spare workers”, which means as the economy grows employers will be able to find more labour. If they couldn’t find these extra workers they wouldn’t be able to grow the economy, or worse still would have to pay their existing staff more in order to “fend off” competition from other employers, particularly those “high paying mining companies”. This is what the RBA is referring to by “capacity constraints” when they talk about threats to future economic growth. By “capacity”, they mean “cheap labour”. It’s much more palatable to say “capacity constraints holding back the economy” rather than “we need more people out of work” as the reason to increase rates.
The real problem, according to the RBA, is the prospect of higher wages, because if all you employees out there had extra money you’d race out and spend it and drive up the price of everything, ultimately blowing up the economy. Fortunately, because you supposedly can’t be trusted, we have the RBA to increase mortgage payments and put enough people out of work each time this looks like happening.
Now remembering that correlation is not causation, let’s just check to see what happens when we chart wages growth versus unemployment, not because we don’t trust the RBA, more for our own education. Obviously what we will see is that as unemployment falls we should see a corresponding rise in wages.
Apparently not here either! The yellow line is our Phillips curve and the green line the Headline CPI versus unemployment. From 2001 to 2006 the unemployment moved steadily from 7% to 5% but CPI kept falling. Then cyclone Larry hit driving up fruit prices coupled with a spike in oil prices and increased housing costs through the RBA’s rate rises. Suddenly we had our Phillips curve as CPI increased and unemployment continued to fall. When we move these clearly non-inflationary issues we get the blue line, which continues the flat meandering of the original green line. No relationship here either.
Next year we’ll look at the promised “valuations” piece as well as further explore the point of the RBA and whether in fact we need it at all (unless of course I get any more interesting suggestions). If you’d like me to explore any other topic, let me know.
 Consumer Price Index – a measure of the change in pricing a select basket of goods & services
 You’d have to start to question this part of the theory – in today’s technology driven consumer world, almost everything depreciates rapidly and there always seems to something else to spend money on.
 See “Why we are so busy” – Feb 09
 Driven by speculative trading oil, not consumption, hence the just as swift reversal a few years later
CEO, Financial Adviser
Analysing what can seem to be like complex issues, Matt is effective in using analogies to better explain scenarios and truths to the rest of us. This is what Matt enjoys – educating clients on the truths and debunking the commonly held (wrong) view.