The Central Banks’ Conceit with Inflation

Another day, another set of confusing signals. Preliminary manufacturing data out of China reached a 7-month high in October. But it wasn’t too impressive; the reading came in at 50.9 (anything above 50 signals expansion). Given the huge amount of credit expansion going on in China right now, you would’ve expected a little more action, no?

Global mining equipment manufacturer Caterpillar preceded the China data release with news that third quarter profits fell 44% on weak demand and dealers running down inventory. The company’s outlook was pretty average too, with demand for new equipment not expected to pick up in 2014.

The Caterpillar results reflect the fact that the mining investment boom is over. During the past decade capacity expansion in the mining sector has been significant. But now you’re seeing many commodity prices trade close to or below their marginal cost of production, which means the demand for new equipment to expand output is very weak.

Yesterday, Reserve Bank of Australia Deputy Governor Philip Lowe gave a speech on the topic of investment in Australia. It was classic central banker monotone. We nodded off a few times while reading it.

Despite the unemotional, robotic language, the speech was interesting…if only as insight into the view of the world from the lofty perch of a central banker.

Lowe pointed out that while the rest of the world has suffered from a drop in investment relative to GDP in recent years, Australia’s investment relative to the size of the economy has boomed. It recently hit 18% of GDP, the highest level in more than 50 years. Lowe provides a simple explanation for the difference:

Most of the advanced economies have been dealing with the fallout of the severe banking and debt problems of the late 2000s. In contrast, we avoided these problems and have been benefiting from the growth in Asia. This growth has pushed up the prices of many commodities, which has encouraged investment in the extraction of Australia’s natural resources, particularly iron ore, coal and natural gas. This investment has boosted our resource exports, and will provide an important source of national income for many years to come.

That’s all true of course. But Lowe glosses over the big question of ‘why’ we avoided the problems plaguing other developed economies.

We would argue that Australia avoided the worst of the GFC because Asia’s largest economy, China, took advantage of the liquidity created by the US dollar/yuan peg and engineered a credit boom. We wrote about this issue in yesterday’s Markets and Money. The post 2008 China boom sent mining investment in Australia soaring. As Lowe stated:

Mining investment has been extraordinarily strong; last year, it was equivalent to around 8 per cent of GDP, which is much higher than in any previous mining boom, at least for over a century. In the non-mining sector, however, investment has been quite weak.

So growth in Asia has only increased investment (which is an increase in capital stocks) in the mining sector, not elsewhere in the economy. And that mining investment is directed towards extracting our natural resources and sending them overseas.

Which is fine, but the benefit to the rest of the economy is questionable. We’ll explain why in a moment.

Lowe then goes on to wonder why non-mining investment remains so low:

The low level of overall non-mining investment has occurred despite corporate balance sheets being in generally sound shape and firms having significant holdings of liquid assets. It has occurred despite financial institutions reporting that they are willing and able to lend. And it has occurred despite lending rates being at record lows for both large and small businesses.’

Let’s get this straight then. Firms have plenty of cash and strong balance sheets. Our financial institutions are willing and ready to lend and interest rates are at record lows…yet investment remains lacklustre.

Lowe then goes on to say that concerns about the fallout from the GFC and generally poor business confidence (tied to political uncertainty) are responsible for the unwillingness to invest.

All true, we suppose. But it doesn’t really answer the question of why, which is the most important question of all to answer. And it’s a question that no central banker would ever answer because it would point to the futility of their role.

We’ll have a crack at the ‘why’ question in a minute, but first, let’s get back to the question of investment in Australia.

Investing in productive capacity is essential for a country to maintain sustainable non-inflationary growth. For example, companies need to invest in new equipment to make sure their output increases, or that their output per hour worked increases.

If they don’t invest in new equipment, productivity will slowly decline. If a company is not productive costs rise faster than revenues, meaning profit margins erode. When profit margins erode a company won’t add new workers, and business shrinks and dies.

It’s the same for an economy. If, in aggregate, we don’t add to our productive stock of capital, costs rise faster than incomes and this erodes the real value of our output. In other words, inflation. With this in mind, take a look at the following chart. It shows domestic inflation (non-tradables) versus imported inflation (tradeables).

chart showing Australian domestic inflation versus imported inflation

As you can see Australia’s overall inflation is benign because of deflation in the prices of the goods we import. Meanwhile the prices of domestically produced goods inflate at a rate of over 4%…each and every year.

The lack of non-mining investment, which is a lack of investment in our domestic productivity, is a big reason for this. But China and Asia’s growth boom, which set off Australia’s mining boom, also pushed up the Australian dollar and had a beneficial effect on overall inflation. So inflation hasn’t really been a problem thanks to the strong dollar.

As the mining boom now comes off the boil, we better hope that non-mining investment picks up. Otherwise we’ll have a weaker dollar, which will promote higher ‘tradables’ inflation. Combined with persistently high ‘non-tradables’ inflation, this could see Australia suffering from rising prices across the board within a few years.

So why aren’t we seeing greater non-mining investment? Why is confidence low?

We would guess that business owners and entrepreneurs see that global marginal demand is a product of artificial stimulus provided by central bankers. When the price of credit is held below the ‘natural rate’ for prolonged periods of time, it creates major distortions in the structure of an economy. It promotes speculation over real, long term investment.

But central bankers will never admit this…or they just don’t see it in the first place. If Lowe thinks that record low interest rates will encourage greater aggregate investment he better think again. It will promote some investment, sure. But it will deter savers from providing capitalists with a genuine pool of savings capital to invest, and will just encourage more people to borrow to buy a house.

How that represents an increase in our productive capital is anyone’s guess.


Greg Canavan+
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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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