Five points on the income tax cut debate

The debate about income tax reduction is getting a bit silly — as these things tend to do when it becomes a partisan political matter. So I wanted to bring some facts to the discussion.

1/ The tax take has been growing fast: between 2011 and now the tax take has grown much more quickly than compensation of employees. This is something the RBA’s Luci Ellis noted on 26 March, in her speech What’s up (and Down) with Households.

2/ Average tax rates have gone up a LOT: the chart below shows a simple approximation of the average rate of income tax (from ABS 5206 table 20). It’s not exact, and misses a few things, but it’s a good approximation. As you can see, the average rate of income tax went up a lot in the 30 years between 1960 and 1990, peaked at ~28%, and has since cycled between ~21% and ~27%.

Due to the faster growth of taxation over the past eight years, the average effective tax rate has increased by ~5 percentage points of income to ~26%.

3/ Bracket creep is a bigger deal than you think: To give you an idea of how important the increase in the general level of wages (mostly due to inflation) is over time, I’ve used the ABS’s Average Weekly Earnings report (ABS 6302) to calculate the average rate of income tax that would have been historically payable under the 2018/19 tax schedules.

Holding the tax system constant for the past ~25 years you can see that the rate of income tax paid by the average earner would have risen by ~13 percentage points to ~21%. So constant inflation of the tax schedules is needed to keep the incidence of taxation rising over time. That’s what’s being debated right now.

4/ This is affordable: while I laughed* at sections of the budget papers — it is true that this is affordable. What’s being discussed is a policy to basically hold the tax take stable at a rate that’s a little above the current level. You might have a problem with the distribution of the tax cuts, but the case for aggregate tax relief seems pretty sound to me.

*I laughed at the claim that this budget is ‘locking in lower tax rates’ and a ‘structural reform to deliver permanently lower taxes’. It is true that these changes will stop the average rate of income tax from rising for a time … but eventually the average person will make 200k. Only indexing the threshold would ‘lock it in’.

5/ The budget should be moved into structural deficit in a downturn: concerns about fiscal sustainability strain credibility — particularly when they come from people who (appropriately) drove the budget into structural deficit in the prior downturn. When harsh winds blow, you should move the fiscal stance into structural deficit. That’s what we did in 2008, and it was helpful. If you are worried about the outlook, you should be open to doing so once again.

So, if you were really worried about the outlook, you wouldn’t be worried about tax cuts that merely leave the budget in structural surplus over the forward estimates. Those who have genuine concern about keeping people in jobs should be in favour of deeper tax cuts. This is a serious issue: unemployment ruins health, breaks up families, and in some sad cases ends lives.

Posted in AUD, Australian Politics, economics, tax | 5 Comments

Fed set for -100bps — starting with -50 in July

The Fed spiked the market with dovishness this morning. Taking the market implied rate for the end-19 fed funds rate down ~18bps to ~1.6%. I think the Fed is likely to match the market: delivering a 50bps cut in July, and 25bps cuts in each of September and December. This will leave the funds rate at 1.5% by the end of the year, which is basically what the market wants.

I don’t think this is about growth. It’s about inflation. The main forecast change was the (slightly) lower inflation profile (core PCE -20bps in 2019 and -10bps in 2020). All the growth related stuff was better: GDP was revised up a touch (+10bps in 2020), and the unemployment rate profile was trimmed by 10bps across the profile (though the LR fell 10bps too, so there’s no incremental signal about capacity).

So what happened? They lost confidence in the stability of inflation expectations.

As i noted earlier, the Fed has (finally) twigged to the fact that a decade of 1.5% inflation has consequences. Their May meeting minutes showed that the staff had lost confidence in the stability of inflation expectations. And of course Clarida’s speech entitled Sustaining Maximum Employment and Price Stability on 30 May, suggested that he was the King of the Doves.

When you look at the dot plot, it’s clear that the committee has split into two camps. A group of eight voters that favour cuts (7 voters who favour 50bps of cuts and one that favours a single cut) and another group of nine voters that favour steady rates. It’s a miracle that there were not more dissents.

In the event, there was only one dissent that this meeting — the reliably dovish Jim Bullard. My guess is that Powell headed off a larger dissent at this meeting by saying that he’s open to cutting rates 50bps in July if data confirms the need. He said as much in the post meeting press conference.

So what happened to ‘transitory’? All this stuff about ‘transitory’ factors lowering inflation is nonsense. The Fed has been delivering ~1.5%y/y inflation for most of the last ten years. Every year or two there’s a new transitory factor.

There’s a name of an ongoing series of transitory inflation shocks — it’s competition. If you get too close to it, there’s always a micro explanation that makes it seem like a once off (cell phone plans, etc) — but over the years, the 2% forecast always ends up converging to a ~1.5% reality.

Posted in FOMC, Inflation, monetary policy, Uncategorized, USD | 1 Comment

What’s right and wrong with Terry McCrann’s Wynx article

Terry McCrann (again) spiked the markets on Wednesday with an explosive article that warned that the RBA could cut 50bps in July.

Even an opposition surprising us all by behaving responsibly is now not going to stop — at the very least — a second rate cut. And the odds of it being delivered immediately, in July, shortened into Wynx-territory after yesterday’s unambiguously and decidedly unwelcome weak GDP numbers. Only a seriously strong jobs report on Thursday week now stands in the way. A seriously bad report could deliver a 50bps cut.

Terry McCrann: Bad news on economy demands both tax and rate cuts

For those that don’t know, Winx is a horse than won 33 consecutive races. So Terry’s claim is that a July rate cut is what you’d call a ‘racing certainty’ — or a very good bet. I’m not so sure myself.

What’s right about this is that the RBA is going to deliver at least 50bps of easing, taking the cash rate to 1%, and that tax cuts won’t stop this … after all, the RBA had assumed 50bps of easing in May and those forecasts were already poor — so 50bps of cuts is a minimum, and more cuts are more likely than fewer cuts.

What is wrong about this is the claim that the GDP numbers would have come as a shock. The RBA only puts mid-quarter (%YoY) values in their forecast tables — but we know from the table that Q2’19 is expected to be ~1.75% and we can see from the fanchart that Q1 was also expected to be around that level.

So yesterday’s 1.8%y/y outcome looks like it’s basically in line with the RBA’s published forecast.

Looking forward, I both agree and disagree with Terry’s comments about the outlook. Here they are:

It makes it all-but impossible for the RBA to reach its — continually revised down — very ordinary 1.7%y/y GDP growth forecast for the June year just ending. It would need quarterly growth to double from March’s 0.4% to 0.8%. It will also take a miracle economic rebound for growth to come near the 2.6% RBA forecast for the 2019 calendar year.

Terry McCrann: Bad news on economy demands both tax and rate cuts

I never really believed that the May GDP forecasts were credible. So while I agree with Terry when he says that the RBA’s forecasts will be hard to hit, I don’t agree that it’s the Q1 print that makes those forecasts ‘out of reach’.

The fact is that both the pace of growth and the level of GDP in Q1’19 are where the RBA forecast them to be in the May SOMP. So we start Q2 exactly where the RBA expected to start it: at 1.8%y/y and needing a strong bounce back in Q2 to meet their projections.

Is a 0.8%qoq print in Q2 likely? No, I don’t think so. But then it never was (the May SOMP forecasts look too much like the April budget assumptions for my taste).

In his speech on Tuesday, Gov Lowe told us that his outlook for the Australian Economy was unchanged; and then Q1’19 GDP printed exactly as his staff had forecast in the May SOMP. So the argument from Q1 GDP to a July rate cut doesn’t persuade me.

Posted in AUD, monetary policy, RBA, Uncategorized | 2 Comments

Clarida: King of the Doves?

Vice Fed Chair Clarida gave a very interesting speech entitled Sustaining Maximum Employment and Price Stability on 30 May.

It was interesting not only because it laid out two paths for rates cuts in 2019, but because it strongly suggests that Clarida is the leader of the dovish camp that keeps popping up in the Fed’s Minutes.

I feel the section laying out the path for cuts has been distorted in most reporting, so I’m going to cut and paste the entire section:

… [1] if the incoming data were to show a persistent shortfall in inflation below our 2 percent objective or [2] were it to indicate that global economic and financial developments present a material downside risk to our baseline outlook, then these are developments that the Committee would take into account in assessing the appropriate stance for monetary policy (my emphasis, and I also added the numbers)

So the two paths to a cut are: 1/ continued low inflation; or 2/ the accumulation of downside risks (not eventualities, just risks).

Trump seems to be working on the downside risks — but who really knows about forecasting shocks … but we can say pretty clearly about core PCE. Q1 core PCE was only 1% and the Cleveland Fed nowcast for Q2 is presently 1.2%. The Fed needs inflation ~2.85% for the second half of 2019 to hit their 2% target (and forecast for 2019). That’s clearly not going to happen. If the Cleveland Fed Nowcast is right, the the Fed will cut by 50bps before the end of 2019.

I noted right after the minutes that the staff appear to have lowered their assessment of inflation expectations. I thought this was staggering. What I didn’t emphasize was the dovish camp among the fed members (or participants, as they are called in the minutes). I had mistakenly believed that it was Jim Bullard — a nice bloke, but not currently at the center of the FOMC.

I was wrong. The speech today suggests that Vice Chair Clarida is the King of the Doves: and this has a meaningful impact on the probability of easing this year. In my view, Vice Chair Clarida is campaigning for a rate cut to protect against declining inflation expectations.

And it’s a good campaign. There’s good reason to worry about falling inflation expectations: the Fed has done a terrible job of hitting their inflation target over the past twenty years. The accumulated miss is ~500bps, with most of that miss being due to inflation averaging ~1.6%y/y since 2009.

Finally, for reference, here are a few excerpts from the Fed minutes and Clarida’s speech.

Compare the below from the minutes of the 1 May meeting:

Some participants also expressed concerns that long-term inflation expectations could be below levels consistent with the Committee’s 2 percent target or at risk of falling below that level.

With this from the speech:

I judge that, at present, indicators suggest that longer-term inflation expectations sit at the low end of a range that I consider consistent with our price-stability mandate.

… and compare this from the minutes:

… a few other participants observed that subdued inflation coupled with real wage gains roughly in line with productivity growth might indicate that resource utilization was not as high as the recent low readings of the unemployment rate by themselves would suggest.

… with this from the speech:

Wages have been rising broadly in line with productivity and prices and thus, at present, do not signal rising cost-push pressure

and finally, this from the minutes:

Several participants commented that if inflation did not show signs of moving up over coming quarters, there was a risk that inflation expectations could become anchored at levels below those consistent with the Committee’s symmetric 2 percent objective—a development that could make it more difficult to achieve the 2 percent inflation objective on a sustainable basis over the longer run.

… with this from the speech:

… a flatter Phillips curve makes it all the more important that longer-run inflation expectations remain anchored at levels consistent with our 2 percent inflation objective.

Posted in FOMC, monetary policy, Uncategorized | Tagged | 1 Comment

Australia’s disappearing Phillips Curve

The RBA’s realisation that the NAIRU is a bit lower than they had thought is a case of better late than ever. The data hasn’t lent much support to it for most of this decade.

The chart below shows that the data is the other way around — or rather classical, if you prefer. Lower unemployment rates are associated with a slower pace of wage gains. Note that I’ve used the state level trend unemployment rates and WPI measures so that you can see the variation across Australia.

It’s tempting to write it off as ‘mining boom’, but that’s not true. As you can see from the below chart, the only place where we find the (expected) relationship — where lower unemployment is associated with higher wages — is in the mining boom states of WA and NT.

The animation below gives a feel for how things have developed over time. It shows a Phillips curve type relationship (estimated using the national as well as state level data) over the past twenty years. The level has been declining and the curve has been flat for some time.

This leaves the RBA quite passive in terms of monetary policy. There’s just no way of knowing when wages might start to accelerate — so they are left trying to glide the unemployment rate down, while they watch for signs of wage inflation.

Posted in AUD, economics, Labour Market | 9 Comments

Fed staff lose hope on inflation

Hidden inside the minutes to the Fed’s 30 April meeting is an alarming paragraph that suggests Fed staff have grave concerns about inflation expectations.

The staff’s forecast for inflation was revised down slightly, reflecting some recent softer-than-expected readings on consumer price inflation that were not expected to persist along with the staff’s assessment that the level to which inflation would tend to move in the absence of resource slack or supply shocks was a bit lower in the medium term than previously assumed. As a result, core PCE price inflation was expected to move up in the near term but nevertheless to run just below 2 percent over the medium term. Total PCE price inflation was forecast to run a bit below core inflation in 2020 and 2021, reflecting projected declines in energy prices

Of necessity, this is written in a very wonkish way — but what it means is that inflation doesn’t get back to target by itself anymore. The period of low-flation has been so long that inflation expectations have fallen.

This is dangerous stuff. If this doesn’t change, risk management calls for easier policy very soon.

Why? because it means that if there’s any sort of shock the Fed is at risk of losing control of inflation expectations (to the downside). That will make it harder to get expected real rates down low enough to stimulate the economy — as if the ZLB problem wasn’t big enough already.

Of course, the market has already priced this in — ten years of missing the target is enough to educate more investors. Notwithstanding, it is notable that inflation expectations have fallen by ~40bps over the past six months.

The chart below shows the 5y5y forward breakeven rate from FRED (which is based on nominal and real cash bonds). This is a CPI measure, and CPI is ~50bps higher than PCE inflation (over the cycle), so 5y5y CPI breakevens at ~2% means the market expects PCE to be stuck ~1.5%.

Posted in Bond Market, FOMC, monetary policy, USD | 3 Comments

Lowe locks June … looks awkward

RBA Gov Lowe delivered a speech that was widely interpreted as locking in a 25bps rate cut in June. The market now has a ~90% chance of a 25bps cut priced in for the June meeting — with a follow up 25bps reduction of the cash rate priced at a probability of ~60%.

The awkward thing about this is that there’s almost nothing in the speech that was new. The heart of Lowe’s case for lower rates is that the NAIRU is lower than they’d thought before … but that’s old news. Lowe said in November that the NAIRU was more like 4.5%, and he told Parliament that again in February.

Perhaps it’s even lower now? Possible, but these things move slowly — and in any case Lowe poured scorn on the idea that these things can be precisely estimated when he spoke to Parliament in February.

So the lower NAIRU isn’t new — and it’s unlikely that the RBA’s NAIRU estimate moved by much. Moreover, it’s been clear for some time that multi-decade lows of the unemployment rate weren’t getting the job done (in terms of inflation targets) anywhere else in the world — so the global picture Lowe painted in the first part of the speech isn’t new either.

So what changed?

Looking over the speech, deduction leads me to conclude that the RBA gave up on the idea that the unemployment rate might fall all by itself. Recall that the RBA had the upside risk “Labour market conditions could improve by more than expected” in the Economic Outlook Chapter of the May SOMP.

Lowe trashed this risk in the 3rd last paragraph of the speech:

The labour market has surprised on the upside over recent times, and it could do so again. While we can’t rule out this possibility, the recent flow of data makes it seem less likely.

So the RBA is now reasonably sure that the unemployment rate isn’t going to continue to decline all by itself — and if it’s not going down, the RBA will cut rates to try and push it down. How much? well the May SOMP forecasts assumed 50bps of cuts and they were still pretty rubbish … so the first 50bps is a lock.

In case you’re worried about easing on too many channels, Lowe endorsed a multi-pronged approach, saying that he favored the concurrent use of monetary, fiscal and structural policies to support investment and hiring.

And why not? The RBA has missed their inflation target for years and don’t currently expect to hit their target until some time (way) outside their forecast envelope.

Posted in AUD, economics, Labour Market, monetary policy, RBA | 5 Comments

RBA’s labour market (cut) test is met

The April employment report revealed a slackening of the labour market — and is probably enough to get a 25bps rate cut in June.

The headline unemployment rate rose ~14bps to 5.20%, with March revised up ~2bps to 5.065%. Don’t get distracted by the strong growth of headline employment (+28.4k) — the household survey is designed to measure the rate of unemployment, and that’s what it does best.

It’s tempting to blame sample rotation — as the incoming sample’s unemployment rate was 160bps higher than the sample it replaced — but i don’t think that’s right. The increase in the unemployment rate is actually larger if we exclude that new rotation group: the matched sample unemployment rate rose 18bps to 4.93%, which is a larger move than the 14bps increase in the total unemployment rate.

The underemployment rate data confirms the softening. This measure increased 30bps to 8.5% on the month (prime age was +30bps to 8.7%).

The details are consistent with what you’d expect in a cyclical downturn. Men tend to work in more cyclical industries, so in downturns you tend to see the male underemployment rates rise faster than female underemployment rates. That’s exactly what we are seeing: in April the prime male underemployment rate (15 to 64) rose 50bps to 7% and the female +10bps to 10.5%. The spread between the two has tightened ~100bps in the past six months (from ~450bps to ~350bps).

Combined with the weakness in the employment component of the April NAB business survey and the disappointing sideways profile of WPI, any fair minded person would conclude that the probability of inflation meeting the profile set out in the May SOMP last week has declined somewhat. The leading indicators are softer, and the transmission of labour market pressure to wage growth is less certain — so the downside risks to the inflation forecast are rising.

The inflation forecast was already too weak (and it was made assuming a rate cut in August and another in Feb’20), so I would expect the board to bring forward the rate cut to either June or July. Most likely June.

Posted in AUD, economics, Labour Market, monetary policy, RBA | 5 Comments

Two points on WPI

The Australian Q1’19 Wage Price index again printed at 0.5%q/q (2.3%y/y). This is the 11th print in the ~0.5%q/q ballpark since 2015 — which is to say that it’s been ~0.5%q/q about two thirds of the time over the past five years.

The theory has it that labour supply curve slope upwards at some point — so as the unemployment rate falls, wage inflation accelerates. That may well be true, but it hasn’t worked recently. The experience of other countries suggests that a much lower unemployment rate might be needed.

The chart below shows the relationship between the unemployment rate (qtr average) and WPI inflation (%yoy). The grey points at the bottom are the period 2015+; the red dot is today. As you can see there has been basically no relationship between the unemployment rate and inflation over the past five years.

There used to be a better relationship. It was fairly stable up until 2008, and then actually steepened in the immediate post GFC period.

Or perhaps that was just wages collapsing due to the forces that are still keeping them down? It’s hard to say for sure.

Whatever the truth is, it’s not looking good for the RBA’s WPI forecast. They have 2.4%y/y for Q2’19, and given the low Q1 print they’ll need a ~0.7%q/q in Q2’19 to hit their prior forecast. We haven’t had a 0.7%q/q print since 2014!

I reckon we’ll get another ~0.5%qoq, which will make Q2’19 WPI ~2.2%yoy. So there’s another core CPI downgrade lurking for the RBA’s August SOMP.

Posted in AUD, economics, Labour Market | 4 Comments

There goes the employment bull-case

I must admit to being a bit stunned by the RBA’s May SOMP. There were a number of elements that strained credibility — but in particular i felt that the labour market sections were a stretch. But, as ever, the game is to predict what they will do, so here we are …

Their bull case appeared to fall apart today, with the NAB Employment index falling sharply to a below average level (-1 sigma to -0.5 sigma).

In the SOMP the RBA wrote that “business employment intentions remain above average according to the NAB quarterly survey and the Bank’s liaison program”. That evaporated today. , with the April NAB business surveys falling 7.4pts to -1.2.

This means that there is no longer an interesting divergence between job advertisements and the NAB survey. The RBA leaned on this divergence heavily in the SOMP, when they noted that “there continues to be some divergence in these indicators; the decline in job advertisements points to a much weaker outcome for employment in the near term than the leading indicators from business surveys”.

Presumably this also means that they will also strike out the upside risk that the labour market is stronger than they anticipated.

So regardless of the outcome of the April employment report on Thursday, we just got some important, and certainly challenging, information about the labour market.

Posted in AUD, economics, Labour Market, monetary policy, RBA | 3 Comments