The importance of understanding monetary policy and its relevance for the Fixed Income asset class

Let's welcome our first speaker this afternoon, Renee Ellis, Head of Portfolio Management at Oculus Funds.

Renny has managed capital in the fixed and credit asset classes for 30 years for individuals, life insurers, corporations, wealth managers and public unit funds.

His topic today is the importance of understanding monetary policy and its relevance for the fixed income asset class.

Welcome.

Thank you for having me.

I'll begin straight away.

No doubt, you will be somewhat confused about how monetary policy actually works because the global financial media are fond of quoting experts that have an inherent conflict of interest when interpreting both the inflation outlook and the central bank policy actions or speeches.

I also find it confusing before I get frustrated.

What I'm going to try and achieve today is provide you with a framework to interpret central bank actions and in doing so,

provide you with an outlook for inflation in both the United States and Australia.

As an absolute return focus manager, we have no bias towards an inflation outcome or interest rate outcome because under our mandates, we can shift portfolio duration as the economic cycle unfolds.

A benchmark aware fixed duration fund manager is biased towards rates falling as this generates higher returns.

Banks also are biased towards rates falling because their business model is based on borrowing short and lending long.

The truth is that developed world central banks have been saddled with a conflicted mandate.

There is an inherent trade-off between achieving both price stability and full employment.

Central banks then have to make one or two basic assumptions about their economy.

one, that inflation is a monetary phenomenon, or two, that inflation is a non-monetary phenomenon.

To begin with, we'll look at inflation is a monetary phenomenon assumption.

This assumption that inflation is a monetary phenomenon is based on Milton Friedman's monetary theory and the formula MV equals PQ.

In a US context, this chart shows both US money growth

and money velocity.

The Federal Reserve has achieved negative money supply growth, but after many years of falling money velocity, it is now rising and this may be negating the Federal Reserve's monetary policy effectiveness.

In Australian context, money supply growth is still near 5% per annum and is in fact increasing.

We would need to see money supply growth remain negative for a considerable period of time in both the Euro area and in the US before it has extinguished the successive rounds of quantitative easing that we have seen since 2009.

Secondly, we'll look at the assumption inflation is a non-monetary phenomenon.

This refers to the trade-off between unemployment, wages growth and inflation.

or what is known as Phillips Curve Theory.

In the US, the central bank has been a believer in inflation being a monetary phenomenon because Phillips Curve Theory has struggled to explain the inflation outcome.

There is a strong relationship in the United States between the unemployment rate and wages growth, but a weak relationship between wages growth and the inflation outcome.

Theoretically, this is due to the diverse nature of the US manufacturing sector and its access to private investment capital that has seen wages growth matched by increased labor productivity.

The increase in labor productivity in the US has offset the increase in wages growth and the inflation outcome has remained stable.

Although it is encouraging that wages growth is now falling and labor productivity is rising in the United States,

Wages growth is at near 5% per annum is still well above the 3% level consistent with the Federal Reserve's target rate of inflation 2%.

In Australia, conversely, there is a weak relationship between the unemployment rate and wages growth historically.

This is due to the rigid wage setting mechanisms in Australia that determine the vast majority of employer wage cost outcomes.

However, in Australia, there is a strong relationship between wages growth and the inflation outcome.

This means that once wages growth moves above the 3% level, we tend to see inflation gathering momentum.

On many occasions of the past, while he was governor, RBA, Governor Lowe said on many occasions that

A wages growth above 3% was not consistent with an inflation outcome of 2.5%.

As this chart on this page shows, unemployment is currently below the RBA full employment estimate, or NIREU, of 4.25%.

We have near record levels of labour participation, wages growth above 4%, and labour productivity in negative territory.

I've included here three slides on modern monetary curve theory, because this is the theory behind RBA Governor Bullock's recent commentary on inflation.

Governor Bullock referred to inflation being caused by aggregate demand exceeding aggregate supply.

Inadvertently, or perhaps intentionally,

Governor Bullock was explaining why, according to modern Phillips curve theory, monetary policy will not be able to reduce or even contain inflation.

We can see from Phillips curve theory why household consumption remains strong in nominal terms.

Private investment is increasing.

Government expenditure at state and federal levels remain is also increasing.

And since March 2019, despite the pandemic lockdowns and China trade bans, Australia has maintained a current account surplus.

So you can see there from the formula for aggregate demand that we should expect to see aggregate demand rate remain robust or perhaps even increase.

This is the most important slide I have today.

The truth is,

that when a country has a flexible exchange rate mechanism, money is free to flow in and out.

A change in the money supply that results in a change in the interest rate will change the exchange rate.

It is then the change in the exchange rate that brings about a change in the price of exports and imports in base currency terms.

An interest rate increase then would result in a currency appreciation so that export prices rise and import prices fall.

This results in factors of production moving away from the export sector and the economy contracts.

The effectiveness of monetary policy actions then since the 1980s has been diminished by developed world central banks acting on monetary policy simultaneously.

This means smaller net changes in interest rates and smaller net changes in currencies.

Right now, we have a terrific example of monetary policy working effectively in Japan.

After 30 years of stimulatory monetary policy that failed to boost economic growth and inflation, we now have the yen falling because other central banks are increasing interest rates.

The falling yen is driving Japanese growth and inflation as described in this flow chart.

In summary,

We see US rates remaining on hold for a considerable period of time.

We see Australian inflation continuing to rise.

And monetary policy does not work unless it achieves a change in the exchange rate.

Thank you.

Thanks, Renny.

Do you have time for two questions?

Yes, of course.

Why do you not charge a performance fee?

We believe it conflicts with our primary goal of capital preservation.

Investors put money into the fixed income and credit asset classes expecting money to be stable, capital preserved, so that it can be reinvested back into other asset classes as need be.

And they also expect transparent pricing and a high degree of liquidity.

We focus on all those aspects so that investors can feel that they can get their money, get access to their money within five trading days.

Do you invest your own capital in the fund?

Of course.

We invest in both these two retail mandates personally, my wife and I, and we have done for many years.

Thanks, Renny.

Thank you very much, Angelina.