In many ways, the COVID-19 pandemic has been defined by the historic levels of stimulus deployed by governments and central banks to combat the crisis.

The huge spending measures have reignited debate around the merits of Modern Monetary Theory. As a school of thought, MMT argues countries with sovereign currencies can (and should) pursue more aggressive fiscal spending measures, with the use of taxes to control inflation.

In a recent speech, RBA governor Phil Lowe poured cold water on the idea of money creation to finance government spending, arguing that “there is no free lunch” and “the tab always has to be paid…in one form or another”.

But in the wake of such a huge economic shock, CBA’s head of Australian economics Gareth Aird reckons some kind of monetary financing approach — defined as “a direct transfer of money from the central bank for government to spend” — will increasingly become part of the conversation.

And investors should be on the lookout for when it does, because at that point “the outlook for inflation, income, debt and many asset markets will shift considerably”, he said.

 

Crystal ball

In a research note this week, Aird said economists had had “a torrid time” trying to predict how economic conditions would play out.

(Hit CTRL+F on this August 7 speech by RBA Assistant Governor Luci Ellis, and you’ll find the word “uncertainty” no less than 12 times).

And a marked feature of the COVID-19 investing environment has been divergence between stock prices and broader economic conditions.

For example, Australian GDP in the June quarter is expected to decline by more than 7 per cent — the largest contraction on record.

But stock markets ascribe value on a forward-looking basis. And the consensus view so far is that (with the support of governments and central banks), most ASX companies will hold strong enough to withstand the pandemic and emerge with earnings intact.

For his part, Aird highlighted five key pandemic-driven changes that would have “medium-term” implications for the Australian economy.

Firstly, he highlighted that while recessions gave rise to a sharp increase in labour market slack, those falls typically took a much longer time to recoup.

“The 2020 pandemic-induced recession will be no different in that regard,” he said. Excess capacity in the labour market is almost sure to keep a cap on wage growth, which ties into Aird’s next medium-term prediction — low inflation.

Until monetary financing measures come up for discussion, Aird expects inflation and wage growth to remain low for a long time. That’s a view shared by the RBA, which last week predicted core inflation growth of just 1.5 per cent through to the end of 2022.

The view is complicated by the fact the central bank has now reached the end of its rate cut cycle.

Technically it could keep going, but the RBA has confirmed its preference not to adopt negative interest rates.

In any event, “there is virtually no prospect of any lift in the cash rate for many, many years,” Aird said.

That same variable will also impact credit growth in the housing market — a key input in the outlook for house prices.

“The expression ‘this time is different’ is highly relevant for the outlook for housing credit,” Aird said.

“The RBA cannot stimulate credit demand by further lowering interest rates as it has done in the past.”

Aird added that Australia’s economy would have to navigate a sharp fall in population growth as net overseas migration slumped by 85 per cent in 2021/22, along with the new reality of big budget deficits and higher public debt.

 

The paradigm shift

So although capital continues to flow into equities, Aird neatly summarised the unique post-pandemic conundrum Australia’s economy finds itself in.

Excess capacity in the labour market with low wages, low credit expansion and high household debt — all without the use of interest rates as a lever to boost growth.

It leaves policymakers with an acute challenge to try and restore the economy to its pre-crisis growth rate.

For now, the RBA remains committed to targeting the yield on three-year government bonds as a key tool to help keep funding costs low and maintain liquidity.

However, Aird said that as a standalone policy that still didn’t address the broader long-term issues facing the economy.

Interestingly, in a speech to parliament on Friday, Lowe said the central bank had “not ruled out a separate bond buying program, or other adjustments to the mid-March package”.

ANZ Bank called that shift in language “an important development” in assessing potential policy pathways out of the crisis.

But for now, Lowe said the best strategy for the RBA was to execute its current strategy with no changes.

Looking ahead though, Aird says there will have to be some changes, and he was fairly definitive in what that will entail.

“The bottom line is that the system as we know it will need to be reset, and the printing press will be part of that reset,” Aird said.

He highlighted that such as change didn’t need to be imminent, given Australia’s bond markets were still functioning smoothly with the RBA’s current policy settings in play.

But by the same token, he said these issues were worth bringing to the table right now. Because for fiscal and monetary policy to remain on a sound footing over the long term, “at some point down the line the conversation will inevitably shift towards some form of monetary financing”, Aird said.