It's time: Lowe's infrastructure call

Dr Philip Lowe, the new governor of the Reserve Bank of Australia, wasted little time during his first appearance in front of the House of Representatives Economics Committee in Canberra last week. While optimistic about Australia's economic prospects – good news for investors – he also urged the Federal Government to take advantage of low interest rates by investing in our nation's future.

Lowe believes that interest rate cuts are becoming less effective in stimulating growth. It's a view that is gaining momentum across financial markets after the RBA cut rates in May and August.

Public investment

Business investment certainly hasn't responded as economic theory would dictate during this low interest rate period following the global financial crisis. This is true of Australia – outside the mining investment boom earlier in the decade – as well as across most advanced economies.

At the heart of the problem is a disconnect between interest rates and the returns that businesses seek from new investment. Evidence suggests that the ‘hurdle rates' for new investment tend to be excessively high for many companies. Australian business leaders are often seeking returns that simply aren't reasonable in a low interest rate environment.

If businesses are unwilling to invest then there is a good argument that government should look to fill the gap. We currently have a once-in-a-lifetime opportunity to invest in our nation's capacity; to fundamentally change the course of our economic future.

According to Lowe, “the government could either use its balance sheet or its planning capacity to do infrastructure spending.”

The public sector can boost investment spending directly, via spending more, or indirectly, via creating an economic and financial environment that facilitates greater business investment.

Ideally public sector investment would help to increase the expected real return on private sector investment. A good example is transportation investment, which helps to link and broaden markets and increases the opportunities available to many businesses. Alternatively they can develop public-private partnerships, which combines the resources and know-how of the public and private sectors.

Achieve this and more businesses will face a return on capital that exceeds the elevated ‘hurdle rates' that have constrained non-mining investment over the past decade.

Critics of this view would point towards rising federal government debt. How can we afford these projects and return the budget towards surplus?

“We need to be very disciplined about recurrent expenditure,” Lowe said. “That does not mean that you cannot simultaneously borrow to build assets.”

This is precisely what well-run businesses do: they “meet their ongoing costs through their revenue flow and they borrow to build assets.” We should never borrow to fund welfare payments or daily government operations but we shouldn't hesitate to borrow in order to fund assets that will provide financial and economic returns for a number of decades.

Public sector investment that is subject to a rigorous and evidence-based selection process is capable of paying for itself via a return on capital that exceeds the cost of borrowing. It's never been easier for public sector investment to achieve that.

Nevertheless, this path isn't without its fair share of risks. As I said, investment needs to be subject to a rigorous and evidence-based selection process and that doesn't always occur.

The Productivity Commission, in a report into public infrastructure released in 2014, declared the need for “a comprehensive overhaul of the poor processes currently used in the development and assessment of infrastructure investments.”

In a damning assessment it cited “numerous examples of poor value for money arising from inadequate project selection, potentially costing Australia billions of dollars.”

It went on to note that “the costs of poor project selection and delivery will be exacerbated if governments decide to increase their infrastructure investment programs without reforming their governance regimes.”

Even if federal and state governments get the selection process right – and that's a pretty big if – there will some politicians who will campaign strongly against further public spending. These ‘small government' advocates or ‘deficit hawks' will point towards the protection of Australia's AAA credit rating to justify the view that Australia needs less public spending.

“To my mind, this focus on the credit ratings agency serves as a useful reminder that we need to make sure the recurrent budget is on a good path,” Lowe said.

There is an argument that it is in the best interests of Australia's economy that federal and state budgets are separated into recurrent and investment spending. Keep the former in surplus or at least in balance and run large deficits on the latter.

As for Australia's credit rating, Lowe isn't particularly concerned.

“For the type of credit rating changes that we might face, the effects on borrowing costs are quite small,” Lowe said.

A credit-rating downgrade, while problematic from a political perspective, is a small price to pay for greater public investment, particularly if that facilitates greater business investment. In this scenario greater public investment facilitates a stronger business sector and that would be great new for domestic investors.  

Interest rates

Finally, I wanted to address monetary policy directly given we:

1. have a new governor of the RBA and; 

2. the monetary policy framework was recently updated.

The ‘Statement on the Conduct of Monetary Policy', an agreement that takes place between the federal Treasurer and governor of the RBA, sets up the objectives for monetary policy. There were a couple of minor changes in this iteration that could have important implications down the track.

The main change was to target inflation of between 2-3 per cent “over time” as opposed to “over the cycle”. This has been interpreted as a greater willingness to tolerate inflation below the target. If interpreted correctly this indicates that the new governor may be more ‘hawkish' than his predecessor, Glenn Stevens.

A second change was greater emphasis on financial stability. Financial stability issues have become a key part of the economic discussion over the past few years, particularly with regards to the housing market and high levels of activity from property investors.

A new ‘hawkish' central bank will have its commitment tested soon. Core inflation currently sits at 1.5 per cent and is expected to remain below the bank's 2-3 per cent target until the end of 2018. My view is that the RBA is reluctant to cut further but that doesn't necessarily mean a lot. They were also reluctant to cut the cash rate when it sat at 2.5 per cent – 100 basis points ago.

If core inflation remains at around this level – its lowest point in over three decades – then I'd be surprised if they refused to cut rates further. The longer inflation remains below its target the more likely inflation expectations adjust towards a persistently lower level.

The RBA might view this low inflation environment as a temporary phenomenon, in which case low inflation is no great concern, but the global experience suggests otherwise. Low inflation has been persistent over the past eight years and is showing few signs of improvement. It will be difficult for Australia to avoid low inflation unless global conditions improve and this is why interest rates will continue to decline despite RBA reluctance.