A few little forecasting tips for Phil Lowe

‘Twas a busy day yesterday so I did not have the full opportunity to deconstruct Phil Lowe’s epic roll over to coming rate cuts. It is worth doing because it offers Governor Lowe the chance to learn from his mistakes. It’s in that spirit of generosity that I offer some forecasting and policy process tips to the good governor and his staff.

The first thing to remember is to have the right people. Sending micro guys out on suicidal confidence missions isn’t going to cut it. You need macro people and evidence. Poor old Professor Harper will never be the same after he was thrown under the bus last week:

The clearest indicators of ongoing momentum of Australia’s economy are strong employment growth and a rapid shift in the federal budget toward surpluses, said Ian Harper, a member of the Reserve Bank of Australia’s policy-setting board.

…“The domestic economy, everything I’ve seen, shows that it is still strong,” Mr Harper told The Wall Street Journal on Thursday.

“So long as jobs growth is strong and unemployment is low, then fears about some sort of collapse in consumption, or inability to be able to pay bills, really have to be put way down the list” of policy concerns, he said.

Prof Harper said his personal view is that the next move in interest rates will be upward.

Next, let’s go through the governor’s reasoning yesterday:

I would now like to turn to the outlook for the Australian economy. Much as is the case globally, the downside risks have increased, although we still expect the Australian economy to grow at a reasonable pace over the next couple of years.

The Australian slowdown has nothing to do with global conditions. In fact, thanks to a bizarre and tragic sequence of events, Australia’s external position is booming. The slowdown is all domestic. It’s best to tell the truth about these things, at the very least to yourself, when forecasting.

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The Australian economy is benefiting from strong growth in infrastructure investment and an upswing in other areas of investment. The labour market is also strong, with many people finding jobs. This year, we will also benefit from a further boost to liquefied natural gas (LNG) exports. The lower exchange rate and a lift in some commodity prices are also assisting. Against this generally positive picture, the major domestic uncertainty is the strength of consumption and the housing market.

No, it isn’t. Infrastructure is peaking right now. This has been widely telegraphed by anyone and everyone that follows the expenditure flows via state and federal budgets. Remember, Phil, that high levels of building don’t drive growth unless they are higher each period. It’s the rate of change that matters!

The labour market has been strong but leading indicators are rolling over sharply. Sadly, LNG exports actually lower domestic activity as projects shift from construction to shipping, shedding 95% of jobs. Plus, the resulting energy shock saps household consumption and weakens business investment.

When forecasting it is always good to look beyond conventional explanations and towards facts.

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Our central forecast is for the Australian economy to expand by around 3 per cent over 2019 and 2¾ per cent over 2020 (Graph 4). For 2018, the outcome is expected to be a bit below 3 per cent. This type of growth should be sufficient to see further gradual progress in lowering unemployment.

Graph 4
Graph 4: GDP Growth

These forecasts are lower than the ones we published three months ago. For 2018, the outcome is affected by the surprisingly soft GDP number in the September quarter and the ABS’s downward revisions to estimates of growth earlier in the year. We are expecting a stronger GDP outcome in the December quarter, with other indicators of economic activity painting a stronger picture than suggested by the September quarter national accounts.

For 2019 and 2020, the forecasts have been revised down by around ¼ percentage point, largely reflecting a modest downgrading of the outlook for household consumption and residential construction. I will talk more about this in a moment.

The outlook for the labour market remains positive. The national unemployment rate currently stands at 5 per cent, the lowest in over seven years (Graph 5). In New South Wales and Victoria, the unemployment rate is around 4¼ per cent. You have to go back to the early 1970s to see sustained lower rates of unemployment in these two states. The forward-looking indicators of the labour market also remain positive. The number of job vacancies is at a record high and firms’ hiring intentions remain strong. Our central scenario is that growth will be sufficient to see a modest further decline in unemployment to around 4¾ per cent over the next couple of years.

Graph 5
Graph 5: Unemployment Rate

The other important element of the labour market is how fast wages are increasing. For some time, we have been expecting wages growth to pick up, but to do so gradually. The latest data are consistent with this, with a turning point now evident in the wage price index (Graph 6). Through our discussions with business we are also hearing more reports of firms finding it difficult to find workers with the necessary skills. In time, this should lead to larger wage rises. This would be a positive development.

Graph 6
Graph 6: Wage Price Index Growth

Given this outlook, we continue to expect a gradual pick-up in underlying inflation as spare capacity in the economy diminishes (Graph 7). However, the lower forecast for growth means that this pick-up is expected to occur a bit later than we’d previously thought. Underlying inflation is now expected to increase to about 2 per cent later this year and to reach 2¼ per cent by the end of 2020. The latest CPI data were consistent with this outlook. The headline CPI number was, however, a bit lower than we had previously expected, reflecting the decline in petrol prices that started late last year. We expect headline inflation to decline further this year as the full effect of lower petrol prices shows up in the figures.

Graph 7
Graph 7: Trimmed Mean Inflation

But back to household consumption and the housing market.

You might recall that 18 months ago, one of the most talked about issues in the country was the high and rising cost of housing. This was understandable. In some of our cities, purchasing a home had become a very difficult stretch for many people, and this had become a major social issue.

Today, the talk is about prices falling in our two largest cities. We have moved almost seamlessly from worrying that prices were going up, to worrying that they are going down.

There is no single reason for this change, but, rather, it is the result of a number of factors coming together.

Importantly, unlike most other housing price corrections, this one has not been associated with rising unemployment or higher interest rates. Instead, mainly structural factors – relating to the underlying balance of supply and demand – in our largest cities have been at work.

The question is: what effect will this change have on household spending?

Here, my earlier observation about not having a crystal ball is relevant. At this point, though, what we are seeing looks to be a manageable adjustment in the housing market. It is not expected to derail economic growth. The previous trends in debt and housing prices were becoming unsustainable and some correction was appropriate. We recognise that this correction will have an effect on parts of the economy. But our economy should be able to handle this, and it will put the housing market on a more sustainable footing.

There are a few considerations here.

The first is that the recent housing price declines follow very large increases in prices (Graph 8). Even after the recent declines in Sydney, prices are still 75 per cent higher over the decade. In Melbourne, they are 70 per cent higher. While the price falls are no doubt difficult for some, including people who purchased in the past couple of years, there are many people sitting on very significant capital gains and there are others who now will find it easier to purchase a home. And of course, in a number of cities and much of regional Australia, things have been more stable.

Graph 8
Graph 8: Median Housing Prices

A second consideration is that most households do not change their consumption in response to short-term changes in their wealth. Sensibly, many people tend to take a longer-term perspective. During the recent upswing in housing prices, the strategy of borrowing against the extra equity in your home looked less sensible than it once was, especially as debt levels rose. Some home-owners also see themselves as being part of the ‘bank of mum and dad’. This meant that they refrained from spending the extra equity so that they were able to help their children purchase their own property.

A third and perhaps the most important consideration, is that household income growth is expected to pick up and income growth usually matters more for consumption than changes in wealth.

The key assumption in this little sequence is this: “most households do not change their consumption in response to short-term changes in their wealth”. Of course they do. Fear and greed and all of that. A twenty year RBA credit bubble has ensured that much. Experience both oversees and here makes it abundantly clear as well. It happened in 1990, 2000, 2007 and 2011. When house prices fall, consumers retrench. It begins with ‘equity mate’ purchases like cars and boats, spreads to discretionary retail then takes down staples and services.

Once that simple truth is accepted then everything else in the RBA’s above rosy edifice collapses. As consumers bunker the labour market weakens. Wages soften (even more). Inflation falls. Business investment tips over. Then all of that feeds back into falling house prices and even more consumer caution.

This is the way of things in lowflation economies. Asset prices are the key driver of all activity. They do not follow cycles they create them. It is always best to bear this in mind when setting your forecasts and interest rates for the future.

Let me just say that, in general, it’s also best to keep your happy thoughts, designed to support household confidence, at least remotely credible. Projecting gigantic above trend booms when the lived experience for most is falling living standards and/or underemployment does not support confidence, it kills it as faith in institutions. It also artificially  inflates yields and the currency, embedding the very deflation mindset one is trying the avoid.

Finally, always remember that forecasting is all about looking forwards not backwards.

I hope these little tips help.

Comments

  1. Hill Billy 55MEMBER

    Why can’t the RBA see the wealth effect on consumption when little ME Bank in its economic forecast yesterday had it front and centre of where our economy is headed? Who are they trying to kid?

  2. Glenn Stevens would’ve already cut by now, in lock step with the rationale above.

    I think Lowe is aware of the dangers and is trying to manage a bubble deflation/household deleveraging. Using the last of his cuts will mean he loses what little control he still has and this will turn truly ugly.

    Your bonds call is a good one. You’ll make a killing off it either way (cut before the crisis or during, either way, cuts are still coming/yields to fall). I don’t know why we’re pushing him to completely throw Australia down the toilet.

    • “Glenn Stevens would’ve already cut by now”
      Probably. And in all honesty, that’s why we are in the pickle we are – because Glenn Stevens cut rates without restraining lending.
      Interest rates are ‘fine’ at 0%, for a short period, IF the debt assumed goes into nation-building, not speculation. Speculation is what Stevens pinned the nations future to.
      It’s all too late now. Now we have the worst of both Worlds; low rates and a mass of speculative debt, which in essence means – there is no painless way out.

      • Jumping jack flash

        “Interest rates are ‘fine’ at 0%, for a short period, IF the debt assumed goes into nation-building, not speculation. ”

        That’s the problem with debt. Unless you target it specifically it just gets spent in China. Or on houses. Neither is any good.

        Some credit to Lowe is that he mentioned small business lending. If debt was specifically targeted at increasing productive capacity then yes it would be the best way to use it, if we ignore the fact that debt should be the absolute last resort to increase productive capacity. It is far better to use proceeds from past production that have been saved for that exact purpose.. but I digress.

        The problem then becomes underutilised productive capacity when the consumers are already tapped out on unproductive debt.

        For example its no good if my missus takes out a small business loan to buy a van to expand her business when nobody has any money to buy her services because its all being spent on repayment of debt!

    • I fear that, by the time Harper’s call is shown to be the croc it is, the global economy will have ridden to his rescue by turning down quite sharply and he will argue that his domestic forecast was qualified by ‘ceteris paribus’.

  3. TailorTrashMEMBER

    Had lunch yesterday at the food court at Westfield Hornsby . Never seen so many seats with out bums on them . People must be having their vegemite sandwiches
    out of brown paper bags at their desks. Or maybe they can’t afford that $10 Westfield sandwich and Uber eats for dinner .

    • Jumping jack flash

      This.

      More anecdotal evidence is I walk past a rather fancy pub on the way home from work. I counted 5 people inside.
      Perhaps it was a bit early at 6:30?

    • Or else the food is rubbish

      No good veg/vegan options, especially stuff that doesn’t have too much garlic.

  4. Sic semper tyrannis

    September 24 2001 Australian Dollar was at $0.49 USD current trajectory is straight back to that point – minor dead cat bounce off Trumps tax cuts – and the slide resumes.

    Only thing holding up Aud at this point is AAA credit rating putting it at investment grade with interest rate spreads for reserve banks, savings, super, retirements etc to maintain in a basket.

    The recent turmoil in the banks – plus the insane level of combined external debt guaranteed by federal government compounded by state debt reliant on stamp duty means the AAA credit rating is now doomed.

    We are entering recession, our credit rating will go, and our dollar is tanking – cutting the official rates will send the dollar through 60 cents to 49 cents. No shock required.

    Inflation will immediately exit all safe territory.

    Inflation is by at least a factor of ten, if not more, detrimental to an economy than any benefit gained from stimulus. In fact inflation is the single biggest threat any economy faces outside of outright warfare or environmental destruction.

    But we have spent so much time in a low inflation world that we relegate, we forget, we ignore, we diminish, we dismiss its relevance, danger and impact.

    It is – BY FAR – and without any doubt – the most damaging externality any economy can ever face and MUST at all costs be placed above all other issues as the primary consideration – AS HAS BEEN THE PRIME DIRECTIVE OF THE RESERVE BANK FOR DECADES.

    Cut away – it will achieve ZERO tangible benefits, while hurting mortgage holders, bond holders, savers, consumers in every single step of the economic supply chain.

    • It’s easy to have a negative outlook on Australia especially if you’re trying to identify opportunities (or a price point / exchange rate) at which Aussie labour has global value, in the sense of labour creating / displacing traded goods and services.
      It’s worth remembering that 2000 was the last time that our economy faced this existential idea of, what is it that we do? why does the rest of the world reward us handsomely for our work-product?
      The 2000’s have been all about China and Australia has profited enormously from servicing this emerging world power. i don’t have the exact figures in front of me but around the year 2000 (and for the decade prior) Iron ore had traded at below $20/tonne and total iron ore exports were a small fractions of today’s levels.
      Australia (and the rest of the world) was struggling to identify productive activities that made sense especially wrt the value of our human capital.
      well that was than and this is now!
      Three things are different : china, China and CHINA.
      Today our human capital value (i.e. our externally productive use ) has all but zero impact on exchange rates…we don’t need people to make the export revenue numbers look incredible and furthermore our Balance of Payments actually improves as the domestic economy slows (which makes perfect sense…it’s knida like the less we do the better off we are…think of it as the rich kid that gets even richer by spending less.
      that’s our Aussie economy in a nutshell.
      Now if you’re looking for a narrative where Aussie human capital is properly priced on the world stage (via Exchange rate mechanisms) than don’t hold your breath because you’ll be waiting a long time.

  5. The marginal price setter of all things in the economy is now the debt soaked sub-prime borrower, the cash-in-hand store worker, the overseas student with dad’s credit card, the hyper-casualised gig worker, the underpaid 457, the retired boomer with a diminishing ASX portfolio, etc. The composition of the economy has fundamentally changed, and so therefore has the way that it grows (or not). I’m sure Phil’s WPI really did report a +2% increase, but the ‘official’ people in that sample are becoming less and less relevant in determining where we are headed.

  6. The RBA are complacent because they think ultimately that a drop in rates would lead to a collapse in the A$ and that would provide the ultimate method of reflating the economy.

    Maybe.

    But what if the collapse in domestic demand and strong key commodity prices lead to a blow out current account SURPLUS??? That’s something no one is thinking of. Add in still massive net FDI inflows and the basic BoP becomes enormous. capital outflows are constrained by index players and so the overall BoP is comfortable and the A$ is under no pressure to fall.

    Granted, this seems like an unlikely scenario, and historically it wasn’t really ever a possibility. But we live in strange times where China is challenging the US and we have Trump as president…this is now a non-zero probability and a nightmare for the RBA

      • @Arrow2: not really, it’s because we don’t make anything anymore. When we buy anything remotely complicated, we import it, and we typically do it on credit. So a reduction in consumption means less expansion of credit and a lower level of imports. As imports require selling of the AUD (for the foreign currency required to buy the product), collapsing consumer demand means less selling of the AUD, so less downward pressure. Constriction of credit also means relatively fewer AUDs sloshing around, making them more valuable.

        So as long as domestic demand is suppressed and foreign demand (for our houses and holes) stays buoyant, we are more likely to run a current account surplus and the currency is strong.

        Counteracting this is foreign participation in our housing bubble and how exposed Megabank is to foreign financing. I don’t believe for a second that Megabank is properly protected against a sudden reduction of credit demand, or a sudden fall in the value of the AUD. As foreigners buy in to the housing bubble, they must buy AUDs to do so (keeping the AUD stronger). if that process is popular enough, then a rising AUD incentivises even more foreign involvement. Turn the thing around and foreigners have to sell AUDs on their way back out (unless they roll into other AUD denominated assets). As they exit, the downward pressure on the AUD can cause it to fall, thereby amplifying losses to foreign market participants, which motivates even more selling in a downward spiral. This is a powerful reason for the RBA to not let the AUD fall too much, too fast.

        The RBA has to try and account for all of this with its interest rates decisions which is why I’ve been saying for a long time that it’s stuck between a rock and a hard place. Either way it moves on rates, the RBA risks blowing something up. Raise and it blows up the RE bubble and domestic economy. Fail to raise (or cut) while the rest of the world keeps recovering then it blows up the banks due to their foreign exposure and it has to bail them out, which then also blows up the economy. So like a deer in the headlights it stands still and hopes for the best, particularly hoping that the rest of the world either tops out, the bubble inflates again, or that Megabank gets free of its international entanglements.

        I do expect to see deep cuts in the future, I just don’t know how long it will take before they start cutting. It even looked for a little while as if they were going to have to raise as the rest of the world was doing well. A more dovish tone from the Fed must be a relief for the RBA now as it takes some pressure off Megabank (although Megabank is still pushing costs through as higher rates; the RBA needs that to stop before it can cut or it’s cutting straight into a QE program).

        Flawse and I had a pretty detailed blah blah about this stuff here: https://www.macrobusiness.com.au/2018/10/rba-minutes-yawn-2/

    • Thankyou Peter. Love your work.

      That is a much more technically rigorous and eloquent way of explaining what I’ve been trying to describe with the label “though RBA may cut rates, don’t assume the AUD will crater. The AUD will still be a ticket to the iron ore and coal and gas that everyone needs”.

      Love your work (again & long time)

    • My biggest question though: How much of the AUD from iron ore/coal exports actually stays inside Australia? Especially after foreign ownership is taken into account (a lot of the sector) and the investment phase of the mining boom is somewhat over? I’m not sure if it will materially make a difference anymore. Besides there’s always QE to bring that dollar down if interest rates don’t work.

  7. Jumping jack flash

    “When house prices fall, consumers retrench. It begins with ‘equity mate’ purchases like cars and boats, spreads to discretionary retail then takes down staples and services.”

    Very true. The economy based on debt and little else ratchets down as the debt is removed.

    “Asset prices are the key driver of all activity. They do not follow cycles they create them.”

    So basically, more debt will fix thing?

    But more debt clearly doesn’t filter through to wages, the proof is the past 10 years where debt has boomed, inflating asset prices, but wages for the plebs have cratered.

    In fact wage capacity is stolen by those who have the most debt, and are in the position to steal wages.
    We see this as wages for the top end of town have boomed.

    So more debt may fix thing, but more debt requires more wages to service it.
    Lowering interest rates 0.25% or even 1.5% isn’t going to do much to serviceability, if in fact the banks – who, let’s not forget, are raising their rates – will pass it onto their debt slaves.