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.

More:

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.

More:

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.

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.

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.

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.

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.

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.