The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Friday, August 13, 2010

Economists missed the RBA’s growth downgrades

Swings and round-abouts. Two years ago the consensus view was that Australia and the developing world would not be able to 'decouple' from their US, UK and Eurozone peers. In the last year, the consensus was that decoupling had, in fact, taken place and Australia was going to endure another four rate hikes to get a handle on the impending boom. Today many of Australia’s positive portents have dissipated, and the recoupling story will shortly come back in vogue.

This brings me to the RBA, which as Australia’s central bank determines the marginal price of money and ultimately the level of all lending rates in the economy. In my opinion, the RBA has recently changed its assessment of Australia’s growth trajectory. But most economists appear to have missed it.

A week or so ago the RBA released its quarterly Statement on Monetary Policy. Aside from offering a comprehensive overview of global economic conditions, the Statement is important because it discloses the RBA’s official forecasts for economic growth and inflation out to the end of 2012. These in turn shed light on the likely path of interest rates, which have a decisive influence on future economic activity.

On the day the August Statement was released, most economists concluded that the RBA had left its forecasts largely ‘unchanged’ and retained a tightening bias given its optimistic outlook. Interest rate yields enthusiastically rose as a result. Yet in all likelihood, this finding was flawed. After reflecting on the RBA’s numbers for some time, I now believe that it has, in fact, downgraded its forecasts for both growth and inflation over the medium term. The extent of these revisions is an open question.

Interpreting the RBA’s projections can be tricky because the basis upon which they are prepared has varied over time. Historically, the RBA supplied the forecasts assuming no change in its target cash rate. However, when the cash rate dropped to an all-time low of three per cent during the GFC, the RBA altered its approach and declared that its projections were based on the “technical assumption of some further rise in the cash rate over the forecast period, with the assumed path broadly consistent with market expectations.”

At the time of the RBA’s May Statement, the futures market and economists were pricing in another three to four rate hikes. In the August Statement published last week, the RBA did not adjust any of its 2011 or 2012 GDP or CPI numbers, much to the glee of those bulls who were growing anxious about the turbulence overseas (there was one upward revision to its 2010 GDP estimate). And the RBA preserved the all-important language that its views were based on “the technical assumption that the cash rate moves broadly in line with market expectations.”

The issue here is that the ‘market’—as it is commonly understood—had massively downgraded its expectations for the path of rates between the August and May Statements. By the time the latest Statement was published, the market was pricing in only one further rate hike.

Taking the above at face value, this tells us that the RBA had, in fact, downgraded its medium-term growth and inflation estimates quite materially. We know this because while the RBA’s GDP and CPI numbers had remained fixed, futures market pricing for interest rates at the time of the August Statement implied that it was assuming that it would avoid three of its circa four previously-expected hikes in order to achieve its medium-term inflation target.

The RBA’s more tempered outlook on growth and price pressures is consistent with Australia’s increasingly uncertain economic environment. Locally, house prices, equity prices (and thus household wealth), business confidence, business conditions, full time employment, and building approvals have all deteriorated in recent months. Credit growth is exceptionally weak. Indeed, housing credit growth, which accounts for the vast bulk of all debt, is at its lowest level in over 20 years, and substantially less than the readings registered during the 1991 recession.

Overseas, we have recently seen expectations for growth abate in China, the US and the UK. The US has further downgraded its historical growth readings, compelling the Federal Reserve to engage in additional ‘quantitative easing’ (QE) by re-investing the cash-flows generated from assets purchased during its first round of QE into new securities. The alternative was to simply allow its balance-sheet to shrink, which it has decided not to do. Many are now talking about the spectre of Japanese-style deflation in the US.

There are some important caveats to the interpretations above. First, there is a sizeable wedge between the futures market’s expectations of less than one further rate hike, and the views of local economists, who are anticipating another 3-4 increases. Having said this, the market tends to be right more often than not.

One technical unknown is what the RBA really means when it talks about ‘market expectations’—the economists that watch it most closely, or investors who put their money where their mouth is? The true answer is not known. What is certain is that most people think it is the latter. I am not so sure this confidence is justified.

Another question is what the word ‘broadly’ means. This might sound trivial, but it is not. The RBA is very deliberate in its use of language. For mine, the use of ‘broadly’ tell us that the RBA is not committing to match market expectations, as is commonly assumed. It is the RBA’s get-out-of-jail card, which needs to be factored in when thinking about its future policy decisions.

Two of the more prescient local interest rate strategists are UBS’s Matt Johnson and Rory Robertson of Macquarie Bank. Both are fairly bearish on Australia’s near-term prospects. Matt was the only economist I know of who successfully picked the RBA’s (subtle) downgrades to its GDP and CPI forecasts.

Matt’s ‘leading indicator index’, which is enclosed below, suggests that Australia’s economic growth trajectory is set to slow sharply in coming quarters. In this context, he argues that, “the economy is probably slowing to below trend, and therefore opening up some spare capacity.”

Matt also notes that if you adjust Australia’s unemployment rate for the number of hours worked, it is actually much higher than one would assume by simply inspecting the headline number of 5.3 per cent, which otherwise implies a tight labour market. More specifically, “adjusting for hours worked, which fell 0.5 per cent in July and 0.1 per cent in June, I estimate the 'effective unemployment rate' around 7.4 per cent.”

Given his sombre views on the immediate outlook with downside risks to our key trading partners’ growth, Matt has opined that there is a chance that unemployment could continue increasing: “employment is no longer growing sufficiently quickly to soak up population growth…if labour market trends in the next 12 months are unchanged, the unemployment rate would rise to around 5.7 per cent.”

Rory Robertson is no more positive. In a note to clients last night, he warned:

“[S]igns of “economic overheating” remain few and far between…There’s still plenty of time for the world to try to fall apart. Almost everyone assumes that the RBA’s next move on rates will be another hike, but - with the developed world still looking rather shaky - that’s absolutely in the lap of the gods."

What does all of this mean for punters? The good news is that we are not likely to get rate hikes any time soon. This will help support business and consumer confidence, and afford the housing market breathing room. Since the advent of the GFC, I have argued that investors should steer clear of equities. That view has been repeatedly vindicated over time. Your safest financial bet is a 6-7 per cent per annum, risk-free term deposit. On a risk-adjusted basis, cash is always king.