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."

Saturday, July 23, 2011

Has my view on inflation and interest rates changed?

I was asked this question last week by a senior investor. I have enclosed my response below. It echoes what Professor Cochrane says in my previous post. And it is why I feel for my economist friends who have to regularly produce "forecasts" which they know have little chance of coming true. Many "commentators" produce "predictions", which they kid themselves are high-probability estimates. Forecasting one path for the world, one so-called state of nature, is a mug's game. There is normally far too much uncertainty. I have previously argued that economists should always attach confidence intervals to their economic and financial forecasts so that we really understand the width of the distribution of errors associated with their expected case. Put differently, are they confident about their central case, or is it just a super uncertain guess? I have only ever seen one economist, Matt Johnson at UBS, do this (and I think it was following a conversation we had). He produced a probability distribution last year for inflation outcomes, which I thought was cool. So this is how I responded to the question on the outlook for rates...

I deal in probabilities. I always look at life as a distribution of future possibilities. So, let me answer your question this way:

1/ Does my base-case of a global inflationary cycle, combined with domestic price pressures, contributing to a strong Australian inflationary cycle still hold?

Yes. This has been partly confirmed by the Northern Hemispherean and Asian inflation data over the last 12 months. Guys like Warwick McKibbin (and Matt Johnson) estimate that about 60% of Aussie inflation is determined by global inflation. Having said that, next week’s domestic CPI will be crucial, and if it is low, the RBA will be on hold until the Q3 CPI print. On this front, the market thinks that a 0.7% core print would fall into the "everything is okay" camp. Yet this would mean that core has been running at a 3% annualised pace over the last six months. I am not sure how this gives the RBA "comfort" to remain on hold. In any other developed country, 3% core inflation would be ringing alarm bells.

2/ In an Aussie inflationary cycle, does your central case of a large number of hikes still hold?

Yes, subject to the Aussie dollar staying within its current trading range. (See my Business Spectator article exploring the alternative contingency.)

3/ Do you think the RBA will cut interest rates?

I believe this is very low probability (and have never wavered from this view!). However, a surprisingly low (eg, core of 0.5% or less) inflation print next week would remove a lot of the obstacles. And a low core print is certainly possible given the strong appreciation of the currency during this and past quarters. I think we would need to see a big deterioration in offshore conditions and, say, a solid increase in unemployment before the RBA pulled the trigger on rate cuts.

4/ Has your view changed in any way?

Yes, I have started thinking more intensively about a new scenario that could generate higher-than-expected appreciation in the AUD, which ends up doing the heavy lifting for the RBA (and thus fewer rate hikes). This is not my central case—I think it is low probability. But I am looking at it nonetheless.

5/ Is there anything else exercising your mind?

Yes, the RBA in a speech a few weeks ago presented very detailed analysis on Australia’s historic inflationary cycle and their ability to predict it. They disclosed that their forecasting models overpredicted inflation in the early phase of the cycle, but significantly underestimated the strength/duration of inflation in the latter part of the cycle. These were important revelations, and afford much food for thought with regard to the RBA's view of the world, which, after all, is the "main game".