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."

Thursday, June 7, 2012

The sub-trenders and the RBA were wrong (column)

As published in Property Observer and Business Spectator...

So it’s now official. All the analysts, commentators, and policymakers who told you that Australian economic growth was decelerating, “sub-trend” (a popular phrase), “modest”, “below capacity”, or about to head into recession were woefully misguided. Anyone who predicted interest rate cuts over 2011 and 2012 on the basis of a weak domestic economy was right, but for the wrong reasons.

Indeed, if the “sub-trenders” had any intellectual honesty, they would be calling for a spate of rate hikes right now. If the (falsely, and now revised) low real GDP print in the final quarter of 2011 was grounds for hysterical calls for cuts, the last four quarters of growth data combined with the many months of jobless rate data are surely an even more persuasive basis for hikes? One of the smartest strategists in Australia did write to me today, unsolicited, and state, “I was wrong – economy doing okay…[and] yes, you were correct.”

Australia’s economic growth rate over the last four quarters has been a stunningly strong 4.3%, well in excess of estimates of the trend rate of growth of around 3% per annum. Australia’s jobless rate was just 5.1% in May, slightly up from a revised 5.0% in April, but down on a three month moving average basis from 5.2% in March. Since 1990, the jobless rate has averaged 6.9%.

At the same time, we know that business investment continues to boom (and businesses plan to invest at record rates for years to come), household consumption, which is the biggest driver of economic growth, is expanding at a rate way above historical trend, housing credit growth is tracking incomes very closely, which is what we would expect, and the total wages bill rose at an above-trend pace in the first quarter.

Based on the information we have available to us today, the RBA’s pre-November monetary policy settings—remember they take 12-18 months to have their full effect—were pitch perfect, as I  argued in the past. It was those settings, and not subsequent cuts, that gave us a more acceptably low inflation rate.

Those calling for savage rate cuts in the second half of last year badly misread the economy. The bottom line is, as both Professor Warwick McKibbin and I have previously argued, if you assume the appreciation of the Australian dollar was a once-off event, there was no domestic economy basis for rate cuts as the inflation benefits (in late 2011 and early 2012) would be temporary.

The RBA board and its staff have a lot of explaining to do for their post-November decision-making. Glenn Stevens has repeatedly told the community that the RBA does not believe it can forecast with accuracy over the long-term. He repeatedly pushed the notion that it needed to focus on “nowcasting” in justifying its rate cuts in late 2011. When the RBA got a downward revision to the second quarter inflation data in June 2011 from 0.8% to 0.6%, it used this data point to materially change the stance of monetary policy from restrictive to neutral. But it turned out that this core inflation estimate was wrong: it subsequently got revised back up to an unacceptably high 0.8%.

As any inflation forecaster knows, you do not get a consistently low inflation rate with real GDP growth of 4.3% per annum, an unemployment rate of 5.1%, and a currency that is stable or declining.

In the latest inflation numbers, domestic (or so-called “non-tradeable”) inflation printed at around 3.5%, well above the RBA’s 2-3% per annum target. Australia’s low inflation pulse in late 2011 and early 2012 was being driven mainly by internationally priced goods and services (or so-called tradeables), which were actually falling in value as a result of the temporary currency appreciation.

So something important in the RBA’s decision-making changed late last year. It stopped nowcasting and started forecasting. It increasingly ignored the very low unemployment data despite the fact that the unemployment rate is the single most important variable in its inflation forecasting models.

It has ignored a great deal of “partial” data—business investment, household consumption spending, wages, domestic demand, and even the narrowly-measured monthly retail data—and calibrated policy on the basis of utterly subjective and, it appears, quite incorrect forecasts.

In a tiny cohort of analysts--including Adam Carr--I have consistently argued that the December, May and June rate cuts were unnecessary (and received immense push-back for doing so). I’ve maintained that the RBA was bowing to pressure from a community that has not seen a recession since 1991, a public that has become incredibly complacent, with many generations having been exposed to declining interest rates and a falling unemployment rate for most of their lives. The RBA has been relentlessly bullied by both sides of politics and their proxies (eg, leading union officials and aligned commentators), and, we know, the six private sector doves that dominate the RBA’s board (to say nothing of the Treasury Secretary).

It is clear that the RBA has rejected its own decision-making logic by setting policy not on hard and dependable economic data, but rather on the basis of speculation and, most worryingly, financial market expectations.

The RBA’s inflation forecasts are now all wrong. The pulse of economic growth is much higher than it has assumed. The unemployment rate is well below the 5.5% it expected. Even after today’s terrific jobs report, the Aussie dollar is still materially lower than the 103 US cents it presumed (as are oil prices).

I coined a term late last year: the “Glenn Stevens put”, which insinuated that the RBA was doling out insurance to vested interests and the financial markets when it had no business doing so.

It has punished hard-working Australian savers in preference for less prudent borrowers. On the basis of today’s data, interest rates in Australia are probably a good half to three quarters of a percentage point lower than they need to be.

There are certainly no signs of a household deleveraging induced recession in the manner predicted by the likes of Steve Keen. Sure, house prices have endured a modest correction. Yet this has been largely driven by the luxury sector.

Since January 2011, 80% of all Australian suburbs have experienced total house price declines of less than 3%. Yet the most expensive 20% of suburbs have suffered house price falls of around 7%.

One of my regular memes has been that we have had a valuation re-rating in the million dollar-plus market due to the (permanent) contraction in financial services earnings growth. That’s not a bad thing.

The droves of analysts that called for much lower rates on the basis of sub-trend economic growth should front up and admit they were wrong. An inquiry is needed into the RBA board’s decision-making processes, which appear predisposed to persistent error.  Australia’s average core inflation rate since 2001 has been amongst the highest of our developed country peers. At a minimum, we need to get rid of the RBA board’s highly conflicted private business sector executives and replace them with professionals who understand how the aggregate economy works.