Don't count on the RBA's rates wisdom

Opinions are divided on what the Reserve Bank of Australia will do next. The bank itself believes that a period of stability is on offer -- already 15 meetings and counting -- but the market thinks that is dubious. Instead, the market is pricing in around a 70 per cent chance of a rate cut by the end of next year.

On the sidelines, hounded by indecisiveness, are our private sector economists. Only a few months ago there was near universal agreement that the bank would raise rates next year. Slowly they shifted their view towards the RBA leaving rates unchanged, and now a few radicals are calling for further rate cuts.

Don't be surprised if more private sector economists join the rate cut bandwagon over the next couple of months.

So what's going on here? How can we explain the disagreement between the three parties?

Shouldn't we simply take the RBA at its word? Surely the bank itself is best placed to tell us exactly what it intends to do?

The problem is that the bank rarely knows what it will do over the next six to 12 months. Sure, it might indicate that a period of stability is prudent but its forecasting performance is dreadful.

Don't believe me? Ask the RBA.

Back in 2012 the RBA released a research paper assessing the bank's forecasting performance. The paper -- Estimates of uncertainty around RBA's forecasts -- found that there is no evidence that the RBA can predict GDP growth, regardless of the forecast horizon.

To its credit, it has in the past had some success forecasting underlying inflation in the near term. However, as the outlook lengthens its forecasts become increasingly worthless.

That admission calls into question much of what the RBA discusses in its monthly board decision. Statements such as “the most prudent course is likely to be a period of stability in interest rates” become increasingly meaningless over anything more than a three to six month horizon.

Since the RBA prefers to ready the market for any interest rate move, RBA statements such as the one above do have some value in the near term. They offer a guarantee that the RBA won't surprise anyone for at least a few months, but beyond that the statement has little meaning at all.

As a result, readers and the market shouldn't treat the RBA's word as gospel. Its board statements and publications are the work of very talented economists, but there is no evidence that they have any special insight into the future.

The Australian economy is faced with a great deal of uncertainty and a number of headwinds resulting from the end of the mining boom. Under the circumstances it is no surprise that recently there are a broad range of viewpoints on what the RBA should do next.

The big question is why it took so long for these viewpoints to arise. Given two economists can rarely agree on anything, it strikes me as unusual that a group of 20 or 30 could almost universally agree -- as recently as a few months ago -- that the RBA should lift rates next year.

More recently there has been greater evidence of dissenting views. Deutsche Bank now expects the RBA to cut rates twice next year, while Morgan Stanley believes there is a 45 per cent chance of a cut. That's not to say that only those predicting a cut are thinking clearly; rather, it is simply good to see a variety of viewpoints during an unusually uncertain period for the Australian economy.

The outlook for the Australian economy hasn't really changed a great deal over the past six months -- for example, my article back in June on the need to cut rates could have been published unchanged today -- but the market's interpretation of the economy has shifted considerably.

It is entirely possible that the RBA will leave rates unchanged next year, but increasingly there is the recognition that Australia is a pawn in a much larger economic game. We've gone through a period of unprecedented prosperity, but we are slowly realising that in its aftermath we will experience a lengthy period of subpar income and employment growth that will make things difficult for a number of households and businesses.

Whether this requires further interest rate cuts is anyone's guess, but at least now the market is openly questioning the wisdom of the RBA.