The Reserve Bank’s flawed growth forecast

The RBA has misread the data … we’re growing, not shrinking.

Summary: The Reserve Bank of Australia downgraded its growth forecasts for the domestic economy in the bank’s latest Statement on Monetary Policy. But its alarming forecast was flawed from the start. That’s because all signs are pointing to higher growth, with global conditions improving, domestic growth accelerating, the cash rate lower, confidence higher, and crude prices lower.
Key take-out: The RBA is unlikely to lift rates any time soon, and that means the outlook for property and equities remains strong.
Key beneficiaries: General investors. Category: Economics and strategy.

In its recent Statement on Monetary Policy, the Reserve Bank downgraded growth forecasts for the domestic economy. It was an action, quite frankly, I find completely disingenuous, at odds with the actual data flow and more – what economic theory would predict. In short, investors should ignore it.

It’s not that the downgrades were significant or anything. You can see from table 1 and 2 below that the downgrades were actually quite modest. So, for instance, year-on-year growth to June 2014 is unchanged at 2.5%. Moreover, the expected range of outcomes for the year to December 2014 was only downgraded to 2-3%, down from 2.5 – 3.5%.   

I appreciate that’s not a material change, yet they were still downgrades, and it’s the message that it sends to the market that is important. It affects the economic debate, and indeed even the rationale the central bank used for the downgrades is material. Quite simply, it’s the wrong message and the rationale is flawed – based as it is on anecdote.


The truth is the RBA, if it was to be credible about it, should have revised its forecasts up, not down, and there are three key reasons for that.

Accelerating growth

  1. Firstly and most importantly – the global economy is accelerating. The RBA has in the past noted that the single-most important ‘variable’ to look at when forecasting the Australian economy, if you had to look at the global economy as one variable, was global growth.  On that front, and compared to the August statement, global growth prospects are much better. Growth is, by and large, surprising on the upside since that statement. Chinese growth came in at 7.8%, US growth was much stronger than expected, almost by a full percentage point – and that’s about one-third of the global economy just there. Elsewhere we are seeing a clear acceleration in growth out of the UK, stronger-than-expected growth in Japan, Canada and Brazil. Europe overall is clearly past the worst.  Global growth forecasters at the major institutions will really have no choice but to revise up their forecasts, and the RBA is behind the curve here.

Domestic rebound

  1. The second point is that the domestic economy is showing signs of life – the much-vaunted rebalancing that the RBA has been so insistent that it needs to see.  Of most importance, the interest rate sensitive sectors are finally responding, showing that monetary policy does indeed work.

You can see this most clearly in the lending and building approval indicators. Since the RBA last did its forecasts three months ago, the new information at hand, which should have seen it revise up its growth forecasts, includes the 24% increase in building approvals – you can see the spike in implied housing starts that points to in the chart below – a 10-year high!

Then, of course, house prices have accelerated.  When the RBA last tried its hand at making guestimates, house prices were showing a 5% annual gain. At this statement, house price gains had risen to 8% annual growth.  That’s not to mention the clear lift in retail sales the country has also seen.

Confidence returning

3. There is a very good reason why monetary policy is now starting to work after 18 months or so of nothing. Confidence is coming back to the market finally. This was always the missing ingredient, and recent indicators show it is turning.  This is critical. But first a little history.

If you ask the average punter on the street, financial market economists and any policy maker, why economic growth is sub-trend, they’ll say it's because the mining boom is ending and non-mining investment is weak. The former is false, the latter is true. What isn’t mentioned is that it was only a year ago, when the cash rate was a full percentage point higher, that economic growth was above trend. It isn’t quite appreciated, from really anyone, that the main change from then to now was consumer spending – not the end of the mining boom, or some deterioration in non-mining investment.  A sudden slump in consumer spending is the reason we have sub-trend growth now, and the question that is never asked by policy makers is what happened to it for it to fall so sharply and suddenly.

With the average Australian carrying little to no debt , it wasn’t high debt levels acting as a restraint. We also know that households in general aren’t deleveraging. System credit growth has been expanding, not contracting, albeit at a slower pace and below household incomes. Moreover, debt servicing ratios are at a decade low. High debt? No chance. Similarly there hasn’t been mass job shedding, as was predicted, so this isn’t it either.

I think it was a sudden drop in confidence that saw consumers close their wallets. Something they didn’t do in 2009, 2010 or 2011 or through half of 2012. If high debt or deleveraging was responsible for the recent cut in consumer spending, then it would have seen a lower spend in those years as well. That it didn’t points to something else – and the only factor that makes sense is confidence.

Fast forward to the present – when consumer confidence bounces back, policy makers should take note! Not by downgrading growth forecasts, but by upgrading them. Consumer spending is about two-thirds of the economy, after all. It matters.

Finally, think of other policy settings.  Since the RBA’s August Statement, the cash rate is lower and there are firmer signs it is working. Similarly, while the exchange rate is slightly higher, it is still down nearly 10 cents from May and the price of crude ($A Tapis) is about 6% lower than when the bank last did its forecasts. Lower crude prices are a significant stimulus for the economy.

Conclusion

I think investors should disregard the RBA’s rhetoric then.  I’m sure any reasonable person would agree that it simply isn’t credible to downgrade growth forecasts when global growth is stronger, domestic growth is accelerating, the cash rate is lower, confidence is higher and crude prices are lower.

For me, it would have been more accurate to do this –upgrade forecasts and then outline the conditions in which growth might be lower. If you want to talk of it in terms of probability distributions, it would be more accurate to have forecasts closer to 3 to 3.5% than 2%. It’s obviously not impossible that growth will be at 2%, but it is unlikely with what we know now.  It’s clear to me that the RBA is not taking into account this information and is instead relying solely on anecdote.

This is a dangerous thing, and it has got investors, commentators and policy makers into trouble through the crisis. Recall all the talk of US double dips, Europe kicking the can, deflation etc. – all anecdotal or talk.

The silver lining in this dark cloud of illusion is that the RBA is probably not close to normalising rates and is unlikely to hike any time soon.  For investors, this is a great thing as it means:

  1. You can invest in property with great confidence -with few headwinds, growth will continue to pick up and policy makers won’t be taking away ‘the punch bowl’ anytime soon.
  2. The outlook for equities is excellent as well. Cheap cash, low discount rates, hunt for yield etc. – all of these will be with us for some time.

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