Credit Suisse thinks the RBA’s optimistic forecasts are creating a credibility problem that’s hurting the economy
David Scutt · Feb 26, 8:29 PM
The Reserve Bank of Australia is often referred to as being optimistic.
It sees economic growth, wage and inflationary pressures all building in the next two years, helped by an expected reduction in unemployment.
Credit Suisse says the RBA has been overoptimistic in recent years, contributing to weakness in wage pressures and household spending, making the task of lifting inflation and interest rates more difficult.
If you ask anyone who has been following the Reserve Bank of Australia (RBA) closely over the past decade or so to describe the bank in just one word, it’s a safe bet that “optimistic” will feature heavily.
Year after year, it seems to be optimistic about almost everything.
The global economy. Check. The Australian economy. Check. The outlook for Australian wage growth. Check. The return of inflation back to within its 2-3% target. Check.
The RBA’s latest economic forecasts, released earlier this month, are a sign that this undying optimism remains as strong as ever in early 2018.
It expects Australian economic growth to accelerate to above 3% over the next couple of years, above the level many deem to be the level where unemployment and inflationary pressures are stable.
As a result, it expects that will help to slowly whittle away unemployment, helping to gradually boost wage pressures.
That, in turn, will help push underlying inflation back to within its 2-3% target by 2020, allowing the bank to begin lifting interest rates for the first time since late 2010.
It’s an economic scenario as close to Goldilocks as one can get: strong growth, lower unemployment, faster wage growth, a slow pickup in inflationary pressures and eventually higher interest rates.
While some may beg to differ, it’s hard to get more optimistic than that.
If the RBA is right, it will enshrine it as the central bank that successfully managed the Australian economy through a once-in-a-generation economic transition following the mining investment boom seen either side of the global financial crisis.
Many doubted that was possible only a few years back, believing the collapse in mining investment would ruin the economy, dragging it back into recession for the first time since the early 1990s.
Those fears have been dislodged by a growing confidence that faster private and public sector investment, stronger commodity export growth, and a recovery in household spending will come to the rescue, extending Australia’s record streak without a experiencing a recession.
While it’s easy to see why the RBA and others are growing increasingly confident about what the future holds, Credit Suisse’s Australian economics team isn’t so sure. They think the RBA has not just been “optimistic”, but “overoptimistic”.
And this is potentially becoming a problem, they say.
“Everyone makes mistakes. The question is whether we learn from them,” Credit Suisse says.
To the Credit Suisse team, the RBA has made plenty of forecasting errors in the years since the European debt crisis, developing a reputation for over-promising and under-delivering when it comes to its expectations for growth and inflationary pressures.
Essentially, what it expects is often not replicated in reality.
Just take a look at charts below to show the RBA’s cumulative forecasting errors for real GDP growth and underlying inflation over recent years.
The first shows the RBA’s track record for forecasting Australian real GDP growth.
And the second shows the bank’s track record for forecasting Australian underlying inflation.
Both have undershot what the RBA was looking for by some margin.
“The RBA has become renowned over the years for delivering hawkish and arguably credible narratives, supported by consistent upward inflection points in its growth and inflation forecasts, virtually dismissing near-term undershoots, resulting in consistent over-prediction of real GDP growth and core CPI inflation,” Credit Suisse says.
As such, it’s not surprised at the RBA’s latest optimistic economic offering, simply noting that its latest forecasts are simply a continuation of prior themes.
However, while the RBA has been given benefit of the doubt from markets about its optimistic outlooks, Credit Suisse says this can’t remain the case forever.
It says the RBA’s credibility is slowly being eroded away by this overoptimism, creating a scenario where it could eventually lead to undesirable economic consequences, especially when comes to inflation, wage growth and household spending.
“We think that there is evidence of erosion in the RBA’s inflation targeting credibility,” it says.
“Net of global factors, cumulative growth and inflation downside surprises are pushing down Australian real yields and inflation expectations.
“We believe that subdued inflation expectations are contributing to low wage inflation.”
This chart shows how Australian inflation expectations — either looking five years ahead or the average level looking five to 10 years into the future — both sit around 2%, the lower-end of the RBA’s 2-3% target.
They’re still anchored around the low-point of the RBA’s target band, but both have eased lower in recent years.
To Credit Suisse, this possibly reflects increased doubt from investors about the RBA’s ability to lift economic growth and inflationary pressures, something it says may be contributing to ongoing weakness in Australian wage growth.
“If sluggish wage inflation is a problem for highly leveraged consumers, and RBA forecasting errors are contributing to low wage inflation by allowing growth and inflation expectations to become unhinged, then it stands to reason that officials bear some responsibility for anaemic consumption growth,” Credit Suisse says.
“It is not just that policy makers have underestimated the degree of slack or competitiveness in the labour market, leading to wage inflation undershoots. Rather, officials also need to entertain the possibility that inadequate forward guidance has undermined credibility to the point that it is now feeding into the wage bargaining process.”
That is, not only have wage pressures fallen due to hidden labour market slack, globalisation and structural changes in the labour market, but increased concern that inflation won’t pick up (as the RBA has been forecasting) may be contributing contributing to weakness in household spending, the largest part of the Australian economy.
As seen in this next chart, annual wage growth, like real GDP and underlying inflation, has also undershot the RBA’s expectations since 2010.
Given high household debt levels, Credit Suisse this may explain why Australian workers remain cautious as they prioritise job security over asking for higher wages.
“Highly geared households may value job stability over wage claims in order to sustain their debt load over time. And the evidence is that if they value job stability, they are unlikely to secure very large wage increases relative to their peers who change jobs more frequently,” it says.
“The premium for job stability increases when growth undershoots, because it becomes much harder to find new work opportunities, and risk appetite falls.”
For a central bank looking for household spending to help lift economic growth and inflationary pressures over the next few years, this presents a problem, potentially repeating the cycle seen in recent years where economic growth falls short of expectations, creating headwinds for achieving faster wage growth, higher inflation and reducing unemployment.
To Credit Suisse, in order to avoid a repeat, the status quo will have to change.
“If the RBA continues on its merry way, lost credibility may become a more significant factor weighing on inflation expectations and bond yields, notwithstanding how global factors evolve,” it says.
“This means that either the Bank materially revises down its forecasts — and adjusts rates accordingly — to win more credibility, or fiscal policy makers need to take on more responsibility to help keep inflation within the target band.”
For the first option — lowering growth and inflation forecasts as a trigger to cut interest rates — Credit Suisse says that appears unlikely at present given the RBA’s increased focus on managing financial stability risks.
“In Governor Lowe’s era, the RBA has explicitly said that it has an asymmetric response function to core inflation,” it says.
“The Bank is prepared to raise rates in response to, or in anticipation of, inflation overshoots, but it is not so willing to cut rates in response to inflation undershoots because, at this juncture, the longer-term costs to financial stability arguably outweigh the shorter-term benefits from reflation.”
Regardless of what happens on the fiscal side of the equation, Credit Suisse says that in order to boost confidence that economic growth and inflation will pick up, the RBA will not only have to meet but exceed its forecasts over an extended period.
“To right the wrongs, we think that it is not enough for the Bank to temporarily hit its forecasts. Rather, consistent overshoots are needed to reverse consistent undershoots,” it says.
“If the RBA embraces this thinking, it will likely re-shape expectations for rate adjustments over the next few years.”
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