The one thing I can say with certainty about Glenn Stevens is that he does not know for sure whether he will be raising rates, cutting them, or holding rates steady at Tuesday’s 3.5 per cent level before the year is out.
Stevens is imbued with a healthy dose of intellectual humility and respect for the fact that history’s only constant is change. He is the first to admit that the current climate is characterised by an unusually high number of Rumsfeldian ‘known unknowns’ and more hazardous ‘unknown unknowns’, which collectively render long-term forecasting more-or-less redundant.
An example of a known risk is whether Greece exits the euro zone. An illustration of a less certain contingency might be sudden military conflict between China and other great powers in the Asia-Pacific.
While the RBA Governor might not know in which direction he will be pulling the interest rate lever over the ensuing six months (if at all), what he can do is attach probabilities to a wide distribution of future possibilities. Right now, they might look something like this: a 50 per cent chance rates remain unchanged; a 30 per cent prospect of cutting rates further in the event the global economy deteriorates; and a one-in-five chance of a hike before 2012 expires.
The very rough estimates that Stevens assigns to these three different states of nature change every day, just as the financial markets re-price their probabilities of the expected path of future interest rates.
This is a significant point that is worth explaining. Whereas the RBA and economists focus on their most likely, or single ‘modal’ base-case, the financial markets (eg, the SFE’s 30 day interbank futures contract) weight together a string of divergent outcomes to get the so-called ‘expected value’. This is a probability-weighted event.
The RBA and economists’ single most likely case is, therefore, fundamentally different from the event implied by the markets. Because market pricing factors in probabilities for a range of extreme scenarios, which are ignored in the economists’ base-case, it can look artificially negative during periods of heightened risk.
That is not to say that one should dismiss market pricing. Quite the contrary. Recent research by the RBA suggests that markets tend to be more accurate forecasters of the policy rate than the consensus estimates of economists (although there could be reverse causality at play).
Here it is worthwhile reflecting on just how capricious the shifting sands of expectations can be. Less than two months ago, Bloomberg published its weekly survey of interest rate projections. A staggering 16 of the 20 economists polled expected Australia’s central bank to cut rates by at least 25 basis points by 2.30pm Tuesday afternoon. Three more bearish analysts, Westpac’s Bill Evans, Stephen Koukoulas, and a Credit Suisse economist, felt the RBA would be forced to drop rates by a hefty 50 basis points by August 8. This would have brought the RBA’s official target cash rate to its all-time historical low of merely 3 per cent.
These June 15 forecasts should be juxtaposed against the fact that the RBA had already slashed rates by a stunning 75 basis points over May and June. Yet for pessimists like Evans and Koukoulas, who had been among a select few prescient predictors to pick the RBA’s 3.5 per cent cash rate months in advance, the extra half percentage point worth of cuts over July and August was still not enough. Evans and Koukoulas pencilled in even lower 2.75 per cent and 2.50 per cent cash rates, respectively, by the end of this year.
The will of the world to compel changes to even the most ardent beliefs is, of course, well documented. Fast forward two months and 15 of the 16 doves had dropped out of the sky. Westpac and Credit Suisse have, in fact, discarded two full cuts. Koukoulas was the only recalcitrant to predict a surprise drop in the cash rate today (although he did truncate his forecast from 50 to 25 basis points).
The bottom line is that the uncertainties associated with the guesses of economists more than a month or two ahead are so high that they are not normally worth the electricity expended on communicating them.
Economists would do themselves a favour by attaching some confidence intervals (or scores) to their predictions. At least then we would get some sense about how much faith they have in their own statements.
I’ve been consistently critical of the RBA’s reflexive desire to assuage our schizophrenic financial markets and the innumerable vested industry and political interests that have previously pressured the bank to relax rates on the basis of incorrect claims that the domestic economy was in the hole in 2011 and 2012.
Thankfully, the antiseptic light of official data have proven that the low growth accusations were a self-serving sham. The ABS’s National Accounts showed us that both the overall economy and household spending were, in fact, expanding at a demonstrably above-trend pace. Combined with more recent partials including the not surprisingly robust retail trade and house price data, this evolving picture will likely encourage the RBA to bump-up its growth forecasts when the next Statement on Monetary Policy is printed on Friday.
The central bank rationalised its December rate cut on the basis of the need to furnish the economy with ‘insurance’ against adverse future outcomes. The hasty double rate cut in May was likewise justified to preserve this insurance given the banks’ out-of-cycle hikes. The RBA argued again in June that a cut was required for insurance purposes notwithstanding the healthy domestic data.
The bottom line is that none of the highly adverse scenarios have materialised. They still might. But the RBA has been wasting limited monetary policy ammunition by acquiescing to the demands of conflicted stakeholders.
Today the RBA is well ahead of the curve, and, thankfully, inflation is presently benign. Ironically, the ascendant Aussie dollar is working hard to negate recent rate cuts in part because of the confidence they have bequeathed. So, for the time being, the RBA will happily watch and wait.