RBA governor defends cash rate forecasting

Speaking to the House of Representatives standing committee on economics for its hearing on monetary policy on Friday (11 February), the governor of the Reserve Bank of Australia (RBA), Philip Lowe, was questioned on the accuracy of the bank’s forecasting given an increasing divergence with market economists.

Committee chair Jason Falinski MP asked the central bank governor why there had been a “marked difference” between what the RBA is forecasting and what market economists are predicting when it comes to the market conditions that would lead to an increase in the cash rate.

The difference largely comes down to when inflation will be “sustainably” within the target rate of 2-3 per cent.

For example, several of the major banks had touted August or September as the month in which the RBA would first raise rates, however some are now revising their forecasts, outlining that the cash rate may rise as early as June 2022. According to Commonwealth Bank senior economist Gareth Aird, inflation could be stronger than the RBA is forecasting and therefore lead to the central bank to raise rates in four months’ time.

However, the RBA’s forecasts have been suggesting that annual underlying inflation will only reach the middle of its 2 to 3 per cent target band by the end of 2023 (revised up from a previous projection of 2024).

While members of the RBA board noted at the recent February meeting that, in underlying terms, inflation had picked up to 2.6 per cent, they flagged that this was the first time in more than seven years that underlying inflation had been around the midpoint of the target range.

Although inflation had picked up, members agreed it was “too early” to conclude that it was sustainably within the target band, according to the board meeting minutes, given that wages growth remains “modest” and there are “uncertainties about how persistent the pick-up in inflation would be as supply-side problems were resolved”. 

‘We’re going to be right sometimes and we’re going to wrong sometimes’

Responding to the question, the RBA governor reiterated comments made to the National Press Club earlier this month that economic indicator had “turned out much better than we had expected”.

“[W]e thought the unemployment rate would be 6 per cent now, not 4.2 per cent. We thought inflation over the past year would be 1.5 per cent or a bit more, and it’s turned out to be 2.5 per cent. The economy has done much better than we thought, and inflation has been higher,” he explained. 

“Our forecasts at the beginning of last year were not that much different to the market forecasts. Professional economists had similar forecasts to our own, and so we’ve all been surprised, and we’re humble about our ability to forecast.

“There are always going to be forecast errors; we don’t have a crystal ball. What we try to do is explain to the public the forces that are driving our forecasts and provide some general details.

“We’re going to be right sometimes and we’re going to wrong sometimes, and last year things turned out better. That, in some people’s eyes, has damaged our credibility. I accept that, but we don’t have a crystal ball and we’re living through incredibly difficult times and having to process in real-time the effects of shocks that we’ve not dealt with before. 

“We get some things right and some things wrong.”

Mr Lowe later said that it was “plausible” that the central bank would raise rates later this year, but caveated that by saying it was dependent on “the data, the evidence, the outcomes of inflation and the trajectory of inflation”.

“It is certainly plausible that interest rates go up this year, but we are going to see what the evidence tells us. It may be that participants in financial markets think the evidence is going to come in in such a way that inflation will be higher, stronger and more persistent. They may well be right; we don’t have a crystal ball. They may be right, but our judgement, for better or worse at the moment, is that the evidence of higher inflation is only going to emerge slowly over time,” Mr Lowe said.

The RBA governor outlined this was based on two judgements: that supply-side pressures will gradually resolve themselves and patterns of demand in the economy will normalise; and that the inertia in the labour market would continue.

“When we come back in six months time, we will see how those judgements have played out,” he told the committee.

“It is certainly plausible, if the economy tracks in line with our central forecast, that an interest rate increase will be on the agenda sometime later this year. We are looking for certain things we have talked about before: evidence that inflation is sustainably in the 2 to 3 per cent range, evidence about the development of labour costs and evidence about the resolution of supply chain problems. They are the things we are looking at. We get the CPI quarterly. I think just having one more CPI is not enough for that evidence to emerge, but, over time, if things line up in a positive direction then we will be discussing this later in the year.”

As well as discussing the nuances of forecasting, the central bank governor also reflected on how rate rises would impact mortgagors.

He said: “Three years ago, the median borrower had a buffer equivalent to one year’s interest and mortgage repayments. We used to think the median borrower having a one-year buffer was a big buffer. Today the median borrower has a buffer of more [than] two years in mortgage repayments. 

“Households have, by and large, been pretty sensible [during COVID]. They’ve spent some of the money, but they’ve also saved a lot, and they’re increasing their mortgage buffers which will stand them in good stead for the day that interest rates do go up.”

However, Mr Lowe acknowledged that while the “median borrower” won't have to adjust their mortgage repayments for a modest increase in interest rates, he added that there is a “large number of households that don’t have the buffers and they will have to increase their mortgage payments”.

“We look at these buffers a lot because it will influence how households react to higher interest rates,” he said.