Interest rate hike worries? Here's some good news

Pity poor old Nostradamus.

The French sage, who published his most famous work, Les Prophéties, in 1555, was expected to live and die by his forecasts.

What a track record!

His devout band of followers reckon he picked everything from the Great Fire of London in 1666, the two world wars of the 20th century, the rise of Hitler and the bombing of Hiroshima, a good four centuries before they occurred.

Compare that performance to our current pack of economic soothsayers who find it difficult to maintain a forecast for more than a month and often are shifting the numbers around on almost a daily basis.

In the internet age, the mantra appears to be “never wrong for long”.

Take the events of the past few weeks.

Late last year, our forecasters were falling over themselves to pinpoint which months this year would feature interest rate cuts.

There were at least two cuts pencilled in for this year, possibly even three.

Suddenly, that’s all changed. We are authoritatively informed that, after the Reserve Bank of Australia’s sudden about turn on interest rates a fortnight ago, we’ll be in for at least another and possibly more.

The warnings have been enough to send a shiver up the collective spine of new homeowners, struggling under a mountain of debt and who last year thought the worst was behind them on the interest rate front.

If there’s any comfort to be had, it’s this: Don’t believe a word of the forecasts. The only certainty with them is that they are always wrong.

Even the RBA’s quarterly Statement of Monetary Policy is open to question. The reason it appears every 12 weeks is so the forecasts can be updated, because the previous set was wrong.

A mug’s game

One of the perennials of old-style newspapers was the markets game.

Every January, tucked away in the business section, a couple of experts would stake their reputations on where the market and the dollar would end the upcoming year.

To make it a little more fun, you’d rustle up a couple of primary school kids or perhaps the paper’s astrologist and pit them against the professionals. Failing that, there was always the gorilla at the zoo or, if you were really desperate, the dartboard.

And guess what? The professionals always struggled to pull a win out of the hat.

It’s not that they were inept. It’s just that there is so much information swirling about, so many variables and an almost unlimited possibility for something out the blue to just upturn the apple cart.

Did anyone see a pandemic coming? Or a war in Europe? Or artificial intelligence?

When the RBA cut rates last August, it did so in full confidence that inflation would gradually ease throughout this year and into next.

Suddenly, that’s not happening. Inflation has crept back into uncomfortable territory and the vast pool of forecasters have turned against it tut-tutting that it was wrong, that it cut too early.

It’s a pretty spurious argument. Inflation had fallen from a 7.9 per cent peak two years earlier down to 2.4 per cent. Even on an underlying basis, it had dropped to 3 per cent.

To not react to that kind of change with a calibrated response would have been entirely irresponsible.

It’s not just the RBA copping heat. The blame is being placed squarely at the feet of the federal government for overspending, putting upward pressure on demand, inflation and interest rates.

Government spending, at 27.7 per cent of GDP, is the highest on record apart from the pandemic, we are told.

That’s a little like saying it is the highest apart from the time when it was the highest.

It’s an argument that is being repeated ad nauseam, despite repeatedly being batted away by RBA governor Michele Bullock and Treasury Secretary Jenny Wilkinson in Senate hearings last week.

Government spending certainly adds to demand. But is it the swing factor that has suddenly kicked inflation higher? The solid bounce in private sector spending is having a far bigger influence.

AUD to the rescue

While many of our economic gurus take a simplistic approach to forecasting — inflation has risen to x per cent so interest rates have to rise to y per cent — others dig into the weeds for longer-term trends.

Peter Downes, a former Treasury economist who now runs Outlook Economics, is one of those. He reckons the RBA has jumped too soon with its recent decision to hike rates.

His economic model AUS-M has been a more consistent predictor of where the economy is headed over the longer term than many others who get the headlines, particularly during times when there are large shocks.

We may well be entering a period where a largely unexpected shock is about to hit Australia that, if sustained, will keep a lid on inflation.

It’s the rise in the Australian dollar.

“For a country like Australia, the largest inflation forecast uncertainties arise from external factors, particularly oil prices and the exchange rate,” he says.

Oil prices have been trending lower for the past year. But it is the rise in the Australian dollar that has suddenly gripped markets, partly as a result of the weaker US dollar, partly due to higher domestic interest rates and partly through booming commodity prices like gold and copper.

A stronger dollar makes imports cheaper.

Since the demise of our manufacturing sector, we now import a far greater proportion of our consumer goods than ever before, as this graph illustrates. And that will elevate the impact of a stronger dollar on inflation.

The Aussie dollar has risen more than 10 per cent against the greenback since late last year and about 7 per cent on the Trade Weighted Index, which is a basket of currencies.

“As a rough rule of thumb, a 10 per cent appreciation in the exchange rate will reduce inflation about 2 percentage points over 12 to 18 months,” he says.

Our money markets rarely take this into account, even though the Aussie dollar is among the most volatile of heavily traded currencies.

Little wonder their forecasts rarely are on the money.

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RBA losing power?

Australia boasts one of the least diversified economies in the developed world. We export raw materials, mostly to one country, and we import almost everything we need.

Back in the 1980s, most households spent about 16 per cent of their income on imported goods, if you strip out rent.

That’s now risen to more than 30 per cent.

Even our fuel these days is mostly refined offshore. A stronger dollar automatically makes fuel cheaper, which is a cost that flows through the entire economy.

Interestingly, Downes also argues that this change ultimately limits the RBA’s power in managing the economy.

In most countries, whacking up interest rates reduces demand and slows growth which then flows through to lower prices.

Because we import so much of what we need, the higher interest rates instead push the currency higher. And that automatically reduces prices for things like laptops, flat screen TV’s, cars and a range of consumer goods.

That’s especially the case when it comes to heavy machinery.

“So, while the RBA is trying to slow down investment in equipment investment by making finance more expensive, at the same time it’s making it cheaper to buy,” he says.

Little wonder it’s now so difficult to forecast where the economy is headed. Perhaps our economists should take a leaf out of Nostradamus’s tome.

Stay vague and stay in vogue.