Monday, May 13, 2019

Let's stop pretending the old normal is just around the corner

Just as a new chief executive makes sure their first act is to clear out all the stuff-ups left by their predecessor, so a new federal government needs to release its econocrats from the ever-more dubious proposition that nothing in the economy has changed and we’ll soon be back to the old normal.

That’s the old normal of productivity improving by 1.5 per cent a year, the economy growing by 2.75 per cent and wages growing more than 1 per cent faster than the 2.5 per cent inflation rate, with unemployment of 5 per cent and a fat budget surplus rapidly returning the government’s net debt to zero.

That’s the happy fantasy the econocrats have been predicting every year since 2012, the year they helped former treasurer Wayne Swan delude himself he was “delivering” four budget surpluses in a row.

It’s the same fantasy guiding the forecasts in this year’s budget and allowing Treasurer Josh Frydenberg to repeat Swan’s prediction.

A new government would do well to start by freeing itself from the purgatory of endlessly under-achieved forecasts. A re-elected government, of course, would find it much harder to free itself from addiction to the happy pills.

A now highly politicised Treasury seems to have had little trouble keeping this dubious faith that nothing fundamental in the economy has changed and that, every year the return to the old normal fails to happen – we’re up to seven and counting – makes this year’s forecast all the more likely to be the lucky winner.

No, it’s the Reserve Bank and its governor, Dr Philip Lowe, that’s had trouble reconciling the she’ll-be-right forecasting methodology with the daily reality of economic indicators that didn’t get the memo. Unlike Treasury, Lowe has to do it in public – and update his forecasts every quarter, not just twice a year.

The Reserve may be independent when it comes to making decisions about interest rates – though, as we saw last week, not still so independent it’s game to risk pricking the political happy bubble by cutting rates during an election campaign – but it has never allowed itself to be independent of Treasury’s forecasts.

Being bureaucrats, the Reserve’s bosses live in fear of ignorant journalists writing stories about Treasury and the Reserve being at loggerheads. So they never allow their forecasts to be more than a quarter of a percentage point at variance with Treasury’s.

Their bureaucratic minds also mean they prefer to initiate rate changes in February, May, August or on Melbourne Cup day, so their move can be justified in the quarterly statement on monetary policy published the following Friday.

All this does much to explain the contortions Lowe put himself through last week. Everything the Reserve said about the immediate outlook for the economy implied it should have begun cutting last week.

It slashed its forecasts for consumer spending, inflation and GDP for the rest of this calendar year, which of itself was enough to justify an immediate cut. Last Tuesday it told us enigmatically it “will be paying close attention to developments in the labour market”, but three days later forecast that unemployment would be unchanged at 5 per cent for the next two years.

What Lowe hasn’t explained is that the only thing in the labour market that would stop him cutting rates in the next few months is if unemployment were to fall. That’s because the one respect in which he’s broken free of the Treasury orthodoxy is his acknowledgement, before a parliamentary committee, that the best estimate of full employment (the “non-accelerating-inflation rate of unemployment”) has dropped from about 5 per cent to about 4.5 per cent. If you’re not heading down to 4.5 per cent, why aren’t you cutting?

Trouble is, if full employment is 4.5 not Treasury’s 5, that means our “potential” growth rate is likely to be below Treasury’s 2.75 per cent (including its assumption of 1.5 per cent annual improvement in productivity). And, if that’s so, then our “output gap” will be less than the 1.25 percentage points that Treasury uses to justify its projection that the economy will grow for five years in a row at 3 per cent, before dropping back to 2.75 per cent a year.

The trick to Treasury’s forecasting is that, though it always cuts its immediate forecasts to accommodate the latest disappointment in the actual data, its mechanical projections assume “reversion to the mean”, so its later forecasts have to rise to meet the start of the we’re-back-to-normal projections. But it’s always the old mean we'll be reverting to, not any new one.

Now get this: measured on a consistent “year-average” basis, the Reserve’s latest “slashed” forecasts differ in no significant way from those Treasury put in this year's budget. When it comes to forecasting, the Reserve is slave to a politicised Treasury.