Parallels between the current situation and the late 2010s highlight the risks of undershooting the inflation target should a major global shock hit – something that is all too plausible now.
The national accounts and other recent key data have broadly tracked as expected. Growth is starting to improve as household incomes recover, though only modestly. Inflation and wages growth continue to decline a little faster than previously expected. Productivity growth disappointed and the labour market remained tight, both partly driven by the expansion in the care economy. Some elements of this set of outcomes are reminiscent of the period immediately before the pandemic. There are also important differences, and it might seem like B.C. (Before COVID) is ancient history. So this is probably a case of history rhyming rather than repeating. The parallels with those years may nonetheless point to some important risks around the outlook.
The late 2010s were not a great time for the Australian economy. Growth was disappointing, and inflation persistently undershot the RBA’s 2–3% target range, despite very low interest rates. Household demand was weak, with a rising tax take squeezing household incomes as the then federal government engaged in fiscal consolidation. Productivity growth was extremely weak in 2017/18 and 2018/19: as a graph in a recent speech by RBA Head of Economic Analysis Michael Plumb showed, much weaker than in the years either side of those two. And like the most recent few months, labour force participation reached a new peak in 2019, at the time the highest rate since records began in 1910.
Along with the drag from tax and fiscal consolidation, a few underlying causes of the sogginess in the late 2010s data suggest themselves. First, with wages growth low and high participation rates making labour plentiful, there just wasn’t much incentive for firms to economise on labour-saving technology, so of course labour productivity growth lagged. Second, the non-mining part of the economy had been squeezed to fit the mining investment boom. That boom was well and truly rolling off by 2018 – WA was effectively in recession. However, the rest of the economy simply could not bounce back quickly enough to fill the gap.
Turning to the current situation, we could see a similar failure to bounce back occurring as the ramp-up in the care economy ends. That suggests a risk to growth beyond the very near term. Judging by the minutes of its February meeting, the RBA Board seems to be alive to this risk. More broadly, the minutes seem to hint that the Board put more weight on the downside risks to growth beyond the very near term than the staff did. And whether they saw the parallels with the pre-pandemic period or not, the Board also seemed to understand the risks of undershooting the target when inflation had already surprised on the downside.
That risk of undershooting also helped drive the Board’s decision to cut the cash rate in February. The minutes and the Deputy Governor’s speech this week both described the results of a scenario where the cash rate was held unchanged at 4.35%, and inflation settled between 2.3% and 2.5%. This result was first noted in Deputy Governor Hauser’s Bloomberg TV interview, and the RBA probably wishes it was included in the Statement on Monetary Policy in the first place. It would certainly have clarified the explanation of the decision to cut despite not agreeing with the market path.
Notice, though, that the base-case was the staff forecasts, which are not entirely model-driven, while the ‘red swathe’ of the unchanged-rates scenario was the span of two very different economic models. So while the difference between 2.7% with 90bp of cuts and roughly 2.3% with no cuts seems like a lot of inflation sensitivity relative to history, perhaps the answer is that the staff forecast using the market path involved some upward judgement that the models did not incorporate.
All of this smacks of fine-tuning, as we have previously discussed. In his speech this week, Deputy Governor Hauser acknowledged the point and – as we had also highlighted – conceded that this was an outworking of the wording of the latest Statement on the Conduct of Monetary Policy. He also repeated the Governor’s comment in Parliament that aiming for the exact midpoint of the target range maximises the chances of actually landing in that range. This, too, is reminiscent of the late 2010s, when some commentators advocated ever more aggressive monetary policy action (fiscal and other levers never came into the discussion) to get inflation right to the midpoint.
As is usually the case though, this interpretation is based on a few unstated assumptions. First, it assumes that the risks around that forecast are symmetric. This is far from assured. Second, it assumes that the base-case forecast is unbiased. A bias need not be intentional: forecasting is hard, models are imperfect, and it is possible that when the wind blows one way, the monetary policy gunsight veers off-centre and needs correction.
Third, it assumes that the appropriate horizon over which to hit the target is the existing forecast horizon. But the length of the forecast horizon is typically determined by how far out your current (or past) approach produces reasonable forecasts. It could also be the optimal horizon to return inflation exactly to 2½% following a shock, taking the nature and duration of the shock and all other policy considerations into account. But if it were, that would be quite a coincidence.
With all those caveats in mind, the reality is that a lot of energy is going into finessing the last 0.2ppt of disinflation. As Deputy Governor Hauser also acknowledged this week, there are plenty of other uncertainties facing Australia that are way bigger than this one. This week marked the moment the US-led trade war went live, along with a major geopolitical realignment around Ukraine. Confidence in the US is already starting to crack, as both financial markets and consumer surveys show. That said, Australia is a small direct target for US tariff policy, and China is likely to stimulate its own economy to offset the tariff hit. The situation is incredibly fluid, though, and – more likely than not – negative for global growth. One wonders if an institution focused on fine-tuning will pivot quickly enough should the situation require it.
