How come the inflation outlook deteriorated so suddenly after the election? Crikey’s feature story yesterday — “Where was Ken Henry’s straight talking on inflation? – highlighted the suggestion by Tony Harris — “Whiff of Budget dishonesty” — in yesterday’s AFR that Treasury was dishonest, or at least pulled its punches on the inflation outlook for political reasons right before the election.
I think both writers owe Treasury Secretary Henry and his team an apology. The issue here is not dishonesty, but the usual uncertainties involved in making economic forecasts. That “no-one is any good at forecasting anything” is an exaggeration, but it’s a good starting point for analysis.
I do not doubt that Treasury most of the time — like the rest of us — does more or less what the boss tells it to do. But every three years — during the election campaign — Treasury has no boss. It is the inflation forecast produced in that small window that is under the microscope.
Mr Harris wrote, “We do not know why Treasury had to warn the new Treasurer about Australia’s worrying inflation only weeks after” Treasury had “reported that all was well”, in its 22 October Pre-election Economic and Fiscal Outlook.
Actually, the answer is simple: the incoming figures on trend inflation since then have been shockers. Everyone has been revising up their inflation forecasts. Mr Harris manages to avoid this conclusion by pointing to a (misleadingly) benign 0.7% print for the headline CPI in Q3 on 24 October. Those actually producing inflation forecasts put much greater weight on the incoming news for underlying or trend inflation, because it is less affected by one-off shifts in banana prices and the like.
Critically, at the time of Treasury’s pre-election update (completed 22 October), officials were looking at one disturbing CPI report in the previous three quarters. Getting technical, the RBA’s “Trimmed mean” (trend) CPI had risen by 0.9% in Q2, following increases of 0.5-0.6% in the previous two quarters. One bad figure in three. Not great, but not too distressing (see bottom RHS of table here).
Then came the bad news on 24 October: the trend CPI rose by 0.9% in Q3, or 3.6% annualised in the language of US economists. That followed the same result for Q2, so the news boiled down to the most disturbing back-to-back inflation results since 2001. Trend inflation over Q2 and Q3 annualised to 3-1/2%, above the RBA’s 2-3% medium-term target.
And today, after the Q4 CPI report a fortnight ago, the latest three readings are 0.9% (Q2), 0.9% (Q3), 1.0% (Q4). In short, it’s much easier to be worried about the inflation outlook now than it was before 22 October, when Treasury’s pre-election forecasts were finalised.
Rightly or wrongly, most economic forecasts boil down to something like extrapolations of recent history. With three of the four trend CPI increases near 1% that have arrived over the past five years having arrived in the latest three quarters, forecasters and policymakers naturally are much more worried about inflation now than they were two CPI reports ago. Perhaps I’ve convinced at least some readers that, as usual, it’s “a stuff-up not a conspiracy”.
Those who think individual inflation reports could not have such a big influence on official forecasts and RBA policy might note that over the past two years we have had six disturbing inflation reports and two comforting inflation reports, each followed within a week or two by six RBA rate hikes and two policy pauses.
Of course, it’s much more complicated than that — strength of demand, commodity prices, China, capacity constraints, etc. But the RBA did choose — in the wake of those comforting 0.5-0.6% prints on its trend CPI — to skip opportunities to hike in February and May last year. Now, with three-straight prints of 0.9-1.0%, the RBA is marketing the potential need for another rate hike in March. If the US economy and global financial markets can hold together until then!