Each quarter the RBA produces forecasts for the key economic indicators within the Australian economy. Arguably the inflation forecast is the most important variable because the RBA’s explicit mandate is to maintain price stability, with inflation being kept within a target band of 2% to 3%. It therefore seems obvious for the RBA to be able to fulfil its mandate, it needs to forecast future inflation accurately and proactively adjust policy settings (primarily the cash rate) to alter stimulus within the economy to keep inflation within the target band.
The RBA publishes its forecast rates of inflation for the upcoming five half years in its quarterly Statement of Monetary Policy (SoMP). Copied in the table below are the RBA’s predictions for Australian inflation going back to August 2019. Figures highlighted in dark blue are the actual annual inflation rates at the prior half year.
The RBA is somewhat “politically constrained” in its forecasts. To explain, from a perception perspective the RBA could not have forecast an inflation rate of 6.10% by June 2022 when it made its prediction 7 months ago in February 2022. This is because it would have been compelled to raise interest rates far earlier and far more aggressively to prevent inflation rising so rapidly (it actually predicted a rate of 2.00% as per the table). However, if it had accurately forecast a 6.10% inflation rate and raised interest rates earlier, this would likely have prevented inflation reaching 6.10% and so its forecast would have been wrong. To summarise, the RBA will nearly always predict inflation within the target band, or if it is not within the target band, the RBA’s prediction will be to have inflation moving from its current level closer to the target band because if this were not the case, the RBA would be expected to adjust policy settings to make it the case.
This logic above is empirically demonstrated in the table as the RBA always predicts in its furthest quarter inflation will move closer towards the target band than it was at the time of prediction and in most cases be within the policy band. In contrast, the actual results show inflation has never been within the 2% to 3% target band at any half year end in the last three years (either being persistently below until December 2021 when it rose rapidly and has continued to rise since).
It can be argued the last few years have been difficult for economic forecasting and the purpose of the article is neither to argue no-one could have predicted the inflation data over this period (given a global pandemic, various central bank responses to the pandemic and Russia’s invasion of Ukraine), nor to say the RBA is incompetent and its forecasts should be better. The purpose is rather to argue whatever the forecasts are currently they are quite likely to be wrong and wrong by significant margins as per the histogram of the RBA errors distribution below.
The RBA’s most recent prediction if for an inflation rate of 6.10% by June 2023 (10 months into the future from the date of the forecast) but its average error on 10-month predictions is above 2% so the actual inflation figure is just as likely to be either 4% or 8% and could well be either 3% or 10% as per the histogram data.
Clearly, if inflation has fallen rapidly from current levels to 3%, it is almost certain the then most recent (June 2023) quarter will show a negative inflation rate fore the annual rate to have fallen that far that fast. In this scenario, the RBA will most likely have already cut or be cutting interest rates close to 0% to stave off or ameliorate a recession. Conversely, if inflation is at 10% then inflation will be continuing to accelerate from current levels and the RBA will most likely have raised rates well above the current predictions of a terminal cash rate of between 3.00% and 4.00%. In the milder scenarios of 4% or 8% inflation, then the cash rate will very likely either be 1% to 2% lower or higher than currently predicted; the current cash rate prediction being appropriately matched to the RBA’s expectation of a 6.1% inflation rate by June 2023.
The lesson to be learnt is the current cash rate and the expected future cash rates are premised on the RBA’s forecasts of inflation being realised. Based on historical data, this is unlikely to occur given the RBA’s extremely poor record in forecasting. However, we are unsure whether inflation with either over-shoot or under-shoot and interest rates will be lowered or raised from current expectations.
This risk in predictions also explains why there is a premium offered for fixed rate investments as there is more risk in taking on fixed rate investments as opposed to floating as with floating rate investments you effectively lock in the margin over the 3 month BBSW rate if you hold to maturity (and the issuer does not default), but with fixed rate investments you are taking a risk (that can either work for or against you) on whether the RBA is over-predicting or under-predicting inflation and this risk is potentially more than is immediately apparent.
