Economic forecasting can be wrong, RBA warns

The Reserve Bank of Australia (RBA) recently defended its economic forecasts, stating that they are an indicative tool for decision-making and not pure predictions of the future.

Speaking at an address to the Committee for Economic Development of Australia (CEDA) on 3 May, the head of the RBA’s economic analysis department, Marion Kohler, noted the central bank’s forecasts cover the coming two and a half years, thus predictions can be changed when unforeseen events happen, such as the pandemic. 

Forecasts are presented to the board each quarter to inform their monetary policy decision, with the details of its latest forecasts published on Friday (5 May).

Ms Kohler explained that in recent years, things have turned out very differently from earlier forecasts, highlighting the limitations of economic forecasting.

“Forecasting is a valuable tool for central bankers, but we will never be able to tell the future perfectly,” she said. 

Ms Kohler emphasised that judgement was necessary when forecasting, especially when something unprecedented happens, like the COVID-19 pandemic.

She also pointed out that the RBA’s central scenario is not a true prediction or promise.

“Rather, they are an indicative tool for decision-making,” Ms Kohler said.

It comes as the central bank has been largely criticised for its rampage in rising interest rates, hitting 3.85 per cent in May, after it said the cash rate would hold until 2024.

It also recently adjusted its inflation target predictions to June 2025, from earlier predictions that suggested inflation would lower to its target range between 2–3 per cent by 2024. 

Pandemic, population growth, and housing demand swayed predictions 

Indeed, Ms Kohler highlighted a number of changes in recent years, which have swayed forecasts, such as population growth, housing demand, and fiscal policies.

She explained one of the biggest changes in view has come from population growth, which has been “stronger than expected six months ago”.

This was reflected by the faster-than-expected return of international students and working holiday-makers following the reopening of the international border and low levels of departures.

“The higher population growth increases demand for housing,” Ms Kohler said.

“Initially we expect this adjustment to come through higher rents and higher average household size as growth in the population is faster than the dwelling stock. 

“But in the longer run, there is also a boost to dwelling investment.”

Indeed, the housing market has also been more resilient than expected, with national housing prices starting to stabilise in recent months.

With housing prices seemingly stabilising a bit sooner and at a higher level than expected, the total effect of lower housing prices on consumption is expected to be smaller, she said. 

“Lower housing prices generally dampen consumption, and the effects of the earlier decline in prices is still working its way through,” Ms Kohler said.

In addition, policy changes have affected future energy costs, thus, forecasts can only be “reasonably based on the fiscal and other government policies that are already known at the time”, she said.

While regulators have announced draft determination increases to default offers for electricity prices in the eastern states, government policies have moderated the expected increases in energy costs somewhat. 

As a result, the forecast now predicts a smaller increase in electricity bills than what was expected six months ago.

Mortgage holders get short end of the stick

Indeed, the central bank has acknowledged that the increase in interest rates over the past year has had an impact on mortgage holders and the broader economy. 

Following its monetary policy decision in May, governor Philip Lowe backed the board’s decision claiming forecasts expectations signalling an end to cycle were inflating asset prices.

Since its decision to hold in April, Mr Lowe said new evidence had suggested that the Australian labour market was still very tight, that services price inflation was “uncomfortably persistent abroad”, and asset prices were responding to the interest rate change outlook.

[Related: 'Further tightening may be required' RBA warns]