{"id":22325,"date":"2013-01-09T18:25:43","date_gmt":"2013-01-09T08:25:43","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=22325"},"modified":"2013-01-09T18:25:43","modified_gmt":"2013-01-09T08:25:43","slug":"treasurer-wants-policy-to-be-driven-by-models-that-cant-beat-a-random-walk","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=22325","title":{"rendered":"Treasurer wants policy to be driven by models that can’t beat a random walk"},"content":{"rendered":"

\t\t\t\tOn Monday (January 7, 2012) – The culpability lies elsewhere … always!<\/a> – I wrote about the unacceptably large forecasting errors from the IMF derived from models that informed their input into bailout packages etc, which in turn set the fiscal austerity agenda and as resulted in millions becoming unemployed. I was interviewed about this today by the ABC National Radio program – the World Today – and told the journalist that if errors of this size occurred in medicine, the practitioner would be jailed for professional negligence. A summarised transcript from the World Today programme is available here – Eurozone jobless rate hits record high<\/a>. A few snippets from a 10 minute interview! I did another interview today about a paper that came out recently from the RBA, which largely admitted its forecasting record was inferior to what we might have gained from assuming a random walk (unemployment) or simple historical averages (real GDP growth). You have to see this incompetence not in terms of some technical boffins waxing lyrical in a research paper about a range of technical measures of their errors but rather, in terms of the damage that the policy that has been informed by these errors. Today we received more evidence of that damage in the form of the ABS publication – Job Vacancies, Australia<\/a> (November 2011). The evidence is clear. Our economy is faltering because policy settings have been wrong. They have been wrong because the policy setting paradigm is wrong and this has led to the use of models which deliver predictions that cannot be sustained given the underlying dynamics of the monetary system that this ideology chooses to ignore.
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\nIn November 2012, the RBA published a research paper – Estimates of Uncertainty around the RBA’s Forecasts<\/a> – which also cast doubt <\/p>\n

The Data<\/a> used for the paper is very interesting and saves one having to track all the RBA forecasting publications and put together the shifting forecasting horizons.<\/p>\n

In that paper, the RBA authors admit that <\/p>\n

\nThe confidence intervals … strike many observers as wide, particularly for GDP growth. In other words, our estimates of uncertainty are surprisingly high.\n<\/p><\/blockquote>\n

The RBA also say that their forecast intervals (standard errors) are very wide:<\/p>\n

\nFor example, the 90 per cent confidence interval for GDP growth in the year ended 2013:Q4 extends from 0.9 per cent to 5.7 per cent. That is, although the central forecast is for growth to be moderate, it could easily turn out to be very strong, or quite weak. Similarly, while little change in the unemployment rate is expected, a large increase or decrease is possible. Although the most likely outcome for headline inflation is within the RBA’s target range, it could easily be well outside. In comparison, we can be somewhat more confident about underlying inflation, which is likely to remain moderately close to the target range.\n<\/p><\/blockquote>\n

Which raises the question as to the veracity of the underlying model being used to generate these forecasts. It also means that such forecasts are virtually useless for policy making purposes. There is no reason, on statistical grounds (at the 10 per cent level of significance), to choose between a 0.9 per cent GDP growth rate and a 5.7 per cent growth rate. In statistical terms, these interval bounds are not qualitatively better or worse than the point estimate.<\/p>\n

I don’t want this blog to be interpreted as an exclusive RBA bashing exercise. There is an extensive literature that shows that the Bank of England, the Federal Reserve Bank, OECD and of-course the IMF, all offer (systematically) poor economic forecasts.<\/p>\n

In relation to real GDP growth, the RBA forecasts are inferior to a simple “historic (since 1959) mean” over a 12-month horizon and breaks even over the second year.<\/p>\n

This led the authors to say:<\/p>\n

\n… the low explanatory power of macroeconomic forecasts is a striking result, with important implications. For example, it affects how much weight should be placed upon forecasts of GDP in determining macroeconomic policy.\n<\/p><\/blockquote>\n

In relation to the unemployment rate, the alternative they test against is a random walk – that is, that the best estimate next period is this period’s actual value. All variation is thus stochastic and by definition unpredictable. The result is that the RBA forecasts are inferior to the random walk.<\/p>\n

Even in relation to the “key” RBA variable, the inflation rate, and especially the forward-looking rate, which the whole premise of inflation targetting is based on, the RBA admits that:<\/p>\n

\n… but – consistent with successful inflation targeting – at longer horizons deviations in underlying inflation from the RBA’s target seem to be unpredictable. Uncertainty about the forecasts for GDP growth and (beyond the immediate horizon) changes in unemployment is about the same as the variation in these variables. In other words, forecasts for these variables lack explanatory power.\n<\/p><\/blockquote>\n

The following graph shows the RBA real GDP growth forecasts and the actual result for quarterly data from February 2008, which was the low-point unemployment rate quarter of the last economic cycle.<\/p>\n

The blue arrowed line represents when the RBA started to tighten interest rates again. The Target rate was increased by 0.25 percentage points in October 2009, November 2009, December 2009, March 2010, April 2010, May 2010, then a break, and another rise in November 2010.<\/p>\n

The recovery in real GDP growth in early 2009 which was sustained through 2010 was largely due to the massive fiscal policy stimulus that the Federal government introduced in late 2008.<\/p>\n

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The RBA fell prey to its own rhetoric about the strength of the rebound in commodity prices and the size of the minerals boom that was restored after the first period of the crisis, largely because the Chinese government kept their growth cycle going by using fiscal policy to inject increased spending on domestic activity as its export markets contracted (due to the decline in World trade in 2008-09).<\/p>\n

As the Federal government started to withdraw its stimulus and begin its obsessive (now-failed) pursuit of a budget surplus the RBA was tightening monetary policy and it was clear that real GDP growth was starting to falter again, notwithstanding the massive investment that was occurring in the mining sector. The external sector was not delivering the bounty that the spin doctors were predicting and households were resuming pre-credit binge saving patterns.<\/p>\n

The result is clear – real GDP started slowing and by early 2011 was heading south. Even at that time, the RBA was predicting strong growth. Over 2011 real GDP growth fell away sharply and despite some odd quarters (such as March 2012) when there was an investment spike, the trend downwards has continued. The RBA only started easing monetary policy again a year after its rise in November 2010.<\/p>\n

For 12 months, it claimed the Target rate was appropriate, despite the on-going fiscal contraction and the faltering real GDP growth rate.<\/p>\n

The other evidence available – construction activity, demand for credit and the labour market information – all pointed in the same direction. Unfortunately, the RBA ignored the underlying message and took far too long to realise that the so-called once-in-a-hundred-years mining boom was not going to deliver anything like the growth that was predicted.<\/p>\n

That boom, was relatively strong, but the other countervailing spending contractions (mainly fiscal policy) were nullifying influences.<\/p>\n

In the Mid-Year Economic and Fiscal Outlook 2012-13<\/a>, which was published in October 2012, the Government re-affirmed its economic logic:<\/p>\n

\nReturning to surplus provides ongoing scope for monetary policy to respond to economic developments and underpins confidence in Australia’s public finances at a time of global economic uncertainty.\n<\/p><\/blockquote>\n

The Treasurer’s claims that the government’s surplus promise has allowed the RBA to cut rates is a strange argument. The Government’s strategy (combined with our excessively high interest rates) has been to deliberately create unemployment in the non-mining regions so that the idle resources could then service the mining boom.<\/p>\n

Not only will the required migration patterns fail to occur but non-government spending is not strong enough to support trend growth – mining investment boom notwithstanding. Many large employing sectors are declining due to a combination of an appreciated currency (exacerbated by high interest rates) and the withdrawal of the fiscal stimulus.<\/p>\n

On Page 35 of the MYEFO we read:<\/p>\n

\nThe Government’s fiscal consolidation should continue to provide scope for monetary policy to be eased, if appropriate, without generating price and wage pressures. This recognises that in normal circumstances, monetary policy should play the primary role in managing demand to keep the economy growing at close to capacity, consistent with the medium-term inflation target. The impact of the fiscal consolidation in 2012-13 should be more than offset by growth in private demand, with the aggregate economy growing around trend.\n<\/p><\/blockquote>\n

The Treasurer has repeated this mantra endlessly over the last three years. The reliance on monetary policy as the principle counter-stabilising policy tool is a world-wide obsession, which stems from the now discredited mainstream view that fiscal multipliers are low if not negative and inflation-first policy approaches are best because any unemployment that results is temporary and incidental.<\/p>\n

The mainstream of my profession actually convinced policy makers that fiscal policy was both dangerous and ineffective. The danger related to when they wanted to run the inflation bogey, while the latter was when anyone suggested the government use budget deficits to tackle the persistently high unemployment.<\/p>\n

What a pack of fools! Both the economists who ran that line and the rest of us (the Royal “us”) for believing them. The last three years has demonstrated categorically that fiscal policy is the main game in the policy kit and monetary policy despite all the gymnastics from central banks is incapable of restoring solid growth without spending support being provided by fiscal policy.<\/p>\n

The mainstream obsession about the primacy of monetary policy should be discarded. The enduring economic crisis has demonstrated that. Even the IMF has been forced to admit that fiscal multipliers are now well over 1 meaning the cuts to net public spending are not offset by greater gains in private spending.<\/p>\n

The fiscal contraction expansion myth is exposed well and truly by these admissions. The superiority of monetary policy is also being exposed by the poor performance of the central bank forecasting models.<\/p>\n

Further, monetary policy changes have uncertain impacts on aggregate demand, which make them unreliable vehicles to influence spending growth. They cannot target regions, sectors or demographic cohorts, other than punishing (or rewarding) debtors and rewarding (punishing) creditors and fixed income recipients. These distributional impacts are unclear in net terms.<\/p>\n

The RBA paper makes it clear that the central bank is aware that its growth forecasts were wrong and it is now trying to backfill the damage that the resulting high interest rates, combined with the Treasurer’s policy stance, are causing.<\/p>\n

That is, of-course, a far cry from the way the Treasurer constructs the events.<\/p>\n

As an historical note, it is not the first time the RBA has caused major damage with its faulty policy settings. In the late 1980s, the RBA held rates at ridiculously high levels (up to 19 per cent) for far too long given the circumstances. It was obvious that such high rates would generate a downturn, especially as the Federal Government was also waxing lyrical about the budget surpluses it had achieved, not realising that this was draining demand too quickly.<\/p>\n

Recession hit in 1991, and the Treasurer then claimed it was “the recession we had to have” – which was a disgrace for a Labor Party Treasurer to say knowing it would drive hundreds of thousands of workers out of a job. The government refused to ease fiscal policy and the RBA refused to relax monetary policy sufficiently and by the middle of 1991, Australia was in the midst of the worst economic downturn since the Great Depression.<\/p>\n

The lengthy recession was totally policy-induced by both incompetent (ideologically-obsessed) policy positions adopted by the RBA and the Federal Treasury.<\/p>\n

The ABS Job Vacancies data shows (seasonally-adjusted):<\/p>\n