It’s time to tango with the economic forecasters

A 2023 recession in the US was predicted with near certainty amongst economists just over a year ago. It didn’t happen.

Economic forecasting is difficult, often wrong and begs the question, is it worthwhile?

Simply put, yes. It helps businesses make decisions about capital allocation, borrowing, staffing levels, and wage rates.

But economists must also include probabilities and alternative scenarios around their core predictions. Neglecting to do so means we would have learned nothing from the past two decades, and we would be falling short of meeting our stakeholders’ needs.

To get the most out of their economic advisers, business leaders and decisions makers need to tango a little. Ask the economic forecasters, which convictions are held strongly, and which are at best a 50/50? Where have the steps not been fully rehearsed? Which part of the story holds the drama? Where is the conviction? Only by seeking that kind of feedback can the dance be wholly interpreted.

So, what should businesses be questioning this year?

At the top of the list is the widely held view that interest rates will be lowered by the Reserve Bank this year. This outcome was expected by 25 of the 34 forecasters interviewed by Bloomberg last week. Similarly, financial markets have priced between one and two 25bp rate cuts by the time our next summer holidays roll around.

There is good logic behind this forecast. Wednesday’s consumer price index is likely to show inflation falling again in the December quarter – maybe even below the Reserve Bank’s latest forecast, which is 4.5 per cent growth. History tells us inflation falls effectively, albeit with a lag, in response to monetary tightening.

But the more important question is, why might inflation stay persistently high?

Domestic sources of inflationary pressure are still very much present in many goods and services.

The labour market is still tight. A recent Ai Group survey of 320 manufacturing, construction and industrial services businesses revealed 87 per cent expect staff shortages in 2024. Labour shortages are slightly weaker than a year ago – when that same ratio was 90 per cent – but not by much.

With 64 per cent of the population employed, the proportion of Australians in a job is still almost at a record high. If employers want specific workers, they may still have to pay a premium to get them.

To make matters worse, when labour costs are also adjusted for productivity changes (which have been miserable) the cost of labour to employers is rising faster than wages alone. This means service prices, which have a higher labour component than goods, are still rising fairly strongly.

Housing is in hot demand, but with new construction hurt by higher interest and inflation rates, it has failed to cope with recent population growth. This is keeping upward pressure on rents and the cost of building a home.

Catastrophic weather events have wreaked havoc on the supply side of the economy, driving up prices for everyday items like fresh food and even insurance. Could there be more? Of course.

Across the world, countries are collectively trying to manufacture an enormous energy transition causing competition for materials, skilled workers and expertise. Inflationary? You bet.

Conflict in the energy-producing Middle East has extended. Energy prices are not as high as when the war in Ukraine broke out, but they remain elevated and, as the World Bank has warned, they could move higher. Global shipping prices have already surged again as normal supply routes are interrupted.

Problems in our own ports have also slowed the movement of goods and could result in upward pressure on prices by impacting supply.

This year, elections in countries that represent 60 per cent of the world’s GDP could lead to significant shifts in government policy. There is potential for further fragmentation and therefore fewer gains from swapping goods, services, people and ideas. That could include missing out on disinflationary forces as well.

Consumer priorities and sensitivities are changing, and so too are government regulations. Few are willing to mindlessly accept the cheapest goods and services without questioning if they were produced by underpaid labour in unacceptable conditions.

If inflation doesn’t come down enough, the Reserve Bank will hold onto higher interest rates – especially if the unemployment rate stays relatively low thanks to a tight labour market.

Additionally, if the Reserve Bank believes the neutral interest rate (the one that neither adds stimulus nor detracts from the economy) has drifted higher, after falling for many years, the cash rate could already be close to where it needs it to be. That would mean further declines are unnecessary.

The consensus view that rates will be lowered this year is sensible. But the fact that 20 per cent of forecasters expect no change, and 5 per cent expect an increase is also telling.

In my view, the probability of the cash rate holding steady at 4.35 per cent is greater than 50 per cent. And the alternative view that inflation stops falling, or indeed creeps a little higher, must be considered. There are no rules in economics that dictate that the inflation rate moves only in one direction during the cycle.

This year’s business cycle may not play out the same as in the past, because of several specific factors. The supply side of the economy simply may not be able to keep up with demand, and inflation may stay too high for the Reserve Bank’s comfort.

As a result, I’ll be advising my tango partners to stay light on their feet. Build a little slack into wage and input cost projections. Make sure there is room for error in their interest costs. And whatever they do, plan for some nimble footwork as they traverse an uncertain 2024.