Australia's central bank admits to a big problem

Photo: Peter Byrne/Getty Images)

The 21st Century has delivered Australia a wild ride when it comes to its terms of trade (ToT).

From around 100 in 2004, the ToT climbed to a peak above 180 in 2011. It’s currently back below 130 and the RBA’s current forecast is for it to bottom out around 120.

But we should all take that forecast with a grain of salt, Alexandra Heath, the RBA’s head of the economic analysis department, told an audience at a department of Industry, Innovation and Science workshop this morning.

Heath asked and answered the question of how good is the RBA at forecasting the terms of trade? And her simple answer was: “Not very.” It’s a notion supported by her own evidence of RBA forecasting failures.

As the chart shows, the RBA consistently under-appreciated the demand for commodities, and thus the increase in the terms of trade. Equally on the way down, the RBA has consistently under-appreciated the crash in prices.

Heath noted:

At the risk of oversimplifying, the task of forecasting the terms of trade for Australia is roughly equivalent to the task of forecasting commodity prices. A large part of the misses during the upswing of the terms of trade came down to an underappreciation of how much demand for commodities would grow, and how long it would take for new supply to come to market. After a long period of low commodity prices, there wasn’t sufficient production capacity to meet the increase in demand from China and other emerging markets. Prices increased, and there was a substantial increase in mining investment around the world in response.

In Australia, mining investment increased from around 2 per cent of GDP in the early 2000s to around 8 per cent in 2012. However, it takes some time for investment to translate into production, so, for a considerable period, growth in demand exceeded the increase in supply and commodity prices continued to increase. Over the past couple of years supply has been growing more rapidly than demand, as new capacity continues to come on line, and commodity prices have been falling.

More recently, there has also been a noticeable slowdown in demand growth.

So there is no guarantee that the terms of trade will stop falling at the current RBA forecast around 120. Equally though, the RBA’s own history and Heath’s admission says the terms of trade may not fall as far as they think.

So if the RBA is not very good at forecasting, what should it do?

Heath said that “at least in theory, spot financial prices should contain all the relevant information about supply and demand if these markets are reasonably deep and liquid. In this situation, it is difficult to do better than a ‘no-change’ assumption for price projections.”

No change. That could make forecasting the impact on the economy problematic, given recent history shows that’s unlikely to be an effective reflection of price movements.

But Heath added that “iron ore and oil”, and hopefully LNG in the future, do “appear to provide information about near-term price movements”.

So what is the RBA to do?

Heath said the bank “acknowledges this is by placing confidence intervals around the forecasts for GDP, the unemployment rate and underlying inflation in our regular quarterly update of our forecasts in the Statement on Monetary Policy.”

In a world of uncertainty, that’s as good as any process.

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