Economic modelling: It’s gone pear-shaped

Around the world, since shortly after the global financial crisis of 2008 and 2009, we economists have found that our economic models do not work as they used to. In particular, old relationships between changes in the pace of economic growth, job gains, wage increases, and inflation have altered in ways we can’t yet quite figure out.

To date, these changes have led to a consistent tendency to over-predict inflation and therefore interest rates. The result has been interest-rate surprises on the low side for over a decade now. This has been good news for borrowers but not good at all for investors who traditionally prefer low-risk assets like bonds and bank term deposits.

The appearance of Covid-19 has in no way improved the accuracy of our economic models or returned them back to where they used to be. Forecasting ability has deteriorated even further and we can see evidence of that all around us currently.

The unemployment rate for the September quarter did not rise to the 11 per cent many forecasters were predicting back in March to June, and instead was just 5.3 per cent. The peak now looks like being near 6.5 per cent, if that. The labour market is proving to be substantially stronger than expected and employers are once again waking up to the realisation that staff shortages could become their biggest problem again.

This will be leading to labour hoarding even by firms which might not need all their staff at the moment, and we can see in surveys that businesses are becoming more determined to hire people. The Government is even having to make special migrant visa changes to allow extra workers to stay and help out some sectors like horticulture and tourism – which is ironic really for that latter sector, considering the absence of foreign tourists.

At this stage, there is little chance that the growing shortages of staff will propel an acceleration in the pace of wage rises. So an inflation threat from that source looks unlikely for two to three years. However, this does not mean that borrowers can rest easy.

Central banks around the world have based their massive easings of monetary policies on failed economic models which say the sorts of output declines we have seen resulting from Covid-19 will cause deflation. But if the models did not work from 2009 to 2019, why would they suddenly start working again now?

The inflation risk is clearly not high even as we contemplate accelerating growth in the New Zealand economy. But the deflation risk is looking less and less strong and at some stage the Reserve Bank is going to have to acknowledge that. Perhaps when it does it will also acknowledge that the housing market does not need more stimulus through the likes of the Funding for Lending programme aimed at delivering even cheaper funding to banks.

In fact, the housing market needs less support and could easily handle higher interest rates without denting either the economic boost from a positive wealth effect property owners feel as prices rise, or the more important boost to housebuilding which rising prices and listings shortages are strongly driving now.

The Reserve Bank has invested a lot of credibility in its strong response to the Covid-19 shock. But that credibility is now eroding as it seems to have a blind spot regarding not just the hyperactive housing market, but the rapidly improving state of the economy and labour market. Its analysis looks out of date.

Its challenge will be pulling back from throwing the kitchen sink at the effects of the shock, and reinstating monetary policy settings more suited to the economy we now find ourselves with and can look forward to next year as businesses start preparing for the economic boost to arrive when the borders reopen.

For borrowers, this does not mean there is an imminent interest rates threat. But the writing is starting to take shape on the wall. For some that might mean forgoing some of the candy offered in the form of very cheap one-year fixed mortgage rates, and choosing to lock in some portion of one’s debt for a longer term – perhaps even five years at 2.99 per cent.

The Government is even having to make special migrant visa changes to allow extra workers to stay and help out some sectors like horticulture.