Why did 88% of economists get last week’s rate call wrong?

Most of us were expecting a cut in interest rates last week, but instead the banks put hem up.

Even the economists called it wrong which made Craig James, CommSec’s Chief Economist, ask “Why is it so?” in his weekly market update.

James went on to explain….

The Reserve Bank always provides a statement accompanying its interest rate decisions.

But that still has left plenty of economists scratching their heads for reasons why rates were left on hold this week.

A survey by Bloomberg showed that 24 of 27 economists tipped rates to fall. So how did they all get it wrong?

Overall, the Reserve Bank opted for a strategic decision rather than one based wholly on economics.

Certainly the economic case for a rate cut was compelling. Inflation is under control and expected to stay that way. In addition, the latest data shows that consumers aren’t spending, or buying and building homes. The Aussie dollar is high, putting pressure on businesses. And interest rates are slightly above long-term averages.

A 25 basis point rate cut would have given the economy a much-needed kick along, without threatening the inflation outlook.

And it would have provided much needed insurance to Australia in a world dominated by jitters about the European debt crisis.

But what about the other side of the equation?

There are signs that the European situation is stabilising – certainly share markets are lifting. China looks to have achieved a soft landing with inflation under control and economic growth at a more sustainable pace. And US economic data has been encouraging. So if times are getting better, why cut rates?

Of course, the European situation could go pear-shaped. And if that’s the case, there were even more reasons to conserve rate cut ammunition.

Then there is the issue of bank funding costs. The Reserve Bank knew that there was a significant risk that banks wouldn’t be able to pass on all, or some of, a 25 basis point rate cut. So they may have decided that it was better to hold off on a rate cut for a month or two when banks may be a better position to cut rates.

Some have also suggested that rates are only cut if the economy is struggling – and the Reserve Bank didn’t share those views.

But the recent rate cuts were not delivered just because the economy is struggling, but also because tighter policy isn’t required when inflation is well behaved. It is the level of rates that matters.

Rates are slightly above long-term averages and that’s why the Reserve Bank still maintains an easing bias.

Craig James is chief economist at CommSec.


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