A pitfall or three in forecasting

Last week the IMF released its latest World Economic Outlook (WEO) in time for its spring meetings with the World Bank. The media seized upon the forecasts and commentary for what we might term easy copy. Anybody who has been a journalist knows that press releases and report launches are a comfortable alternative to investigative research. At the same time, anybody who enjoys political power knows that the IMF’s forecasts still carry weight.

So the UK government hailed the fact that the WEO has the UK as the second fastest growing G7 economy in 2017 (after the US). If the Fund’s forecasts had told a more negative story, as they had before and directly after the referendum on EU membership, the government would have tried to pick them apart. Sovereign downgrades by ratings agencies can produce a similar response. The French government was not happy with the downgrade to AA by S&P in November 2013 and said so publicly.

Political posturing aside, there are several reasons to be wary of the forecasting industry. Firstly, there is the use of forecasts as a marketing exercise, a good example being the call for crude oil at US$100/b by a well-known investment bank. Secondly, there is their use with bonds, for example, in support of a bank’s trading position. We will not enter the litigious territory of giving an example.

A third criticism is their chequered record in terms of accuracy. We should be particularly careful when the industry shares the same position. This is neither a macro nor an asset variable but it was striking how all large financial institutions got the result of the UK referendum wrong. It may have been laziness on their part, or it may have been a failure by analysts to take the temperature outside London and south-east England. Whatever the reason, it was embarrassing. A safer alternative would have been to construct scenarios around the two possible results rather than try to call the outcome of the vote.

Forecasters can get it wrong on a regular basis, and we naturally include ourselves in this generalization. That said, economic forecasts have many important applications. Governments and companies must make them for their forward planning.

Consumer goods companies have to develop a view on income growth and distribution. This is more difficult than calling the next month’s inflation rate because of the number of variables involved. In June 2015 a very large multinational in this space announced that it was cutting 15 per cent of its workforce across 21 African markets for the following reason cited by a senior executive. “We thought this would be the next Asia, but we have realized the middle class here in the region is extremely small and is not really growing”. We have a lot of sympathy with the company. Estimates of the size of the middle class in Africa at the time ranged from 350 million across the continent to just 15 million in a sample of eleven countries.

Forecasters have to do a better job, learn from their past mistakes and avoid short cuts. One sure way to improve one’s track record is to monitor what decision-makers say and write. In January 2015 the Swiss National Bank abandoned the franc’s four-year peg to the Euro. It was reported at the time that several high-profile investment houses racked up large losses on a decision they had not seen coming. There must have been a suggestion that this was at least a possibility in the relevant statements, press articles and conferences. We cannot believe that the decision came without a hint in some form.

Along with monitoring decision-makers, we have to identify them correctly. This process includes assessments as to the autonomy of a central bank, for example. The challenge goes beyond success at the identification parade. To give another example with a macro slant: President Donald Trump, undoubtedly a decision-maker, has a fiscally expansionary agenda and plans for huge public investment in the US armed forces and infrastructure yet, if we want to make a call on US monetary policy and GDP growth, we have to form a view on how much of Trump’s agenda will be accepted by Congress.

Supranational organizations present their own challenges. The governing council of the ECB consists of six in-house appointees and the central bank governors of the 19 Eurozone countries. The council is divided on the ECB’s direction, which has been seen most recently on the issue of tapering. In this case, we can see the decision-makers but we have to be alert to changes in their opinion and in the economic landscape in their home countries. These are not the core skills of a forecaster but of somebody who reads extensively around the subject.

So we conclude with a plea for patience. Forecasters have to raise their game, read more and deploy skills that are not peculiar to economists. We do not have a strong view as to how far modelling is used. We favour scenario-building, even in the crudest form, in the construction of forecasts. We also feel that forecasters should not enter unfamiliar territory because they may well be embarrassed by the result.

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Gregory Kronsten

Kronsten is the Head, Macroeconomic & Fixed Income Research, FBNQuest