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Old Bad Habits Plague Economic Forecasting

Thursday, 30 June 2011 10:00 AM

Three years after the Great Recession ought to have challenged even the most basic assumptions made by economists, they have instead settled back into the costly habits of old.

The same experts who largely missed the onslaught of the worst recession since World War II have consistently overestimated the strength of the recovery in major Western economies.

An analysis of Reuters polls shows economists were too optimistic about 20 out of 27 major monthly indicators for April and May in the United States, the euro zone and Britain — a list that includes industrial output, jobs, business and consumer sentiment data, and purchasing managers' indexes.

While oil price surges earlier this year and March's devastating earthquake in Japan have undoubtedly made forecasting trickier in recent months, the schism between what was "expected" and the gloomier reality that follows reappears with regularity.

All too often these indicators — the May U.S. non-farm payrolls and The Federal Reserve Bank of Philadelphia's June business conditions index, to name just a couple — came in well below even the lowest forecasts provided by dozens of economists from banks and research institutions.

"They've underestimated the scale of the shock and people think it's all over, and they want to be back to business as usual," said David Blanchflower, professor of economics at Dartmouth College in New Hampshire, and a former member of the Bank of England's Monetary Policy Committee.

"The problem is that it isn't, and we are not 'back to business' any time soon."

Blanchflower, who in January 2008 warned that his MPC colleagues were "fiddling while Rome burns" by fretting over inflation, argues economists have assumed a return to trend after the recession and have thus returned to old, failed models.

"In many of the models, back in 2008 the efficient market hypothesis basically told you that you didn't need the financial markets in these models because they perfectly priced assets," Blanchflower said.

"Well, a) that's still true in these models, and b) if we ever believed it was true in 2008, we don't believe it's true today."

Too Cheery

In June 2008, not one of a sample of 24 top economists who track the UK saw a recession coming at any point from the start of 2008 to the end of 2009.

We know now Britain's recession, one of the worst on record, had already started when the questionnaire went out, and latest evidence shows the UK economy is still barely growing.

The story was exactly the same with the euro zone survey, in which economists failed to identify that a contraction was already underway.

Similarly, polls of U.S. economists at around the same time showed no grave concern that the world's largest economy was about to plunge into its hardest times since the Great Depression, citing just a 50 percent chance of any recession.

Echoes of this persistent over-optimism linger today.

None of the 24 monthly Reuters long-term economic surveys conducted in advance of the release of UK fourth quarter GDP for 2010 showed any consensus for a negative figure, nor did the poll conducted just before the preliminary release.

In the event, there was a 0.5 percent quarter-on-quarter contraction — a whole percentage point off the consensus of 0.5 percent growth. While economists protested the figures would be revised up, the final estimate showed no such revision.

"When the average error forecasting GDP shoots up from 0.1 (percentage point) pre-crisis to 0.5, you know something's wrong in the way the consensus is forecasting GDP," said Alan Clarke, economist at Scotia Capital, one of the most accurate forecasters on the UK economy over recent years.

Clarke said there was a tendency for some economists to assume an inevitable return to a definition of "normal".

"Say, that growth will go back to a more trend-like pace, that inflation will revert back to the two percent target, that BoE policy will go up from 0.5 (percent) because it's below its long-term average — I disagree with probably all of those."

"The lazy assumption is that it'll mean-revert, and it probably won't."

Perhaps as a consequence, economists' models — including those of central bankers — have often failed to mark turning points.

Over the past year, the Bank of England has had to revise its inflation forecasts dramatically higher, while just last week the Federal Reserve took an axe to its growth outlook.

While missing the start of recession was one thing, they also underestimated the spurt in growth immediately after the recession, and now the extent of the subsequent slowdown.

Looking to future growth, not one amongst the dozens of economists polled by Reuters each month sees another recession between now and 2013 in any of these economies, despite near-term threats to growth from sovereign debt crises and austerity.

While this consensus view is perfectly valid, the uniformity of opinion among market economists while policymakers continue to emphasize uncertainty is striking.

What the Data Say

Economists have overestimated the strength of U.S. economic growth in both the preliminary and advanced GDP readings for the last two quarters, while jobs and industrial data over the last few months have generally turned out worse than expected.

For instance, releases for U.S. industrial production and durable goods orders have been worse than expected in four out of the last five months, while the Philadelphia Fed Index — a reliable leading indicator for manufacturing — has come in below expectations in each of the last three releases.

Indeed, the June Philly Fed index was a shocking minus 7.7, far below even the lowest forecast of 0.0, to say nothing of the consensus for a rise to positive 6.8.

It was a similar story with May's U.S. nonfarm payrolls, which rose by 54,000 — well below the lowest forecast in a snap Reuters poll. One economist revised down his forecast from 300,000, to 225,000, and then to 160,000 in the space of a couple of weeks and was still off by 106,000.

Economists have done a better job of gauging the strength of headline GDP and inflation numbers in the euro zone, no doubt helped by the overpowering strength of the region's biggest economy, Germany, which recently reported its best growth rate since reunification in 1990.

But their views on the health of the euro zone's largely moribund consumer sector have been too cheery. Euro zone consumer sentiment and retail sales have each underperformed the consensus in four out of the last six releases.

Conversely, perhaps the only major indicator in the Western world that economists have underestimated persistently is the Ifo index of German business confidence. It has exceeded expectations in five of the last six releases.

Get Real

Asked how standards of economic forecasting can be improved, Blanchflower was forthright: "Chuck it all in the bin and start again! We have to get realistic; other people are."

As an example, he points to the Bank of England's latest fan charts, which visually represent the range of prospects for growth and inflation in the future.

Within the 90 percent probability range, the fan charts show growth could hit around 5 percent year-on-year by the end of 2011, with hardly any chance of zero or negative growth.

"Well, go and get real. Put a bit of common sense in here. When I give this chart to business audiences, everybody laughs," said Blanchflower.

He said timeliness should be of the essence when looking at economic indicators.

"I'm a real reader of business and consumer confidence surveys. They're timely, they don't get revised away, and they predicted very well what was going to happen in the U.S., the UK and Europe."

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Three years after the Great Recession ought to have challenged even the most basic assumptions made by economists, they have instead settled back into the costly habits of old. The same experts who largely missed the onslaught of the worst recession since World War II have...
Thursday, 30 June 2011 10:00 AM
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