There is an avalanche of economic predications and forecasts available, but how reliable are they? Derek Parker looks at the limitations of business weathervanes.
The future, said Winston Churchill, is just one damn thing after another. True, but managers and executives usually need some indication of where the economy is heading, if they are to judge demand, opportunities, constraints, and market conditions. For economists in the corporate sector, forecasting is usually a key function, and to do the job they draw upon a wide range of statistical data.
But economic forecasting is a long way from a precise science. Forecasters must, after all, start somewhere, and their assumptions about how an economy works can vary widely.
The differences in beliefs are enormous; so varied and conflicting that economics is jokingly said to be the only field in which two people can get a Nobel Prize for saying exactly the opposite thing, says William Sherden, author of the highly-regarded, The Fortune Sellers *.
So there is the ‘First Law’ of economics: for every economist, there is an equal and opposite economist. By the way, the ‘Second Law’ is: they are both likely to be wrong.
Sherden argues that, at least in the US , the record of economic forecasters is rather poor, especially for volatile statistics such as interest rates; although they do better for some stable statistics, such as government spending, and about the same for statistics such as real GNP growth and inflation. On average, he says, economists’ forecasting skills are about as good as guessing.
Melinda Cilento, Chief Economist of the Business Council of Australia (BCA), acknowledges that many forecasts fall wide of the mark but points to the inherent difficulty of the exercise.
There are many elements to consider, she says. Structural factors, cyclical factors, one-off events… In my experience, economists often pay too much attention to a new and particular event, expecting a big impact when it turns out to simply fade into the background. On the other hand when you’re talking to an economist, there’s always an ‘other hand’ there have been times when economists have relied too heavily on long-term patterns and trends in the face of more recent evidence that suggests that the predictive power of a relationship is no longer strong.
You need to understand the context of a forecast: what assumptions are used, what are the major issues in the economic environment at the time, the limitations of the data, and so on. If you bear these in mind, a good forecast can be a useful business tool; but one that should be used in conjunction with other information and ideas.
Unfolding the future
At the heart of the forecasting process are two types of data: the first aims to extrapolate from information about the near past, producing information on future trends. The weakness of such forecasts is the assumption that the future will unfold on the same course as the past: that is, there will be no external shocks or radical changes.
In Australia, one of the most widely reported forecasts of this type is the ANZ’s monthly survey of job advertisements, which began as a tally of the number of advertisements in the newspapers in the major cities, on the basis that employment and job growth reflects the broader economic situation and the direction in which the economy is moving. In the past few years, the survey has undergone modifications, to take account of the popularity of the Internet as a recruitment device, and of the growth of part-time and casual work.
There is a degree of personal judgment involved when it comes to interpreting the data from our own survey and integrating information from other employment-related sources, says Saul Eslake, Chief Economist of the ANZ Bank. Some people might not like the idea that a certain degree of ‘feel’ for the numbers is involved, but that’s the way it works. There is always an element of judgment, and there is always the possibility of getting it wrong. In fact, all forecasters make an error at some point it’s an occupational hazard. Any forecaster who claims a 100 per cent success rate is either overlooking some previous mistakes, or hasn’t done enough forecasts for it to count.
Eslake is firmly of the view that job advertisements are a good indicator of the short-term outlook for employment, but he adds some important caveats. General economic changes follow changes to the number of job advertisements by about six months, he says, and longer in some cases.
He also points to the number of job advertisements as a good indicator of changes to the cash rate set by the Reserve Bank. The precise reasons for this connection are unclear but when the two trends are set together on a graph the correlation is hard to deny. But there is a time lag of nine months approximately.
Eslake makes clear that the important aspect of the jobs survey, and with most periodic economic forecasts, is the underlying trend rather than a specific figure.
Errors in individual forecasts are usually ‘smoothed out’ over time, he says. That’s why it is important to look at the larger picture, not just at a headline figure.
The point that there is a difference between a economic forecast and the simplistic way in which it might be covered by the mainstream news media is important. Most credible forecasts come with a list of caveats and assumptions; these are often lost in media reporting.
Television news programs are keen to cover employment trends because of the political sensitivity of the issue.
Another survey often mentioned in the media is the Westpac/Melbourne Institute Index of Consumer Sentiment, conducted by the Institute of Applied Economic and Social Research, based at the University of Melbourne. Much of the media coverage of the Index of Consumer Sentiment reports the survey as describing the community mood as upbeat or gloomy, but the whole story is often more complex.
The survey is a monthly telephone poll of at least 1200 people (often more, if particular additional issues are canvassed). The survey’s aim is to gauge the overall mood of Australian households, on the assumption that how people feel about their economic situation will translate into changes in patterns of spending, saving, and so on. The index is a contrast to the statistics-based ANZ job vacancies survey insofar as it uses a representative sample to measure attitudes and feelings.
The Index of Consumer Sentiment has offered some very useful signposts for overall direction, says Bill Evans, Westpac’s Chief Economist. But at the same time you have to be aware of what is going on when the survey is being done; to take account of specific events that could affect survey responses but not have a significant impact on economic behaviour. That said, the value of the index is that it can give the first indication of movement.
For instance, several interest rate rises last year did not have much effect on consumer feeling. But the increase in March sparked a major change, indicating that a threshold had been reached and the policy was having the intended effect.
But Evans is aware of the methodological limitations of the survey, and suggests that the Index of Consumer Sentiment be read in conjunction with another regular Westpac/Melbourne Institute forecast: the Index of Economic Activity. This index draws together a range of figures relating to the real economy housing starts, for example to give a picture of recent economic health.
Together, they offer a good perspective of where the economy is going, Evans says. But even then, you have to bear in mind that economic forecasts can only offer qualitative measures, not precise details.
Saul Eslake agrees. Data-based forecasts are not good at pinpointing turning points, he says. Economists might be able to tell when a particular sector of the sharemarket is overheated, for example, but getting the timing and extent of the correction right is virtually impossible. There are a lot of self-proclaimed gurus usually selling investment newsletters of some type who say they called the date of a particular event correctly, but when you check back through their forecasts you usually find that they have been saying the same thing for a long time. It’s the sort of accuracy associated with a stopped clock: it’s correct if you look at it at the right time of day.
It would be dangerous for someone in business to treat any economic forecast as gospel. It’s an art, not a science. Forecasts should be used as a guide and a supplement to your own business judgment, not as a detailed road map.
Fair enough, but William Sherden points to a branch of forecasting that, he believes, has done much to undermine the credibility of the economic profession as a whole: the proliferation of sensationalised even histrionic doomsday predictions.
The publication of books that forecast economic calamity is a micro-industry unto itself, he says. They are often based on parallels with the period leading up to the Great Depression, or on long-term economic cycles. This level of belief comes close to superstition, akin to astrology and numerology. The books might be best-sellers, but the prophecies never come true.
Given all this, it might be possible to posit an inverse relationship: the more certain and infallible an economist claims to be about their forecast, the greater the wariness with which it should be approached. Think of it as the Third Law’ of economics. It means that, for the person in business, the best asset when looking at the future is an informed but cautious eye.
Australian web sites providing economic forecasts for business:
- ANZ Bank: www.anz.com go to ‘Economic Briefs’.
- Australian Chamber of Commerce: www.acci.asn.au go to ‘Surveys’ for information on overall business expectations, views of the small business sector, investor confidence, industrial trends, and the political outlook.
- Australian Industry Group: www.aigroup.asn.au go to ‘Ai Group economics’ for information on the performance of Australia’s manufacturing and construction sectors and economic forecasts.
* The Fortune Sellers: The Big Business of Buying and Selling Predictions , William Sherden, Wiley, 1998. Chapters three and four look specifically at economic and financial forecasting.
Data from Westpac/Melbourne Institute surveys.Visit: ww.melbourneinstitute.com