How to read economic forecasts correctly
20 February, 2015
A client recently questioned how forecasts prepared by different analysts and economists could vary so much, given they all base forecasts on the same set of information.
I was about to deliver my standard line that forecasters are there to make astronomers look good but then I thought, 'don't be glib, forecasters do have a role and we should learn to use their predictions to good effect'.
Economic forecasts are an essential part of planning. Companies don't know how much product they are going to sell in the coming year but they still need to plan. They need to make some assumptions, predictions or just plain guesses re demand for each of their products in each of their markets. Without these assumptions, targets become meaningless. You have to start somewhere.
The 'somewhere' this year seems to be more straightforward than in past years. Judging by the economic forecasts we have seen so far, the more or less consensus view is that global economic growth will be similar to last year but China and India will grow strongly because they are big beneficiaries of the plunge in the oil price while Russia will be hurt by it.
But here's the thing about forecasts. While the rate of economic growth around the world may indeed fall within the forecast range, nobody predicted the oil price plunge which has become one of the most important factors used to arrive at that forecast range.
Economists should be able to review such things as consumer and business confidence, unemployment and the overall supply and demand of products and services to figure out whether the economy is going to grow, remain flat or shrink.
But they can't predict unforeseen influences that can derail the most successful forecaster — natural disasters, political upheavals, epidemics and changes in social patterns and behavior.
While numbers are numbers, neither economic analysis nor financial analysis is an exact science. The quantity of data that needs to be considered can be immense. There are 45,000 sets of economic data released annually by the US government alone.
In economies, as in companies, any forecaster must also take account of the 'x' factor, the unpredictable or unknown influence that could see a forecast completely wrong.
The other factor that introduces variability is the philosophy or attitude of the forecaster. That is important and must be considered when deciding whether a forecast can be relied on. Forecasts are like the forecasters' offspring — they often resemble their parents.
Some of us are natural optimists who are prepared to believe good things are possible in the future. Others are naturally cautious and reluctant to give the benefit of the doubt. These attitudes will affect us when we are forecasting a company's profit growth or predicting the strength of an economy.
Some commentators seem to enjoy issuing warnings about the hard times that lie ahead. The joke about the forecasters who predicted 10 of the last five recessions has its basis in truth...
Since 1990, economists have forecasted only two of the 60 technical recessions that have occurred around the world. Even the OECD has admitted that its US GDP growth forecasts were wrong 28 times in the past 30 years. Similarly, analysts making profit forecasts are influenced by their own philosophy or attitude — typically by being too optimistic. A study in the Journal of Business Finance and Accounting in 2011 showed persistent evidence of prediction errors as large as 36 per cent and consistent over-optimism in earnings growth forecasts.
Not all forecasts are created equal. Among the thousands of economists and forecasters, some have shown outstanding accuracy. There are lists released each year acknowledging those individuals and teams with the most accurate forecasts. It should be noted the lists are relatively short and different names can appear each year!
Forecasting is an imperfect science but knowing the track record of a forecaster's picks and having an idea of their personal disposition can point to whether they will be accurate. We shouldn't dismiss all forecasts but we should be critical.
As philosopher Henri Poincare said: "It is far better to foresee, even without certainty, than not to foresee at all."