Failing at Economic Forecasting

29 June 2017 | by Sean Stannard-Stockton, CFA

“He who sees the past as surprise-free is bound to have a future full of surprises.” – Amos Tversky

We’ve written a lot about how we focus on analyzing individual companies and spend a lot less time thinking about economic forecasts. There’s a certain type of investor who takes an odd sort of pride in seeming to be oblivious about economics. That’s not us. While we don’t work hard trying to forecast the economy, we spend a lot of time trying to understand the current condition of the economy and the range of ways the economy might evolve in the future.

Understanding how the economy works and the economic context in which you’re making investments is important. For instance, investing in a capital equipment company after many years of strong economic growth is very different from investing in the same company in the midst of a recession. While you might not be able to predict next year’s GDP growth, understanding where the economy has been, where it is, and the range of possible futures that might unfold are an important part of our investment process.

But why don’t we seek to accurately forecast the economy? Wouldn’t it be great if we could guess how GDP would grow, what the rate of unemployment will be, whether inflation will pick up or where the Federal Reserve will set interest rates? Well, yes. That would be kind of great. But the fact is, it isn’t possible.

The Federal Reserve gets a lot of grief from investors. A lot of people disagree with their policies. But regardless of your opinion of the Fed, the fact is the Fed is made up of some of the most highly educated economists, has massive resources to study the economy, and even has access to highly valuable data and information that is simply not available to private investors. Yet by the Fed’s own admission, they are simply terribly at making economic forecasts. It isn’t just that they’ve overestimated the rate of economic growth since the financial crisis, its that for the last 20 years they’ve made large, systematic forecast errors.

Below is a chart showing the Fed’s forecasts as of September 2016 along with bands that show the “typical range of possible outcomes based on accuracy of forecasts over the past 20 years”.


Source

The shaded bands are meant to capture the range of outcomes that will occur 70% of the time based on the Fed’s forecasting accuracy and their current projections. Fully 30% of the time, the actual economic outcomes will land outside of these already wide bands.

So the Fed’s forecasts for real GDP growth over the next couple of years is about 2%. But based on their historical accuracy, we know that this forecast simply means that real GDP growth has a 70% chance of being between 0% and 4%. There’s a 30% chance it will actually be worse than 0% or better than 4%. In other words, the Fed is telling you that based on their incredibly exhaustive research on economic conditions, they expect the economy to produce results somewhere between a recession and an economic boom, but there’s about a 1 in 3 chance that things will end up even better or worse than that already huge range of outcomes.

It isn’t just GDP that’s hard to predict. The Fed expects the unemployment rate to end up between 2.5% and 6.5%, and inflation to be between 1.0% and 3.0% (with a 30% chance that each indicator will fall outside that range). The Fed can’t even predict what the Federal Funds rate will be, despite the fact they set the Fed Funds rate themselves! While they forecast it to be about 2.75% in 2019, their historical forecasting accuracy suggests that means it will end up at some rate between 0% and 5% (again, with a 30% chance it ends up even outside of that wide range).

This by no means meant to criticize the Fed. In fact, I find it rather charming that they report on the size of their forecasting error. The Fed might be bad at forecasting the economy, but its not because they’re bad economists. Its because even the smartest economists in the room can’t forecast the economy.

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