Fed at Issue

Fed @ Issue

The Exercise of Economic Forecasting

Photo of Mike Bryan
Photo by Brad Newton
Mike Bryan is a vice president and senior economist in the Atlanta Fed's research department.
Whenever I give an economic outlook speech, I like to begin by pointing out how notoriously inaccurate economic forecasts are. I usually show the year-ahead predictions of top economists and then report what actually happened. Ordinarily, the predictions aren’t very close. In fact, the standard error for the year-ahead growth forecast is about 1.5 percentage points, meaning that the typical one-year-ahead growth forecast encompasses a range of reasonable possibilities so large that it usually includes the likelihood of both strong growth and considerable weakness.

I can usually count on getting a big laugh at this point, which is partly why I do it. But showing how poorly economic forecasts predict the future makes me feel more honest about whatever economic prediction I'm about to lay on the audience.

And here's another humbling observation: Economic forecasts are especially inaccurate when you need them most—around turning points in the business cycle. Forecasting models have a hard time seeing a recession in the making, and—as in the current environment—they have a hard time spotting when recovery will begin.

It’s not a number, it’s a conversation
So why even bother with economic forecasts? The value of an economic forecast isn’t justly measured by the accuracy of a specific prediction over a specific horizon. The forecast guides a discussion on issues that are crucial to making decisions: What are the key assumptions on which the forecast is based? What is the strength of these assumptions? How does this forecast compare with forecasts based on alternative beliefs? And how do we weigh one forecast path relative to another one? In the case of the Federal Reserve Bank of Atlanta, I think the underlying value of an economic forecast is that it represents the foundation of an important dialogue between the research department and Atlanta Fed President Dennis Lockhart.

So our forecast exercise doesn't rely on just one economic model for our forecast; we run a collection of them. Some of the models we use are purely statistical, some are stripped-down economies, and some are large empirical models. None of these models is likely to be "accurate" in that it consistently produces the best prediction. However, taken as a whole, these models provide guidance about a range of possibilities that influence how a Reserve Bank president weighs policy options.

The current conversation
In recent months, the Atlanta Fed has judged that the incoming data indicate greater economic stability. We've seen signs that financial markets are improving and key markets such as residential real estate are no longer deteriorating. But we remain very cautious in our assessment of the immediate future.

While our forecast shows the recession ending sometime in the third quarter, we see impediments to growth that could cause the economy to bump along the bottom for some time. So while we might soon begin the process of recovery, it might not be a very strong recovery. The key assumptions in this outlook are that financial markets will recover only gradually, consumer spending will remain unusually subdued as households rebuild their savings, and lingering uncertainty about the economy's health will keep a lid on business investment.

Forecasting in the current environment has been made all the more difficult because monetary policy has drifted into uncharted, or maybe imperfectly charted, waters.

There are also a few key issues that are still unfolding and require close monitoring. Perhaps at the top of this list is the state of the real estate market. Has the bottom in home prices been found? How far do home and commercial property prices have yet to fall before they reach a bottom? Another issue is the global economic environment. How sustainable is the recent upturn in the European and Asian economies?

Closely related to these issues is the still fragile state of the financial sector and how financial market dysfunction is likely to prolong the economic recession or weaken a recovery. Atlanta Fed research economists have been working to incorporate financial market dysfunction into a simple dynamic model of the economy.

Clouds amid the clouds
Forecasting in the current environment has been made all the more difficult because monetary policy has drifted into uncharted, or maybe imperfectly charted, waters. With our traditional policy lever—the fed funds rate—now resting at essentially zero, our policies have shifted to include a new set of instruments, many of which are designed to operate beyond the usual channels of monetary policy (see "Snapping Rope and Breaking Bricks," EconSouth, first quarter 2009). The innovative actions taken by the Federal Reserve during this financial crisis are historically unprecedented. From a forecasting perspective, we don't have much experience gauging the impact of these actions on the business cycle.

Difficult or not, the process is about to begin again. I can't say at this time how the new forecast will turn out. But there is one thing I can say with perfect certainty: It's going to be an interesting conversation.