Forecasting? Tell them they're dreaming

From Challenger Chief Economist Dr Jonathan Kearns

Forecasts are critical for anyone who is forward looking including central banks and investors. Unfortunately forecasts are frequently wrong, particularly in the past few years. That does not mean we should stop forecasting. But we should think about the implications of forecast errors.

Private sector forecasters in the United States completely missed the rise in inflation and then consistently expected a faster fall. The latest forecasts have core PCE inflation (the Fed’s preferred measure of inflation) slowing to 2.3% in a year’s time, above but close to the Fed’s 2% target.

Forecasts for US unemployment aren’t much better. Forecasters were too pessimistic on both the size of the rise and speed of the fall. More recently they’ve expected a faster pickup than we’ve seen.

It’s easy to pick on forecasting errors, especially over the past few years. Forecasts are frequently wrong. Sometimes badly. However, errors do not mean a forecast is useless. What matters is what action is taken because of a forecast.?

For central banks that means considering the potential policy action from forecasts. Even if the economic risks around forecasts are symmetric, the policy risks may not be.

With the RBA forecasting that inflation won’t return to the centre of its target until late 2026 – keeping it outside the target for over 4 years – the policy risks are skewed towards inflation exceeding expectations rather than falling below them. In contrast, for say the Reserve Bank of New Zealand with an economy heading back into recession and inflation slowing sharply, the policy risks are skewed to overly tight policy. It’s worth considering the policy risks, and not just the economic risks, when thinking about the likely path for interest rates.