The Next Forecasting Error

Economic forecasting can be a stab in the dark. With hindsight however, much of the inflation forecasting error relates to underestimating the initial shocks, not modelling flaws. Criticism of central banks is common, but let's focus on understanding the underlying, rather than arguing about the superficial.

In the dynamic realm of economic forecasting, errors are common, and recently, attention has gravitated towards inflation predictions due to widespread and unusually large deviations. Initially, forecasts adjusted gradually to increasingly higher peak inflation. As the tide turned, predictions retreated, but not without emphasizing risks of persistence above normal levels. Some attribute this to modelling flaws; I believe it's rooted in the severe underestimation of the initial shock and careless economics.

It seems we've now come full circle. Sub-2% inflation forecasts are becoming more comon. Central banks, still scarred, hesitate to fully acknowledge this, perhaps to avoid validating market expectations of imminent rate cuts. In my perspective, rear-view forecasting prevails, as we grapple with imagining a future significantly different from our recent past.

With hindsight, there hasn't been a glaring failure in framing and understanding the shock. The initial energy shock, though larger than anticipated, eventually unfolded as predicted, causing a negative term of trade shock to energy-importing economies (such as the UK and EA). Real wages fell, and activity slowed. Central banks reacted promptly, frontloading rate hikes to cap inflation expectations and contain accelerating wages in tight labor markets. While there were variations in timing and speed, the monetary tightening (rates, balance sheet, and capital ratio) was decisive.

With hindsight, there hasn't been a glaring failure in framing and understanding the shock. Monetary policy worked, Fiscal policy too!

Fiscal policy played a pivotal role in mitigating the impact of higher energy costs and monetary policy tightening. Excess savings from the pandemic allowed mortgage holders to cope with increased borrowing costs, while targeted income support shielded low-income households. In the US, lax fiscal policy facilitated a stronger economic rebound than elsewhere.

Yet, commentators seem mired in minutiae, fixated on semantics and technicalities. Central bank communication drew scrutiny. But despite missteps, such as BoE Governor A.Bailey and Chief economist H.Pill stoking rate hike expectations ahead of the November MPC, only to vote for a status quo, the Bank hike a month later and still acted decisively thereafter. The ECB's forecasts may be underwhelming, but the Governing Council delivered when necessary. Yes, Fed’s soft-landing rhetoric may have been misleading at the time, but who cares today?

While constructive criticism is welcome, the prevailing consensus that central banks are dysfunctional fails to inspire. Central banks operate within specific institutional and informational confines, unable to cater to everyone's needs in every circumstance. This underscores the importance of market analysts, journalists, and academics in improving common understanding and facilitating informed decision-making.

Consider, for instance, the growing pressure for Central Banks to produce scenarios and highlight risks around their central forecast. What would that be good for? scenarios already exist everywhere in the form of individual forecasts. And Central Banks already publish extreme scenarios, labelled stress tests, often unnoticed (unless you’re a risk manager). And even though, the human brain seems wired to average different outcomes and focus on the most likely, rather than embracing multiple radically new possibilities.

Not all predictions are born equal: forecasts, projections and views have each their own context depends merits

it is crucial to maintain perspective on the nature of these predictions.

- Forecasts by larger institutions or think tanks aim to be as comprehensive as possible. Accordingly, they rely on large models, have built in structural stability (equilibrium models) or complexity (Agent based model) and may include future policies. Despite their limitations, they are our best theoretical effort to forecast what can be.

- Projections are a simpler version, relying on statistics and accounting to project variables into the future based on minimalistic inputs. Projections are often used to compile population growth, based on static mortality, birth and immigration rates.

- Views, prevalent among sell-side economists, are not strictly based on modelling and may diverge from economic regularities or actual data. They serve as a way to explore alternatives and position oneself relative to the consensus.

More often than not, a forecast is a stab in the dark

Each approach carries its own merit, albeit context-dependent. There are instances when forecasting are a stab in the dark. However, even in such uncertain terrain, a meticulous economic framework enhances understanding, enabling the exploration of possibilities while steering clear of glaring errors.

The 2024 outlook has evolved significantly: inflation is less of a concern, markets anticipate central bank cuts, and a soft landing seems plausible. Despite political and geopolitical uncertainties, discussions about the future of financial markets and the world economy remain captivating. Asking the right questions is crucial. Does the future level of interest rates hinge more on inflation or trend growth? When did discussions about productivity fade? Are forecasts of persistent inflation driven by structural changes or relative price adjustments?

I’d say that is a better use of our time than argue about the the number of scenarios central banks should publish.

Happy 2024!

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