Wednesday, April 4, 2007

How Reliable are Economic Forecasts?

How accurate are economic forecasts?

The “joke” goes put 12 economists in a room and you’ll get 13 different answers. I think it was President Truman who, exasperated at the economic profession, yearned for a “one armed economist” What Truman meant is he wanted an economist who wouldn’t invariable go onto the other point of view. It is the same with economic forecasts ask economists predictions for future house price inflation in the UK and you could get answers ranging from -7% to +10%

Economic forecasting is important. For example it is the basis of the UK’s pre emptive monetary policy. Because there is a time lag in interest rates having a deflationary effect, it is important to be able to predict future inflation. If inflation is forecast to rise then the MPC knows it needs to increase interest rates now to avoid inflation in the future. However if forecasts turned out to be wrong then they could easily increase interest rates too much, causing a slowdown in the economy.

In recent years it has been relatively easy to forecast inflation because it is has been low and has fluctuated by little. However this is not always the case and economists have a bad track record of being able to predict unexpected economic shocks. To give a few examples

* 1929 wall St Crash and great Depression.
* 1990s deflation and low growth in Japan.
* 1997 -01 dot com boom and Bust.

On the other hand there have been economists predicting a major recession in America and with defaults in the sub prime mortgage sector it appears they may soon be vindicated. I have a good friend in America who has been predicting the imminent collapse of the US economy for the past 7 years. I guess at some stage there will be a recession and he will feel vindicated. However this kind of economic forecasting reminds you of the boy who cried wolf. If you predict a recession every year, by the time it comes most people no longer take you seriously.

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