The Perils of Economic Forecasting in Uncertain Times

Economist Ezra Solomon said, „Astrology is the only function of economic forecasting to be respected.” once said. It seems less respected today as practitioners try to minimize the fallout from a number of shocks, including the pandemic, the war in Ukraine and the changing geopolitical landscape.

Bank of England Governor Andrew Bailey knows this all too well. As the central bank raised interest rates by 25 basis points on Thursday, he faced several questions about the bank’s big upward shift in its growth and inflation forecasts. Economic forecasting is indeed an inexact science; But the biggest revisions don’t promise the public to know what central bankers are doing.

It’s not just the BoE. Both the US Federal Reserve and the European Central Bank have also missed their inflation forecasts, especially since the start of the pandemic. The International Monetary Fund has also cut its recent growth outlook. Given the role that forecasts play in informing the decisions of investors, households and policymakers, accuracy is critical. For central bankers, a decent forecast record is also important to build credibility More confidence Helps stabilize inflation expectations.

Recent criticisms of false predictions should be tempered. Economists face a world of extraordinary uncertainty starting in 2020. They had to take positions on epidemiology, war scenarios, supply chain changes, and rapidly evolving domestic and international policies. Another element is the limited public understanding of what the predictions actually mean. They are based on judgments made at a particular point in time. As new data comes in, those judgments must be readjusted. They should be considered pointers, not gospel truth.

Economists still have some questions to answer. Central bankers have been slow to raise rates when inflation picks up in 2021, sticking to the notion that price pressures are „intermediate.” There were misjudgments on the effects of fiscal stimulus, how sustainable inflation expectations were, and the damage to supply caused by the pandemic, which contributed to monetary policy makers lagging behind inflation. Low inflation in the previous decade lulled them into a false sense of security. Mistakes have also been made during the rate hike cycle. Both the BoE and the ECB fail to understand how sticky food inflation can be.

Forecasting can be enhanced in a few ways. Recent shocks underscore the importance of specializing beyond the economic profession. Economists should also continue to explore how advances in big data, machine learning, and AI can provide opportunities to improve economic analysis and better model complexity.

Improving how forecasts are communicated, especially in times of uncertainty, is essential. Displaying projections under different scenarios can help you gain a deeper understanding of the range of possible outcomes. Likewise, although central banks try to highlight the probability distributions surrounding their forecasts, they can be communicated in a more accessible way.

Above all economists need to be clear in setting out how and why their key judgments have changed between forecasts – and how that affects the numbers. A greater effort to show how they arrive at their forecasts would go some way to building confidence and normalizing the understanding of economic forecasts as reference points rather than forward. After all, the famous economist John Maynard Keynes is often credited – perhaps incorrectly: „When the facts change, I change my mind. What do you do?”