1. Maurizio Bovi Are the Representative Agents Beliefs Based on Efficient Econometric Models? Brussels 15 November 2012 EUROPEAN COMMISSION DIRECTORATE GENERAL ECONOMIC AND FINANCIAL AFFAIRS EU WORKSHOP ON RECENT DEVELOPMENTS IN BUSINESS AND CONSUMER SURVEYS

2. 2 Plan Motivation: several assumptions but little evidence on how laypeople form expectations Occasion: Real-Time Data thanks to BoE, Survey Expectations thanks to European Commission Data Analysis: Survey: Heterogeneous expectations as Signal/Noise Ratios (SNR) Real Time Hard Data: Econometric models and MSE horse race Contributions: i) Representative agents expectations may be not grounded in optimal econometric models ii) VAR Analysis of the Expectations Feedback System (beliefs realizations) resulting in: SNR => MSE Concluding Remarks and a Tentative Agenda

3. 3 Are the Representative Agents beliefs based on efficient statistical models? People form rational expectations (Muth, 1961): agents know and use the same true model. People learn the correct model (Evans and Honkapohja, 2001): agents act as econometricians and relentlessly estimate models. People are infected by professional forecasters models (Carroll, 2003): economists produce forecasts => mass media report forecasts => (more or less frequently) people read forecasts. People use the model with the highest fitness (Brock and Hommes, 1997): People examine different forecasting models switching from one model to another after a cost-benefit analysis based on relative mean squared errors. Model uncertainty (i.e. the kind of the optimal model changes with high frequency), preferences and inertia in the dynamic switching can create heterogeneous expectations (even to a greater extent wrt sticky information, Branch, 2004 & 2007).

4. 4 Issues People form rational expectations (Muth, 1961): Several authors find evidence rejecting this assumption. People act as smart econometricians (Evans and Honkapohja, 2011): This is the typical assumption maintained by the adaptive learning literature. Finding evidence on that is one of my goals. People are infected by professional forecasters (Carroll, 2003): If so, why household surveys are still among the most watched market movers even among professional forecasters? Predictor Choice Approach (Brock and Hommes, 1997): To be able to calculate the relative success of their own choice, agents must know the success of all competing models: individuals have already paid the computational cost. Then, the question can be asked whether the determinant of the choice should deal with forecasting accuracy only. Also, preferences towards a single model are at odds wrt both the dynamic switching and learning activities.

5. 5 Alternative Views on the Expectations Feedback System Pigou (1927), Keynes (1936), Simon (1957), Tversky and Kahneman, (1974) Psychology matters and not-econometrically-based factors is what surveys could/should capture (Katona, 1944, 1975; Bovi, 2009) Ludvigson (2004) additional Many empirical papers have been looking, with some success, for the additional information content of survey expectations, whereby the adjective additional stands exactly for extra economic elements and/or independent information Cass and Shell (1983) Heterogeneous beliefs – e.g. in models with self-fulfilling prophecies sunspot equilibria - can drive macroeconomic outcomes.

6. 6 Key Questions and Logic Are representative agents (=>laypeople) beliefs based on optimal econometric models? Do heterogeneous beliefs Granger-cause the predictive power of efficient econometric models, or vice versa? Here the logic: Think about an economy whereas a simple model turns out to be the best predictor for many years, but survey-declared expectations do not converge. Think about an economy whereas evidence points out that SNR precede MSE, but not vice versa. All in all, the general validity of assuming best model-based expectations would be weakened.

7. 7 2. Survey Data Source: Business Surveys Unit of the European Commission Sample Period: January 1985 – March 2009 (simple mean for quarterly data) Features: No genuine panel (bad), continuously refined (good), Laypeople (good: it is likely that economists use econometric models to forecast) Query: How do you expect the general economic situation in the country to develop over the next 12 months? Reply Options: It will… …get a lot better (=LB); …get a little better (=B); …stay the same (=E); …get a little worse (=W); …get a lot worse (=LW); don't know (=N). LB, B, E, etc., are the shares of respondents having chosen the corresponding option so that they sum up to one.

8. 8 2.1 Survey Expectations Signal/Noise Ratios

9. 9 2.1aSurvey Expectations Signal/Noise Ratios

10. 10 2.1b Survey Expectations Signal/Noise Ratios Unlike the previous methods, the IQV does not account for the ordered nature of the data.

11. 11 2.2 Survey Expectations and Reality

12. 12 3. Real Time Data When comparing econometric models and survey expectations, the former should be estimated in real time (and known by the representative agent: VAR before 1980?) Why? Because otherwise one is assuming that representative agents use information which will be available only in future dates or that they have remarkably good foresight about data revisions Trivial? Not so much: attention to actually available data is becoming widespread in the literature only recently (Croushore, 2010). As for the techniques, sometimes laypeople are asked to act as leading econometricians.

13. 13 3.1 BoE Real Time Data Set Real GDP: the first disposable vintage (released in 1976Q1) covers the period 1955Q1-1975Q4, the second was published a quarter later and covers the period 1955Q1-1976Q1... the last release I use here covers the period 1955Q1- 2009Q1 Prices (GDP and Private Consumption Deflators): the first release includes data from 1970Q1 to 1989Q4 (released in Jan. 1990)… the last 1970Q1 to 2009Q1 Interest rate (3M Treasury Bill Rate): no data revision, available since 1957Q1

14. 14 3.2 The Competing Models All models estimated recursively, AR and VAR models via rolling regressions, too

15. 15 3.3 Real-Time Estimation I sequentially estimate the mentioned models using real time data: Example: in 1976Q1 (=t+1) the very first y t time series, running from 1956Q1 to 1975Q4 (=t), is made available. The 1 st four-steps-ahead prediction refers to 1976Q4 (=t+4). To compare this with its realization we have to wait until 1977Q1 (=t+5), when the actual data for 1976Q4 is eventually released. According to survey and hard data availability, Univariate models generate 97 recursive forecasts, from 85Q1 to 09Q1 VAR models produce 74 recursive forecasts, from 90Q4 to 09Q1

16. 16 3.3a Real-Time Estimation AE model. Each quarter grid search over all (0,1], with step size 0.04, choosing the value of gamma that minimizes the squared forecasting errors. Rolling windows estimation: Minimum window size = 32 quarters; Max window size = 56 quarters. So, to find the optimal (MSE-minimizing) window size, I perform 24 separate rolling regressions for each (non naïve) model.

17. 17 3.4 Real-Time Forecasting Metric To mimic the forecasting exercise elicited in the surveys, I forecast the next twelve months, computing the quarterly squared errors as follows: MSE t+5 = ( t+5 y t+4 – t+1 y e t+4 ) 2 where: y t = (GDP t -GDP t-4 )/GDP t-4 t+1 y e t+4 = Expected value of y in t+4 based on the vintage released in t+1 t+5 y t+4 = Actual value of y in t+4 as reported by the vintage released in t+5 Due to data availability, the first useful squared error is MSE 85:Q1 for univariate models MSE 90:Q1 for multivariate models

18. 18 3.5 Real-Time Econometric Models Forecasting Ability Model 85Q1-89Q490Q1-96Q296Q3-02Q403Q1-09Q190Q1-09Q1 RW 3.735.341.734.313.8 AE 1.172.490.423.092.01 AR1 1.985.110.983.723.27 AR1 rolling 1.83.520.93.712.73 VARPC1 (y, ) NA6.641.454.244.11 VARPC1 rolling NA4.291.273.793.12 VARPC2 (y, ) NA7.071.664.564.43 VARPC2 rolling NA3.711.343.742.94 VAR1 (y,, r) NA6.973.165.825.32 VAR1 rolling NA4.11.013.122.75 VAR2 (y,, r) NA6.523.185.985.24 VAR2 rolling NA3.450.953.482.64 Sample averages of the MSE of the corresponding models

19. 19 Naive Expectations Forecasting Accuracy (MSE) as a Proxy of the Great Moderation

20. 20 3.6 Relative Forecasting Ability wrt RW t-stat of the constant term in the (MSE_J-MSE_RW)=const regression. When a curve is below the -1.69 horizontal line (indicating the 5% p-value), then the corresponding model J dominates the benchmark.

21. 21 3.6a Relative Forecasting Ability wrt AE t-stat of the constant term in the (MSE_J-MSE_AE)=const regression. When a curve is below the -1.69 horizontal line (indicating the 5% p-value), then the corresponding model J dominates the benchmark.

22. 22 Upper Panel: correlation(SNR t-i ;MSE_AE t ); Lower Panel: correlation(SNR t ;MSE_AE t-i ) i=0,…,12. NB: Correlations within (-0.2;+0,2) are statistically zero.

23. 23 4.Where Do We Stand? So far, we have: Twelve time series made up by quarterly MSE (85/90Q1-09Q1) pointing out that the AE model outperforms all the others all the times. Despite of that: Five quarterly signal-to-noise ratios (85Q1-09Q1) point out that great variety in expectations exists and persists. Then: SNR and MSE seems to co-move according to SNR => MSE. This calls for more formal tests. Specifically, I estimate a battery of bivariate VAR made up by one SNR and one MSE (stemming from the best model) in order to perform Granger, FE variance decomposition and Geweke tests

24. 24 4.1Granger Causality

25. 25 4.2No Instantaneous Feedback

26. 26 5Comments on Results Granger-causality, Gewekes instantaneous feedback and VD tests: Past, present and future values of MSE are not a determinant of the dispersion across agents' expectations. Instead, Divergent expectations significantly affect the forecasting accuracy of optimal econometric models. Then, interpreting the MSE as a proxy of volatility, Disagreement across laypeoples expectations Granger-causes macroeconomic uncertainty, but not vice versa. These outcomes are in line with the literature on the extra information content of the surveys, and contrast with some of the assumptions behind i) the adaptive learning, ii) the predictor choice, and iii) the epidemiological frameworks.

27. 27 5a. Comments on Results Negative correlations A more perturbed signal coming from the surveys leads to: i) higher model-based MSE; ii) greater macroeconomic uncertainty No model uncertainty, but high and persistent disagreement Evidence strongly indicates that a relatively simple AE predictor outperforms all the other proposed models all the time. Evidence strongly indicates that laypeople expectations are persistently heterogeneous. Results are robust to several SNR and models, including univariate and multivariate models even estimated via optimal-size rolling windows.

28. 28 6 Concluding Remarks Should heterogeneity depend on model uncertainty only, UK citizens expectations should likely converge Should lay consumers expectations be best-model-based, then SNR i)should not significantly help predict optimal model-based MSE and ii)should not follow univariate processes wrt past information about MSE Since data show opposite findings, then there must be some additional explanation behind the formation of disparate expectations The identification of these disagreement-widening factors is in my research agenda

29. 29 THANK YOU!