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Chapter 20 Macroeconomic Forecasting: Methods and Pitfalls.

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1 Chapter 20 Macroeconomic Forecasting: Methods and Pitfalls

2 Useful Elements of Macroeconomic Forecasting for Business Managers Unexpected events are, by definition, not predictable. Yet macroeconomics can still say something useful about what happens after these events. Even a totally unexpected shock is likely to set in motion a predictable series of events. To a certain extent, various leading indicators can indicate when trends are likely to shift or be reversed, although no indicator is 100% reliable.

3 What Sorts of Factors Are Predictable? We have mentioned earlier that an inverted yield curve is always followed by a recession the following year. Sales of cars and housing will follow changes in short-term rates with an average lag of about two quarters. Changes in the stock market will affect capital spending with a lag of two to four quarters. Changes in the value of the dollar will affect net exports with a lag of three to six quarters.

4 What Sorts of Factors are Not Predictable? Obviously truly exogenous shocks, such as wars and terrorist attacks. Major fluctuations in energy prices used to have a significant impact on the economy, but as firms learned to hedge against these changes, they now have only a small effect. The impact of changes in income tax rates is mixed. It depends on the phase of the business cycle, whether the changes are seen as permanent or not, and what happens to government spending at the same time. Similarly, changes in corporate income tax rates, including investment incentives, have a mixed record.

5 Macroeconomic Forecasts with Econometric Models Not much used any more They didnt work for several reasons 1. Incorrect underlying theory 2. Instability of underlying relationships 3. Errors in econometric method 4. Inadequate and incorrect data 5. Tendency to cluster around the consensus forecast 6. Inability to predict exogenous events 7. Erroneous assumptions about policy variables

6 Are Econometric Model Forecasts Likely to Improve? Suppose these errors were fixed. Would the models work any better? Probably not. Monetary and fiscal policy have generally improved to the point where future recessions are likely to be caused by exogenous shocks, which by their very nature are unpredictable. If it appeared likely that a recession would occur the following year, the Fed would probably take steps to ward off the downturn. As a result, this chapter focuses on non-econometric methods of prediction

7 Non-econometric methods of forecasting Consensus forecasts Financial market surveys Leading indicators Surveys of consumer expectations Surveys of manufacturing activity Surveys of capital spending or inventory planning

8 Consensus Forecast Best known is Blue Chip Economic Indicators, other surveys give approximately the same results. For real GDP and the inflation rate, have about the same errors as a naïve model that says the change this period will be the same as the change last period. Has missed all the recessions.

9 Surveys of Upcoming Indicators They are often seen in the financial pages and screens these days. Surveys are designed to predict upcoming monthly and quarterly indicators. Obviously you cant make any money trading on this information. Chasing a will o the wisp. Preliminary data themselves are random. Dont waste your time. Even if some brilliant financial analysts actually found the key to predicting (say) employment or inflation, they certainly wouldnt tell the rest of the world about it.

10 Leading Indicators As previously mentioned, never miss a recession (unlike the consensus) but have predicted several downturns that never existed. Nonetheless, they should not be ignored. This index did a very credible job of predicting the 2001 recession at a time when most economists missed it.

11 Leading Indicators, Slide 2 Isnt it possible that not all components of this index are created equal, and some are better than others? In that case, why not follow the better components and ignore the poorer indicators? To answer this question, lets look at what is included in the leading indicators.

12 Components of Leading Indicators. 1. Length of workweek for production workers in manufacturing 2. Average weekly initial unemployment claims 3. New orders, consumer goods and materials 4. New orders, nondefense capital goods 5. Vendor performance (percentage of firms reporting longer delivery delays) 6. Building permits 7. S&P 500 index of stock prices 8. Real M2 money supply 9. Yield spread between 10-year Treasury note yield and the Federal funds rate 10. Index of consumer expectations (University of Michigan)

13 Leading Indicator Components, Slide 2 Some of these are outdated. The M2 money supply is not closely correlated with economic activity any more, and loans and credit are coincident indicators. New orders would appear to be a valid leading indicator but because of shorter delivery times, it too has become a coincident indicator. Similarly, improvements in inventory planning and control means vendor performance (delivery delays) is no longer relevant. Length of the workweek is dominated by random events and has little information content in the short run. That immediately eliminates (1), (3), (4), (5), and (8). How about the other five components?

14 Leading Indicator Components, Slide 3 Initial claims. A valid leading indicator. But look at the 4-week moving average, not the actual weekly stats. Building permits. Monthly data tend to be distorted by weather conditions, so you need to look at 3 consecutive months Yield spread; we have already shown that is an important and useful indicator Stock market and consumer expectations will now be examined separately.

15 Stock Market as a Leading Indicator Until 2001, worked quite well in anticipating downturns, but major declines in 1962 and 1987 were not followed by recessions. In 2000, market peaked in March, but almost matched those highs again in September. Either way, that was a valid signal since the recession did not start until 2001. The upturn in October 2001 gave only a 1 month lead, far less than the previous average of 5 to 6 months. More serious, the severe downturn in 2002 was not followed by another recession. Earlier in the previous decades, substantial dips in 1994 and 1998 were not followed by recessions. Scorecard: over the past decade, 2 right, 3 wrong. Use with extreme caution.

16 Consumer Expectations as a Leading Indicator Same general idea. Doesnt miss recessions, but gives too many false signals, including 1992 and 1994. Double-dip in 2001 a confusing signal, although 9/11 presumably not part of the usual pattern. Decline in late 2000 and sharp recovery in late 2001 were both valid indicators. Worth watching, but be careful of false signals.

17 Industry Surveys: ISM The Institute for Supply Management, formerly known as the National Association of Purchasing Managers, issues a closely followed monthly survey. It contains several components, including individual series for production, orders, and employment, but the overall index is the most closely followed. Used to emphasize trends in inflation, but obviously that is not a major issue lately.

18 ISM Survey, Slide 2 Gave a valid signal for the downturn in early 2001 and the upturn in late 2001. Major problem with this index is it generally gives very short lead time signal, or no signal at all. Attempts to disaggregate and use only the leading indicator components have not worked. Even with short lead time, worth following so you dont miss the recession or recovery when they do start.

19 Other Surveys Regional Federal Reserve Bank surveys of economic activity in those regions. Regional ISM surveys Help wanted and employment hiring surveys Weekly index of consumer sentiment For the most part, these have not passed the market test in the sense they are ignored by financial market traders because they do not contain enough useful information.

20 Copper Prices An old saying has it that Dr. Copper is a better predictor than 95% of PH.D. economists. Did a credible job of predicting the downturn and upturn in 2001.

21 Summary: What to Follow 4-week moving average of initial unemployment claims Yield spread (when inverted) Index of consumer expectations ISM overall index Commodity prices, especially copper Please note: list does NOT include stock market Good luck! Forecast at your own risk.

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