For Good Economic Forecasts, Try Flipping a Coin

For Good Economic Forecasts, Try Flipping a Coin: Caroline Baum

Commentary by Caroline Baum

Aug. 2 (Bloomberg) -- By the time the Bureau of Economic Analysis releases its first estimate of the previous quarter’s gross domestic product one month after quarter-end, economists have honed their forecast, if you can call it that, to within a few of tenths of a percentage point of the actual number.

Like the statisticians at the BEA, private-sector economists rely on monthly reports on consumer spending, housing and business investment to compile their estimates. They have less complete information on international trade and inventories. In many cases, their models fill in the blanks.

At post-time on Friday, economists surveyed by Bloomberg News were handicapping second-quarter growth at 2.6 percent, down from a median estimate of 3.3 percent a month ago, before the data releases turned sour. The report showed a 2.4 percent annualized increase in real GDP last quarter.

Not bad for a forecast. Not great for what is really an “accounting exercise,” said Michael Bryan, senior economist at the Federal Reserve Bank of Atlanta and co-author of a 2007 study, “Mirror, Mirror, Who’s the Best Forecaster of Them All?”

How do economists fare when it comes to real forecasting, to predicting GDP growth and inflation one year out? About as good as a coin toss, according to Bryan’s research. Less than half the economists did better than the “naive” forecast, which is based on no understanding of the economy and merely assumes next year’s outcome will be the same as this year’s. It’s what you’d expect if the results were purely random.

Job Justification

The study looked at economic forecasts from the 64-year-old Livingston Survey, now under the aegis of the Philly Fed, during the period from 1983 to 2006. It was conducted by Bryan and Linsey Molloy when both were at the Cleveland Fed.

Contrary to appearances, Bryan isn’t trying to talk himself out of a job.

“My job is economic forecasting,” he said in a telephone interview Friday. “My boss could say to me, ‘OK, you’ve demonstrated that economic forecasts aren’t very good. Why do we pay you money?’”

Good question. Bryan said it’s not just about getting the number right. “It’s about the narrative.”

That’s what I’m interested in as well. In my line of work, I talk to lots of economists. I don’t particularly care if they missed the last three monthly reports on retail sales ex-autos by 0.6 percentage point or got the direction of weekly jobless claims right.

Fooled by Randomness

I’m interested in the Big Picture, in how they see the world. I want to know their views on what drives growth and inflation; on where they see a role for government in the economy; on when the U.S. public debt will become so large that foreigners dump the world’s reserve currency; on why we should expect our children to be better, or worse, off than their parents; and on how we can fulfill our promises to the elderly without imposing unsustainable burdens on the young.

I want to hear a plausible scenario, based on what we know and what we expect, for how things are going to play out in the U.S. and on the global stage. Getting the number right is a job for an accountant. Putting that number in the context of a larger trend is a job for an economist.

So I’m not sorry, or even surprised, to learn that the median forecast for GDP was “accurate,” which Bryan defines as within 0.5 percentage point of the realized outcome, only 30 percent of the time. (The group did a bit better forecasting inflation, with a 39 percent accuracy rate.)

Sure, some economists outperform the consensus in any given year, but that advantage is unlikely to be sustained, “at least no more than random chance would suggest,” Bryan said.

Something for Everyone

Which brings us to last week’s something-for-everyone GDP report.

The pessimists can point to the 27.9 percent annualized increase in residential investment, which isn’t likely to be repeated now that the homebuyers’ tax credit has expired and home sales plummeted to new lows.

The optimists can highlight the 21.9 percent jump in business investment in equipment and software and the 4.1 percent increase in final domestic demand as a sign the economy is on the mend.

And both groups can find support in the 9.2 percent increase in federal government spending last quarter: It’s either a sign the stimulus is working (federal spending added 0.72 percentage points to growth) or a harbinger of slower growth as the government consumes an ever-larger share of the economy.

The consensus GDP forecast, gleaned from both optimists and pessimists, was a slim 0.2 percentage points off the mark. Not bad for rear-view mirror forecasting. If you want something more forward-looking, it’s as easy as heads or tails.