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The Economy Rarely Takes Direction from Forecasters

Top of the Ninth

September 1, 2001


The Economy Rarely Takes Direction from Forecasters

Economists state their GNP growth projections to the nearest tenth of a percentage point to prove they have a sense of humor.

—Edgar R. Fiedler

There is always considerable interest in the economic outlook, and that interest has intensified given the current slowdown. I am inevitably asked in public settings to provide a short-term forecast of the economy and, more specifically, to identify the month or quarter when growth will accelerate. While I sometimes comply, my sense is that the difficulty of responding to these requests is not generally recognized.

Let me review some recent history, which serves to put the issue of accurate short-term forecasting in context. In the second half of 1999, the U.S. economy expanded in excess of 7 percent at an annual rate, a truly remarkable performance. The rate of growth was more than twice what the Blue Chip consensus of economic forecasters had predicted at the onset of the period. Then, in the first half of 2000, the economy grew about 5 percent (annual rate), a rate that again was about twice what the consensus had predicted. After these positive surprises, over the past four quarters growth has diminished to just over 1 percent on average. Although forecasters anticipated a slowing, the deceleration that has occurred was about twice as bad as the consensus had predicted.

There is a lesson in these errors, and it is that accurate near-term forecasting of U.S. economic performance is a difficult, and ultimately humbling, task. Errors over just the past two years have been enormous. Neither business economists nor policymakers nor academics have a distinguished track record.

It is not entirely clear why short-term forecasting remains so challenging. It may be partly because the economy is buffeted with shocks that are hard to predict. For instance, it was difficult to foresee much in advance the spike in energy prices and their subsequent decline. And it may be partly because the performance of the economy rests on the moods of producers and investors, and moods can turn on a dime. It seems like the stock market and business investment went overnight from an aura of optimism and expansion to one of pessimism and contraction.

As economic circumstances changed, an inventory-correction process was set in motion. This process has been restraining business activity, but we do not know how long it will take for inventories to reach desired levels. The correction process began earlier in some sectors of the economy than in others, it has proceeded more rapidly in some sectors than in others, and demand has recovered relatively more quickly in some sectors, to illustrate just a few of the complexities involved in analyzing the economy at the moment.

Because of the lags in monetary policy—that is, the time between policy actions and their effects on the economy—policymakers must give short-term forecasts of the future path of the economy serious consideration. At the same time, experience teaches that it pays to keep an open mind about forecasts because they are inevitably erroneous, occasionally by substantial margins. The limitations of forecasts make it difficult, other things equal, to pursue preemptive policies and, indeed, it is tempting to advocate policy caution under almost all circumstances. But excessive caution could lead to paralysis, an outcome that so far the Federal Reserve has avoided. Perhaps the saving grace is that monetary policy is inherently very flexible, and thus we can change our policies, or our minds, as incoming evidence on the economy helps us estimate the size of our forecast errors.