Wednesday, September 21, 2005

Why economists shouldn't forecast

Hindsight provides an opportunity to learn from our mistakes.

Ideally, we learn enough about our mistakes never to repeat them again.

Economists who make forecasts disagree: The past is in the past. The future is different and uncertain. It's hard to disagree with that. After all, economists know what they're doing, right?

Not quite.


Over a year ago I wrote about the assumptions economists need to make. The International Monetary Fund has just published its World Economic Outlook, with it's regular section on assumptions (pdf, p.viii).

In 2004, the IMF made the following assumptions about oil prices:

"... the average price of oil will be $30.00 a barrel in 2004 and $27.00 a barrel in 2005, and remain unchanged in real terms over the medium term." (viii)

These levels were clearly way off course, as were their forecasts for economic growth.

In 2005, they now assume the following for crude oil prices:

"... the average price of oil will be $54.23 a barrel in 2005 and $61.75 a barrel in 2006 (viii)

Naturally, these forecasts are wrong as are their forecasts for economic growth.


The moral of this story?

(1) Always consider the assumptions behind an economist's forecast;
(2) Never trust an economist's forecast;
(3) Economists shouldn't make forecasts.


(4) Your forecast is as good as an economist's!

Sunday, September 18, 2005

A real dilemma

If you're one of those people who expects the U.S. Federal Reserve to stop raising interest rates next week then you probably don't look at enough charts.

If you were to look at the charts the Fed looks at then you would understand why to stop raising interest rates now would defeat the purpose of the past 12 months of rate hikes.

One piece of data the Fed takes very seriously is the real interest rate; the interest earned on overnight deposits after taking account of inflation (i.e. higher inflation means lower real interest).

Going up

What the chart shows is that real interest rates are currently zero. Putting $1 in your bank account today will earn no interest in real terms. Your dollar today buys you less tomorrow. That's not going to help anyone, including those who survived the hurricane.

What the Fed is aiming towards is a neutral real interest rate. Judging from the past that means we should expect at least another 2% of interest rate hikes by the Fed (measured, not stirred).


Nothing can stand in the way of the Fed on a mission, not even a hurricane. When the time is right, interest rates will stop going higher. If history is anything to go by, that usually means they're ready to head in the opposite direction.