Why Are Mainstream Economic Forecasts So Often Wrong?

The second lesson, particularly after years of financial repression, is that most forecasts tend to assume an optimistic and extraordinary multiplier effect of government spending and central bank stimulus plans. In most cases, when we look at the estimates of large central banks and international entities, the biggest mistakes in forecasting come from expecting a surprisingly large positive impact on consumption, growth, employment, and investment from demand-side policies. In my experience, the two largest divergences between forecast and reality tend to appear in capital expenditure (capex) and inflation. This is not a coincidence. When the forecaster gives too much impact to demand-side policies while ignoring the accumulated debt, overcapacity, and the poor track-record of most of these measures, the mistakes in capex and inflation forecasts are almost inevitably going to be enormous and much larger than the mistake on output and employment. Likewise, the tendency of large forecasting entities of ignoring or dismissing supply-side policies leads to forecast errors on the side of caution. This was particularly evident in the recovery of some Eurozone countries in 2014 or the estimates for jobs and growth of 2018-19 in the United States. One of the clearest examples is the almost annual slump in growth in the eurozone relative to early estimates.

The third lesson is that forecasts tend to be significantly more accurate when negative news are already consensus. Even when considering risks that may erode significantly the estimates for the next year, large entities tend to consider a lower probability of occurrence of those events in order to maintain a “positive” outlook. There are still too many politicians and economists that believe that the economy is a matter of sentiment and animal spirits and that, as such, some believe that one should maintain a healthily optimistic outlook to support the economy. This has obviously been debunked by reality. Being too optimistic has impacted the credibility of very valuable forecasts while done nothing to lead economic agents to see a brighter prospect in a recession.

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Edward Smith 2 months ago Member's comment

Dear Mr. Lacalle, Your article is very interesting coming from my view as a financial advisor and student of domestic and foreign economics, stock/bond markets and geopolitical impacts. I read from a huge list of sources each month, but not to be able to espouse impressive statistics, if I could even remember them all. It's because, in my humble opinion, one must be a student of the aforementioned in order to understand risk and the requisite portfolio adjustments to consider for clients based on a 'homework rationale' approach. Your sentence on using different sources of research is spot on. I read your posts on Twitter regularly and enjoy them. When your article talks about inflation, in my opinion, and even though I have no level of training as you, both CPI and PCE need to be retooled. The Federal Reserve had a 'target' of 2% for a long time, and if I understand it correctly, they just changed that to seeking an 'average' of 2%. Yet, from what I've read, PCE has barely ever hit that number. To use an analogy, I'm a 15 handicap golfer. But, if I have a target to hit 12 or want to have an average of 12 is irrelevant if I haven't seen 14 yet, and that's what the Fed-speak tells me, they're disconnected in their communications. I've had clients invested in TIPS (among many other things), both US and foreign TIPS, for most of 2020 and have done well for them doing so. And that's because, to your point, I do my own homework. While the US Fed and politicians and too much of the media state that inflation is benign, and only recently admitting that it is starting to show up, it's already been here. Case in point, the US Bureau of Labor Statistics (BLS) report for CPI for 12 months ending October of this year. There are SO many consumer categories in that report that show their 12 month rates anywhere from +3% to +10%. Yet, energy is a high negative number which probably negates all of the others, so I assume the CPI weighting math is wrong. Yet, consumers don't spend the vast majority of their money at the gas pump, they spend it on food, clothing, on-line purchases, etc. so, in my opinion, the CPI data, and most likely PCE data that the Fed and politicians rely on, are both out of touch, or need to be rebalanced, or both. Accordingly, that data is what the politicians and the Fed rely on because it's probably politically inappropriate to do otherwise, and market impacts would be high to address it as the BLS reports it. So I continue to make returns for clients in inflation based investments as appropriate while I chuckle at Fed and political speak saying that it might show up someday. BLS data shows otherwise. And to me, they're talk on 5yr/5yr data and other mathematical views means they need to step out of their cubicles and do surveys on actual consumer costs in stores, on line, etc., since consumers make up something like 60% of US GDP? SO, if their understanding of inflation is off, might not their evaluation of GDP be the same? Anyway, this is my view, sir, and I very much enjoy your writings and learning from you. Please let me know if my understanding above is incorrect or how I should adjust it, if you have time. Very sincerely, Ed

Angry Old Lady 2 months ago Member's comment

Wow, that's quite a lot to pack into a single paragraph!

Edward Smith 2 months ago Member's comment

Sorry, it actually wasn't, I typed it as paragraphs and this program changed it into just one. Odd.

Angry Old Lady 2 months ago Member's comment

Lol, I know what you mean. That has happened to me sometimes if I edit a comment. Must be a bug.