“The sole function of economic forecasting is to make astrology look respectable,” economist Ezra Solomon once said. It seems even less respectable today as practitioners attempt to demystify the aftermath of multiple shocks including the pandemic, the war in Ukraine, and the shifting geopolitical landscape.
Andrew Bailey, governor of the Bank of England, knows this all too well. When the central bank raised interest rates by 25 basis points on Thursday, it faced a number of questions about the bank large upward change to its growth and inflation projections. Economic forecasting is indeed an inexact science; but heavy revisions do little to reassure the public that central bankers know what they’re doing.
It’s not just the BoE that has been out of place. The US Federal Reserve and the European Central Bank have also both gotten their inflation forecasts wrong, particularly since the start of the pandemic. Even the IMF has cut and changed its recent growth prospects. Given the role forecasts play in informing the decisions of investors, households, and policymakers, accuracy matters. For central bankers even a decent forecasting record is vital to building credibility, especially how greater confidence can help anchor inflation expectations.
Recent criticisms of erroneous predictions need to be tempered. Economists have faced an unusually uncertain world since 2020. They have had to take positions on epidemiology, war scenarios, changes in the supply chain, and rapidly changing national and international policies. Another element is a limited public understanding of what forecasts actually represent. They are conditioned by judgments made at a given moment. As new data arrives, these judgments need to be recalibrated. They should be treated as indicative, not as gospel truths.
Economists still have some questions to answer. Central bankers were probably too slow to raise rates as inflation picked up in 2021, clinging to the idea that price pressures were “transient”. There they were misjudgments on the effects of the fiscal stimulus, the stability of inflation expectations and the damage caused by the pandemic to supply, which have contributed to the monetary authorities lagging behind on inflation. The previous decade of low inflation may also have lulled them into a false sense of security. Mistakes have also been made during the rate hike cycle. Both the BoE and the ECB failed to understand how sticky food inflation would be.
Predictions can be increased in several ways. Recent shocks underscore the importance of tapping into expertise beyond the economics profession. Economists should also continue to explore how advances in big data, machine learning, and artificial intelligence may provide opportunities to improve economic analysis and improve model complexity.
It is essential to improve the way forecasts are communicated, particularly in times of uncertainty. Showing projections under different scenarios can help deepen your understanding of the range of possible outcomes. Similarly, while central banks have attempted to highlight probability distributions around their forecasts, these could be conveyed in a more accessible way.
Above all, economists need to be clearer about how and why their key judgments have changed between forecasts and how that affects the numbers. More effort to show how they achieve their projections may go some way towards building confidence and normalizing the understanding of economic forecasts as point of reference rather than forward thinking. After all, John Maynard Keynes, the famous economist, is often credited… perhaps wrongly – how to ask: “when the facts change, I change my mind. What are you doing?”
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