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The forecast record

Economists expect the economy to grow by 1.2 per cent next year, and the retail price index to rise by 2.8 per cent between now and the fourth quarter of 2012.

This, of course, is extremely unlikely to happen. Economic forecasts are prone to large errors. This is not necessarily evidence that forecasters are bad at their job. Instead, it is (also) because the future is inherently unknowable. (So too is the present, but that’s another story.) We should, therefore, regard forecasts not as descriptions of the future, but as guide-posts for telling us how surprised we should be by events in 2012.

My table summarizes forecasters’ record in recent years; I’m using the consensus forecast, as surveyed by the Treasury, in December for the following year – for example, the forecast in December 2008 for growth and inflation in 2009. The average error in GDP forecasts has been 1.1 percentage points. By this standard, this year - which is likely to see growth fall 0.9 percentage points shy of expectations - has been a normal one for forecasters.

I would therefore interpret the current 1.2 per cent forecast as meaning that growth will probably – and no more than probably – be between 0.1 and 2.3 per cent.

The consensus's forecasting record
GDPRPI Inflation (Q4)
In December:ForecastOut-turnErrorForecastOut-turn Error
20002.63.20.62.41.0-1.4
20011.82.70.92.32.50.2
20022.33.51.22.62.60.0
20032.63.00.42.93.40.5
20042.52.1-0.42.53.40.9
20052.12.60.52.34.01.7
20062.43.51.12.94.21.3
20071.9-1.1-3.02.52.70.2
2008-1.5-4.4-2.9-0.80.61.4
20091.31.80.52.84.71.9
20101.91.0-0.93.55.31.8
Average:-1.11.0
Average error ignores sign. Source: HM Treasury and ONS. Out-turn for 2011 is the consensus's current estimate.

The average error in RPI forecasts has been one percentage point. This implies that inflation in Q4 2012 will probably be between 1.8 and 3.8 per cent.

There are some other interesting aspects of the forecasting record.

One is that there were huge errors in the GDP forecast for 2008 and 2009. Economists did not see the recession coming. This is not unusual. Back in 2000, Prakash Loungani, an IMF economist, looked at international GDP forecasts between 1989 and 1998. He found that whilst there were 60 episodes of recession, economists had forecast only three of these the year before they began.

Secondly, economists have tended to under-predict inflation. They’ve done so in every one of the last eight years. They’ve had more faith in the Bank of England’s ability to stick to the inflation target than they should have had.

My table also tells us something else about the type of surprises we’ve had. Roughly speaking, macroeconomic surprises fall into two categories. There are demand shocks, which see both stronger growth and inflation than expected if the shock is positive and both weaker growth and inflation if it is negative. And there are supply shocks, which see weaker growth and higher inflation if the shock is adverse, and higher growth and lower inflation if it is positive.

According to this classification, the last eleven years have seen five positive demand shocks (2002, 2004, 2006, 2007 and 2010), four adverse supply shocks (2005, 2008, 2009 and 2011), and one favourable supply shock, in 2001; the fact that economists were spot-on about inflation in 2003 means that year falls into no category.

We have not seen a negative demand shock – one which sees both growth and inflation fall short of forecast; in the recession years, inflation exceeded expectations. This might surprise you, but remember that I'm defining a shock as relative to forecast, not relative to the year before; by the latter definition, 2008 and 2009 did indeed see negative demand shocks.

Now, I don’t know whether this pattern tells us about the nature of shocks or the nature of forecasts; maybe economists have been irrational as well as wrong in their optimism about inflation.

But it might be revealing. If the pattern of the last eleven years is any guide – and this is only an if – then it tells us that whilst there is a fair chance of us getting a nice surprise about economic growth next year, there is rather less chance of a nice surprise about inflation.

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By Chris Dillow,
19 December 2011

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Chris Dillow

Chris spent eight years as an economist with one of Japan's largest banks. Here, he provides insightful commentary on the latest economic news and data, along with thought-provoking articles about investor behaviour.

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