The newspapers and magazines are full of economic forecasts for 2012, and I will release my own on January 4. According to most of these, we will see continued economic growth for the year, but nothing too exciting. Employment growth won’t be strong enough to reduce unemployment by much. This is what we have to look forward to – unless things will be different.
To put it mildly, economic forecasts have been missing the mark over the past few years. Every month the Wall Street Journal surveys between 50 and 55 of the most notable economic forecasters. At the end of 2006, 65 percent of these forecasters believed that the housing bust was nearing its end, 35 percent believed that it wasn’t, and a few responded, “What housing bust?” In any case, the housing sector was too small to drag down the overall economy, so there was no cause for alarm. The survey results in December 2007 – the month that the recession began – were gloomier but not gloomy enough. The average probability of a recession in 2008 was pegged at 38 percent. The December 2008 survey did exactly call the end of the recession (June 2009) but the forecasters consistently underpredicted the declines in Gross Domestic Product (GDP) through the recession and consistently overpredicted the GDP increase in the recovery.
The forecast in the most recent Wall Street Journal survey is GDP growth of 2.1 percent in the first quarter, gradually struggling up to 2.6 percent by the fourth quarter. (Three percent is generally considered strong growth.) How accurate will this forecast be? We will find out. But the track record is not encouraging for a poor regional economist relying on it to forecast the Central Ohio economy – or much more important, a business owner trying to put together a budget or a purchasing manager trying to determine how much inventory to stock.
Dennis Lockhart, president of the Atlanta Federal Reserve Bank, deftly confronted this problem in a recent speech. He cites three reasons why forecasts have gone astray. First, forecasts may correctly predict economic activity but they get the timing wrong. Strength predicted during a specific quarter may occur during the preceding quarter or the following one.
Second, in Lockhart’s words, “Stuff happens.” Unforeseen events can throw forecasts off. For example, the Japanese earthquake and tsunami at the beginning of 2011 disrupted supply chains and production throughout the U.S. (The impact here in Central Ohio can clearly be seen in early 2011 monthly employment both in manufacturing and wholesale trade.)
Third, forecasters can get the story wrong by missing some of the myriad interrelationships at work in the economy, and hence the significance of seemingly unrelated trends and events. In forecasting the course of the recession, many economists expected rapid consumer-driven growth that has been the consistent pattern in postwar recessions. But research looking at financial crisis-driven recessions suggested a much slower recovery. This has turned out to be the case, and the current growth trend is well within the historical pattern of these recessions. But it is outside the experience of most economists and their models, which cannot possibly hope to capture more than a small fraction of the complexity of the economy. (Another example is the failure to understand the impact that the housing market would have on the derivatives held by financial institutions and consequently on the institutions themselves. This market was far from transparent, though, so economists cannot be blamed for failing to recognize this.)
So what is someone using these forecasts to plan for 2012 to do? Economic forecasts should always come with a discussion of risks to the forecast, how they might change the predicted economic growth path, and what sectors are most vulnerable to the risk factors. It is important to pay attention to these risks as time goes by. Lockhart and other economist cite a European recession as the most significant risk to the U.S. Economic troubles in Europe would reduce demand for U.S. exports; Europe is our most significant customer. Ongoing European government debt problems also affect financial markets. U.S. banks have direct exposure to these debt securities, but more important is the impact on still-fragile financial markets in general. Our own ongoing fiscal uncertainty (including the failure of the Congressional supercommittee to reach a deal) is another important factor affecting financial markets and consumer and business confidence. On the upside, consumer spending has been pleasantly surprising forecasters lately. Further, the recession has led to significant pent-up demand. Businesses and consumers have been doing without for years. Machines, computers, appliances, and cars will wear out and will eventually need to be replaced. So as 2012 gets underway, pay attention to Europe, to Congressional tax agreements (or lack thereof), the housing market, and to consumer confidence.