Forecasting is a mug’s game.
Central banks, economists, strategists, investors, even some traders all feel the need to forecast the future of the economy, markets, and asset prices even though they know their chances of being right are low and forecasts are subject to a huge margin of error.
And when you are the central bank of a small open economy, subject to external as well as internal influences and with a currency, the Aussie dollar, that’s a favourite plaything of global forex traders your job is doubly hard.
It was against this backdrop that Christopher Kent, RBA Assistant Governor (Economic), addressed the Economic Society of Australia in Hobart on the somewhat dry, but uber-important, topic of economic forecasting at the RBA.
It’s important because, as Kent noted, forecasting “assists in interpreting economic developments and, because monetary policy typically affects economic activity and inflation with a lag, it is a necessary part of determining and communicating the appropriate stance of policy”.
He said the current process had served the RBA well but a recent review by Professor Adrian Pagan of the University of Sydney and Dr David Wilcox of the Federal Reserve Board of Governors had suggested some changes.
The good news is that the review said the RBA’s “forecasting practices were fundamentally sound and produced information conducive to good policymaking”.
But they recommended changes to the RBA’s modelling tools including “developing and analysing ‘full-system’ or ‘general equilibrium’ models of the economy – that is, models which account for the simultaneous responses of a large number of key variables to unexpected developments (or shocks)”.
It also suggested a reexamination of the models being used because of the changed structure of the economy.
As a result of the review the RBA has redeployed resources, changed the way it talks about unemployment forecasts, given more time to explaining the reality that there are uncertainties around the forecasts and established a new macro-economic modelling unit.
But in the end, Kent said what anyone who has ever forecast anything knows: it’s a mug’s game.
He said the review was a health check on the RBA’s approach and methods and provided valuable suggestions. But the reality is even though the changes “have the potential to enhance the role that forecasting plays in the policy process and facilitate the usefulness of the forecasts as an important tool of communication” they “are unlikely to see much of an improvement in forecast accuracy”.
That’s something to remember the next time someone forecasts the future