Economic and Policy The first edition of this book became a valuable reference tool in the field of economic forecasting. This new edition takes into account what the profession has learnt during this century’s first , which so few foresaw. It also restructures the material to make it more user-friendly. Policy-relevant analyses have been expanded, providing key insights for macroeconomic management and supervisory authorities.

The book offers a comprehensive overview of macroeconomic forecasting. It presents a wide range of approaches, including business cycle analysis, time series methods, macroeconomic models, medium- and long-run projections, and fiscal and financial forecasts. The book then explores the main issues surrounding the use of forecasts, including accuracy and communication challenges. All along, the economic policy implications are highlighted, together with a focus on their financial stability dimension. A tour of the and forecasting institutions is also provided.

This book will be essential reading for economists and professional forecasters as well as students. This page intentionally left blank Economic Forecasting and Policy Second Edition

Nicolas Carnot Vincent Koen and Bruno Tissot © Nicolas Carnot, Vincent Koen and Bruno Tissot 2005, 2011 Foreword © Jean-Philippe Cotis 2011 Softcover reprint of the hardcover 1st edition 2019 978-0-230-2432 1- 7 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6–10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First edition 2005 Second edition 2011 Published by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave® and Macmillan® are registered trademarks in the , the United Kingdom, Europe and other countries ISBN 978–0–230–24322–4 ISBN 978–0–230–30644–8 (eBook)

DOI 10.1057/9780230306448 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Carnot, Nicolas. Economic forecasting and policy / Nicolas Carnot, Vincent Koen, Bruno Tissot. p. cm. Published in 2005 under title: Economic forecasting. Includes bibliographical references and index.

1. Economic forecasting. I. Koen, Vincent. II. Tissot, Bruno. III. Carnot, Nicolas. Economic forecasting. IV. Title. HB3730.C35 2011 330.9001'12—dc22 2011011750 10 9 8 7 6 5 4 3 2 1 20 19 18 17 16 15 14 13 12 11 Contents

List of Figures viii List of Tables x List of Boxes xi Foreword by Jean-Philippe Cotis xiii Acknowledgements xv List of Abbreviations xvi

Introduction 1 What is economic forecasting? 2 The book’s aims 2 Roadmap 3

1 Overview 5 1.1 What to forecast? 7 1.2 Why forecast? 12 1.3 How to forecast? 16 1.4 Frequently asked questions 21 2 Business Cycle Analysis 24 2.1 Monitoring the ups and downs 25 2.2 Collecting economic information 26 2.3 Business and consumer surveys 29 2.4 Making sense of the data 38 2.5 Bridge models 54 2.6 Final health warning 59 Appendix 2.1 Some useful concepts and tools 61 3 Real Sector Building Blocks 66 3.1 Business investment 70 3.2 Household spending 80 3.3 Imports and exports 88 3.4 Employment 93 3.5 Prices and wages 95 Appendix 3.1 Sectoral forecasting 107 Appendix 3.2 Commodity prices 112 Appendix 3.3 Semi-structural estimation of the NAIRU 117

v vi Contents

4 Financial Sector Dynamics 119 4.1 Dealing with volatility 121 4.2 Short-term interest rates 125 4.3 Long-term interest rates 145 4.4 Bond prices and yield spreads 151 4.5 Stock prices 153 4.6 Real estate prices 155 4.7 Exchange rates 159 Appendix 4.1 Integrating the financial stability perspective – lessons from the 2007 financial crisis 170 Appendix 4.2 Technical analysis 182 Appendix 4.3 Country risk analysis 184 5 Public Finances 191 5.1 The macroeconomic view 193 5.2 The detailed approach 193 5.3 Long-run fiscal trends 203 5.4 Fiscal policy analysis 205 5.5 Forecasting performance 215 Appendix 5.1 Fiscal implications of financial sector rescues 219 Appendix 5.2 The fiscal response to the 2007 financial crisis 221 6 Medium- and Long-Run Projections 223 6.1 The medium run 225 6.2 The long run 246

7 Risks and Accuracy 265 7.1 Conceptual issues 267 7.2 Analysing errors 271 7.3 Forecasters’ track record 274 7.4 What causes errors? 281 7.5 Can accuracy be improved? 285 7.6 Accuracy is not enough – assessing the risks around forecasts 288 Appendix 7.1 Measuring accuracy in practice 296 Appendix 7.2 Can forecasters predict severe crises? Recent lessons 302

8 Policy Making and Forecasts 309 8.1 Economic forecasts’ virtues and limitations 311 8.2 Forecasts and macroeconomic policy 316 8.3 Private sector uses 324 8.4 Explaining the technicalities 326 Contents vii

8.5 Transparency 331 8.6 Science or politics? 334 Appendix 8.1 A world tour of the forecasting institutions 339

Epilogue 354 Annex I The data 357 AI.1 The national accounts framework 359 AI.2 Quarterly national accounting 374 AI.3 Technical hurdles 377 AI.4 Open questions and limitations 388

Annex II Time series methods 396 AII.1 Time series methods used for macroeconomic forecasts 398 AII.2 Volatility modelling 422

Annex III Macroeconomic models 435 AIII.1 General features 436 AIII.2 Macroeconomic logic 437 AIII.3 Estimation and simulation properties 443 AIII.4 Forecasting with a model 448 AIII.5 Overall assessment 456

Bibliography 463

Index 484 List of Figures

1.1 Real GDP levels since the 1960s 8 1.2 Real GDP growth rates since the 1960s 8 2.1 Business confidence 37 2.2 Alternative ways to average 40 2.3 Year-on-year versus quarter-on-quarter changes 41 2.4 Two incarnations of German real GDP 43 2.5 Yield spread and recessions 46 2.6 Activity versus growth cycle: turning points 48 2.7 Inherited growth 61 2.8 The base effect 64 3.1 Stockbuilding: contribution to US GDP growth 78 3.2 US GDP, household consumption and residential investment 86 3.3 Wage–price dynamics in a closed economy 97 3.4 Reduced forms of the wage–price dynamics 97 3.5 Oil prices 112 4.1 Short-term interest rates 126 4.2 Libor minus OIS spreads in major financial centres 127 4.3 Balance sheet of the US Federal Reserve 140 4.4 Long-term interest rates 148 4.5 Stock prices 154 4.6 Real house prices 156 4.7 Real effective exchange rates 159 5.1 Forecasting public finances and the macroeconomy 195 5.2 Tax receipts: the effects of spontaneous developments and new measures 197 5.3 Headline and structural fiscal balance for the OECD region 206 5.4 Errors in forecasting the US federal budget balance 216 6.1 The output gap and inflationary pressures in the USA 226 6.2 GDP, potential GDP and the output gap 228 6.3 US labour productivity growth 242 6.4 Growth expectations in the euro area: early and late 2000s 245 6.5 Solow’s growth model 248 6.6 Convergence to a steady-state growth path with physical and human capital 254

viii List of Figures ix

6.7 GDP rankings 258 6.8 US old-age dependency ratio 259 7.1 Four types of shocks 291 8.1 Fan chart for forecast 330 AII.1 Business cycle asymmetry 413 List of Tables

2.1 Global manufacturing PMI coverage 35 2.2 Leading, coincident and lagging indicators for the US economy 50 2.3 Variables used by the OECD in nowcasting and near-term forecasting 58 4.1 The 2007 financial crisis: key stages 170 4.2 Selected financial crises in history 175 4.3 Rating criteria 186 4.4 Rating scales 187 5.1 The CBO’s long-term projections for US Social Security 205 5.2 The EC’s sustainability indicators S1 and S2 212 5.3 Upfront financial sector support 219 5.4 Fiscal expansion in the course of the 2007 financial crisis in the G20 countries 222 6.1 Components of projected US potential real GDP growth 238 6.2 A long-run simulation of ageing-related public spending pressures 260 7.1 Accuracy of OECD real GDP growth projections for G7 countries 275 7.2 Accuracy of IMF forecasts by regions 277 7.3 The 2007 financial crisis: economic impact of policies 294 7.4 Directional tests 300 8.1 Density forecast of US growth 332 8.2 International forecasters 340 8.3 Forecasting institutions in the G7 economies 346 8.4 Selected forecasters in the BRICS economies 352 AI.1 Main national accounts aggregates in the USA 365 AI.2 Balance of payments 371 AI.3 Main national accounts aggregates in the UK 372 AI.4 Annual chain-linking and quarterly data 385 AI.5 Illustrative natural resource asset account 393 AII.1 Properties of ARMA processes 403 AIII.1 Selected macroeconomic models 445 AIII.2 Range of responses to fiscal shocks across models 447 AIII.3 Impact of an oil shock 447

x List of Boxes

2.1 European Commission surveys 31 2.2 Some leading US surveys 32 2.3 The Tankan survey 34 2.4 What does the yield curve say about future growth? 46 2.5 The US Conference Board’s composite indicators 50 3.1 Error-correction models: a primer 68 3.2 Investment and the capital stock: theories 71 3.3 World demand 90 3.4 Competitiveness indicators 92 3.5 Technical progress: three long-run employment relationships 96 3.6 The NAIRU and the equilibrium rate 104 4.1 Bubbles, noise and herds 122 4.2 Monetary policy reaction functions 129 4.3 The Taylor rule 131 4.4 Monetary and financial conditions indices 134 4.5 Central banks’ objectives 136 4.6 Central banks’ traditional policy apparatus 138 4.7 Central banks’ unconventional instruments 140 4.8 Macro-prudential tools 144 4.9 Modelling long-term interest rates 146 4.10 Modelling stock prices 153 4.11 Modelling real estate prices 157 4.12 Long-run exchange rate equilibria 164 4.13 Uncovered interest parity 167 5.1 The macro-fiscal framework: a starter 194 5.2 Temporary fiscal measures 200 5.3 Projecting debt service 202 5.4 Computing structural deficits 208 5.5 Debt-stabilizing deficits and primary gaps 211 5.6 The European Commission tax gap indicators 212 6.1 Statistical approaches for estimating potential GDP 229 6.2 Production-function based approaches for estimating potential GDP 232 6.3 Econometric models and potential growth estimates 235 6.4 Contributions to medium-term growth: the role of productivity 239 6.5 What is trend labour productivity in the USA? 241

xi xii List of Boxes

6.6 Impact of financial crises on potential growth 243 6.7 Steady state in the Solow model 247 6.8 Extension of medium-term projections to the long run 250 6.9 The augmented Solow model 254 7.1 Ex ante versus ex post errors 273 8.1 Decision-making under uncertainty 313 AI.1 GDP: a mixed bag 361 AI.2 Benchmarking the quarterly national accounts 376 AI.3 Capturing labour market trends 378 AI.4 Base-year versus chained indices 383 AI.5 Generational accounting 389 AI.6 Greening the national accounts 392 AII.1 Exponential smoothing methods 409 AII.2 How to use more information in VARs 422 AII.3 Reminders on autocorrelation 423 AIII.1 From RBC to DSGE models 441 AIII.2 Mixing methods: DSGE-VAR 460 Foreword

While macroeconomic and economic policy handbooks abound, they rarely dwell on the important question of economic forecasting. Many even bypass it altogether. Yet scores of economists, in both the private and public sectors, spend their working days constructing forecasts, and worry at night whether they got them right. The techniques they use blend traditional macroeconomic analysis, statistical and econometric tools, microeconomic insights and a fair dose of eclectic judgement. Granted, some of them are described in journal articles, but few if any books pull these various strands of knowledge and exper- tise together in a comprehensive survey. Bruno, Nicolas and Vincent aptly fill the void with this book, drawing on their experience built up at first-hand, in particular at the BIS, the IMF and the OECD.

Economic Forecasting and Policy is accessible to anyone with a general back- ground in economics, yet it is nuanced and state-of-the-art. It provides the complete toolkit for forecasters, with clear presentations of the technicalities and numerous up-to-date, real-life exhibits, and relates these to the challenges faced by economic policy makers. It covers a broad range of areas, including national accounting, monitoring of financial markets, business cycle analysis, building and usage, long-term projections and fiscal forecasting.

But this book also steps back from the basics of day-to-day forecasting to put things in perspective. It sets out the theoretical underpinnings of forecasting models. It shows how forecasts feed into policy making or private agents’ deci- sions. It discusses forecasting (in)accuracy, arguing convincingly that forecasts are essential even if forecasters are almost inevitably bound to be off the mark. It points out candidly the shortcomings of existing analytical frameworks and gives readers a glimpse of forthcoming developments on the frontier of national accounting, economic analysis and forecasting. It looks at some of the key lessons from the financial crisis that began in 2007, regarding in par- ticular the feedback loop between the real economy and financial markets as well as the associated financial stability dimension. Last but not least, it offers a unique round-the-world tour of the institutions producing forecasts – a precious guide through what has become a crowded jungle.

An early version of this book was published by Economica in French in 2002 and received a prize from the French Academy of Moral and Political Sciences for the best book on economic policy. The first global edition, in English, was

xiii xiv Foreword published in 2005 and rapidly became popular with students, academics and practitioners alike. I trust that this second global edition, which draws lessons from the profession’s chastening failure to predict the Great Recession, will be even more successful. JEAN-PHILIPPE COTIS Head of the French National Statistical Institute Former OECD Chief Economist Acknowledgements

This book – both the first and the second, revamped, edition – owes a lot to what we learnt from colleagues as we built up forecasting experience since the 1990s as economists at the Bank for International Settlements (BIS), the International Monetary Fund (IMF) and the Organisation for Economic Co- operation and Development (OECD), but also in national policy making bo dies, as government and central bank staff in Paris.

A number of current and former colleagues are quoted in the book, but attempting an exhaustive list of thanks would be as fastidious as it would be vain. We would none the less like to single out those who supported our efforts most directly – the former or current chief economists of the BIS, IMF and OECD, namely Bill White, Olivier Blanchard and Jean-Philippe Cotis. Our gratitude also extends to Jean Pavlevski and Frédéric Bobay as well as to our families, who bore with us during a long march.

While grateful for all the wisdom and backing, we take full responsibility for the views expressed in this book, as well as for any residual shortcomings, which should not be ascribed to the aforementioned institutions or individuals.

NICOLAS CARNOT VINCENT KOEN BRUNO TISSOT

xv List of Abbreviations

ABS asset-backed security ADB Asian Development Bank; African Development Bank AGE applied general equilibrium (model) AIG American International Group AR autoregressive (model) ARCH autoregressive conditional heteroskedasticity (model) ARIMA autoregressive integrated moving average (model) ARMA autoregressive moving average (model) AS/AD aggregate supply/aggregate demand (model) BEA Bureau of Economic Analysis (USA) BEER behavioural equilibrium exchange rate BEKK Baba, Engle, Kraft, Kroner (volatility model) BIS Bank for International Settlements BLS Bureau of Labor Statistics (USA) BNP Banque Nationale de Paris (France) BRIC group of countries: Brazil, Russia, India and China BRICS group of countries: Brazil, Russia, India, China and South BVAR Bayesian VAR (model) CAE Conseil d’Analyse Economique (France) CANSIM Canadian socioeconomic database CASE Center for Social and Economic Research (Poland) CBI Confederation of British Industry CBO Congressional Budget Office (USA) CBOLT CBO Long-Term (model) CCC constant conditional correlation (model) CDO collateralized debt obligation CDS credit-default swap CEA Council of Economic Advisors (USA) CEO chief executive officer CEPII Centre d’Etudes Prospectives et d’Informations Internationales (France) CEPR Centre for Economic Policy Research CES constant elasticity of substitution CGE computable general equilibrium (model) c.i.f. cost of insurance and freight CLI composite leading indicator

xvi List of Abbreviations xvii

CPB Central Planning Bureau (now Dutch Bureau for Economic Policy Analysis) (Netherlands) CPI consumer price index (see HICP) DCC dynamic conditional correlation (model) DEER desired equilibrium exchange rate DGT Direction Générale du Trésor (France) DIR Daiwa Institute of Research (Japan) DIW Deutsches Institut für Wirtschaftsforschung (German Institute for Economic Research) (Berlin) DSGE dynamic stochastic general equilibrium (model) EBRD European Bank for Reconstruction and Development EC European Commission ECB European Central Bank ECM error correction model ECOFIN Economic and Financial Affairs Council (EU) ECRI Economic Cycle Research Institute EGARCH exponential GARCH (model) EMS European Monetary System ESA European System of Accounts (EU) ESRI Economic and Social Research Institute (Ireland) ETLA Research Institute of the Finnish Economy (Finland) EU European Union EVT extreme value theory FCI financial conditions index FDI foreign direct investment FEER fundamental equilibrium exchange rate f.o.b. free on board FOMC Federal Open Market Committee (USA) FSA Financial Services Authority (UK) FY fiscal year GARCH generalized ARCH (model) GDP GIMF Global Integrated Monetary and Fiscal (model) GLI Global Leading Indicator (Goldman Sachs) GNI gross national income GNP gross national product GPM global projection model GSE government-sponsored enterprise (USA) HBOS Halifax Bank of Scotland HDI Human Development Index (UNDP) HICP(CPI) Harmonised Index of Consumer Prices (EU) HP Hodrick-Prescott (filter) xviii List of Abbreviations

HSBC Hongkong and Shanghai Banking Corporation HWWI Hamburgische Welt-Wirtschafts-Institut (Germany) IADB Inter-American Development Bank IEA International Energy Agency IFL Instituto Flores de Lemus (Spain) IFO ifo Institute for Economic Research (Munich, Germany) IFS Institute for Fiscal Studies (UK) IfW Institut für Weltwirtschaft (Kiel, Germany) IGIER Innocenzo Gasparini Institute for Economic Research (Italy) IIF International Institute of Forecasters IKB Industriekreditbank (Germany) ILO International Labour Organization (UN) IMA integrated moving average IMF International Monetary Fund INSEE Institut National de la Statistique et des Études Économiques (France) IOSCO International Organization of Securities Commissions IRR internal rate of return ISAE Istituto di Studi e Analisi Economica (Italy) ISIC International Standard Industrial Classification ISM Institute for Supply Management ISTAT National Institute of Statistics (Italy) IT information technology IVCCA inventory valuation and capital consumption adjustments IWH Institut für Wirtschaftsforschung Halle (Germany) JCER Japan Center for Economic Research LFS Labour Force Survey LIBOR/Libor London interbank offered rate MA moving average (model) MAE mean absolute error MBS mortgage-backed securities MCI monetary conditions index ME mean error METI Ministry of Economy, Trade and Industry (Japan) MFCI monetary and financial conditions index MPC marginal propensity to consume; Monetary Policy Committee (Bank of England) MSE mean squared error NACE Classification of Economic Activities in the European Community NAICS North American Industry Classification System List of Abbreviations xix

NAIRU non-accelerating inflation rate of unemployment NAPM National Association of Purchasing Management (later ISM) NATREX natural real exchange rate NBER National Bureau of Economic Research (USA) NCAER National Council of Applied Economic Research (India) NDRC National Development and Reform Commission (China) NIESR National Institute of Economic and Social Research (UK) NiGEM NIESR Global Econometric Model NIPA National Income and Product Accounts (USA) NPI non-profit institution NPISH non-profit institutions serving households NPV net present value OBR Office for Budget Responsibility (UK) OECD Organisation for Economic Co-operation and Development OEEC Organisation for European Economic Co-operation (forerunner of OECD) OEF Oxford Economics (formerly Oxford Economic Forecasting) (UK) OFCE Observatoire Français des Conjonctures Économiques (France) OFHEO Office of Federal Housing Enterprise Oversight (USA) OIS overnight index swap OLS ordinary least squares (model) OMB Office of Management and Budget (USA) ONS Office for National Statistics (UK) OPEC Organization of the Petroleum Exporting Countries PEER permanent equilibrium exchange rate PER price-to-earnings ratio PMI Purchasing Managers’ Index PPP purchasing power parity PS price-setting (equation) QE quantitative easing R&D research and development RBC real business cycle RE rational expectations RIW Rheinisch-Westfälisches Institut für Wirtschaftsforschung (Essen, Germany) RMSE root mean squared error RPI Retail Prices Index (UK) RPIX Retail Prices Index excluding Mortgage Interest Payments (UK) S&P Standard & Poor’s SEEA system of integrated environmental and economic accounts SETAR self-exciting threshold auto-regressive (model) SIFI systemically important financial institution xx List of Abbreviations

SNA system of national accounts STAR smooth transition autoregressive (model) STING short-term indicators of growth (model) TAR threshold auto-regressive (model) TARCH threshold GARCH (model) TARP Troubled Asset Relief Program (USA) TFP total factor productivity UIP uncovered interest parity UN United Nations UNCTAD United Nations Conference on Trade and Development UNDP United Nations Development Programme VAR vector autoregressive (model) VaR value at risk VAT Value Added Tax VECM vector error correction model WEO World Economic Outlook (IMF) WIFO Austrian Institute for Economic Research WS wage setting (equation) WTO World Trade Organization ZEW Center for European Economic Research