Economic Forecasting Economic Forecasting Nicolas Carnot Vincent Koen and Bruno Tissot © Nicolas Carnot,Vincent Koen and Bruno Tissot 2005 Foreword © Jean-Philippe Cotis 2005 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph 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, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorised 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 published in 2005 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world. PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN 978-1-4039-3654-7 ISBN 978-0-230-00581-5 (eBook) DOI 10.1057/9780230005815 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Carnot, Nicolas. Economic forecasting / by Nicolas Carnot,Vincent Koen and Bruno Tissot. p. cm. Includes bibliographical references and index. 1. Economic forecasting. I. Koen,Vincent. II. Tissot, Bruno. III. Title. HB3730.C35 2005 330Ј.01Ј12—dc22 2004063677 10987654321 14 13 12 11 10 09 08 07 06 05 Contents List of Figures viii List of Tables ix List of Boxes x Foreword by Jean-Philippe Cotis xi Acknowledgements xii Acronyms xiii Introduction xvii 1 First Principles 1 1.1 What to forecast? 1 1.2 Why forecast? 6 1.3 How to forecast 9 2 The Data 15 2.1 The national accounts framework 16 2.2 Quarterly national accounting 28 2.3 Technical hurdles 29 2.4 Open questions and limitations 41 3 Incoming News and Near-Term Forecasting 51 3.1 Monitoring the ups and downs 51 3.2 Collecting economic information 53 3.3 Business and consumer surveys 58 3.4 Making sense of the data 64 3.5 Bridge models 79 3.6 Final health warning 83 4 Time Series Methods 85 4.1 Empirical extrapolation 85 4.2 ARIMA models 87 4.3 Decomposition into trend and cycle 90 4.4 VAR models 96 5 Modelling Behaviour 103 5.1 Enterprise investment 103 5.2 Household spending 112 5.3 Imports and exports 118 5.4 Employment 121 5.5 Prices and wages 125 v vi Contents 6 Macroeconomic Models 133 6.1 What is a macroeconomic model? 133 6.2 Forecasting with a model 141 6.3 Building alternative scenarios 148 6.4 How far can models go? 151 7 Medium- and Long-Run Projections 155 7.1 The medium run 156 7.2 The long run 166 8 Financial and Commodity Markets 176 8.1 Dealing with volatility 176 8.2 Interest rates 177 8.3 Bond, stock and real estate prices 186 8.4 Exchange rates 190 8.5 Commodity prices 194 8.6 Country-risk analysis 200 9 Budget Forecasts 207 9.1 A more or less detailed approach 207 9.2 Forecasting budget flows over the short and medium run 208 9.3 Forecasting long-run fiscal trends 213 9.4 Putting together a budget scenario 214 9.5 Top-down and bottom-up approaches 216 9.6 Uncertainties 219 9.7 An analytical view of the budget 222 10 Sectoral Forecasting 229 10.1 Microeconomic forecasts 230 10.2 Input–output analysis 232 11 Accuracy 235 11.1 Conceptual issues 235 11.2 Measuring accuracy in practice 237 11.3 Analysing errors 240 11.4 Forecasters’ track record 243 11.5 What causes the errors? 245 11.6 Can and should accuracy be improved? 248 12 Using the Forecasts 251 12.1 Economic forecasts’ virtues and limitations 251 12.2 Forecasts and macroeconomic policy 256 12.3 Private sector uses 262 13 Communication Challenges 265 13.1 Explaining the technicalities 265 13.2 Transparency 270 13.3 Science or politics? 271 Contents vii 14 A Tour of the Forecasting Institutions 275 14.1 Types of forecasters 275 14.2 International institutions 280 14.3 Forecasting bodies in selected countries 284 Epilogue 291 Bibliography 292 Index 303 List of Figures 1.1 Real GDP levels since the 1960s 2 1.2 Real GDP growth rates since the 1960s 3 2.1 Elusive trends 32 2.2 US GDP and industrial output during the Asian crisis 33 2.3 Three measures of UK inflation 35 2.4 Sources of 2003 revisions to nominal US GDP 41 2.5 GDP per capita and the human development index 48 3.1 Inherited growth 53 3.2 The base effect 55 3.3 Business confidence 63 3.4 Alternative ways to average 66 3.5 Year-on-year versus quarter-on-quarter changes 67 3.6 Two incarnations of German real GDP 69 3.7 Activity versus growth cycle: turning points 73 4.1 Asymmetries 95 5.1 Stockbuilding: contribution to US GDP growth 111 5.2 US GDP, household consumption and residential investment 117 5.3 Wage-price dynamics in a closed economy 125 5.4 Reduced forms of the wage–price dynamics 126 6.1 Four types of shocks 149 7.1 Output gap and inflationary pressures in the United States 157 7.2 GDP, potential GDP and the output gap 158 7.3 US labour productivity growth 165 7.4 Diminishing growth expectations in the euro area 166 7.5 Solow’s growth model 168 7.6 Convergence to a steady-state growth path with physical and human capital 171 7.7 US old-age dependency ratio 173 7.8 GDP rankings today and in 2050 175 8.1 Short-term interest rates 179 8.2 Long-term interest rates 185 8.3 Stock prices 187 8.4 Real house prices 189 8.5 Real effective exchange rates 190 8.6 Oil prices 197 9.1 Errors in forecasting the US federal budget balance 220 9.2 Two measures of the underlying US federal budget balance 226 13.1 Fan chart for inflation forecast 269 viii List of Tables 2.1 Main national account aggregates in the United States 20 2.2 Main national account aggregates in the United Kingdom 24 2.3 Balance of payments 26 2.4 Annual chain-linking and quarterly data 39 2.5 Mean revision to preliminary GDP estimates in the G7 countries 40 2.6 Illustrative natural resource asset account 47 3.1 Investment intention surveys: fickle animal spirits 62 3.2 Leading, coincident and lagging indices for the US economy 75 3.3 Variables used by the OECD in near-term forecasting 82 4.1 Properties of ARMA processes 89 6.1 Selected macroeconomic models 136 6.2 Responses across models to fiscal and monetary shocks 138 6.3 Impact of an oil shock 139 7.1 Ageing-related public spending pressures 173 8.1 Rating criteria 202 8.2 Rating scales 203 11.1 Directional tests 240 11.2 Accuracy of the OECD’s growth projections 244 13.1 Density forecast of US growth 269 14.1 Forecasting institutions 276 ix List of Boxes 2.1 GDP: a mixed bag 18 2.2 Benchmarking the quarterly national accounts 30 2.3 Capturing labour market trends 31 2.4 Base-year versus chained indices 38 2.5 Generational accounting 42 2.6 Greening the national accounts 47 2.7 Human development indicators 49 3.1 Carry-over effects 52 3.2 Statistical workhorses 54 3.3 European Commission surveys 59 3.4 Some leading US surveys 61 3.5 The Tankan survey 62 3.6 Seasonal-adjustment software: X-12 68 3.7 What does the yield curve say about future growth? 72 3.8 The Conference Board’s composite indicators 75 4.1 How to use more information in VARs 102 5.1 Error-correction models: a primer 104 5.2 Investment and the capital stock: theories 106 5.3 World demand 120 5.4 Competitiveness indicators 122 5.5 Technical progress: three long-run employment relationships 124 5.6 The NAIRU and the equilibrium unemployment rate 131 7.1 Semi-structural estimation of the NAIRU 162 7.2 What is trend labour productivity in the United States? 165 8.1 Bubbles, noise and herds 178 8.2 The Taylor rule 182 8.3 Technical analysis 195 9.1 Project appraisal 217 12.1 Decision-making under uncertainty 253 x 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, both in the private and in the public sector, 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 judge- ment. Granted, some of them are described in journal articles but few if any books pull these various strands of knowledge and expertise together in a comprehensive survey.