economic forecasting

Prediction of future economic activity and developments.

Economic forecasts, which range from a few weeks to many years, are widely used in business and government to help formulate policy and strategy. Macroeconomic forecasts predict the course of the aggregate economy and concentrate on variables such as interest rates, the rate of inflation, and the rate of unemployment. Forecasts of private consumption and investment, government expenditures, and net exports help government policymakers responsible for fiscal policy. For example, part of the justification for a change in taxes is a forecast of its economic effects. Microeconomic forecasts are designed to project the effects of change at the level of an industry or a firm. Most microeconomic forecasts begin with assumptions about the aggregate economy before focusing on the projected effects in the specific sector that is of interest. Manufacturers and retailers use such forecasts to formulate business plans such as those involving inventory, production levels, or hiring.

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Introduction

      the prediction of any of the elements of economic activity. Such forecasts may be made in great detail or may be very general. In any case, they describe the expected future behaviour of all or part of the economy and help form the basis of planning.

      Formal economic forecasting is usually based on a specific theory as to how the economy works. Some theories are complicated, and their application requires an elaborate tracing of cause and effect. Others are relatively simple, ascribing most developments in the economy to one or two basic factors. Many economists, for example, believe that changes in the supply of money (money supply) determine the rate of growth of general business activity. Others assign a central role to investment in new facilities—housing, industrial plants, highways, and so forth. In the United States, where consumers account for such a large share of economic activity, some economists believe that consumer decisions to invest or save provide the principal clues to the future course of the entire economy. Obviously the theory that a forecaster applies is of critical importance to the forecasting process; it dictates his line of investigation, the statistics he will regard as most important, and many of the techniques he will apply.

      Although economic theory may determine the general outline of a forecast, judgment also often plays an important role. A forecaster may decide that the circumstances of the moment are unique and that a forecast produced by the usual statistical methods should be modified to take account of special current circumstances. This is particularly necessary when some event outside the usual run of economic activity inevitably has an economic effect. For example, forecasts of 1987 economic activity in the United States were more accurate when the analyst correctly foresaw that the exchange value of the dollar would fall sharply during the year, that consumer spending would slacken, and that interest rates would rise only moderately. None of these conclusions followed from purely economic analysis; they all required judgment as to future decisions. Similarly, an economist may decide to adjust an economic forecast that was made by traditional methods to take account of other unique conditions; he may, for example, decide that consumers will alter their spending patterns because of special circumstances such as rising prices of imports or fear of threatened shortages.

      Although judgment may be based on experience and understanding, it may also be no more than unconscious bias. Forecasts based on judgment cannot be subjected to the kind of rigorous checks applied to forecasts developed by the use of more objective techniques. Consequently, the most accurate and useful forecasts are likely to be those founded on essentially economic considerations and standard statistical techniques. Though they can then be modified by the application of judgment, the resulting changes should be stated explicitly enough so that anyone wishing to use a forecast will know where, and how, it has been affected by the forecaster's own judgment, or bias.

      Economic forecasting is probably as old as organized economic activity, but modern forecasting got its impetus from the Great Depression of the 1930s. The effort to understand and correct the worldwide economic disaster led to the development of a vastly greater supply of statistics and also of the techniques needed to analyze them. After World War II, many governments committed themselves to maintaining a high level of employment. Most governments of the industrialized Western countries were prepared to intervene more often and more directly in economic affairs than previously. Business organizations manifested more concern with anticipating the future. Many trade associations now provide forecasts of future trends for their members, and a number of highly successful consulting firms have been formed to provide additional forecasting help for governments and businesses.

Types of forecasting

Forecasting the GNP and its elements

      Perhaps the forecasts most familiar to the public are those of gross national product and its elements. Gross national product, or GNP, is the total value of the goods and services produced in a nation. It is, therefore, a convenient and comprehensive measure for assessing changes in general economic welfare. A forecast of the GNP also provides a useful framework for more detailed forecasts of specific industries. Almost all developed nations maintain sets of national income accounts and make forecasts as well.

      The GNP can be regarded as being composed of three major components: spending by government, private investment spending, and spending by consumers (consumption). Net exports (that is, exports minus imports) are also counted in the GNP but their magnitude, which may be positive or negative, is usually small. (For the nations that depend more heavily on foreign trade, like Japan after World War II, or that incur substantial imbalances in their trade accounts, like the United States in the 1980s, net exports are of course more important.)

      Government spending is usually the easiest part of the GNP to forecast. Government expenditures can be determined with a fair degree of accuracy for well over a year in advance by studying existing budgets and appropriations, modified to take account of new political or economic developments. Most such adjustments are relatively minor for any forecast that runs only a year or two into the future; new government programs usually have only a small effect on expenditures in the short run. An obvious exception to this is a major change in the military situation, which can drastically alter spending plans.

      It is important to note that government (government budget) spending, as counted in the GNP, is not the same as total budgeted expenditures. Spending gets into the GNP only when money is paid for goods—military equipment, buildings, and so on—or services, which principally means the wages and salaries of government employees. These kinds of expenditures account for only part of the government budget; the remainder represents money transferred to bondholders, other private citizens (particularly people receiving pensions), and state and local governments. These funds affect the GNP only when they are finally spent by the recipients.

      Private investment poses far more difficult forecasting problems because it reflects many thousands of individual and corporate decisions that are not recorded publicly (as government budgets are) and that can be, and often are, changed very substantially. Private investment is the most erratic of the major categories of the GNP—the most subject to “boom and bust” cycles. A good forecast of investment spending is therefore essential to an accurate appraisal of the overall economic situation.

      Capital investment by business (spending for new plants and equipment) is particularly important. The incomes generated in the process of manufacturing new equipment and building new plants play a major role in increasing consumer spending during periods of expansion. But when investment slumps, employment and incomes generally also suffer, slowing the entire economy. Business investment has thus been studied with great care, and a wide variety of methods to guide forecasters have been developed, including econometric models, surveys of business investment plans, regular reports on commitments for investment, and fundamental studies of the condition of the nation's stock of capital goods (see below Forecasting techniques (economic forecasting)).

      Business also invests in inventory—that is, goods in the process of production and finished goods not yet sold to the final consumer. Most of the time, inventories increase roughly in line with the trend of sales. If sales fall short of expectations, however, inventories tend to become excessive. Business then moves to reduce stocks by cutting back production. Such cutbacks can aggravate economic recessions (recession); as production is reduced because of disappointing sales, incomes are thereby reduced and sales fall further, inventories must be cut even more, and so on in a downward spiral. Consequently, correct forecasts of inventory investment are both essential to good economic forecasting and also particularly difficult. Surveys of business plans to build or reduce inventory have been helpful; econometric methods have also been applied; but inventory investment remains one of the weak links in the forecasting process.

      New home construction accounts for a relatively small share of the GNP, but it is important to the forecaster because home construction is a relatively volatile industry. Homebuilding activity responds quickly to changes in the availability of mortgage money from the principal mortgage lending institutions, and thus forecasters follow closely the flow of savings to these institutions and also the level of commitments that have been made to finance future construction. Information on the number of building permits issued is also helpful, as are statistics on the volume of new construction contracts.

      Economists used to believe that forecasting consumer spending was fairly simple; as a rule of thumb, consumers could be counted on to spend 94–95 percent of their current income and save the rest. Thus an analyst could calculate the amount of personal income generated by government spending, private investment, and past consumer spending, adjust for tax payments, and arrive at a good estimate of consumer spending. This method still works well in determining the average rate of spending over an extended period of time. But in rich countries consumers as a group are quite free to vary their spending patterns in the short run; they may at any particular time spend more than usual because they anticipate shortages or because they believe that their incomes will rise further; or they may cut back their spending if they fear that a recession is about to develop. Such variations from normal spending patterns have their main effect on durable goods such as automobiles and household appliances; spending is far more stable for nondurables (food, clothing, and the like) and for services.

      Because consumers account for such a large proportion of all economic activity, a shift of just 1 or 2 percent between spending and saving can make the difference between rapid growth or recession for the entire economy. Economists now use surveys of consumer attitudes in attempting to read the mood of the public; surveys of intentions to buy durable goods have also been helpful.

Forecasting for an industry or firm (business organization)

      General economic conditions set the tone for all parts of the economy. Good forecasting for an industry or firm begins, therefore, with a good analysis of the overall economy. Within this framework, the analyst must then take account of the particular factors that are most important to his own industry. In some cases, the sales of an industry may correlate fairly directly with one or more of the elements of the national income and product accounts—lumber sales with home construction, for example, or sales of nondurable consumer goods with consumer income and total consumer spending. Forecasting for industries that produce basic materials usually requires a series of projections for specific markets. A steel forecast might be based on the outlook for such major steel markets as automobiles, construction, and metal containers. The basic forecast would then be adjusted for expected shifts in exports and imports of steel and for changes in inventories of steel or steel-using products.

      Forecasting is most difficult for companies that produce durable goods such as automobiles (automotive industry), industrial equipment, and appliances and for companies that supply the basic materials for these industries. This is because sales of such goods are subject to extreme variation. In a five-year span in the early 1970s, annual sales of automobiles in the United States increased by 22 percent in one year and declined by 22.5 percent in another. Consequently, the durable goods industries in general and automobile companies in particular have developed especially complex and sophisticated forecasting techniques. In addition to careful analysis of income trends (based on a general economic forecast), automobile companies, which are particularly sensitive to competition from imports, support a number of studies of consumer attitudes and surveys of intentions to purchase automobiles.

      Forecasting for an individual firm obviously begins with a forecast for the industry or industries in which it is involved. Beyond this, the analyst must determine the degree to which the company's share of each market may vary during the forecast period. Such variations can result from the introduction of a new product, the improvement of an existing product, the opening, closing, or expansion of plants, the activities of domestic or foreign competitors, a change in sales effort, or a variety of other factors. Information required to make such assessments may come in part from the company's own investment and marketing plans. Information on the activity and sales prospects of competitors is frequently collected from the firm's own salesmen. An increasing number of companies now employ sophisticated market research techniques to determine the probable reaction of their customers to new products.

Long-term forecasting

      In recent years, increasing effort has been devoted to long-range forecasting for periods extending five, 10, or more years past the normal “short-term” forecast period of one or two years. Business has come to recognize the usefulness of such forecasts in developing plans for future expansion and financing.

      Long-range forecasts usually are based on the assumption that activity toward the end of the period will reflect normal “full” employment. Given this assumption, the overall rate of growth depends on two principal factors: the number of people in the labour force and the rate at which productivity (output per worker) increases. The number of people of working age is known, barring some natural disaster (and excluding immigration), far into the future; they have already been born. Forecasters usually assume that productivity will continue to grow at the typical rates of recent decades. Expected technological developments, however, may alter the projected rate of change. The combination of changes in the labour force and productivity produces an estimate of the total growth rate for the economy.

      A measure of total economic activity arrived at by such methods as these serves, in effect, as a control total for making long-range forecasts of the constituent elements of the economy. If estimates for spending by consumers, government, and business add up to more than the total of goods and services that can reasonably be expected, then the projection for one or more of these elements must be reduced. If the sum of the projected parts is less than the probable total, the analyst is likely to assume a shift in economic policy that will move the economy up to full employment by the end of the forecast period and adjust his various projections up to the appropriate total.

      Long-range forecasts for individual parts of the economy depend on many of the same factors as do short-range forecasts, except that cyclical factors are usually ignored. Over the longer range, however, additional factors enter. Among the most obvious of these are growth in the population and shifts in its age composition. Changes in age composition have had a major effect on both consumer and government spending patterns in many countries since World War II. The unusually large age cohorts born in the years following World War II had enormous influence on patterns of consumption and on labour-force composition. As young adults they tended to buy large amounts of durable goods and to add to the need for home construction; on the average, they saved less and borrowed more in relation to their incomes than most older people had. Their children constituted a secondary “baby boom,” who could expect to see their parents become the largest generation of retired persons ever known.

      In addition to population pressures, a number of other trends and assumptions influence long-range forecasts. Assumptions about war and peace are obviously critical. Assumptions must be made about government spending programs; expensive new programs may bring higher taxes and less consumer spending, whereas slower growth in government spending may lead to tax reductions. Over longer periods of time, technological discoveries or changes in financial institutions can affect the overall economy. When the forecast is made for an industry or a firm, the expected introduction of new products is also important.

Forecasting techniques

      Economic forecasters have a vast array of information to work with and a growing variety of techniques. A few economists, believing that just one or two key factors determine the future course of the economy, limit their observations to these factors and develop forecasts based on them. A leading example of this is found in the school of thought that ascribes most importance to changes in the money supply. But most economists use a wider range of material.

Information on spending

      Some elements of the future are known with reasonable accuracy. Government spending is reflected in existing budgets. These budgets indicate how much will be spent and how much money will be extracted from the stream of private spending by taxation. Similar information is available on some parts of the private economy. Periodic surveys conducted both by government and by private organizations measure business plans to invest in new plants and equipment. Increasingly, attempts are made to probe the mood and intentions of consumers concerning the possible purchase of automobiles, houses, appliances, and other durable goods. Regular surveys are also made to determine the general mood of the public—whether people are optimistic or pessimistic about their own economic future and thus whether their spending is apt to be relatively strong or relatively weak. In general, such information obtained from the various surveys of investment plans, spending plans, and attitudes has been highly useful to economic forecasters. Such information helps to limit the range of possibility. But plans and attitudes change, sometimes quite abruptly, and although the surveys are useful tools they are not clear and reliable guides to the future.

Selection of turning points

      Probably the single most difficult economic forecasting problem is to pick the turning points in economic activity—the times at which the economy turns from growth to recession or from recession to recovery. Because of the difficulty and importance of the problem, major efforts have been made to develop tools for this purpose. The National Bureau of Economic (economic indicator) Research in the United States has identified a number of statistical (statistics) series that normally turn up or down before the economy does. Common stock prices, business inventories, and changes in consumer installment debt are among these series, which are known as “leading indicators.” Other statistical series normally move in line with overall activity (“coincident indicators”), and a third group changes direction after the economy does (“lagging indicators”). Although careful study of these groupings of statistics can be helpful, unfortunately there is no fixed relation between the movements of the economy and those of the various indicators. Although the “leading indicators” do ordinarily lead, the length of the lead varies. This reflects the dynamic nature of a complex economy that is constantly changing and in which strength or weakness may come from a variety of sources.

      Some economists also use sets of statistics called diffusion indexes to calculate economic turning points. A diffusion index is a method of summarizing the common tendency of a group of statistical series. If a greater number of the series are rising than are declining, the index will be above 50; if fewer are rising than declining, it will be below 50. In effect, a diffusion index measures the degree to which either strength or weakness pervades the economy. If, for example, most of a group of industries are increasing their production rates, the economy as a whole is probably expanding; if the proportion of industries that are growing begins to decline and falls significantly below 50 percent for a period of time, the economy is probably in a recession, or at least moving in that direction.

      Economists frequently use mathematical equations to express the normal relations between various economic factors. As a simple example, a given increase in consumer income will ordinarily produce a certain increase in sales, saving, and tax revenue, and these developments can be expressed mathematically. With a sufficient number of equations, all the important interactions within the economy can be simulated in a mathematical model. With the advent of computers able to make millions of calculations in a few moments, economists began to construct more and more complex sets of equations, called econometric models. These models, some of which include hundreds of equations, can be used to forecast overall economic activity (macroeconomic forecasting) or developments in particular parts of the economy (microeconomic forecasting). The success of econometric forecasting has so far been limited because the exact nature of economic relations is not fully known, and also because of the inadequacies of existing statistics. Nevertheless, the improvement of these techniques represents the greatest hope for more accurate economic forecasting in the future.

      The computer has also stimulated development of another potential forecasting tool, input–output analysis. Input–output tables show the relations between the various industries and sectors of an economy. They show, for each industry, the amount of its output that goes to every other industry to be used as raw materials or semifinished products, as well as the amount that goes to the final markets of the economy. Input–output tables also show each industry's consumption of the products of other industries, as well as each industry's contribution to the production process. With such a table it is possible to trace the effects of changes in one industry or sector upon all the other industries and sectors.

      The usefulness of input–output analysis for forecasting purposes has been limited by a number of factors. One problem is that it takes years to put such complex sets of statistics together; in a changing economy, relations may have shifted by the time the data for a base period have been assembled. Progress has been made, however, in developing methods to bring these relations (called technical coefficients) up to date, and input–output analysis shows increasing promise as a forecasting tool.

The accuracy of economic forecasts

      Major improvements have been made in the accuracy of economic forecasting. A competent economist can usually predict accurately enough to provide guidance to those who make policy decisions. Consensus forecasts—the average of a group of forecasts made by different individuals or organizations—have come closer and closer to the mark in recent years. Errors (error) persist, nevertheless, and they occasionally lead to bad decisions.

      The sources of error in economic forecasts are many. Some lie outside the realm of economic analysis; wars, agricultural or other natural disasters, or political upheavals are examples. Some forecasts go wrong for essentially ideological reasons: people who do not believe that an economic system will function tend to forecast its failure, which accounts for the many predictions of another great depression. Adherents of a political party in power have a notable tendency to optimism, whereas their opponents, including economists, tend to view the future with alarm. The student of forecasts must obviously consider their source; purity of motive is an important virtue for economists.

      The most vexing sources of error, however, lie within the realm of economic knowledge. Many are statistical. Not only are some of the published data inaccurate but even the best statistics are available only after a period of time; the forecaster is forever predicting the future when he cannot be completely sure of the present. Statistics of inventories, among the most volatile economic elements, are noteworthy in this respect.

      The most persistent form of error in economic forecasting, however, is probably theoretical. Man's knowledge of his own economic institutions is limited. Good analysis is made more difficult by the fact that these institutions are constantly changing. This means that economic theory based on experiences of the 1950s may be of limited use in the 1980s. Some of the greatest contributions to the continued improvement of economic forecasting may come from economists who are not necessarily forecasters themselves but have the insight to understand the changing economy of today.

Richard W. Everett

Additional Reading

Various of the economic indicators commonly used for forecasting are surveyed in Kenneth C. Land and Stephen H. Schneider (eds.), Forecasting in the Social and Natural Sciences (1987); John Llewellyn, Stephen Potter, and Lee Samuelson, Economic Forecasting and Policy—the International Dimension (1985); and Geoffrey H. Moore, Business Cycles, Inflation, and Forecasting, 2nd ed. (1983). Techniques for selecting appropriate data and models for use in economic forecasting are discussed in Giles Keating, The Production and Use of Economic Forecasts (1985); Lawrence R. Klein and Richard M. Young, An Introduction to Econometric Forecasting and Forecasting Models (1980); Steven C. Wheelwright and Spyros Makridakis, Forecasting Methods for Management, 4th ed. (1985); and Norman Frumkin, Tracking America's Economy (1987). One of the most useful sources of timely statistical data for U.S. economic forecasts is Survey of Current Business (monthly).Richard W. Everett Ed.

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