Economics
Forget forecasts, trust markets
Sep 29th 2010, 18:12 by R.A. | WASHINGTON
I LEFT one interesting paper out of the weekly research round-up, because I thought I'd highlight it here. It's titled, "Are central banks' projections meaningful?" You may not be surprised to learn that the answer is no:
Central banks' projections"“i.e. forecasts conditional on a given interest rate path"“are often criticized on the grounds that their underlying policy assumptions are inconsistent with the existence of a unique equilibrium in many forward-looking models. Here I describe three alternative approaches to constructing projections that are not subject to the above criticism, using two different versions of New Keynesian model as reference frameworks. Most importantly, I show how the three approaches generate different projections for inflation and output, even though they imply an identical path for the interest rate. The latter result calls into question the meaning and usefulness of such projections.
I like to point out that in June of 2008 the Federal Reserve forecast real GDP growth in 2009 of 2.0% to 2.8%, when in fact the economy shrank in 2009 by over 2%. Of course, this doesn't mean that central banks have no basis on which to make policy. All they need do is look at the evidence in front of them. Markets have been signalling falling inflation expectations for months now. In late 2008, the Fed might have taken comfort from its forecasts. Had it been looking at market signals"”falling equity and commodity prices, a rising dollar, and movements in bond yields"”the need for aggressive monetary easing would have seemed clear. Central bankers should be sure to constantly mark their forecasts to market to make sure they're not missing the forest for the projected trees.
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So expectations are the only thing that affects inflation? If so, then inflation should never surprise, yet it regularly does. How does that happen if only expectations determine inflation?
Economists can't predict the future ? My dreams are shattered . . . where can we turn ?
The shorter the time they've gone on, the less meaningful market signals. Consider where we were in early March of 2009. There are other explanations for what has been happening. When confidence is weak, markets are much less likely to look ahead rationally than to react to immediate events.
In this blog, our correspondents consider the fluctuations in the world economy and the policies intended to produce more booms than busts.
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