Jon Faust says that "I regularly hear the accusation that economic forecasting is no better than weather forecasting, but this does a disservice to weather forecasters. It is also an unfair comparison..." How well does the Fed forecast economic conditions? It turns out that "naïve" forecasts of GDP do better than a wide range of more complex econometric models:
Whither macroeconomics? The surprising success of naïve GDP forecasts, by Jon Faust, Vox EU: Over the past ten days, the U.S. Federal Reserve has lowered its policy interest rate 125 basis points based largely on its assessment of the need to battle strong recessionary forces. This comes after a December 12 meeting at which the Fed lowered rates a mere 25 basis points, still hoping to "foster maximum sustainable growth and provide some additional insurance against risks." To some, this rapid change in sentiment might seem surprising. In my view, though, these events mainly serve to remind us of how extraordinarily challenging it is to forecast economic activity.
Economic forecasting challenges I regularly hear the accusation that economic forecasting is no better than weather forecasting, but this does a disservice to weather forecasters. It is also an unfair comparison: weather forecasters have immense advantages over economic forecasters.
When making a forecast, weather forecasters have access to data on the current and recent past conditions. In contrast, when the Fed made the forecast for the January Federal Open Market Committee (FOMC) meeting, the latest available GDP data were for the third quarter of the previous year. On January 30, we will get an advance release of fourth quarter GDP for the U.S., but this initial estimate will be highly speculative. Historically, the root mean square revision of the annualised quarterly growth rate in the advance release is about 1.5 percentage points--easily enough to spell the difference between slow growth and deep recession.
Further, the GDP data will continue to be revised in important ways indefinitely. For example, the 1999 benchmark revision of GDP data raised measured average growth over 1997 and 1998 by more than one-half of a percentage point. A significant piece of the much-discussed productivity boom of the late 1990s was not in the GDP data until the 1999 benchmark. The weather equivalent would be forecasting temperature without knowing the current temperature, having only a fuzzy estimate of temperature in the recent past, and knowing that, years after the fact, a hot spell might be revised into the data.
Given that we cannot even measure GDP without considerable hindsight, we cannot expect forecasts of real economic activity to be very precise. We can and should, however, ask whether Federal Reserve forecasts are as accurate as possible.
How well does the Fed do? Research over the years has generally supported the view that the Fed's Greenbook forecast, prepared for each FOMC meeting, is outstanding. Recently, discovery of a new dataset has made a more stringent evaluation possible. This dataset has a snapshot of (part of) the Fed's dataset as it stood at the time of about 150 Greenbook forecasts since 1979. Using this dataset, Jonathan Wright of the Federal Reserve Board and I assessed how a wide range of models would have performed if they had been used to forecast based on the information actually available to the Fed when it made its forecasts.
Our results again confirm the high quality of the Greenbook forecast, but are sobering in some respects. When we give ten alternative models only those data that were available to the Fed, the Fed's forecast generally outperforms the alternatives by a wide margin. Chris Sims and others had speculated that the Fed's good performance might be due to the immense resources the Fed pours into assessing GDP in the current period and recent past. Since many of the raw inputs used by the Bureau of Economic Analysis (BEA) to construct the GDP data are public, the Fed attempts to assess current GDP by replicating many aspects of the BEA's efforts. It is probably not surprising that conventional models have trouble competing regarding current and past conditions with a thorough attempt to mirror the data construction machinery of the BEA.
A surprisingly simple forecast While the Fed has a clear edge in assessing current conditions, policy decisions can only affect the future. To assess how the Fed does in projecting where real activity will be in the future, Jonathan and I give the alternative models the data available to the Fed and the Fed's estimate of the current state of the economy. Then we compare how well the models forecast when they all know the Fed's assessment of the current and recent past values of variables.
We find the surprising result that no model clearly outperforms the univariate autoregressive model. This is one of the simplest possible models: it basically forecasts in every period that the GDP growth will simply follow its historical average rate back to the mean. This may be sobering for not only the Fed but for the macroeconomics profession as a whole: knowledge of interest rates, labour market conditions, capacity utilisation, inflation, or any of about 50 additional variables does not systematically improve our ability to foretell where real activity is headed.
There are many details and caveats to be considered in fully understanding the meaning of these results. We can, however, give a bit more precise statement. The univariate autoregressive model, which predicts GDP growth based on four lagged values of growth, has smaller prediction errors than Greenbook and essentially every other model at every forecast horizon between one and five quarters into the future. Our measure of the prediction error is an estimate, however, and one should consider whether the differences in estimated forecast precision are statistically significant. This raises complex statistical issues, but our basic conclusion is that no method significantly outperforms the univariate model.
It is important to emphasise that the results for forecasting inflation are dramatically different than those for real activity. For inflation, Greenbook outperforms all other models, often by a wide margin.
Conclusions Returning to the weather analogy, our results would translate something like this. We are forecasting temperature without knowing current temperature and having only a fuzzy estimate of temperature in the recent past. Further, we find that given a good estimate of recent temperatures, we do not know any systematic way to improve our temperature forecast using measures of other variables such as precipitation, barometric pressure, location of the jetstream, etc.
While necessary, forecasting real activity is a nasty endeavour. Our recent research confirms the basic conclusion of earlier work that the Fed's Greenbook forecast is excellent. No model we assess, however, including Greenbook, historically outperforms a naïve forecast based only on the best available estimate of recent GDP itself.
Note: This column draws conclusions from research that was started when I was an employee of the Federal Reserve Board and joint with Jonathan Wright of the Fed. The opinions stated here are my own and need not reflect Jonathan's opinion or those of anyone in the Federal Reserve System.
1 Minutes of the Federal Open Market Committee, Dec. 11, 2007, p.8, 2 For a summary of GDP revisions across the G-7, see Faust, et al., 'News and Noise in G-7 GDP Announcements,' Journal of Money, Credit, and Banking, v.37, n.3, June 2005, 403-417. 3 This is based on the author's calculation using the data discussed below. 4 Two notable sources are Romer, C.D. and D.H. Romer (2000): 'Federal Reserve Information and the Behavior of Interest Rates', American Economic Review, 90, pp.429-457, and Sims, C.A. (2002): 'The Role of Models and Probabilities in the Monetary Policy Process', Brookings Papers on Economic Activity, 2, pp.1-40. 5 This new dataset was created and preserved over the years by Fed Staffer Douglas Battenberg. 6 Jon Faust and Jonathan Wright, 'Comparing Greenbook and Reduced Form Forecasts using a Large Realtime Dataset', NBER Working Paper 13397, Sept. 2007. 7 See Table 5c, panel 2. Size of the errors is measured by root mean square prediction error (RMSPE). The RMSPE for the autoregressive model is lower at every horizon than 9 of the other 10 models. One model beat the simple model at a few horizons using the RMPSE criterion, but the difference was only few hundredths of a percentage point.
If Ricardo Hausmann was chair of the Fed, or in charge of fiscal policy, things would be different. He says consumption has been above its natural, sustainable rate and needs to adjust downward. Thus, monetary and fiscal policies designed to increase consumption and avoid a slowdown only delay the inevitable adjustment of consumption back to its natural rate:
Stop behaving as whiner of first resort, by Ricardo Hausmann, Commentary, Financial Times: The same voices that supported tough macroeconomic policies to deal with the excesses of spending and borrowing in east Asia, Russia and Latin America are today pushing for a significant relaxation in the US to deal with the so-called subprime crisis. Interest rates should be slashed quickly and $150bn put into taxpayers' pockets...
The goal seems to be to avoid a 2008 recession at all costs. As Larry Summers ... put it, failure to act would make Main Street pay for the sins of Wall Street.
It is easy to lose sight of the overall picture. Main Street consumers have overspent and over-borrowed and are unable to meet their obligations. ... Consumption has been above sustainable levels and needs to adjust down, whatever view one has about the responsibility of adults over their financial decisions.
The adjustment of private consumption to sustainable levels is necessary, but is likely to have a negative influence in the short run on the growth of aggregate demand... It is hard for this adjustment to take place without bringing down the rate of growth of gross domestic product, possibly to negative numbers. ...
Returning to a sustainable path is good for the US and the world economy over any horizon that assigns some value to what happens after 2008. Sustainable growth is not the consequence of an unsustainable consumption boom but of the progress and diffusion of science, technology and innovation – which show no sign of slowing down.
An efficient adjustment to the US over-consumption imbalance (and Chinese under-consumption) in a way that does not hurt longer-term growth should be based on compensating for the decline of US consumption with an increase in domestic investment and in consumption abroad. It should not be based on giving the US consumer more rope with which to hang himself.
Hence, macroeconomic policy should not be based on a panicky attempt to avoid a 2008 recession at all costs but on a forward-looking strategy that achieves the needed reduction in consumption at the lowest cost in terms of the stable growth. This is not achieved by giving US households a $1,000 cheque by April, a trick that no macroeconomic textbook would argue is particularly effective. If there is fiscal room – a big if, given the weak structural position of the US government and its likely cyclical worsening – it would be better spent in accelerating investments in plant and equipment via accelerated depreciation schemes, to improve the capacity of the economy to keep on growing after the crisis.
The logic behind monetary easing is also suspect. ... It is understandable that politicians facing a November election and bankers with a lot of their money at stake should feel that this is the worst crisis ever and have an obvious interest in exaggerating the consequences for Main Street.
They all assume that if banks lose capital, they will stop lending. This is what happens in developing countries because of incomplete financial markets, but is not what one would expect in the world's most sophisticated capital market. In fact, bank capital has already been lost and the solution is not to put more air into the bubble but to put more capital into banks. This is already happening: Citibank, UBS, Merrill Lynch and Morgan Stanley have raised more than $100bn from foreign investors and sovereign wealth funds. Authorities might use their moral suasion to accelerate this process.
The US should face its need for adjustment with courage and reason, not fear. It should stop behaving as the whiner of first resort, ready to waste all its dry powder on a short-sighted attempt to prevent a 2008 recession. Many poorer countries with weaker markets and institutions have survived and benefited from an adjustment that involves a year of negative growth. Faster bank recapitalisation, fiscal investment stimulus and international co-ordination should be first on the policy agenda.
Even with effective monetary and fiscal stimulus, all adjustment costs can't be avoided - some people will incur losses no matter what monetary and fiscal authorities do. Some already have and adjustments are underway. The question, as noted above, is how to get to the long-run sustainable path for consumption and investment at the smallest possible cost.
This comes partly from using a different analytical framework, one oriented in the New Keynesian rather than in the Real Business Cycle tradition, but for me minimizing adjustment costs means avoiding the chance of sharp, abrupt, severe, self-reinforcing downturns where consumption initially falls way below its long-run sustainable path only to crawl back up to the long-run equilibrium later. Thus, I prefer supporting aggregate demand in the short-run so that it falls slowly to the long-run equilibrium rather than doing little or nothing and taking a chance that it falls precipitously, even if this means it will take longer for the adjustment process to be completed.
Here's the press release:
For immediate release
The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 3 percent.
Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.
The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.
Today's policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Voting against was Richard W. Fisher, who preferred no change in the target for the federal funds rate at this meeting.
In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 3-1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Atlanta, Chicago, St. Louis, Kansas City, and San Francisco.
So the vote wasn't unanimous (9-1 as there are two open seats), Richard Fisher from the Dallas Fed dissented, and nine of the twelve district banks asked for a change in the discount rate consistent with the 50 bps rate cut. The other three banks, Dallas, Minneapolis, and Richmond, either did not agree with a 50 bps rate cut prior to the meeting, and/or they wanted to alter the spread between the discount rate and the federal funds rate.
While noting inflation concerns, the Committee also appears to be ready to cut rates further should incoming data suggest further cuts are necessary. Hopefully, though, we can now all catch our breaths for a little while and get a better assessment of exactly where we are.
Update: Fed cuts rates by 50 basis points (Financial Times), Fed Cuts Rates by Half Point (WSJ), Fed Lowers Rate Half Percentage Point to 3%, Says `Downside Risks' Remain (Bloomberg), Fed Cuts Rate for Second Time in 8 Days (NY Times).
Update: The Lone Dissenter: Dallas's Fisher (WSJ Economics Blog),50 Bps and a Song... (Barry Ritholtz), Fed Cuts Fed Funds Rate 50bps (Calculated Risk), Another 50 basis points (William Polley), 50bp, Right on Schedule (Felix Salmon), Half Point Cut (Jeffrey Cane), Fed rate cut (Jim Hamilton)
Guillermo Calvo responds to Larry Summers call to to move beyond monetary and fiscal stimulus and begin repairing the underlying problems in the financial system. While he agrees that the financial system needs to be strengthened, he does not have much faith in monetary and fiscal policy and believes their use will result in stagflation:
Guillermo Calvo, Economic Forum: I agree that we need "consistent, determined approaches" which will probably take us far beyond conventional monetary and fiscal policy. The main problem, however, is that we don't seem to have a consistent macro view that is widely agreed upon and is itself consistent with the stylized facts of the current crisis. Thus, for example, policy has strongly relied on lowering the reference interest rate, a policy that is typically justified in models that abstract from credit market difficulties. The same applies to fiscal expansion. This lack of intellectual consistency is bound to create further confusion. Thus, I would encourage Larry and the other high-profile commentators to give a simple but clear view of their underlying assumptions.
To be consistent with my preaching, let me say that I am of the view that the current subprime crisis is starting to look more and more like those in emerging markets. The big but somewhat superficial difference, however, is that initially the problem did not entail a whole country but a sector (and, incidentally, since a sector does not print its own money, its situation is similar to that in emerging markets which suffer from Liability Dollarization, or Original Sin). Since the subprime sector hit the global financial market, it had the potential to damage other sectors through contagion, much like it happened in emerging markets after the Russian August 1998 crisis. Thus, we are witnessing the effects of a "supply" shock, implying that the crisis is unlikely to be fully resolved by a stimulus to aggregate demand through lower interest rates. And even less by transitory fiscal expansion, for the additional reason that credit crises involve "stocks," while transitory fiscal policy involves "flows." Thus, if you agree with my view, a key to resolving the current crisis is to reinforce the financial sector which, incidentally, leads me to enthusiastically agree with Larry's thrust in his column. But, on the other hand, I have a much less favorable opinion about expansionary monetary and fiscal policy. These aggregate demand policies are easy to implement in the short run, while strengthening the financial sector is time consuming. Since the latter would be key for avoiding a slowdown, expansionary aggregate demand policies are likely to bring about a period of stagflation, seriously undermining the credibility of policymakers.
Chimpanzees are reluctant to trade "a very good commodity (apple slices)" for "an even more preferred commodity (grapes)." This research attempts to explain why and in the process learn something about how barter might have arisen among humans:
Why don't chimpanzees like to barter commodities?, EurekAlert: For thousands of years, human beings have relied on commodity barter as an essential aspect of their lives. It is the behavior that allows specialized professions, as one individual gives up some of what he has reaped to exchange with another for something different. In this way, both individuals end up better off. Despite the importance of this behavior, little is known about how barter evolved and developed.
This study (published in PLoS ONE on January 30) is the first to examine the circumstances under which chimpanzees, our closest relatives, will exchange one inherently valuable commodity (an apple slice) for another (a grape), which is what early humans must have somehow learned to do. Economists believe that commodity barter is one of the most basic precursors to economic specialization, which we observe in humans but not in other primate species. First of all, the researchers found that chimpanzees often did not spontaneously barter food items, but needed to be trained to engage in commodity barter. Moreover, even after the chimpanzees had been trained to do barters with reliable human trading partners, they were reluctant to engage in extreme deals in which a very good commodity (apple slices) had to be sacrificed in order to get an even more preferred commodity (grapes).
Prior animal behavior studies have largely examined chimpanzees' willingness to trade tokens for valuable commodities. Tokens do not exist in nature, and lack inherent value, so a chimpanzee's willingness to trade a token for a valuable commodity, such as a grape, may say little about chimpanzee behavior outside the laboratory.
In a series of experiments, chimpanzees at two different facilities were given items of food and then offered the chance to exchange them for other food items. A collaboration of researchers ... found that the chimpanzees, once they were trained, were willing to barter food with humans, but if they could gain something significantly better – say, giving up carrots for much preferred grapes. Otherwise, they preferred to keep what they had.
The observed chimpanzee behavior could be reasonable because chimpanzees lack social systems to enforce deals and, as a society, punish an individual that cheats its trading partner by running off with both commodities. Also because of their lack of property ownership norms, chimpanzees in nature do not store property and thus would have little opportunity to trade commodities. Nevertheless, as prior research has demonstrated, they do possess highly active service economies. In their natural environment, only current possessions are "owned," and the threat of losing what one has is very high, so chimpanzees frequently possess nothing to trade.
"This reluctance to trade appears to be deeply ingrained in the chimpanzee psyche," said one of the lead authors, Sarah Brosnan ... at Georgia State University. "They're perfectly capable of barter, but they don't do so in a way which will maximize their outcomes."
The other lead author, Professor Mark F. Grady, Director of UCLA's Center for Law and Economics, commented: "I believe that chimpanzees are reluctant to barter commodities mainly because they lack effective ownership norms. These norms are especially costly to enforce, and for this species the game has evidently not been worth the candle. Fortunately, services can be protected without ownership norms, so chimpanzees can and do trade services with each other. As chimpanzee societies demonstrate, however, a service economy does not lead to the same degree of economic specialization that we observe among humans."
The research could additionally shed light on the instances in which humans also don't maximize their gains, Brosnan said.
- From the Berbers to Bach (Culture and Globalization) - Yo-Yo Ma
- The Economic State of the Union - Jared Bernstein
- The tenuous future of Africa-EU trade relations - Vox EU
- President's Push to Make Tax Cuts Permanent is Irresponsible - CBPP
What's behind the Republican's "inability to govern"? Do Democrats overreach?:
The Party of Stinkin', by Eric Rauchway, TNR: If the mixed results in the early Republican primaries--a Huckabee here, a McCain or Romney there--portends a split between the GOP's religious, fiscally conservative, and security-state wings, it won't be the first time a national American political coalition has failed. But it will be the third time in a hundred years an apparently strong Republican majority cracked up due to the party's inability to govern. By contrast, Democratic coalitions have failed mostly because the party has overreached after governing successes.
In the midst of an economic depression, the Republican Party assembled a presidential majority in 1896 for William McKinley and his conservative platform. McKinley won despite the revolt of many traditionally Republican western states, whose citizens believed the party's elite had grown too cozy with industrial and financial leaders, while leaving the stricken farmers of the heartland in the cold. ...
With McKinley, the Republican Party shifted away from its post-Civil War habit of bludgeoning the South, and McKinley ran as a candidate of sectional reconciliation. He wooed the South with symbolic gestures, like declaring that their soldiers had demonstrated "American valor" in battle... He wooed the West with promises of renewed prosperity under his tariff and monetary policies. And Roosevelt's subsequent presidency--he took 56% percent of the popular vote in 1904--appeared to show that the Republicans could campaign and govern as a truly national party.
But the seeming solidity of this coalition concealed real divisions, owing largely to the Republicans' unwillingness to give Westerners what they demanded. Out there in the new states, voters began agitating for and adopting democratic measures--women's suffrage; initiative, referendum, and recall; and ways to popularly elect Senators and presidential candidates. Mere national prosperity, unevenly spread as it was and almost never trickling down to farmers, wasn't going to satisfy them. They actually wanted to take part in the country's government and change it for themselves.
Roosevelt made the right noises in response to this stirring insurgency... But, since he was a Republican beholden to eastern industry, he could do little more than talk... As another student of Rooseveltiana more acutely mentioned, he was "the greatest concocter of 'weasel' paragraphs on record."
Roosevelt's successor, William Howard Taft, couldn't weasel charmingly enough for an electorate increasingly dissatisfied with Republican complacency. In 1910, the Democrats took the Congress.
Roosevelt tried to push his party back in his direction, and when that failed, he led a third-party movement in 1912 that put Woodrow Wilson into the White House, along with a Democratic House and Senate. [...continue reading...]
Update: Underbelly Buce comments.