By Mike Dolan
LONDON, December 21 (Reuters) – It’s that time of year for financial and economic forecasts – but you might as well ignore them all.
An ordinary year, assessing the ebb and flow of the business cycle, is often difficult enough. This is due to the inherent uncertainty about the future – there is no such thing as a crystal ball.
But when you add in brittle geopolitics and associated energy or global public health shocks, it becomes a crap shoot – as 2022 is displayed in Technicolor. Few financial forecasters who were fortune tellers this time last year got the big decisions right.
Whether or not people could have seen Russia’s invasion of Ukraine coming is debatable. But even if you did, your skills were probably more in Kremlinology than central bank or corporate profits.
And much like the COVID pandemic, the announcement of the big event wouldn’t necessarily have made your financial market forecast for the year ahead that much better, or fatter your bottom line.
If you could have somehow known in December 2019 that a once-in-a-century pandemic would hit the world and cripple major economies for months, you probably wouldn’t have bet that stock markets would rise 14% in 2020.
If you’d known this time last year that Russia would invade Ukraine by February — and reap isolating financial and energy sanctions in return — you probably wouldn’t have bet on crude oil prices ending this year flat — as they are .
All the same. Professional investors trade continuously and not once a year. Forecasting is the lifeblood of markets because no one can take a position without having at least some belief about what might happen next.
Markets ebb and flow, constantly correcting their thinking with new information. And there’s a blizzard of high-frequency economic and corporate data or surveys that fuel these assumptions every workday.
But this uncertainty and guesswork has a much larger impact in the world of government or central bank forecasting and often feeds on the innate nervousness of markets, in many cases relying entirely on the pricing of market futures contracts for inputs to their own models and possibly large errors aggravated.
The story goes on
These sometimes flimsy assumptions influence how central banks set the cost of money today and directly alter future activity. And then, in turn, the financial markets feed on both today’s policy decisions and official forecasts – and form futures prices on this basis, even though many central banks have decided to destroy explicit forward guidance as a policy tool this year.
There is a risk that everything will become a whirlpool of guesswork.
With the often-illegible international politics that make even-number-crunching so brittle, the big background fear is that it will lead to serial policy mistakes that involve more macro and market volatility than we have seen in decades.
“SIGNIFICANT UNCERTAINTY”
To be fair to central banks, they have at least been upfront about this and are publishing how they are doing it wrong – in part to dissuade the public from seeing forecasts as set in stone.
The Federal Reserve’s quarterly three-year economic and policy rate projections are a case in point.
Since the Fed began releasing forecasts for 2023 two years ago, the median forecasts of 19 Fed policymakers for both core inflation and unemployment have risen, their GDP estimate has more than halved and their reasonable Fed rate estimate is off increased from near zero to over 5%.
Of course, a lot has happened in the meantime. But it wouldn’t make you particularly optimistic about its projections for 2025 – aside from the fact that it’s making policy today based on those projections and, since policy arrives with a 12-18 month lag, that outcome itself in some kind of self – fulfilling prophecy
But the Fed is issuing a huge “cautionary waiver” with all of these forecasts: “These forecasts come with significant uncertainty.”
How much of a red flag is then dissected in many ways – highlighting how far the projections were over 20 years away, as well as soliciting estimates from policymakers as to whether the uncertainty surrounding their claims is now higher or lower, and whether risks exist too of this forecast are biased in one way or another.
The typical failure over 20 years was something special. The “average historical projection error” for three years – currently 2025 – is plus or minus 2.6 percentage points for policy rates and more than two points for GDP and unemployment.
For comparison, the 4-point margin of error in unemployment rate forecasts represents a difference of nearly 6 million jobs, and a 4.6-point margin in GDP represents more than $1 trillion in output.
One-year forecast errors are smaller – but that would still mean plus or minus margins of more than 1 point for all these variables for 2023 – and all together there is a 70% chance that the actual result will be in that range.
So let’s just look at the median assumption of 5.1% for the Fed’s target interest rate next year. That’s based on a range of forecasts between 4.9% and 5.6% — but historical error suggests there’s a 70% chance of landing anywhere between 4.1% and 6.1%.
The European Central Bank makes it clearer which market price assumptions it uses in its forecasts.
After raising interest rates by half a point last week, it spooked markets of an impending tightening by forecasting inflation still above its 2% target through 2025 — and inflation rates for 2023 and 2024 also behind revised above. The large upward revisions in labor costs seemed to be the main reason – so maybe it was a signal to wage negotiations.
But it goes into great detail about what energy, commodity and interest rate assumptions it is making in the coming years — based on expectations embedded in market prices three weeks earlier. For example, crude oil price futures for the end of next year are already more than 10% lower than the ECB forecast for next year.
The Bank of England and the UK’s Office for Budget Responsibility have been even more caught up in market price assumptions throughout the year – with rates still rising and fiscal tightening, although both forecast nearly two years of deflation from 2024 onwards. This is mainly due to gas price assumptions and associated subsidies, but there is a thick fog here.
What should everyone do? It’s probably best to avoid forecasts of 12 months or more altogether.
The opinions expressed here are those of the author, a columnist for Reuters
(by Mike Dolan, Twitter: @reutersMikeD)
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