Forecasts, though routinely wrong, are still worth listening to

“There are two classes of forecasters: those who don’t know and those who don’t know they don’t know.” John Kenneth Galbraith, the esteemed Canadian economist, could have added a class of politicians to the mix – those who don’t know the point of it all.

Economists are routinely lambasted when their forecasts turn out to be wrong. Just last week Andrew Bailey and his colleagues at the Bank of England were grilled by MPs on the treasury select committee for underestimating inflation.

Cabinet ministers in recent years have also aired their scepticism of forecasts coming out of the Bank of England and the Office for Budget Responsibility.

They are right to be sceptical because forecasts are almost always wrong. This should come as a surprise to no one.

Economists cannot predict the future (although some tend to oversell their abilities). Their models rely on a set of assumptions about the world that can be drastically thrown of course.

War, pandemics and extreme weather events have cropped up in recent years. That doesn’t mean that forecasts, even when imprecise, aren’t valuable or useful.

Their value lies in pointing out the direction of travel. A two-year recession and inflation at 11% are the facts that may grab the headlines, but forecasters can be held hostage by them. After the Brexit vote, the profession was widely criticised for predicting a recession that never happened.

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Yet, economists have been broadly right about the consequences of Brexit. Economic output is lower than it would have been had Britain not left the European Union.

The value of forecasts

The value of forecasting is not necessarily in its precision. This was brought into sharp relief last month when Liz Truss and Kwasi Kwarteng decided to do away with the Office for Budget Responsibility forecasts when unveiling billions of pounds worth of unfunded tax cuts in their “mini budget.”

Investors were not impressed. Fearing that the government was attempting to mark its own homework, they turned their back on Britain. Government borrowing costs soared as did mortgage rates.

The OBR has technically been wrong on many occasions, but it plays an important institutional role. It allows the government to map its policy decisions against a framework that broadly makes sense.

These forecasts send an important message that the country has a track in mind for the public finances, even if things may get in the way.

In its latest forecast, published last week, the OBR made significant downward revisions to its forecast. It sees the economy contracting by 2.1% and does not expect a recovery to pre-pandemic levels until the end of 2024. It is predicting a shallower recession than the Bank of England, which is pencilling in a 2.9%, and a faster recovery.

The Organisation for Economic Co-operation and Development offered another view today, predicting a contraction of 0.4% next year, a whole percentage point lower than the 1.4% pencilled in by the OBR next year.

All three have made a different set of judgements. The OBR is more optimistic than the Bank of England because it thinks household consumption will hold up more strongly.

It expects people to continue spending by running down their lockdown savings instead of making the kind of cutbacks the Bank anticipates.

The OBR, having put out its forecast later, also benefitted from the recent fall in market interest rate expectations, which underpins both forecasts.

What about ordinary households?

This last point has caused some concern. The Bank of England cautioned its forecasts would probably turn out to be far too pessimistic because market interest rates had climbed to improbably high levels when it made them.

This had the effect of causing markets to readjust their expectations but what about ordinary households who have been reading these dire warnings in the news?

Financial markets may be in a smooth dance with the Bank and the OBR but communication with the rest of the public has often been poor.

The average person does not, and does not care to, understand the limitations and parameters of Bank of England forecasts. When they are told the country is heading for a two-year recession they may adjust their behaviour, which risks making things worse.

Instead of criticising the Bank for publishing incorrect forecasts that are based on sensible assumptions, it may be fairer to challenge them for putting out forecasts that it knows are flimsy.

While it is only right that forecasters and their models are subject to scrutiny, a dogged focus on precision can distract from fair criticism.

Speaking to MPs last week, Andrew Bailey was able to blame the “exogenous shock” of the war in Ukraine when explaining why the Bank misjudged the surge in inflation.

While that has been the largest contributor, warning signs were present earlier. The Bank missed these.

Jagjit Singh Chadha, director of the National Institute of Economic and Social Research, said MPs should instead have asked Bailey to consider the following question: “If the Bank’s forecasts are often wrong, how much time do you spend thinking about the consequences of being wrong?

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