Ouija Board

How to Improve Your Economic Forecast

Ouija Board

Knowing that we at Index Fund Advisors do not engage in economic forecasting, you can safely assume that the above title is meant to be facetious, just like this Wall Street Journal opinion piece titled “Government Forecasters Might as Well Use a Ouija Board” by Edward P. Lazear, a former chairman of the President’s Council of Economic Advisers and currently a professor at Stanford University’s Graduate School of Business.

Professor Lazear analyzed the government’s 1999-2013 economic forecasts and found that real GDP growth forecasts by the non-partisan Congressional Budget Office for the next year were off, on average by 1.7 percentage points, either too high or too low. This may not sound like much, but given that the average growth rate for the whole period was only 2.1%, it is actually quite substantial. Here is the best part of Lazear’s analysis:

“Perhaps most damning: History is a better predictor of annual growth than government forecasts. Simply assuming that GDP growth will be 3.1% in each year—the average annual rate for the 30 years that precede the study period—results in an average forecast error of 1.5 percentage points.”

It makes you wonder just what exactly are we paying these wonks to do for us? When looking at the forecasted vs. actual costs of legislation, it only gets worse. As Lazear concludes, “Forecasting is inherently difficult and almost always inaccurate. When basing decisions on forecasts, even those issued by government agencies, it is important to remember that there may be less than meets the eye.”

The inevitable conclusion is that if government economists with all their access to relevant data cannot produce an economic forecast that is worth the paper it is printed on, then ordinary investors have zero chance of profiting from a superior forecast. Should they just give up and go home? Not necessarily. The good news is that the market itself provides a forecast of several economic variables that reflects the combined intelligence and knowledge of all participants that choose to trade. For example, the “breakeven” rate of inflation for the next ten years (as of 10/17/2014) is 1.9% based on the yield difference1 between a nominal Treasury bond and an inflation-protected Treasury bond. Regarding future actions of the Federal Reserve, we have interest rate futures, which currently indicate the expectation of a rate hike in 2016, according to this Reuters article. Regarding the question of whether investors should actually pay attention to the Fed, we answered negatively in this article, citing evidence and statements from Nobel laureate Eugene Fama.

With the unfortunate closing of Intrade last year due to government opposition and possible price manipulation, we no longer have a prediction market that is open to anyone who is willing to put their money where their mouth is. While we still have the IEM (Iowa Electronic Markets), it is of very limited size and scope. Nevertheless, it has been found to have uncanny accuracy in predicting election outcomes.

To summarize, the best course of action for most investors is to put aside all predictions and forecasts. If, however, they feel they must have something to justify their positions, then they should ignore the experts and simply rely on the wisdom of the crowd.

 

1Ten-Year Treasury bond yields as of 10/17/2014 were obtained from http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/default.aspx