Mystic mugsNovember 2015

2 Outlook 2016

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Here’s a prediction: economists’ forecasts for 2016 are no more likely to be correct than they have been in 2015.

Comparing the consensus at the start of this year with where we stand now, global growth expectations for 2015 have been marked down, while inflation in the advanced economies has been much weaker than projected – and all despite unforeseen stimulus measures from some central banks (the Eurozone and China) and low-for-longer interest rates from others (the US and UK). Furthermore, some of the events that have shaped the world economy in 2015, and which could continue to influence it for years to come, were off most economists’ radars at the start of the year, including sharp falls in commodity prices and large-scale migration into Europe from Syria, Afghanistan and elsewhere.

This is not a new phenomenon: economists’ reputation for predicting the future probably ranks alongside that of weather forecasters and fortune tellers. And yet, like those professions, there is a demand for economists’ services – from businesses making strategic plans to central banks attempting to hit inflation targets and investors seeking opportunities. Why, then, are we so bad at predicting what is going to happen and – since recognising a problem is the first step in solving it – what predictions for 2016 does this sobering self-awareness lead us to?

In an uncertain world, forecasting errors are inevitable. Predictions can be knocked sideways – or up, or down – by events that are familiar but cannot be predicted in advance, such as changes in the supply of oil, fluctuations in harvests or political surprises. Projections can also go awry because of technical errors, such as forecasting models

that exclude variables which turn out to have a strong influence on economic behaviour. Over time, we would hope to learn from such mistakes, and improve forecast accuracy – in much the same way as UK weather forecasters did following the (unpredicted) storms of October 1987. Other sources of forecast error are trickier to deal with because they are, by definition, harder to assimilate. They include Nassim Nicholas Taleb’s ‘black swans’ – events that occur without precedent – and structural breaks in relationships previously treated as constants, such as that between unemployment rates and wage inflation.

But since economists are not the only profession to get their predictions wrong, could there be some common behavioural traits underlying the dry, technical explanations? One possibility is excessive confidence in our own predictive powers. As UK Monetary Policy Committee member Ben Broadbent has noted, experiments show that people who have reported being “100 percent certain” of something turn out, on average, to be correct only 70-80 percent of the time. Another is the tendency, with hindsight, to exaggerate the probability we had assigned to events that did occur, and understate the likelihood attached to things that did not. This is a variant of the ‘stopped clock’ phenomenon: even a broken watch tells the correct time twice a day. And

the International Monetary Fund (IMF) has noted that economists – despite practicing the dismal science – tend to be excessively optimistic about the future, systematically over-predicting growth rates in the period 1990-2007. The IMF suggests that this trait may reflect natural selection: we exist against the odds, so let’s celebrate!

If this is what we do, and why we do it, the next step is surely to correct our biases – or at least try to. Indeed, focusing not only on central forecasts but also risks around them is exactly what economists have done more of in the aftermath of the global financial crisis. Firms, central banks and investors can then check how well business, policy and investment strategies perform in scenarios beyond the baseline. And since studies show that some professions are more realistic about their predictive powers than others – weather forecasters apparently score better than doctors – regular feedback from users about forecast and scenario accuracy could also be performance enhancing.

So bearing these lessons in mind, what will happen to the world economy in 2016? First, central banks are likely to remain of the view, eight years on from the financial crisis, that the risk of doing too little outweighs the risk of doing too much. In this environment, interest rates will remain at exceptionally low levels and fresh stimulus measures are possible. Second, while an outright currency war is unlikely – given that it would ultimately damage all – a currency war of attrition is another matter. Finally, history will be rewritten. Growth estimates are often revised as statistical agencies receive new information, and these revisions can be sizeable – enough, in the case of the UK, to wipe out what was originally a ‘double-dip’ recession following the global financial crisis. This matters because it alters our – and central banks’ – views of the health of the world economy. Little wonder, then, that economic forecasts perform poorly at times: it is not easy making (informed) guesses about where the world economy is going when you do not know exactly where it has come from.

Lucy O’Carroll Chief Economist – Investment Solutions

Central banks are likely to remain of the view, eight years on from the financial crisis, that the risk of doing too little outweighs the risk of doing too much.

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