Importance of Economic Forecasts

A reader was asking how the credit crunch may have been different if banks had correctly forecasted falls in house prices. To be sarcastic, we could say if the Captain of the Titanic had know he was going to hit an iceberg, he probably wouldn’t have sailed.

Certainly, if banks knew house prices were going to fall 20-25%, they would (presumably) never have lent the raft of unconventional mortgages which had little chance of repayment. (This was particularly a problem in the US)

The credit crunch was caused by many other factors, and not just a failure to predict house price falls. But, better forecasting or more realistic forecasting would definitely have helped minimise the problem.

Difficulty of Forecasting

It is very difficult to predict economic data such as house prices.

• At the end of the last crash in 1995, how many would have predicted a near tripling of house prices in the next decade?
• Some were predicting house price collapses in 2007. But, many of these commentators had started predicting house price falls as early as 2003.
• Not many predicted the rise in house prices we saw in 2009

But, it is important to retain a sense of perspective and try and avoid any irrational exuberance which can lead people to ignore possibilities such as house price falls. Predicting house price falls

I tend to be most sceptical of those forecasts which display a fundamentalist assurance of ‘collapse in prices’ or ‘hyperinflation’

Importance of Forecasts for Monetary Policy

Economic forecasts are very important for determining monetary policy / fiscal policy. If the economy is really expected to recover, then inflation may pick up and the Bank may need to raise interest rates. If the economy is likely to continue to shrink, the Bank may need to pursue further quantitative easing.

Another issue for the Bank of England is that interest rate changes can take up to 18 months to have an effect. Therefore when the Bank change interest rates, they are trying to set the optimal rates for the future economic situation. See: How Bank of England set interest rates

Importance of Exchange Rate Forecasts

For firms trading with other countries, movements in the exchange rate can be very important. A sharp appreciation in sterling could reduce demand for exports. Firms may need to plan ahead by hedging exchange rate movements or seeking to sell to domestic markets.

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• Economic Forecasts