The eagerly awaited autumn financial statement from UK pm Rishi Sunak and chancellor Jeremy Hunt features a key ingredient: a study in the Office for Budget Responsibility (OBR) around the predicted overall results of the government's policies around the economy. This is something the Liz Truss government studiously avoided producing, which played a component in triggering the dramatic market reaction to the September 2023 mini-budget.
The UK government setup the OBR in 2010 to supply an independent research into the economy. It now produces regular forecasts of key economic indicators for example UK growth, unemployment and price inflation. It publishes these forecasts twice a year and appears five years in to the future.
But how accurate are these forecasts? The chart below shows the forecasts for that consumer price index for March 2023. These forecasts started 5 years earlier in November 2023 and subsequently appeared in March 2023, October 2023 and so forth up to the month of March 2023.
Inflation forecasts for March 2023
The first five forecasts from 2023 to March 2023 predicted a 2% inflation rate for March 2023, the Bank of England's target rate. Next, the forecasts for November 2023 and March 2023 fell below this, but then started to climb in October 2023.
The final forecast, in March 2023, predicted a 7.4% inflation rate. This was underneath the actual March 2023 inflation rate of 8.5% – the final bar in the chart above. This reflects the fact that statistics are revised after they are initially published as new information is gathered. What this means is it takes here we are at the state rate of inflation to become finalised.
The Bank of England uses data such as this forecast to create UK interest rates to keep inflation under control. It has been criticised for failing to raise rates fast enough to cope with recent inflation.
But the reason behind this really is apparent within the chart. The very first seven forecasts were the same or less than the Bank's preferred rate of inflation, suggesting the OBR's model was of little use in enhancing the bank to calculate inflation as much as five years in advance. It was actually higher. Even when the prospective month arrived, the prediction was still being not accurate.
The policy implications
Given that interest rate changes affect inflation after long and variable lags, this means that the people in the Bank of England's monetary policy committee (MPC) – whose job it's to set rates of interest – are flying blind until the date from the forecast is very close. This adds to the difficulty for the committee of exercising what's going to happen to the economy if it raises rates, something it's had to perform a lot recently.
Much of the problem stems from the rather complex equation in the OBR type of the economy accustomed to make inflation forecasts, which is heavily dependent on measuring inflation previously. This means that the forecast is more of the projection, using the past dominating the image. In reality, policy makers need to know what will happen in the future.
To be clear, the economists who draw up the forecasts are not trying to manipulate the figures. It is simply their models aren't up to the task of accurate forecasting past the very temporary. The outcomes are particularly skewed by unexpected events like the COVID-19 pandemic or even the Russian war in Ukraine.
The OBR acknowledges this problem in the discussion of the forecasting models:
– the model is really a tool that we use, as the forecast is the consequence of the judgements and assumptions that we feed in it. Other forecasters utilizing the same model will almost inevitably generate different forecasts.
This basically means the experts do their best to try to make up for the deficiencies in their models with ad hoc judgements.
An alternative approach
Is there any way of improving these forecasts later on? It could assistance to consider what's been referred to as the “wisdom from the crowd”.
This may be the concept that large categories of people may perform a better job of guessing the outcomes of an uncertain event than the usual small group, even when the latter are experts inside a particular field. People rely on this theory when they use forums like Quora or Reddit to crowd source answers to all kinds of questions and dilemmas – from parenting to partners and punctuation.
Richard Curtin, a behavioural economist in the Survey Research Center in the University of Michigan, has measured consumer expectations of inflation and other economic variables in america because the 1970s. His approach is dependant on surveys of representative samples of the American public. He's looked closely at the relationship between these expectations and actual outcomes and located that the American public are very good at forecasting US inflation.
This is true for respondents with different amounts of education, based on Curtin, even if the highly educated or individuals with more expertise (such as MPC members) may be expected to fare better.
These findings advise a way forward. Rather than counting on equations dominated by past observations, the OBR may also conduct regular surveys of UK consumers to find out what they think about inflation later on.
Policy makers already monitor household reactions to rate changes and inflation news, believing inflation forecasts can be something of the self-fulfilling prophecy that influences consumer behaviour. But feeding consumer expectations into inflation forecasts could create stronger predictions for consumer price rises.
This article is republished from The Conversation. Read the original article.
