Economic Forecasting: Definition, Use of Indicators, and Example

What Is Economic Forecasting?

Economic forecasting is the process of attempting to predict the future condition of the economy using a combination of important and widely followed indicators.

Economic forecasting involves the building of statistical models with inputs of several key variables, or indicators, typically in an attempt to come up with a future gross domestic product (GDP) growth rate. Primary economic indicators include inflation, interest rates, industrial production, consumer confidence, worker productivity, retail sales, and unemployment rates.

How Economic Forecasting Works

Economic forecasts are geared toward predicting quarterly or annual GDP growth rates, the top-level macro number upon which many businesses and governments base their decisions with respect to investments, hiring, spending, and other important policies that impact aggregate economic activity. 

Business managers rely on economic forecasts, using them as a guide to plan future operating activities. Private sector companies may have in-house economists to focus on forecasts most pertinent to their specific businesses (e.g., a shipping company that wants to know how much of GDP growth is driven by trade.) Alternatively, they might rely on Wall Street or academic economists, those attached to think tanks or boutique consultants. 

Understanding what the future holds is also important for government officials, helping them to determine which fiscal and monetary policies to implement. Economists employed by the federal, state or local governments play a key role in helping policymakers set spending and tax parameters.

Since politics is highly partisan, many rational people regard economic forecasts produced by governments with healthy doses of skepticism. A prime example is the long-term GDP growth forecast assumption in the U.S. Tax Cuts and Jobs Act of 2017 that projects a much smaller fiscal deficit that will burden future generations of Americans—with drastic implications to the economy—than independent economist estimates.

Limitations of Economic Forecasting

Economic forecasting is often described as a flawed science. Many suspect that economists who work for the White House are forced to toe the line, producing unrealistic scenarios in an attempt to justify legislation. Will the inherently flawed self-serving economic forecasts by the Federal government be accurate? As with any forecast, time will tell. 

The challenges and subjective human behavioral aspects of economic forecasting are not limited to the government. Private-sector economists, academics, and even the Federal Reserve Board (FSB) have issued economic forecasts that were wildly off the mark. Ask Alan Greenspan, Ben Bernanke or a highly compensated Wall Street or ivory tower economist what GDP forecasts they produced in 2006 for 2007-2009—the period of the Great Recession.

Economic forecasters have a history of neglecting to foresee crises. According to Prakash Loungani, assistant director and senior personnel and budget manager at the International Monetary Fund (IMF), economists failed to predict 148 of the past 150 recessions.

Loungani said this inability to spot imminent downturns is reflective of the pressures on forecasters to play it safe. Many, he added, prefer not to stray away from the consensus, mindful that bold projections could damage their reputation and potentially lead them to lose their jobs.

Special Considerations

Investors should also not overlook the subjective nature of economic forecasting. Predictions are heavily influenced by what type of economic theory the forecaster buys into. Projections can differ considerably between, for example, one economist that believes business activity is determined by the supply of money and another that maintains that hefty government spending is bad for the economy.

Many conclusions do not come from objective economic analysis. Instead, they are regularly shaped by personal beliefs on how the economy and its participants work. That inevitably means that the impact of certain policies will be judged differently.

History of Economic Forecasting

Economic forecasting has been around for centuries. However, it was the Great Depression of the 1930s that gave birth to the levels of analysis we see today.

After that disaster, a greater onus was placed on understanding how the economy works and where it is heading. This led to the development of a richer array of statistics and analytical techniques.