The Smart Bird: Forecasting Optimism

Let’s talk forecast.  I forecast over optimism in forecast.  Over optimism is persistent in forecasts about the economy, earnings, manufacturing and the stock market.  But you don’t have to trust me, the Fed’s own research shows they have Persistent Overoptimism about Economic Growth.

My favorite line in the report is, “In a cross-country study of private-sector forecasts from 1989 to 1998, Loungani (2001) finds that the record of failure to predict recessions is virtually unblemished.”  The report adds, “An updated study by Ahir and Loungani (2014) finds that the private-sector’s record of failure to predict recessions remained intact through 2008 and 2009.”

But the report points out central bankers may be worse, “A study by Alessi, et al. (2014) finds that one-year-ahead growth forecasts from the Federal Reserve Bank of New York and the European Central Bank from 2008 to 2012 exhibited substantial over optimism, averaging 1.6 to 2.4 percentage points above actual growth.”

You got that.  You can subtract 2% from long term economic forecast from the Federal Reserve to get an accurate prediction.  And not unlike Wall Street earnings forecast, revisions continue in the same direction.  The report states, “He also finds that forecast revisions in one direction tend to be followed by further revisions in the same direction and that one-year-ahead growth forecasts are typically too optimistic.”

Failure to Predict Turning Points

So does the Fed or Wall Street ever predict turns in the economy and the markets?  Of course not, as the report talks about the last recession, “Despite the expressed view of many on Wall Street and in Washington that the crisis could not have been foreseen or avoided, there were warning signs.  The tragedy was that they were ignored or discounted.  The report lists such red flags as an explosion in risky subprime lending and securitization, an unsustainable rise in housing prices, widespread reports of egregious and predatory lending practices, [and] dramatic increases in household mortgage debt.”

Since Wall Street created and was making a killing on those “red flags” we know why they did not say anything.  Although they did not ignore them, Goldman Sachs bet against their own red flag products by shorting some of the garbage after they packaged and sold to it to their clients.  Remember Wall Street learned their lessons in previous crisis and “encouraged” politicians to change the laws so they no longer had fiduciary responsibility to their clients.   Of course, no one told their clients this.

As for the Fed seeing turning points in the economy and the depth of the damage caused by their policies, the report adds, “In particular, the SEP midpoint forecast (1) did not anticipate the Great Recession that started in December 2007, (2) underestimated the severity of the downturn once it began, and (3) consistently over predicted the speed of the recovery that started in June 2009.”  Note in the report’s graph below the forecast for 2008 – a bit off.

Forecast FOMC

The report goes on to say, “In five out of six years, the actual growth rate for a year is below the starting value of the SEP forecast for that year,”  That one year where actual growth was higher than the year’s starting value was 2009.   Human nature tends to project recent history into the future.  Once the markets and the economy were firmly established in a downtrend, economist could not see how the economy was going to turn back up.

So What Does the Fed Really Track?

If it seems the Fed is now flip flopping on monetary policy on a monthly basis based on the stock market, maybe it is because they are.   The report tells us, “The pattern of revisions appears roughly aligned with movements in the S&P 500 index. The S&P index movements would be expected to capture investors’ reactions to incoming economic data and the implications for future growth and profits.”

Remember the Fed’s “worried” September statement came after the August plunge in the markets.  Now that the SP500 bounced back, Janet Yellen is comfortable with hiking rates on 15 December.  My guess is many of my readers react the same way.  My readership tends to spike when the market goes down and fall off after it rallies for a while.  Nothing has changed.  The underlying conditions are still the same.  I know where we are going to end up.  But for investors it is fear and greed and for the Fed it is fear and optimism.

It’s Not Just the Fed

But it is not just Fed that is over optimistic, our friend Mike Shedlock of Mish’s Global Economic Trend Analysis did a piece on Tracking Manufacturing’s Perpetual Overoptimism.  Using the Empire State Manufacturing Survey that asks manufacturers what general conditions are now and what they think they will look like in six months, he shifted the expectations 6 months to see how they did.

Opt Manufacturing

He found in 167 months there were only five months (3%) in which current conditions exceeded estimates from six months earlier.  And as usual, those 5 month projections that exceeded estimates were made near the bottom of slumps when respondents were overly pessimistic based on the current situation.  Maybe manufactures should stop listening to the Fed’s forecasts about the economy.

Categories: Perspectives, The Smart Bird

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