By Christopher Farrell Do you think the June 27 quarter-point rate cut by the Federal Reserve, aided by this summer's $40 billion tax rebate, is enough to turn the economy around? Or are you convinced that the economy is sliding into recession as new orders for computers, telecom equipment, and capital goods decline?
Many people turn for guidance to economic forecasters. Just one problem: the profession's record of predicting the economy's future course is pretty dismal, despite huge advances in computer power and data collection. The batting average of economists is in the cellar when it comes to calling major turns in the business cycle, especially recessions.
SMOKE SIGNALS. So should we simply ignore economic forecasts? No, but skepticism is healthy. For one thing, many forecasters convey much valuable information and analysis. They're definitely worth paying attention to. Going over forecasts can illuminate the larger economic and political forces shaping the economy.
Indeed, that's the approach recommended by Peter Bernstein, the dean of finance economists. He points to low inflation, deregulation, rising global competition, and a shrinking federal government as critical dynamics behind the economic expansion of the '90s. The key questions to ponder now, he says: To what extent will increased labor militancy, doubts about American leadership abroad, rising energy prices, and soaring health-care costs signal a different economy going forward? "The objective," he writes in a recent newsletter, "is not to delude ourselves that we can identify the shape of change but, rather, to smoke out those signals that would warn us change is coming."
In that spirit, it seems the key economic question for consumers, business, and investors concerns the long-term outlook for productivity growth. Advances in information technologies and organizational innovations pushed the productivity growth rate to an average of 2.8% a year from 1995 to 2000 -- about double the annual pace of the previous two decades. Is that pace sustainable, or did the productivity gains collapse along with the bursting of the Nasdaq bubble? It's something to watch closely.
TWENTY FAT YEARS? Put it this way: Fed Governor Laurence Meyer recently observed that periods of strong productivity growth, with gains of about 3% a year, have alternated with periods of sluggish productivity growth, a mere 1.5% a year. Since 1889, the average duration of both the high and low periods of productivity growth has been about 20 years. By this calculation, we are only six years into a high productivity period, argues Bruce Steinberg, chief economist at Merrill Lynch. And a 3% productivity growth rate suggests that the economy can expand at an average annual rate of 4% without generating inflation. Sounds reasonable to me.
Trying to predict the future, however, has always been dangerous. Look at the history of 20th century economic forecasting. Irving Fisher, the leading economist of his day, predicted from his perch at Yale University in 1929, "stocks have reached what looks like a permanently high plateau." In the 1940s, Thomas Watson, Sr., president of IBM, then one of the world's leading adding-machine companies, confidently proclaimed: "There is a market for maybe five computers."
Economists hardly covered themselves with forecasting glory during the heady expansion of 1995 to 2000. As Fed chairman Alan Greenspan complained in May, 1998: "Forecasts of inflation and growth in real activity for the United States, including those of the Federal Open Market Committee, have been generally off for several years. Inflation has been chronically overpredicted and real gross domestic product growth underpredicted."
BEHIND THE CURVE. How off were the professionals? Between 1995 and 2000, the average forecast missed the true trajectory of GDP growth by some 2 percentage points and wrongly assumed that the unemployment rate would be half a percentage point higher than it actually was. A breakdown of the performance of individual economists over the same time period shows that they didn't do much better, most being too pessimistic about GDP growth, the job market, and inflation.
These sobering figures come from a recent study by Scott Shuh, senior economist at the Federal Reserve Bank of Boston. In Evaluation of Recent Macroeconomic Forecast Errors (New England Economic Review, January/February 2001), Schuh also looked at forecasts over long periods of time from several data sources, including the Survey of Professional Forecasters (SPF) from 1969 to 2000.
The SPF is comprised of approximately 40 anonymous forecasters, and it's considered the most reliable since the participants have little incentive to shade forecasts for publicity or to avoid offending clients. Shuh concentrated on one-year-ahead forecasts, since changes in monetary policy typically affect the economy with a lag of 6 months to 18 months. His results show large forecast errors during the tumultuous '70s and '80s, when the economy was battered by oil shocks, double-digit inflation, and several recessions.
LIMITED VISION. The forecasting mistakes continued during the late 1990s, despite the relative stability of the longest economic expansion on record. The severity of the 2001 downturn largely took the profession by surprise, since few economists expected business confidence to plummet along with the bursting of the dot-com bubble in 2000. "Better research and models will produce better forecasts," says Shuh. "But consumers and business need to be aware of the limitations of macroforecasts."
Fair enough. That said, I'm still throwing in my lot with Steinberg and his forecast that we've got 14 more years in this cycle of 3% average annual productivity growth and 4% average annual GDP growth. I guess I won't bet the farm on it, however, knowing what I do about the track record of economic forecasters.
Long Waves of Productivity
Merrill Lynch & Co. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BW Online