How the Pros Look at the Future

December has distinguished itself as a time when people reflect on the outgoing year and guess what the new year will bring. But on Wall Street and in Washington, forecasting is a year-round business. Executives, policymakers, business planners, money managers, and others who need to make assumptions about the health and direction of the economy take a keen interest in the latest predictions.

Who makes the forecasts that the financial world looks to, and how accurate are they?

The Big Three

Perhaps the most popular U.S. economic forecasters travel in a pack of three: the Congressional Budget Office (CBO), the Blue Chip consensus, and the White House. These groups typically make positively correlated projections and have similar track records.

For example, if the CBO greatly overestimates gross domestic product (GDP) for a given two-year period, it's common for the Blue Chip consensus and the administration also to greatly overestimate GDP (see chart). This correlation suggests the presence of limitations within the common data on which these groups rely. However, the fact that most forecasters have a poor record of anticipating changes in the business cycle or in the labor-productivity growth rate indicates that common forecasting methods may have significant limitations.

Necessary But Unproven

Economic forecasting is a respected practice and a necessary aspect of decision making, but it is also an attempt at the impossible. There is no reliable method for predicting the future. All forecasts must be evaluated with this in mind. For example, few forecasters were able to accurately anticipate the business boom of the late 1990s, an event with repercussions that endure today.

When comparing the accuracy of forecasters, it's useful to understand the different reasons they may have for making forecasts in the first place.

The CBO needs reliable economic projections in order to make accurate budget projections for Congress. In general, CBO projections are based on the assumption that the economy will continue to reflect historical trends and that fiscal policies will not change.

The administration bases its forecasts on the projected economic effects of its own policy proposals, usually in order to demonstrate their merits to Congress and other policymakers.

The Blue Chip consensus is provided by a publishing company that regularly polls about 50 private-sector economists, who may base their opinions on a variety of unstated assumptions. The Blue Chip consensus has an incentive to be accurate because it sells the forecasts to subscribers in the form of monthly newsletters.

Economic forecasting is an important part of business, but the future is elusive. Forecasts have limitations that should be considered when making decisions about your portfolio.